Arundel Partners
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1. INTRODUCTION
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.
2. OBJECTIVE
Our report aims to investigate the viability of the implementation of Arundels 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.
3. STRATEGY
Before we go on to evaluate the value of the sequel rights that can be purchased by Arundel, we will first consider the Arundels 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 Arundels 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 of each sequel rights purchased by Arundel can be calculated by the sum of the overall positive PV of the 26 film sequels divided by the total number of films (99). This has been calculated to be $4.96M.
This value of $4.96M is evidently larger than the $2M paid by Arundel for each individual sequel rights.
Optimistic or Pessimistic estimate?
With this value of $4.96M as our value for each sequel rights purchased, we are now allowed to compare it with other values of sequel rights to understand if we were too optimistic or pessimistic in our estimate.
Driving Miss Daisy, Dead Poets Society and Batman were chosen to be the representative movie sequels with their varied sequel rights values that can be compared to $4.96M. They were chosen because they are all one of the most highly anticipated successful films that can generate sequels. In particular, the PV of these successful sequels will help us determine if we are underpaying or overpaying the current sequel rights for each individual movie.
From Appendix 1, it has been determined that the PV of Driving Miss Daisy, Dead Poets Society and Batman are $95.42M, $41.27M and $27.21M respectively. The large magnitude of the PV of these 3 film sequels undermine the relatively smaller $4.96M we calculated earlier.
If the studio obtains information that a film is going to be very successful, there is a probability and incentive for them to hold back their production of the initial film so that the sequel contract with Arundel will expire first. This would imply that Arundel may need to pay a higher value for sequel rights of movies that studios deem to be popular and successful so as to entice the studios to sell these sequel rights to them. Hence, our earlier estimate of $4.96M for each sequel rights may be overly optimistic as we need to adjust this value upwards to take into account of more popular and successful movies.
5. REAL OPTION APPROACH
The real option approach is used as the second approach in estimating the value of sequel rights. This approach can be contrasted with the DCF approach as it takes into account the option of exercising their sequel rights.
The Black-Scholes option formula is used to calculate the value of the option of exercising the sequel rights. Different valuables needed for the formula needs to be identified first in order to obtain an