Arundel Partners: The Sequel Project
Advanced Corporate Finance Case Analysis I|
ZUBOV,Vasily 1072582 LI,Xinyuan 05403613 WU,Yun 08426959 LU,Yuan 08426975 9/21/2009
In 1992, an unusual business idea came into the eye of David A. Davis, a movie industry analyst in Los Angeles. The idea is basically about creating an investment group, Arundel partners, which would purchase the sequel rights associated with films produced by one or more major movie studios before the first films are made. With the sequel right, Arundel could decide whether to make the second film based on the result of the first film. Arundel's profitability is dependent upon the price it pays for a portfolio of sequel rights.
Profitability of the project
Arundel would purchase the sequel rights of the entire production of a studio over an extended period of not less than a year. If a particular film was a hit, it is believed that a sequel would also be profitable, and Arundel would exercise its right to produce the sequel. Alternatively, it can sell the right to the highest bidder. It is of critical importance to Arundel that a number of films and a price per film are agreed upon before either Arundel or the studio knew which films would generate the option of a sequel. In addition, once production started, the studio would inevitably form an opinion about the movie and the likeliness that a sequel would be possible. This would put Arundel at a disadvantage, because they would then have to negotiate the price for sequel rights on each film produced, while knowing much less than the production studio about the film.
Valuation of sequel rights
In the following context, we are going to present two approaches to value the per-film value of the portfolio of sequel rights. All the calculations are based on the information given in Exhibit 7. Major results are included in the Appendix. The risk free rate is 6% semiannually as indicated in the case, which is equivalent to an annual rate of 12% with semiannual discounting.
1. NPV approach
In this approach, the difference between the PV of Net Inflows and PV of Negative Cost is used as criteria to determine whether Arundel will exercise the options. If the difference is positive, which means that the hypothetical sequel is profitable, Arundel will exercise the option and thus we would have positive future cash flow from the sequels. We take the average of profits of all the profitable sequels and get the per movie value, which is 4.43 million/film. The procedure is equivalent to taking the real expectation of terminal payoffs assuming all outcomes are equiprobable and discounting at a risky rate for the underlying.
Since the assumption for original Black-Scholes formula is that the strike price is fixed, while here the PV of negative (analogous to strike price in original BS formula), we are going to adopt the BS formula for exchange option according to Margrabe(1978),
Where x1 is average PV of net inflows,
x2 is average of PV of negative costs,
t*- t= 4,
ν is the volatility estimate and ν=σ12+σ22-2×ρσ1σ2.
By plugging all the elements in the formula, the value of the option using BS approach is 14.8 million/film.
Advantages of 2 approaches
For NPV approach: only simple calculation is implemented in this approach and this procedure is equivalent to taking the real expectation of terminal payoffs assuming all outcomes are equally probable and discounting at a risky rate for the underlying. For BS approach: the BS formula for the exchange option is chosen as it would produce more precise result than the basic BS formula in the case of floating strike price.
Disadvantages of 2 approaches
For both 2 approaches: only pre-tax data are implemented in...