Arundel : Options Case Essay

1681 words - 7 pages

Arundel Partners – The Sequels Project

After evaluation of the proposed acquisition of the movie sequel rights, we recommend to offer movie studios as a per-movie price to purchase the sequel rights for their entire portfolio of movies the studios are going to produce over the next year. 

Arundel should make an offer to buy sequel rights as the average NPV (on a per film basis ) is $5.51 mn (this is the value calculated using real options method).
Hence, we should pay a price below $5.51mn. As per informal inquiries made by us, the studios would be tempted to accept the price of $2mn or more and would not even consider a price below $1mn.

We propose that we should negotiate for ...view middle of the document...

The results are as below

Studio | Average value of sequel rights per film( in $mn) |
MCA UNIVERSAL | 12.3 |
PARAMOUNT PICTURES | 5.12 |
SONY PICTURES ENTERTAINMENT | 4.89 |
TWENTIETH CENTURY FOX | 3.33 |
WARNER BROTHERS | 12.17 |
THE WALT DISNEY COMPANY | 17.68 |
All Studios | 8.61 |

Drawbacks and improvements of the DCF analysis method

DCF models underestimate the value of investments where there are embedded options to follow up with a second investment if the first one does well (follow-on option)

1. Discount rate: The analysis assumes that the discount rate is the same for the complete throughput time of the project. This can be countered by using different discount rates for different years, in case required.
2. Static model: Once the decision to go for the project has been made, possible future changes are not taken into account anymore. It does not account for future decisions (such as hold or abandon a part of the project) based on better information or change in scenario. The NPV of the project should be split in multiple projects whereby the decision is postponed until more information is known about a particular part of the project
Valuation of Sequel rights using Real Options model
Reason to use options model

The valuation of sequel rights involves contingency. This makes options model a better tool for this analysis since it is dynamic. Using the options method firstly provides us the flexibility to defer, contract, expand or abandon an investment. With an options model, Arundel Partners gets a right but not an obligation to produce the sequel. This is based on the success of the first film.

Secondly the options model helps us get a gauge of the probability of the first film (if we use the returns of first film in the option price) before taking a decision on the sequel. We are given how the sequel is expected to perform based on cash flows of previous sequels. From here we can get the expected net payoff of the sequel. However, if we used the DCF model, we would have to settle down with this net payoff as the value of the sequel. In contrast, the options model gives us the opportunity to calculate a “probability of success” of the first film, and multiply this probability with the net payoff of the sequel. Thus, options model is bound to give us a more accurate value of the sequel.

Black Scholes Model

It makes more sense for Arundel Partners to buy a European call option on the sequel than an American call option. This is because Arundel Partners can invest in a sequel only in Year 3, while the success factor of the first film will be known by the end of Year 1. Therefore, there is no advantage for exercising an option to make a sequel earlier than Year 1.
In theory, Valuation of Sequel Rights = probability that first film is a hit * net payoff of sequel
Probability that first film is a hit = European call option price
The parameters of this European call option on sequel rights...

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