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Arundel case

EMFC, Financial management 25 February 2011 Group 3: Dirk Antonius Fons Claessens Matthijs Theunisen Ronald Teulings Willem Voeten

Question 1
1A What is the timeline of events for a movie that results in a sequel?

A producer can only start with the production of a movie when he owns the film rights of a literary property, by purchasing the rights or by creating the property on their own. The sequel rights are purchased before the production of the original movie starts. The production will take one year time. The 1st movie will be released 1 year after start of production. The sales/revenues realized in the first month after release date of the 1st movie in the US movie theaters determine the possible success of the sequel (the proof of the pudding is in the eating). Right then Arundel Partners (AP) decides whether to keep the sequel rights or sell the sequel rights in the market. If AP decides to keep the sequel rights we assume that AP must exercise the option to produce the sequel (median release date of the sequel) within three years after the start of the production of the 1st movie. Depending on the terms of the purchase contract agreed upon with the studio the expiration time of the option can differ. According to the case information the expiration time differs from 1 to 5 years. The figure below summarizes the timeline of events for a movie that results in a sequel.


When doe Arundel Partners (AP) buy the sequel rights? Why?

AP will buy the sequel rights when the studio owns the rights for the first movie and just before the start of the production, so at the end of the pre-production phase. AP would contract to purchase all the sequel rights for a studio's entire production during a specified period (1 to 2 years) or alternatively for a specified number of major films (15 To 30). The reasons to buy exactly at this moment are the following: the studio has decided to exercise the option to produce the 1st movie; if AP would buy sequel rights before the studio actually owns the producing rights (option phase) it would buy the sequel rights based on an underlying option but could finally have bought an empty box if the studio would not be able to exercise the underlying option; the producing studio of the 1st movie has financial needs and is therefore willing to take the cash offer of AP at this moment; there is still uncertainty about the release results of the 1st movie: therefore the pricing of the sequel rights can still be low; 2

the production takes off meaning that financial institutes/private investors that are financing the production as well as distributors expect a successful 1st movie; there is still information symmetry, suggesting the studio is willing to sell, since they have the same information. Theres a level playing field. If AP would wait longer and buy during production the studio would probably not sell the sequel anymore or would sell the sequel at a higher price.

Question 2
2A What would be the value of each sequel using the conventional NPV approach? Consider an average sequel and the sequel rights to the 1989 films. Assume a discount rate of 12%.

We draw the calculations based on exhibit 7, page 16 as follows: The present value of the net inflows at year 4 is calculated at US$ 21,6 million. The present value of the negative costs at year 3 is calculated at US$ 22,6 million. Year 0 is start production 1st movie. Both numbers discounted at 12% result in the following NPV in year 0: PV net inflows t=4 US$ 21,6 / 1,124 is US$ 13,73 million. PV negative costs t=3 US$ 22,6 / 1,123 is US$ 16,09 million NPV at year 0 is US$ 13,73 - US$ 16,09 is - US$ 2,36 million. Based on this outcome AP will not pay for the sequel rights but instead will ask to receive cash, assuming AP will buy the rights of all 1989 films. Based on this NPV calculation it is unlikely that AP will make a bid on all 1989 movies in one package. 2B How much would Arundel Partners pay per sequel right?

To answer this question AP will have to diversify the conventional NPV approach for all 1989 films and will now have to draw alternative NPV calculations, for instance: 1. Selection of sequels based on the average NPV per studio: Studio NPV (in US $) MCA universal 4,58 Paramount pictures -4,68 Sony pictures entertainment -7,71 Twentieth century Fox -4,84 Warner Brothers -0,47 The Walt Disney Company 6,21 (See Annex 1 for detailed calculation): 2. Selection of sequels based on the 1-year return

Any sequel with a return less than 12% will not have a positive NPV and is eliminated from the calculations. The average NPV for the 26 sequels selected is US$ 18,8 million. See Annex 1 for detailed calculation. Comparing the two alternative calculations we expect that it is more likely that AP will use the calculation based on an average per studio since we expect that negotiations to acquire sequel rights are done with each studio separately.

Question 3
3A What are the implicit assumptions of the conventional NPV analysis ?

Conventional NPV is based on a static world without flexibility in the future. At the time the decision to go for the project has been made, possible future changes are not taken into account anymore. Conventional NPV does not take into account the possibility that after the green light for the project there will be further decision moments e.g. to abandon (a part of) the project, to expand the project or to defer (a part of) the project. All these decisions can be made in the future, based on better information and or changed situations. Conventional NPV calculates with a discount rate which is rather arbitrary. The discount rate, normally the wacc, consists of the risk free rate and a risk premium. The risk premium in calculations is often set too high. Especially when an investment is discretionary, companies using Rwacc are over discounting. With discretionary investments the risk-free rate (at which the company can put money in the bank) is a better discount rate. Conventional NPV assumes that the discount rate is the same for the complete throughput time of the project.


Are some of these assumptions unreasonable?

The assumption of a static world is unreasonable, because attention should be given to the managerial choices in an uncertain environment after the now or never decision has been made. The assumption of calculating with a discount rate is not unreasonable, the problem is only how to assess the risk premium. The NPV assumes also that all decisions are predetermined and consequently that all movies will have a sequel. In reality only successful movies will lead to sequels. The assumption of the same discount rate during the project can be solved within the conventional NPV model, by using different discount rates.


How could you provide a more realistic analysis within the conventional NPV approach?

NPV can be extended with scenario analysis but this scenario analysis does not give one answer. The NPV of one project should be split in multiple projects whereby the decision is postponed until more information is known.

Its better to monitor the possibilities with the help of the Real Options model with two metrics NPVq (in fact profitability) and t (factor consisting of rate of volatility of future opportunities and factor of time to get better information). In this view the Real Options model is an analytical tool to monitor and indicate the opportunities and can be used in the creative work of strategy. The conventional NPV is not a dynamic tool and is only used for checking the numbers.

Question 4
How could you value the sequel rights using an option pricing framework? What is the option characteristics of APs investment? What are the sequel rights worth? Assume a discount rate for risky film cash flows of 12% (as above) and a risk-free rate of 6%. In the option pricing framework Black and Scholes present a model for valuing options. Although the option pricing framework is based on valuing financial options, corporate investment decisions have option-like characteristics; an investment can be done now or the next year. By delaying an investment (assuming there arent any deferring costs), a company can gain more insight in future cash flows and hence decrease uncertainty regarding the investment. This is what makes an option valuable: the right to delay an investment and only invest (at the same cost) later in time, before the option or right to invest forfeits. Therefore we can use the Black and Scholes model to value the options a company wants to buy. To relate this choice to the Arundel Partners case: the investment in the initial movie is set in stone. Arundel Partners [AP] cannot influence these costs, but has a choice with the sequel. If the movie isnt a hit AP wont make a sequel, if its a box-office hit there can be (multiple) sequel(s). By delaying the decision to invest AP will reduce the uncertainty regarding the sequel success. In the Black and Scholes option pricing model we need five parameters to determine how to value an investment option. In the table below these parameters are listed and applied to the Arundel Partners case. Table 4.1 Factor What is it? S Value of projects assets

Applied to case AP Present value of net inflows of hypothetical sequel 1989 data (exhibit 7) @ year t=0 Present value of negative costs of hypothetical sequel 1989 data (exhibit 7) @ year t=0 Time between buying option (t=0) and last possible exercise date (t=3) for a median release date sequel. Risk-free return rate Standard deviation of one-year return of hypothetical sequels 1989 data (exhibit 7).

Investment needed to acquire asset Length of time decision can be deferred Time value of money Riskiness of projects assets

Rf 2

Before we can apply the Black and Scholes model we need to make a few assumptions: When buying an option Arundel Partners has the right to produce a sequel on any given moment (exercise the option), as long as the expiration date hasnt been reached. This classifies the option as an American option. Though in an efficient market risk-neutral companies will exercise their option rights as late as possible. The reason is that theres always a chance that the option will become more valuable as more times expires (less uncertainty). If all companies act this way, as a result all options will be exercised at expiration date. This means the options can be classified as European options which give the holder the choice to buy the underlying assets at a fixed strike price at a fixed future date. Due to this assumption we can use the Black and Scholes table for valuing European call options. 5

To get the value of the projects assets we took the average present value of the net inflows at year 4 and discounted them at t=4, using Rwacc = 12%. We used t=4 because this is the time between the net inflows and the moment AP makes the decision whether to buy the option or not. We used the Rwacc to discount the net inflows because this is the rate of return AP requires. Otherwise other projects will be chosen. The investment needed to acquire the projects assets we assumed to be the present value of the negative cost at year 3 discounted at t=3 using Rf = 6%. We used t=3 because this is the time between the production costs (one year prior to release) and the moment AP makes the decision whether to buy the option or not. We used the risk-free rate of 6% because the investment is discretionary; AP could also chose to put the money in the bank and not make a sequel. As can be seen on the timeline (question 1) we assumed the time the option can be exercised to be 3 years. For the riskiness of the projects we assumed the best proxy was the standard deviation of all hypothetical sequel one year returns of the 1989 produced movies (defined as PV net inflows -/- PV negative costs / PV of negative costs). The high standard deviation of the one-year returns represents the uncertain characteristics of the movie industry. In table 4.2 we show our outcomes of our calculation. For detailed formulas see the attached Excel file (Annex 2). Table 4.2 Factor What is it? S Value of projects assets X Investment needed to acquire asset t Length of time decision can be deferred Rf Time value of money 2 Riskiness of projects assets NPVq t B/S table Option value

Calculation =21,6/1,12^4 =22,6/1,06^3

Value 13.7 19.0 3 6% 1,21

= S / PV(X) = 13.7/19.0 = 1,21 * 3 (lookup) = 74% * S

0.72 2.10 62.4 8.55

What do these numbers mean? According to our calculations Arundel Partners would value the option to buy the sequel rights to an average 1989 movie at US$ 8,5 M. This is the value of the option for AP, but not the price they are willing to pay. According to the case studios are tempted at a price of US$ 2 M. Assuming this price the net-value of the option is : US$ 8,5 -/- US$ 2 = US$ 6,5 M. One note we would like to make is that the option right now is not in the money. The current NPVq is smaller than one. But the option still has (substantial) value, due to its high volatility. This is because standard deviation, and t is quite high. This means there is still a lot of uncertainty and by influencing S or X. Arundel Partners can reach a positive NPVq at expiration date. The option value can be characterized as maybe later. Suggestion to influence S or X: Lower production costs of the sequel Increase net income by investing in more PR.

The value of the option is visualized by the figure below.

value option
0,00 0 0,5 1 1,5 2 2,5 value option 1,00 2,00

Finally we would like to recommend further analysis of the data by Arundel Partners by calculating the option value per studio. By doing this Arundel partners can select the more successful studios with good track record. As a start for this exercise we included in the Excel file (Annex 3) a calculation of the option value per studio for an average 1989 movie. In the table below and the graph we visualized a summary of the results, arranged by value. Here it can be seen that MCA Universal is the best studio to acquire the sequel rights from. It has a NPVq > 1 with a relative low volatility. Second is Walt Disney with also a NPVq >1 but with a higher volatility. The rest of the studios NPVqs are out-of-themoney but with a big volatility. Warner Brothers is also interesting (may be later).

Table 4.3 Studio MCA UNIVERSAL WARNER BROTHERS PARAMOUNT PICTURES 20TH CENTURY FOX SONY NPVq 1,09 0,82 0,62 0,58 0,44 t 1,20 1,82 2,75 1,43 0,97 2,25 Score action (6 = highest) 6 maybe now 5 4 3 2 1 maybe now maybe later probably never probably never probably never


0,00 0,00