Arundel Partners Case Study
Why This is an Attractive Project
The Arundel Partners' believe that they can make money on this project as it allows them to capitalize on the idiosyncratic risk of the motion picture business. Producing and distributing motion picture films is a risky business due to the uncertainty of moviegoers' tastes and a studio never knows if they have a blockbuster on their hands until after the movie has started production or even later after it has been released. The financial resources of even the largest studios often become strained. Arundel's value proposition, to purchase the rights to movie sequels in a sequence of payments during the producing of the first movie, is to provide funds to the movie studios when they most need it. Arundel benefits from this arrangement as the greatest risk is taken by the movie studios when they produce the original film. Almost all sequels follow successful films and in the last 10-20 years it has become common for successful films to spawn one or more sequels. Arundel will be able to determine the success of the first movie before they decide if they would like to make the sequel so there is a limited down side as they can always choose not to produce a sequel if the first movie performance is poor. In addition, Arundel also has the option to sell the sequel …show more content…
rights to the highest bidder if they do not want to produce the sequel themselves
Why Purchase Movie Rights in Advance
If Arundel Partners' do not negotiate the rights in advance they will find themselves in a position which requires the sequential resolution of uncertainty, successive negotiations of contracts, and a position where each round of negotiations carries the risk of terminating the relationship. The approach that helps Arundel take care of these issues with the studios is that they negotiate the terms and conditions of buying the sequel rights before even the first movie is made. Additionally Arundel can take care of the following issues:
Once the production starts the studio inevitably forms an opinion about the movie and Arundel would not want to have to bargain over individual projects about which it knew less than the studio. This not only undermines Arundel's bargaining position but also increases the transaction cost.
Since the upside potential from a successful sequel is unlimited (with limited downside), Arundel can take maximum benefit of it only by paying an average price across the sequel rights. This is possible only if studios have no opinion formed about the movie or its sequels.
By getting into a deal with studios when their need for finances is the most can earn Arundel Partners not only good deals but also goodwill.
Assumptions of our DCF Analysis and Black-Scholes Model
Applying the DCF method to the hypothetical sequel cash flows provided, we calculated a per-movie value of $4.96M.
This was calculated using a discount rate of 12%. The PV of Net inflows were discounted back 4 years and the PV of Negative Costs were discounted back 3 years. The movie value of the positive NPV sequels ($490.87M for 26 movies) was then divided by the total 99 movies in the sample. Detail of our DCF calculation is provided in Exhibit 1. Assumptions and table for the Black-Scholes model can be viewed in Exhibit 2. Exhibit 3 provides a comparison of the two methods broken down by movie studio. The advantages and disadvantages of the two methods are detailed
below.
Advantages/Disadvantage of the Two Models
Advantages of the DCF Model
Easy to understand. The DCF model requires few variables, which are easy to apply and understand in the real world.
DCF indicates the intrinsic value of a project rather than the pure comparison between different projects by using the ratios like ROI.
DCF works well when evaluating mutually exclusive projects.
Disadvantages of DCF model
The changes in future cash flows will result in volatile outputs.
Forecasting cash flows more than a few years into the future is tough, crafting results into eternity, which is a necessary input, is even more difficult.
The DCF analysis does not address the option value well in its basic model. Even when the option may play a critical role in the investment decision.
The DCF does not allow for new information to be quickly assimilated and capitalized upon.
Advantages of Option Value Model (Binomial Tree/Black-Scholes)
By choosing a short time interval, one can closely approximate the actual investment movements in the up-state and down-state. The Black-Scholes assumes the time interval as infinitesimal. The necessary input here is the stock price volatility, measured by the size of the up and down jumps.
The model does not depend on the expected return, which will be considered different by different people. Investors with different assessments of the expected return will nevertheless agree on the call/put price. In such, the investment decision is unified.
The investor's risk aversion does not affect value. The Binomial tree/Black-Scholes can be used by anyone, regardless of willingness to bear risk.
A negative NPV investment project may be considered if it creates value through future opportunities/options.
Disadvantages of Option Value Model (Binomial tree/Black-Scholes)
The Black-Scholes is only applicable to valuing an European Option where the option can be excised on the excise date only
The binomial tree usually requires the estimation of investment value in different periods. However, the long-term estimate is usually based on historical information, which works poorly when predicting future results.
Black-Scholes assumes that both risk free rate and variance of the investment value are constant. In the long run, such variables may not be constant.
Black-Scholes assumes that the investment value changes are continuous; however, such an assumption would be violated in the case of critical unpredicted issues.
Black-Scholes value, on average, is too high for deep out-of-the money calls and too low for in-the-money calls. Such biases grow larger when option approaches expiration.
Additional Data Required to Refine the Estimate of Value
The comparative cost and revenue data of the first films and their sequels on an individual studio basis. If we have such data, the σ in Black-Scholes could be more accurate for the films produced by different studios.
The Arundel Partners' cost of equity and debt-to-equity ratio, which could help to identify the discount rate used in the DCF model.
Additional historical data on the performance of both "First Films" as well as actual "sequels".
Expected Problems, Disagreements, and Contractual Provisions
While the prospects of Arundel moving forward seem advantageous, there are underlying assumptions about timing and rights that would need to be resolved as they could result in conflict between the two negotiating parties: Arundel and the movie studio. Once such question has to do with the extent to which Arundel's rights would extend. Marketing and Merchandising rights are the up and coming sectors of revenue generation. While Arundel should insist on rights to all sources of future revenues, this would likely be a conflict point with the studios. The issue of future sequel rights would also need to be resolved--in cases of movies like Rocky, James Bond, and Batman, studios would likely be hesitant to give away rights to all sequels when it is easily expected that multiple films would follow. In these cases, a standard agreement where Arundel has diminishing rights as the number of sequels increases makes sense, but the way in which this arrangement would be structured could be difficult and confrontational. The length of the term of agreement must also be clearly defined. It is likely that Arundel would want to lock in its pricing for a long period; the studios however, would most likely want to limit the time commitment to see how well the arrangement works. If Arundel is able to negotiate multiple exit points, it should try to do so. The timing of funding and access to the funds for the studio could potentially be a very contentious situation. We feel that Arundel should fund an escrow account at the time production begins but that all interest earned prior to the end of production would belong to Arundel. Since the value of the film is in the completion of the negative, that is the most attractive point in which funds are distributed to the studio. Along these same lines, for productions that are scrapped prior to completion, the funds should revert back to Arundel along with a "cancellation" fee due to indecisiveness. Lastly, Arundel should ensure that it has the option to bid out the production of sequels to other studios--this will insure competitive pricing through a bidding process and will not tie its hands to any individual studio.
The Arundel Partners' believe that they can make money on this project as it allows them to capitalize on the idiosyncratic risk of the motion picture business. Producing and distributing motion picture films is a risky business due to the uncertainty of moviegoers' tastes and a studio never knows if they have a blockbuster on their hands until after the movie has started production or even later after it has been released. The financial resources of even the largest studios often become strained. Arundel's value proposition, to purchase the rights to movie sequels in a sequence of payments during the producing of the first movie, is to provide funds to the movie studios when they most need it. Arundel benefits from this arrangement as the greatest risk is taken by the movie studios when they produce the original film. Almost all sequels follow successful films and in the last 10-20 years it has become common for successful films to spawn one or more sequels. Arundel will be able to determine the success of the first movie before they decide if they would like to make the sequel so there is a limited down side as they can always choose not to produce a sequel if the first movie performance is poor. In addition, Arundel also has the option to sell the sequel …show more content…
rights to the highest bidder if they do not want to produce the sequel themselves
Why Purchase Movie Rights in Advance
If Arundel Partners' do not negotiate the rights in advance they will find themselves in a position which requires the sequential resolution of uncertainty, successive negotiations of contracts, and a position where each round of negotiations carries the risk of terminating the relationship. The approach that helps Arundel take care of these issues with the studios is that they negotiate the terms and conditions of buying the sequel rights before even the first movie is made. Additionally Arundel can take care of the following issues:
Once the production starts the studio inevitably forms an opinion about the movie and Arundel would not want to have to bargain over individual projects about which it knew less than the studio. This not only undermines Arundel's bargaining position but also increases the transaction cost.
Since the upside potential from a successful sequel is unlimited (with limited downside), Arundel can take maximum benefit of it only by paying an average price across the sequel rights. This is possible only if studios have no opinion formed about the movie or its sequels.
By getting into a deal with studios when their need for finances is the most can earn Arundel Partners not only good deals but also goodwill.
Assumptions of our DCF Analysis and Black-Scholes Model
Applying the DCF method to the hypothetical sequel cash flows provided, we calculated a per-movie value of $4.96M.
This was calculated using a discount rate of 12%. The PV of Net inflows were discounted back 4 years and the PV of Negative Costs were discounted back 3 years. The movie value of the positive NPV sequels ($490.87M for 26 movies) was then divided by the total 99 movies in the sample. Detail of our DCF calculation is provided in Exhibit 1. Assumptions and table for the Black-Scholes model can be viewed in Exhibit 2. Exhibit 3 provides a comparison of the two methods broken down by movie studio. The advantages and disadvantages of the two methods are detailed
below.
Advantages/Disadvantage of the Two Models
Advantages of the DCF Model
Easy to understand. The DCF model requires few variables, which are easy to apply and understand in the real world.
DCF indicates the intrinsic value of a project rather than the pure comparison between different projects by using the ratios like ROI.
DCF works well when evaluating mutually exclusive projects.
Disadvantages of DCF model
The changes in future cash flows will result in volatile outputs.
Forecasting cash flows more than a few years into the future is tough, crafting results into eternity, which is a necessary input, is even more difficult.
The DCF analysis does not address the option value well in its basic model. Even when the option may play a critical role in the investment decision.
The DCF does not allow for new information to be quickly assimilated and capitalized upon.
Advantages of Option Value Model (Binomial Tree/Black-Scholes)
By choosing a short time interval, one can closely approximate the actual investment movements in the up-state and down-state. The Black-Scholes assumes the time interval as infinitesimal. The necessary input here is the stock price volatility, measured by the size of the up and down jumps.
The model does not depend on the expected return, which will be considered different by different people. Investors with different assessments of the expected return will nevertheless agree on the call/put price. In such, the investment decision is unified.
The investor's risk aversion does not affect value. The Binomial tree/Black-Scholes can be used by anyone, regardless of willingness to bear risk.
A negative NPV investment project may be considered if it creates value through future opportunities/options.
Disadvantages of Option Value Model (Binomial tree/Black-Scholes)
The Black-Scholes is only applicable to valuing an European Option where the option can be excised on the excise date only
The binomial tree usually requires the estimation of investment value in different periods. However, the long-term estimate is usually based on historical information, which works poorly when predicting future results.
Black-Scholes assumes that both risk free rate and variance of the investment value are constant. In the long run, such variables may not be constant.
Black-Scholes assumes that the investment value changes are continuous; however, such an assumption would be violated in the case of critical unpredicted issues.
Black-Scholes value, on average, is too high for deep out-of-the money calls and too low for in-the-money calls. Such biases grow larger when option approaches expiration.
Additional Data Required to Refine the Estimate of Value
The comparative cost and revenue data of the first films and their sequels on an individual studio basis. If we have such data, the σ in Black-Scholes could be more accurate for the films produced by different studios.
The Arundel Partners' cost of equity and debt-to-equity ratio, which could help to identify the discount rate used in the DCF model.
Additional historical data on the performance of both "First Films" as well as actual "sequels".
Expected Problems, Disagreements, and Contractual Provisions
While the prospects of Arundel moving forward seem advantageous, there are underlying assumptions about timing and rights that would need to be resolved as they could result in conflict between the two negotiating parties: Arundel and the movie studio. Once such question has to do with the extent to which Arundel's rights would extend. Marketing and Merchandising rights are the up and coming sectors of revenue generation. While Arundel should insist on rights to all sources of future revenues, this would likely be a conflict point with the studios. The issue of future sequel rights would also need to be resolved--in cases of movies like Rocky, James Bond, and Batman, studios would likely be hesitant to give away rights to all sequels when it is easily expected that multiple films would follow. In these cases, a standard agreement where Arundel has diminishing rights as the number of sequels increases makes sense, but the way in which this arrangement would be structured could be difficult and confrontational. The length of the term of agreement must also be clearly defined. It is likely that Arundel would want to lock in its pricing for a long period; the studios however, would most likely want to limit the time commitment to see how well the arrangement works. If Arundel is able to negotiate multiple exit points, it should try to do so. The timing of funding and access to the funds for the studio could potentially be a very contentious situation. We feel that Arundel should fund an escrow account at the time production begins but that all interest earned prior to the end of production would belong to Arundel. Since the value of the film is in the completion of the negative, that is the most attractive point in which funds are distributed to the studio. Along these same lines, for productions that are scrapped prior to completion, the funds should revert back to Arundel along with a "cancellation" fee due to indecisiveness. Lastly, Arundel should ensure that it has the option to bid out the production of sequels to other studios--this will insure competitive pricing through a bidding process and will not tie its hands to any individual studio.