Arundel Partners: The Sequel Project
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 of Arundel Partners think they can make money buying movie sequel rights because they can use unpredictability of a movie’s success to their advantage. This can be done by exercising the right if the movie is a success or selling rights to another bidder in the event of the movie’s failure. By doing this, they limit the losses on bad sequels to the option price, and maximize the profits on winning movies. This works well since the majority of sequels are losers with …show more content…
winners being large profit gains.
• The partners want to buy a portfolio of rights in advance rather than negotiating movie-by-movie as they know less information about movies than studios do. Additionally, if the movie is a success, the studio would have higher bargaining power and be hesitant to give Arundel Partners the right to produce sequels.
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 an option valuation approach (such as Black-Scholes).
• Per movie value of a portfolio of sequel rights by:
o DCF approach = $4.88 M
We obtained $4.88M through the DCF approach (Exhibit 1) by a taking a summation of all positive NPV sequels and dividing it by the total number of sequel rights available i.e. 99.
Originally, by taking an average of all sequel rights available, we obtained a negative NPV value of $2.4M. Although this value gives us an estimate of the average project value, assigning equal weighting to successful movies as well as failures, does not seem plausible. Since there is significant volatility for the movie business, which DCF cannot account for, we attempted to incorporate it by following the method described above.
o Option Valuation Approach = $4.97M
This value was obtained by using Black-Scholes formula (Exhibit 2). Additionally, sensitivity analysis was performed (Exhibit 3) which determined that volatility is critical for pricing an option. We looked at three
scenarios:
▪ 70% volatility- representing the standard deviation if outliers are removed.
▪ 80% volatility - representing historical standard deviation of movies in 1987.
▪ The upper bound of 120% volatility - representing the standard deviation based on the hypothetical returns.
Given this information, one can see the full spectrum of option prices based on possible volatility. Also, this sensitivity analysis shows that the risk-free rate does not have much impact on the values.
A more in depth look at how the options prices change based on average cost and cash flow of the movies was also performed as it can help in determining future outcomes. The analysis showed that standard deviation of the cost of movies is much smaller than that of cash flows, so future cash flows directly affect the price of the options.
3. What are the primary advantages and disadvantages of the prior approaches, DCF and option valuation, that you took in valuing the rights? Please be specific about their assumptions. What further assistance or data would you require to refine your estimate of the right’s value?
|DCF valuation |Option Valuation |
|Advantages |
|It is a simple model if there are stable cash flows and |It incorporates volatility of the project |
|decision can be made based on NPV values | |
|Disadvantages |
|It does not account for volatility in projects |It is complicated and information is not easily obtained |
DCF Assumptions:
• Included only positive NPV projects while determining the NPV.
• Discounted future cash flows at an annual rate of 12.4%
Option Valuation Assumptions:
• Riske free rate = 6%
• Volatility = 70%
• Adjusted Cash flow - average of cash flows generated in Yr 4 and discounted to their present value, at a rate of 12.4%.
In order to refine our estimate of the right’s value, we would require
• More historical data, as compared to just 2 years
• Cash flows and future volatility projections
4. What problems or disagreements would you expect Arundel and a major studio to encounter in the course of a relationship like that described in the case? What contractual terms and provisions should Arundel insist on?
• Probable problems between a major studio and Arundel Partners:
o Studios would want Arundel to negotiate on a per-movie basis, instead of portfolio
o Disagreement with studios on % of revenues that each one gets
o Studios would demand payment for movies upfront
o How to define volatility and what historic measurement to use to value options
o If Arundel is making money, then the option writers are losing money, so if Arundel is right, then the Studio will definitely want to adjust.
• Contractual terms & provisions to be insisted on:
o Agreement on the number of films in a portfolio & price/film before hand
o Payment terms which incorporate that payment will not be made upfront, but in installments, as movie progresses through production. This could even help keep the studio committed to the sequels.
o Possible agreement on using the studio for distribution or giving them 10 – 15% of revenues to keep the studio committed
o Legal asset ownership if Studio does not “pay-up”
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 of Arundel Partners think they can make money buying movie sequel rights because they can use unpredictability of a movie’s success to their advantage. This can be done by exercising the right if the movie is a success or selling rights to another bidder in the event of the movie’s failure. By doing this, they limit the losses on bad sequels to the option price, and maximize the profits on winning movies. This works well since the majority of sequels are losers with …show more content…
winners being large profit gains.
• The partners want to buy a portfolio of rights in advance rather than negotiating movie-by-movie as they know less information about movies than studios do. Additionally, if the movie is a success, the studio would have higher bargaining power and be hesitant to give Arundel Partners the right to produce sequels.
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 an option valuation approach (such as Black-Scholes).
• Per movie value of a portfolio of sequel rights by:
o DCF approach = $4.88 M
We obtained $4.88M through the DCF approach (Exhibit 1) by a taking a summation of all positive NPV sequels and dividing it by the total number of sequel rights available i.e. 99.
Originally, by taking an average of all sequel rights available, we obtained a negative NPV value of $2.4M. Although this value gives us an estimate of the average project value, assigning equal weighting to successful movies as well as failures, does not seem plausible. Since there is significant volatility for the movie business, which DCF cannot account for, we attempted to incorporate it by following the method described above.
o Option Valuation Approach = $4.97M
This value was obtained by using Black-Scholes formula (Exhibit 2). Additionally, sensitivity analysis was performed (Exhibit 3) which determined that volatility is critical for pricing an option. We looked at three
scenarios:
▪ 70% volatility- representing the standard deviation if outliers are removed.
▪ 80% volatility - representing historical standard deviation of movies in 1987.
▪ The upper bound of 120% volatility - representing the standard deviation based on the hypothetical returns.
Given this information, one can see the full spectrum of option prices based on possible volatility. Also, this sensitivity analysis shows that the risk-free rate does not have much impact on the values.
A more in depth look at how the options prices change based on average cost and cash flow of the movies was also performed as it can help in determining future outcomes. The analysis showed that standard deviation of the cost of movies is much smaller than that of cash flows, so future cash flows directly affect the price of the options.
3. What are the primary advantages and disadvantages of the prior approaches, DCF and option valuation, that you took in valuing the rights? Please be specific about their assumptions. What further assistance or data would you require to refine your estimate of the right’s value?
|DCF valuation |Option Valuation |
|Advantages |
|It is a simple model if there are stable cash flows and |It incorporates volatility of the project |
|decision can be made based on NPV values | |
|Disadvantages |
|It does not account for volatility in projects |It is complicated and information is not easily obtained |
DCF Assumptions:
• Included only positive NPV projects while determining the NPV.
• Discounted future cash flows at an annual rate of 12.4%
Option Valuation Assumptions:
• Riske free rate = 6%
• Volatility = 70%
• Adjusted Cash flow - average of cash flows generated in Yr 4 and discounted to their present value, at a rate of 12.4%.
In order to refine our estimate of the right’s value, we would require
• More historical data, as compared to just 2 years
• Cash flows and future volatility projections
4. What problems or disagreements would you expect Arundel and a major studio to encounter in the course of a relationship like that described in the case? What contractual terms and provisions should Arundel insist on?
• Probable problems between a major studio and Arundel Partners:
o Studios would want Arundel to negotiate on a per-movie basis, instead of portfolio
o Disagreement with studios on % of revenues that each one gets
o Studios would demand payment for movies upfront
o How to define volatility and what historic measurement to use to value options
o If Arundel is making money, then the option writers are losing money, so if Arundel is right, then the Studio will definitely want to adjust.
• Contractual terms & provisions to be insisted on:
o Agreement on the number of films in a portfolio & price/film before hand
o Payment terms which incorporate that payment will not be made upfront, but in installments, as movie progresses through production. This could even help keep the studio committed to the sequels.
o Possible agreement on using the studio for distribution or giving them 10 – 15% of revenues to keep the studio committed
o Legal asset ownership if Studio does not “pay-up”