BF322: Advanced Corporate Finance Case Study Arundel Partners: The Sequel Project

Group Members: Chen Yanheng Loon Shu Juan Melissa Ong Joseline Tan Hui Kiow

Fundamental Analysis Arundel Partners is an investment group, set up to purchase sequel rights associated with films produced by one or more major U.S. major studios. By owning such rights, Arundel will be able to wait and see if the movie was successful, before deciding whether to exercise its right and produce a second film based on the story or character of the first. However, Arundels profit margin would depend on how much it has to pay to purchase such a portfolio of sequel rights, and this problem would be analyzed in our report. 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 film-by-film to buy them? The principals of Arundel believe that they can make money with the purchase of the movie sequel rights due to the volatility associated with a movies success. Such volatility is precious in an option and therefore, the principals think that they can make use of such unpredictability in the movie industry to their advantage. Furthermore, the principals have the right not to exercise the option if the movie was not successful, and therefore not produce any sequel. Therefore, the loss associated with such a movie with bad response from the public would be limited to the premiums paid by Arundel for the option. However, the gain on the upside can be unbounded and this provides Arundel with the opportunity to make money. Furthermore, Arundel can also sell the rights to the highest bidder if it does not want to produce the sequel itself. This is also another method where Arundel can make money with the purchase of the rights. It is of critical importance that Arundel buy the portfolio of rights in advance rather than negotiating film-by-film as once production starts, the studio would gradually form an opinion about the movie, and Arundel would be placed at a disadvantaged position by having to bargain over individual projects. Furthermore, there is also the

presence of informational asymmetry, where the studio holds more information about each individual film than Arundel. Such negotiation held for film-by-film also takes up more time and efforts, and may not even be successful in the end. Therefore, it is in Arundels best interest that they buy the portfolio of rights before production starts.

2. Estimate the per-film value of a portfolio of sequel rights such as Arundel proposes to buy. [There are several ways to approach this problem, all of which require some part of the dataset in Exhibits 6-9. You may find it helpful to consult the Appendix, which explains how these figures were prepared.] Using the Discounted Cash Flow method: Discount rate = 12% PV of Net inflows were discounted back 4 years. PV of Negative costs were discounted back 3 years. Movie value of the positive NPV sequels = $490.87 million for 26 movies Per-film value = $490.87m / 99 = $4.96 million

Using the Black-Scholes option-pricing model with figures taken from Table B of Exhibit 9 Length of time in which cash outflow for hypothetical sequel may be deferred (t) = 3 years Discount rate (tf,) = (1.06^2) 1 = 0.1236 Present value of cash inflows from hypothetical sequel (S) = (28.2 / (1.1236^4) ) = $17.693 miillion Present value of cost to produce hypothetical sequel (X)

= (31.3 / (1.1236^3) ) = $22.065 million

Standard deviation per year on present value of cash inflows = $29.3 million = (29.3 / 28.2) * 100% = 103.901% NPV = 17.693 / 22.065 = 0.802 t = 1.03901 X 3 = 1.80

3. What are the primary advantages and disadvantages of the approach you took to valuing the rights? What further assistance or data would you require to refine your estimate of the rights value? DCF Model Advantages: The DCF model is easy to understand as it just requires two variables (cash inflows and discount rate) so it is easier to estimate and apply in reality. Also, the DCF model indicates the intrinsic value of a project rather than just comparing different projects by using ratios. Furthermore, it gives a simple accept/reject decision based solely on NPV. Lastly, DCF model provides a better estimate when evaluating mutually exclusive projects.

Disadvantages:

However, there are disadvantages of the DCF model. Firstly, changes in future cash flows will result in volatile outputs. It is difficult to estimate cash flows more than a few years into the future, and forecasting cash flows for a large number of years is even more difficult. Secondly, DCF analysis does not address the option value well in its model, even when the option may be a critical part of investment decision. It multiplies the probability of success (and conversely failures) with their associated costs to arrive at a expected cash flow, when in reality as this case shows, firms have the option not to proceed with producing the sequel and incur the negative cash flows. Lastly, DCF does not allow for new information to be quickly assimilated and capitalized upon. Additional data required would be the comparative cost and revenue data of the first films and their sequels on an individual studio basis. With that data, the Black Scholes formula could be applied more accurately for the films produced by the different studios. Another piece of information required would be the Arundel Partners cost of equity and debt-to-equity ratio. This information could help to identify the discount rate used in the DCF model. In addition, historical data on the performance of both First Films and actual sequels would be required to refine the estimate of the rights value. Black Scholes Model Advantages: With the Black Scholes model, Arundel can estimate the actual investment movements in the up-state and down-state more closely and accurately. Some of the inputs required in the model include the stock price volatility. Furthermore, this model does not depend on the expected return, which would vary significantly when valued by different people. Arundels risk aversion also does not affect the value given by this model. Disadvantages:

However, this model has its own disadvantages. Firstly, the Black Scholes model can only value European options, where early exercise is prohibited. In addition, the model assumes that the risk free rate and variance of the investment values are constant, both of which are not held true in the real world. Therefore, the value obtained in this model would not be totally accurate. 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? One problem that Arundel would encounter when contracting with the studio would be how many of the future sequel rights will Arundel own. For example, certain movies not only have a 2nd sequel, but may have up to 4 or 5. In such a case, the studio may be unwilling to grant all the rights to Arundel, losing the chance to profit on a potential blockbuster. Furthermore, if all the future sequel rights are granted to Arundel, the studio will probably be disincentivised to pull all shots to ensure that the initial movie is as successful as possible.

However, Arundel would prefer to own as many of the future sequel rights as possible and therefore, this contract term must be clarified and written clearly in the agreement on how many rights and which rights Arundel can own for a particular movie, or whether Arundel would have some diminishing rights as the number of sequels increase. Another problem would be the length of the agreement. Arundel would prefer to have a long term agreement as it would then be able to lock in the pricing for a longer period, without having to negotiate for a better deal every once in a short while. However, the studio would prefer to review the pricing more frequently so that they can command a option premium closer to the market rates. For example, should a large number of productions yield successful sequels, the studio may want to charge Arundel more for the sequel right. This however conflicts with the rationale brought

up earlier about Arundel wanting to purchase a portfolio of rights to reduce costly film-by-film negotiation and information asymmetry. Therefore, the length of the agreement must also be negotiated and written in the agreement.