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Advanced Corporate Finance

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Application of real options valuation:

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Arundel Partners: The Sequel Project
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 Innovative ideas – In pursuit of movie sequel
rights

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 Arundel Partners is created to buy sequel rights of films

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produced by one or more major U.S. movie studios. Arundel

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wants to see if a movie is successful then decides whether to

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produce a sequel.
 What is innovative about this?

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Arundel buys the sequel right before the first movie is even made, let alone

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released.

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 Not choosy: Arundel buys all the sequel rights for a studio’s entire production

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during a specific period (1 or 2 years).

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 Why might this business model be profitable?
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 The question: How are sequel rights valued?
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 The timing of sequel rights

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 Let’s assume a timeline:

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 T=0: The time at which the first movie goes into production.

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 T=1: The first movie is released to U.S. theaters, followed by

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home videos, pay per view, pay TV, and network TV (Exhibit 3).
T=3: The sequel goes into production.

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 T=4: The sequel is released to U.S. theaters.

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 Why would Arundel purchase even before t=0?
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Why not purchase the sequel rights between t=0 and t=1?
Why not purchase the sequel rights after t=1 and before t=3?
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 Valuation – DCF approach

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 Movie sequels are one-year investments:

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 The net cash inflows received at T=4; the mean present value of net cash

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inflows is $21.6 million (Exhibit 7).

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 The negative (production) costs occur at T=3; the mean present value of
negative cost is $22.6 million (also in Exhibit 7).

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 Discount rate is 12% (Appendix)
 Mean NPV (at T=3) = $21.6m/1.12 - $22.6m = - $3.314m

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 Mean NPV (at T=0) = -$3.314m/(1.12)^3 = -$2.359m

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 Conclusion: The studios should pay Arundel to take the

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rights.
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 But what is missing if we use the DCF approach?
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 By buying the rights at or before T=0, Arundel does not have to make all the
sequels.
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 Arundel will only make the hits and it will know which are “hits” by the time it
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has to decide– the essence of decision.

 DCF methodology ignores Arundel’s ability to delay a decision about a sequel
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until after T=1.

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 Valuation – Modified DCF approach

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 Suppose Arundel owns all the sequel rights, which rights

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would it exercise?

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 Exercise all the rights for which the hypothetical sequel is expected to have

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positive NPV (i.e., the return is at least 12%).
 There are 26 (supposedly) positive NPV sequels on Exhibit 7:

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 Sequel PV of Net Inflows (m) PV of Negative Costs

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(m)

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Parenthood 76.8 28.2

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Born on the Fourth of 56.8 25.4
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Field of Dreams 47.3 22.6
Uncle Buck 47.0 21.2
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Sea of Love 44.4 35.3

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…and all other 21 … …

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sequels
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Average per sequel 57.2

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 Valuation – Modified DCF approach

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 Note that the $57.2m of mean net inflows take place at T=4.

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So the mean NPV for the 26 sequels at T=3 = $57.2m/1.12-

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$24.5m = $26.6m.

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 Total NPV from the 26 sequels at T=3 = $26.6m*26 = $692m.

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 $692m/a total of 99 sequels = $6.99m. This is the average
value per sequel at T=3

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 Discount back to T=0: $6.99m/1.12^3 = $4.98m per sequel.

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 What is the shortcoming of the above analyses?
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 Valuation – Real option approach

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 In essence, Arundel plans to purchase a portfolio of out-of-

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the-money call options.

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 European call option with no dividends.

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 What is the “right” duration (t) for the option?
If the first movie flops at T=1, there will be no sequel. So uncertainty is solved

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at T=1.

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 Therefore, t=1.

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 The setup and assumptions:

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 The value of the underlying asset (S) = $21.6 million/1.12^4 = $13.73 million.
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The exercise price (X) = $22.6 million/1.12^3 = $16.09 million.
We assume the risk-free rate is 6% (as opposed to 12% of discount rate for
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risky film cash flows).
 σ = 1.21; the variance is 1.4641.
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 Dividend yield = 0%.

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 Based on Black-Sholes model, the value of the sequel rights is

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$5.876 million.
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