Case 1. Arundel Partners: The Sequel Project
1. Why do the principals of Arundel Partners think they can make money buying movie sequel rights? Why do the partners want to buy a portfolio of rights in advance rather than negotiating movie-by-movie to buy them? The principals at Arundel Partners believe that there is value that is not captured in a discounted cash flow when analyzing the launching of a film. They believe that by launching a new film, there is immediately an option to launch a sequel that can generate future cash flows not accounted in the discounted cash flow. Since creating a sequel of an original film is not an obligation, the studio can wait and see if the original film had a positive net present value and decide whether or not to go ahead with the project. By valuing the rights of the movie sequels and offering them to investors like Arundel, the producers of the film can obtain financing for the early stages of the original film. Conversely, Arundel believes that by valuing these rights using a Black-Scholes Option Pricing model, they can calculate a value for the rights to produce these sequels and take a position by investing in a portfolio conformed of these rights. Arundel Partners plans to make money by negotiating an option price below its net present value calculation and obtaining its expected returns on the option. If indeed a movie becomes a sequel then the value of the option will increase and Arundel will either exercise the right to make the sequel or sell the right either to the original studio or a third party willing to take on the project. The principals at Arundel Partners are inclined to buy a portfolio of all these sequel rights rather than individual films given that Arundel wants to avoid buying the rights of movies that are not expected to perform well. Arundel would need to know exactly the number of films as well as the name of the films that will make part of the individual selection. Also, buying a portfolio diversifies the risk of a movie not becoming a sequel considering that the majority of films do not have sequels that follow. Also, buying an individual option to a sequel could create incentives for the studios to invest more money on a movie with the same possible outcome where the studio owns the rights to a sequel rather than Arundel.
2. Estimate the per-movie value of a portfolio of sequel rights such as Arundel proposes to buy. Use both a discounted cash flow (DCF) approach and Black-Scholes option valuation approach. Discounted Cash Flow Method
Using the data for hypothetical sequels, we calculated the NPV of each of these sequels considering that the future net inflows would be received in 4 years and that the future negative cost would be incurred in 3 years. With it, we came with a per-sequel NPV as we can see in Exhibit 1. But Arundel partners will not make a sequel of each movie that they buy the rights to. They have the option to make or not make the sequel in the future, depending on what the NPV of each specific sequel is. To account for this, we only considered those movies where a sequel has a Positive NPV (26 of them from the sample provided). Then, we calculated the per movie value to be $4.958 million, since we have to consider 99 movies for this calculation because we buy them as a package. We can see in Exhibit 2 the results from this method. Black-Scholes Option Valuation
Again, we used the data for the hypothetical sequels and their expected inflows and costs. We know that for the Black-Scholes valuation we need certain parameters, so we used for the current stock price (S0) the average inflows from the 99 sequels, discounted to today. For the strike price (K), we used the average negative costs of the sequels. The standard deviation is the standard deviation of the 1 year returns, but since T is 3 years, we need to account for this, so we divide the standard deviation of the returns obtained in the sample (121%) for the square...
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