In 1992, Arundel Partners was looking into the idea of purchasing the sequel rights associated with films produced by one or more major movie studios. Movie rights were to be purchased prior to films being made. Arundel wanted to determine if this innovative business strategy is viable by estimating the value of the sequel rights.
Our report aims to investigate the viability of the implementation of Arundel's strategy in purchasing sequel rights to produce potential successful movie sequels. The discount cash flow (DCF) approach and the real option pricing approach were adopted in valuing the sequel rights purchased by Arundel respectively. The value of these sequel rights is then compared to the estimated $2M per film required in purchasing the rights to see if Arundel will gain by purchasing these sequel rights.
Before we go on to evaluate the value of the sequel rights that can be purchased by Arundel, we will first consider the Arundel's reason behind the purchasing the sequel rights before the first films are even made.
Arundel hopes to escape the riskiness of producing a movie in the movie industry for a price by purchasing the option to produce potential successful sequels. Moviegoers' tastes are unpredictable and predicting the success of any film was almost impossible. Therefore, Arundel used an innovative way of managing this risk by only purchasing sequel rights to films even before they are produced so that they can go on to make sequels for successful first films.
Arundel has chosen to purchase a portfolio of sequel rights from one or more major studios. This is probably because Arundel does not possess the necessary knowledge in determining which movie will turn out to be successful and have potential for sequels. Without this knowledge, Arundel has to diversify and purchase a whole portfolio of sequel rights from the different studios in order to guarantee the rights to any future successful films.
This diversification of purchase of sequel rights with a fixed price per film also helps to avoid any hassle of future negotiation of values of sequel rights with studios. This is especially helpful as Arundel avoids the ugly situation of studios asking for higher sequel rights prices when they determine the current film in production to be successful.
4. DISCOUNT CASH FLOW APPROACH
Discount cash flow approach is a common methodology to value a financial asset using the concepts of time value of money. It is used here to help us estimate a value for the sequel rights.
With reference to Exhibit 7, Arundel will purchase the entire sample size of 99 films in hopes of obtaining more successful first films due to insufficient knowledge of the choice of successful films. Since the expenses incurred (negative cost) and revenue obtained (net inflows) with the first film are not credited to Arundel, they will be of no significance in the calculation of the value of sequel rights using the DCF approach.
With the purchase of all 99 films, all the cash flows of each individual movie will be discounted using Arundel's discount rate (12%) to the start of Year 0 in order to obtain the present value (PV) of each movie.
Arundel will only exercise the rights of first films with a positive PV and produce a sequel for them. From Appendix 1, we have determined that 26 first films have a potential for subsequent sequels.
Now that Arundel has determined the number of films for production of sequels, it still needs to determine the value of the sequel rights it is going to purchase. One thing to note here is that the value of the sequel rights can vary from the actual cost of the sequel rights. It has been explicitly stated in the case study that Arundel will be paying $2 million and above for the purchase of each sequel rights. The value of the sequel rights could be higher or lower than this $2 million.
With reference to Appendix 2, the value...