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Autor: anton 29 March 2011
Words: 1865 | Pages: 8
Arundel Partners: The Sequel Project
Investment Analysis and Opportunity Review
The proposed business venture, Arundel Partners, is an investment group which would purchase the sequels rights associated with all films produced by 1 or more selected U.S. movie production studios for a specified period of time, or a specified number of films. As your investment analysts, our goal is to assess the value of the sequel rights to allow a determination of the value of the overall investment as well as a reasonable price-per-film for the sequel rights.
Arundel Partners plans to pay to obtain a guarantee to the ownership of sequel rights for a set of films prior to production. It is assumed that only a small percentage of the films produced by a studio will be sequel candidates, based on the profitability of the initial film release. It is also recognized that the profitability of a sequel is typically lower than the initial release. This estimated profit will determine the proposed contract offer by Arundel Partners to the selected studio.
Sequence of Events
**Note: The diagram in Figure 1.1 outlines the timeline as it applies to the Arundel investment described.
Prior to proposal, Arundel will need to determine which studio they feel offers the best potential success, and propose the contract prior to knowledge of films to be produced during the contract period. Arundel will then own the sequels rights as defined in the contract. History suggests that a studio would entertain an offer around $2 million per film for the rights to the sequels of each move it produces that year.
FIGURE 1: SUMMARY OF EVENTS BY YEAR
Arundelâ€™s ownership rights begin on day 1 (year 0) of the contract. The lifeline of a film, as shown in the timeline above (please see Figure 1), is: 1 year in production; release to theaters and on video over the next calendar year; and, Pay TV in year 2 and Network TV in the 3rd calendar year. A sequel is typically released to theaters 3 years after the orignal filmâ€™s initial release. Sequel rights also expire 3 years from the films initial release. Note that Arundel must declare, based on the profitability of the first release, whether or not it will produce the sequel, prior to the expiration of the rights at year 4.
Based on our valuation of the investment, as outlined below in the Analysis portion of the report, we have determined a per-movie-value of $8.9 million when considering purchasing the rights to the entire portfolio of 99 movies analyzed in the sample data. Based on production of 10 sequels, the per-movie-value of the portfolio would be $52.25 million. Our calculations based on the hypothetical portfolio is that Arundel Partners should make this investment as long as the present value of the expected cash flows from the sequel revenues exceeds the cost of production plus the cost of the investment. Depending on what value a studio will accept as payment per sequel, there appears to be significant profitability in the investment.
As with all options there is more potential profit if the value of the underlying asset is very volatile. Purchasing sequel rights prior to release of the films makes this a very volatile investment. The proponents of this venture believe that Arundel Partners can make money buying sequel rights because the investment is structured as an option. They are not required to produce every sequel, but can determine which they will choose to produce based on the success of the initial release of the film. In some sense, much like real options, this is the extension of financial option theory to options on non-financial assets.
The strategy of buying a portfolio of rights rather than negotiating film-by-film gives Arundel advantage in that a studio could not negotiate higher rates of sequel rights based on the success of an individual film. Purchasing prior to the release of the initial film (t=0) gives Arundel the possibility they will obtain the rights to the next great Terminator 2, without the initial release success increasing the risk of losing the rights to the sequel or paying increased prices based on the original studio having production interests or demanding more money for the rights.
Our initial analysis determined, based on data from past years movie releases (1989) and the hypothetical sequel profitability based on data cost data associated with sequel production, the estimated the Net Present Value (NPV) of the cash flows from the sequel movies, if produced, accounting for revenues (inflows) and negative costs (outflows). The calculation yields a negative average NPV of the portfolio at -$2.405 million. However, this data is not complete. We have to remember that the business plan does not include producing a sequel for every first film released, only those that are profitable on their initial release. In the situation where a first film was not profitable, Arundel would not incur the costs of producing a sequel limiting potential loss and therefore would also not recognize any revenues from that film. In order to account for this stipulation, we must approach this investment as a real option.
Decision Tree Models
To investigate further, we constructed a binomial decision tree to determine the per-movie-value of the entire portfolio of 99 films today. Arundelâ€™s profit comes if a filmâ€™s market value rises above the sum of the strike price and the amount paid for the sequel rights option. On a per film basis the binomial decision tree model below (please see Figure 2) based on the entire portfolio of 99 films shows a per-movie value of $8.90 million for the sequel rights to the entire portfolio of 99 movies released in 1989 by the six major studios. It is then assumed then that Arundel will only invest in production of the sequel if the first film is profitable enough to predict profitability of a sequel. (See Appendix A â€“ Binomial Decision Tree, 99 Film Portfolio.)
FIGURE 2: SAMPLE DECISION TREE â€œPROCESSâ€
Assuming that only 10 of the 99 films would be produced in any given year, we can calculate a per-movie-value for the portfolio of 99 films in the same manner. In selecting which 10 sequels would be made based on the given set of data, we considered basing our decisions on film revenues or returns (profits). In looking at each option, we discovered 7 of the 10 films were in both lists. In making a business decision, we are concerned with profitability; we therefore chose to look at returns each film provided for our selection criteria. Based on this approach our per-movie value increased significantly. Using the binomial decision tree model we now arrive at a per-movie value of 52.55 million for the 10 movie portfolio. We then took the value per movie and multiplied it by the 10 movies to get a total portfolio value of $525.5 million. Dividing that total portfolio value by the 99 movies gives a per-movie-value of $5.308 million.
The next step in our analysis was to conduct the same analysis based on a simulation using the Black-Scholes model. This allows us to test the same input values around a model that incorporates many more iterations of possibility, therefore providing a more exact value, as well as a justification for the per-movie-value determined from our decision tree model. Using the Black-Sholes approach, we calculate a per-movie value of sequel rights to the entire portfolio of 99 movies released in 1989 by the six major studios to be $8.82 million. The estimates for the inputs into the B-S formula were determined as follows:
a. Asset value â€“ the value of the underlying asset (S) is the NPV at year 0 of the net inflows produced from the portfolio of 99 films, and is determined by taking an average of the NPV at year 4 of the revenues from each film in the portfolio, and discounting it back to year 0 to determine todayâ€™s value.
b. Exercise price â€“ or strike price (K) is based on the negative costs necessary to create the product (produce the sequel), at year 3, which is when Arundel would have to make that initial investment.
c. Volatility of asset returns â€“ is the standard deviation of the expected returns from the portfolio of 99 sequels presented.
d. Time to maturity â€“ or the time to expiration of the sequel rights, as given in the case, is 3 years after release of the first films to theaters, which would be considered year 4, as shown in the timeline in Figure 1.1.
e. Risk-free rate â€“ given in the case as 6%.
To confirm our findings, we conducted a sensitivity analysis on the value of the sequel based on incremental changes in the values of the underlying asset, the exercise price, or the volatility. To isolate the sensitivity of the value of the sequel, we altered only 1 variable at any point in time. Additionally, the analysis was conducted based on the results given in the Black-Scholes model due to the increased accuracy of the results produced by a simulation over the binomial decision tree. Note, as shown below (please see Figure 3), the line illustrating the result of altering the value of the underlying asset on the option (sequel) price has a higher slope which indicates higher sensitivity.
FIGURE 3: SENSITIVITY ANALYSIS
The sensitivity analysis shows that changes in the revenue earned from the first film has a larger impact on the value of the option of the sequel than does a percentage change in the exercise price or volatility.
Our initial analysis shows the potential value of Arundel Partnerâ€™s investment. With appropriate contract negotiations, this deal could turn out to be an extremely profitable investment. In acting as a true partner and consultant we would like to outline a few recommendations for Arundel in deciding whether or not to move forward with this investment.
Initial legal control of the produced film rests with the studio, which is also the copyright holder. Specifically, copyright law vests the copyright holder with exclusive ownership of five rights: 1) reproduction of copies; 2) distribution of copies; 3) performance rights; 4) public display rights; and, 5) the right to prepare derivative works. It is important that Arundel understand how this may impact long term profitability of their investment, and any criteria required as part of the transaction should be incorporated into the proposal contract.
Major studios might place restrictions on transfer of copyright ownership on highly profitable movies. Arundel partners should insist on a contract where by purchasing the sequel rights transfers the copyright as well. Such a clause included in the contract would protect the rights of Arundel from being diminished or impaired and avoid litigation over the literary property.
By optioning to acquire the sequel rights, Arundel Partners should be free to transfer the rights to third party to make a profitable deal and such clause should be included in the contract.