Arundel Case Solutions

Question 1

Arundel Partners believes that the positive NPV arises from the real option value, which is the value of being able to decide whether or not to produce a second film based on the result of the first film. The real option value is driven by the volatile returns on the sequel investments indicated by the high standard deviation (more than 100%) in Exhibit 7.

The partners want to buy a portfolio of rights in advance rather than negotiating film-by-film to buy them because of the following reasons:

First, predicting the success of any one film was extremely difficult, if not impossible. Thus, it is not feasible for Arundel partners to invest on a firm-by-firm basis especially when the studios know much about the films than Arundel Partners.

Second, a portfolio of rights will diversify out the idiosyncratic risk associated with individual films, and thus allow Arundel’s investment thesis to exploit the volatility of returns in sequels and realise the real option value in the sequel rights.

Last, negotiating for sequel rights on a film-by-film basis may price into the transaction the probability of the sequel success, thus substantially reducing the returns to Arundel Partners. By purchase the rights of many films; Arundel Partners also has a larger bargain power since it helps the studio to reduce the borrowing with substantial payments.

In conclusion, it is better for the partners want to buy a portfolio of rights rather than negotiating film-by-film.

Question 2

The per-film sequel rights have been calculated using two methods: firstly, using a simple NPV approach; and secondly, using a real option pricing model based on Black-Scholes formula. For both methods, the input parameters have been taken from the financial projections for hypothetical sequels (Exhibit 7 from the case), which provides the present value of net cash inflows from a movie projection and the net cash outflows for the film’s ‘negative’ costs. The ‘one-year returns’ that were calculated for the hypothetical sequels, and all the first film data, have been ignored.

The first method results in a ‘per-film’ yield value of US$6.5m, and the real option method results in a value of US$6.4m.

For the first approach, a Net Present Value for today (i.e. t = 0) has been calculated for each of the 99 films in the sample data. This was calculated by summing the PV of cash inflows and PV of cash out flows to year 0, using the project discount rate of 6% (semi-annual). Then, for each film yielding a positive, expected NPV, the value was summed to give a total portfolio sequel value (see appendix). Given that Arundel will have the time and luxury to determine which sequels will be successful for not, the sequels yielding an expected negative NPV (value destructive) can be ignored as we can assume that Arundel do not invest in those projects in the future. This gives a total portfolio value of US$643m. Finally, the “per-film” value is determined by taking the total value and dividing by the total number of films in the portfolio (99 films) resulting in US$6.5m per film.