Arundel Partners : The Sequel Project

I. Introduction

A. Movie Industry Overview

Movie industry is characterized by a high level of uncertainty and competition such as audience
preference and lack of objective quality for media content. The uncertainty concerning consumer
preferences and needs in the industry is very high. This is mainly due to the fact that audience
have heterogenous tastes and socio-demographic characteristics. Furthermore, lack of objective
quality criteria for media content makes it very hard for movie industry investors to identify right
movie to invest prior to the production process.

Moreover, each stage of film-making process: production, distribution and exhibition involves
high operating risks. These may include pre-production expenses, salaries and distribution
expenses. These costs are normally fixed, and sometimes requires upfront payments. Moreover,
reselling potential of these resources is usually low, and normally at a huge discount to another
media company. Hence, the investments in the movie industry is irreversible as well.

B. Background of Arundel Partners

In 1992, David A. Davis of Paul Kagan Industries looked into an out-of-the-box investment idea:
purchase the sequel rights of films produced by one or more major movie studios in the U.S by
creating an investment group, Arundel Partners.

Arundel Partners will purchase sequel rights of a studio’s entire production over a number of
years, before the first movie is even made, in order to gain potential profits made from producing
follow ups of successful movies. Since it has no reliable way to predict which movies might be
made and which movies might be successful, they will purchase entire portfolio in the studio
rather than an individual film. In exchange for Arundel’s investments to fund initial production
of films, major studios will give up a portion of their equities of subsequent sequel rights to
Arundel. Major studios are willing to do so as they will have a healthy boost at the start of the
filmmaking process to tie down some of contracts with investments from Arundel.

It is very important for Arundel Partners to purchase the pool of sequel rights prior to production
of first movie. Once the production begins, movie studios will have more information whether
the movie will be a hit in the market, causing asymmetric information for Arundel. In addition,
it’s unlikely for studios to sell sequel rights if they release the film as there’s little uncertainty
left, and they are less likely to misprice the rights. Purchase as an entire portfolio also reduces
negotiation time throughout the process if it were an individual film purchase.

C. Timeline
 Although the time required for filmmaking process varies for different movies, based on the
information given on exhibit 3, we can draw the following timeline in order to better assist the
analysis in the later paragraph.

t=0
t=3
start production of first t=4
t=1 Sequel production
movie Sequel release
Release of first movie Cost for sequel
Costs for purchasing Revenue of sequel
production
sequel rights

The timeline for the proposal is to purchase rights to movie sequels in one to two year blocks. At
t=0, studios will start to produce After one year, the first movie will release in theatre first
followed by videocassettes a few months later and pay TVs a year later. Therefore original film
revenue can be expected to occur in t=1. Determination of a sequel’s success is predictable
within the first few weeks of the original’s release.

The median sequel release date is 3 years after the first movie’s release and therefore can be
expected in t=3. Therefore, sequel rights purchased at t=0, on average, will not accrue revenue
until t=4. If the original movie did not produce impressive returns, Arundel Partners would
reserve the right to not make a sequel at all or elect to abandon the sequel and sell the sequel
rights to another studio for a fee.

In the following discussion, we will discuss 2 different methods to value the sequel rights: Net
Present Value Method and Black-Scholes Option Pricing Model.

II. Net Present Value Method

A. Net Present Value Overview

Net present value is the present value of the cash flows at the required rate of return of your
project compared to your initial investment. In practical terms, it’s a method of calculating your
return on investment for a project or expenditure. The formula is below:

𝑁𝑃𝑉 = 𝑃𝑉(𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠) − 𝑃𝑉(𝑁𝑒𝑔𝑎𝑡𝑖𝑣𝑒 𝐶𝑜𝑠𝑡𝑠) -------Equation (1)

Where
NPV = net present value
PV = present value

Based on Exhibit 7, we could estimate the net present value of hypothetical sequels of 99 films in
6 U.S. major studios. As the table in Exhibit 7 only provides PV of net inflows at year 4 and PV
of negative costs at year 3, we need to use the appropriate discount rate to discount the cash
inflows and negative costs to the current value as the investment decision is today.

From Appendix, 6% compounded semi-annually, therefore the effective discount rate = (1 +

12%)2 − 1=12.36%, this discount rate is appropriate based on the time value and risk premium.
In addition, inflation is given at 1.5% semi-annually, therefore the effective inflation rate
=(1 + 3%)2 − 1=3.02%.

B. Calculation

Based on Equation (1), we have obtained that sum of NPV for all 99 films = -$240.38m, and the
price per sequel (in 1991 dollar) = -$2.43m. Furthermore, if we adjust for inflation, price per
sequel (in 1992 dollar) = -$2.50m. This indicates that the studio should pay Arundel to take the
sequel rights, which is clearly wrong.

As Arundel will only produce sequel if the first movie is hit, only project with positive NPV
should be accepted, we have obtained the following:
Table 1:

Although we only invest in projects with positive NPV, yet contracts were fixed so that Arundel
PARA- 20th THE WALT
MOUNT SONY CENTURY WARNER DISNEY
Buying Options All MCA PICTURES PICTURES FOX BROTHERS COMPANY
Number of Movies
26 9 3 4 2 3 5
with Positive NPV
Sum of Positive NPV
483.17 92.08 26.33 96.92 19.20 137.21 111.42
(million)
Number of Movies 99 14 10 34 11 19 11
Price per Sequel
4.88 6.58 2.63 2.85 1.75 7.22 10.13
(million - 1991 dollar)
Price per Sequel
5.03 6.78 2.71 2.94 1.80 7.44 10.44
(million - 1992 dollar)
were obligated to buy options for all films in each studio. However, the right to exercise the
option can be given up.

Therefore, we still use 99 to calculate price per sequel, and obtain $5.03m in 1992 dollar after
adjusted for inflation. As $5.03m is greater than $2.0m, movie studios are likely to accept this
investment from Arundel.

C. NPV Assumptions and Limitations

A major assumption of net present value is that risks are predictable and nature of the investment
will not change during the project life span, therefore we could use a uniform discount rate to
calculate the net present value. However, it is unlikely to be true for this sequel project.
Furthermore, it also assumes that films on which Arundel will buy sequel rights will be drawn
from the same distribution that characterizes the 1989 data presented in Exhibit 7. However,
when Arundel approaches different studios in Hollywood, these expected revenue and costs may
no longer be applicable. These may due to factors such as change in audience taste and film
industry new developments.
It also assumes that there are no systematic differences between studios, i.e. buying sequel rights
from Warner Brothers is the same as buying from Paramount Pictures. Again, it is unlikely in
real life.
 Another major limitation of net present value is it only considers investment projects as now or
never decisions. As a consequence, it does not recognise and value flexibility, which is quite
unrealistic.
Hence, Net Present Value (NPV) rule is not quite applicable for this project. Yet, it provides a
good starting point to think more optimal solutions beyond this method.

III. Black-Scholes Option Pricing

A. Real Option Valuation Overview

As explored in the above net present value method, we should use real option valuation to value
sequel rights, and it rests on three important principles below:
1) No Gestalt in valuation: The value of the whole project equals the sum of its component
cash flows
2) Nothing in a name: the value of the component cash flows does not depend on who owns
them
3) The present value of the future is its current price: The present value of payoffs from an
asset equals the asset’s current market price

We should adapt the risk-neutral valuation methodology and take underlying assets into
consideration.

B. Black-Scholes Option Pricing Overview

As Arundel Partners would purchase a portfolio of options to produce sequels, it will have the
flexibility below:
1) Avoid producing a given sequel if it’s very likely to be a negative NPV project, or
2) Produce a given sequel if it’s very likely to be a positive NPV project

Fundamentally, this represents a European call option: the option to buy an underlying asset at
specified price at a specific point in the future. Therefore, we could use Black-Scholes formula to
value sequel rights, the formula is below:

𝐶 = 𝑆 𝑁(𝑑1 ) − 𝐾𝑒 −𝑟𝑇 𝑁(𝑑2 ) -------Equation (2)

𝑆 𝜎2
ln( )+(𝑟+ )𝑇
𝐾 2
𝑑1 = -------Equation (3)
𝜎√𝑇
𝑑2 = 𝑑1 − 𝜎√𝑇 -------Equation (4)
Where
C = Value of the call option
S = Present value of the underlying asset
K = Strike price of the option
r = Risk free rate corresponding to the life of the option
T = Life to expiration of the option
σ = standard deviation of the underlying asset
𝑁 = cumulative distribution function of the standard normal distribution

While the Black-Scholes formula is originally developed for stocks (a real financial assets),
Arundel can easily develop similar inputs in order to estimate the value of sequel rights. Below
are required inputs of Black-Scholes formula, and the respective sequel projects counterparts.

Model Input Sequel Counterparts

S, Present value of underlying asset
K, Strick Price
T, life to expiration of the option
r, risk free rate
σ, standard deviation
Present Value of Net Cash Inflows
Present Value of Sequel Negative Cost
1 year – typical production time
1-year U.S treasury in 1992
1.21 (Exhibit 7)

1) S Calculation:
𝑃𝑉(𝑁𝑒𝑡 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 4)
𝑆 =
(1 + 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒)4

As we make purchase sequel decision in year 0 and receive sequel revenues in year 4, we should
discount four periods back in order to calculate S.
Furthermore, we should use the project-specific required rate of return as the discount rate, i.e.
12.36%. This is justified by project risks associated with the project’s future revenues including
production process of both the first film and its corresponding sequel, spanning from Year 0 to
all future time. As a result, the discounting for net inflows required the use of project-specific
required rate of return.

By taking average of S from 99 data points, we have obtained present value of net cash inflows
per film = $13.53m.

2) K Calculation:

𝑃𝑉(𝑁𝑒𝑔𝑎𝑡𝑖𝑣𝑒 𝐶𝑜𝑠𝑡 𝑖𝑛 𝑦𝑒𝑎𝑟 3)

𝐾 =
(1 + 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒)2

As we make decision to produce sequel in year 1 after the release of first movie, and start
producing sequel in year 3, we should discount two periods back in order to calculate K.

For negative costs, the discount rate is the risk-free rate. The risk-free rate is applied because
negative costs is certain cash outflows, and if investors decide not to produce the sequel,
investors could instead put the investments into a bank. The risk-free rate in 1992 is obtained
from federal reserve website by calculating the average of weekly 1-year treasury yield, and it is
3.72%.

Similarly, by taking average of K from 99 data points, we have obtained present value of
negative cost per film = $21.05m.

3) Other variables in the formula

T, life to expiration of the option = 1 year, as 1-year is the typical production time for a film.
σ, standard deviation = 1.21, this is directly observable from the Exhibit 7, and it is the standard
deviation of one-year return of hypothetical sequel production.

4) Calculation

Substitute variables into equation (3), we obtained 𝑑1 =0.27, and the normal distribution of 𝑑1 is
0.61. Substitute variable into equation (4), we have obtained 𝑑2 = -0.94, and the normal
distribution of 𝑑2 is 0.17.

Therefore, from equation (2), C = S N(d1 ) − Ke−rT N(d2 ) = 13.53*0.61-21.05*e−3.72%∗1*0.17

= $4.69m in 1991 dollars.

When adjusted for inflation, we have obtained that price per sequel in 1992 dollars = $4.83m. As
$4.83m is greater than $2.0m, movie studios are likely to accept this investment from Arundel.

C. Black-Scholes Assumptions and Limitations

Black-Scholes formula is originally developed for real financial assets valuation, and it rest on
below assumptions:
1) The option is European and can only be exercised at expiration
2) No dividends are paid out during the life of the option.
3) Markets are efficient (i.e., market movements cannot be predicted)
4) There are no transaction costs in buying the option.
5) The risk-free rate and volatility of the underlying are known and constant
6) The returns on the underlying assets are normally distributed.

For assumption 1, this is quite applicable for this project as Arundel will be given the option to
exercise its right to produce sequel in year 1 based on box office performance of first movie.
For assumptions 2, 3 and 4, they are not really applicable in this scenario as sequel rights can’t
be traded on an exchange, and it won’t pay out dividends.

For assumption 5, the risk-free rate and volatility are constant is unlikely to be true. As sequel
rights are extremely uncertain to value, the 99 data points based in 1989 is not really reliable, and
it is one of the shortfalls of this analysis.
For assumptions 6, the returns on the underlying assets are normally distributed, this assumption
is quite ideal. In reality, the cross-sectional distribution of returns on sequel production is not
likely to be normal distribution.

Although discussed above, Black-Scholes option pricing has certain limitations and shortfalls,
yet it still provides reasonable accuracy in terms of sequel rights valuation for Arundel.