Arundel Case Study

BACKGROUND & PROPOSAL

In April of 1992, a movie industry analyst name Mr. David Davis of Paul Kegan Associates, Inc. was approached with an interesting and fresh business idea. The proposal was to create a new investment group, Arundel Partners, that would exist solely for the purpose of purchasing sequel rights to motion pictures produced by major U.S. movie studios. The proposal was unusual in that studios rarely sold rights to sequels prior to 1992, and interesting in the sense that it did not target specific movies or negotiate prices based on performance of the first movie. Instead, Arundel wanted to create a portfolio of options to produce all sequels at a studio for a given time period. The incentive to the studios is that Arundel would give them cash during production or up front, which would help finance the original movies.

Increasing quantities of sequels were being created in recent years as the industry realized that they are lower risk investments as opposed to new, unproven motion pictures with no sure signal of how it will do at the box office. The risk in buying rights to sequels appears in the form of guessing which originals will be successful, and Arundel hopes to mitigate this by creating a portfolio of all possible sequels and pricing it accordingly as a whole. Therefore, they will not have to deal with analysis of individual movie proposals or interfere artistically with the production of pictures in an attempt to boost perceived expected box office sales. They want to minimize their risk and direct involvement in matters they would have difficulty fully immersing themselves in and comprehending.

The specifics of the proposal were as follows: Arundel would agree with one or more studios separately on a period of time over which it had rights to all potential sequels (more than a year). If a certain movie was deemed eligible (likely profitable) for sequel production, Arundel could produce it, or possibly hire professionals to do so. It could alternatively sell the rights to production off to the highest bidder. There would also need to be an expiration date, let’s say 3 years from the release date of the original movie, by when Arundel must declare their intention to produce a sequel, lest they forfeit their rights.

Statistically speaking, sequels to hit movies are usually hits themselves, and end up profitable the vast majority of the time. Their production cost (negative cost) is higher by about 20% on average, and the revenues lower by about 30%, but a lot of uncertainty about the predicted cash flows is eliminated by using the first movie as a predictor. Although this means that it is unclear whether a sequel will be profitable until the original is produced, the studio itself would have the most information regarding this, and would be best able then to gauge the profitability of a sequel early on, even perhaps during early production of the first movie. This is unfavorable for Arundel, as they would be in a worse position to bargain prices as the less informed party. Their best bet is then to make the purchase at t=0, before production begins and more information regarding probable success becomes apparent to the studios. It effectively levels the playing field as far as equal information regarding the investment is concerned. For this same reason, Arundel would like to buy a portfolio of rights rather than individual rights, as they would put themselves at a disadvantage by having to analyze individual movies’ prospects, something that studios are constantly doing directly and indirectly during production. Through a portfolio of sequel rights, they diversify some risk and take all the guesswork and additional analysis out of the picture.

PRICING THE DEAL

We next needed to answer the question of how much Arundel should be willing to pay for these sequel production rights. If they are interested in creating a broad portfolio encompassing all six major studios, we can use several different approaches: We could calculate an NPV of the proposed portfolio, we could use decision trees to calculate an NPV, or we could use an option pricing formula and apply it to our situation.

To calculate the Net Present Value for all sequels, we needed to calculate the individual NPV of each hypothetical sequel first. We found these values by taking the Present Value of the negative cost incurred and then adding the PV of the inflows the next year divided by the discount rate, which was given to us as 12%. Once NPVs were found for each individual sequel, we took the sum and divided it by the number of sequels, which is 99. This calculation led us to an NPV of -$3.38. Then we had to discount these values back 2 years to get an average NPV per sequel of -$2.69. We need to discount back 2 years because the NPV for our years 3 and 4 (for the film sequel) give us years 2 and 3, but we want years 0 and 1, so we need to discount again. This is also the year when Arundel would make the purchase. With a negative NPV, it would not make sense for Arundel to purchase sequel rights. Of course this calculation method doesn’t account for the fact that Arundel would in reality only take on sequel production in cases where the original was successful enough to warrant it; it simply assumes that we would take on all projects, when we already know that statistically speaking, the majority of movies are not popular enough to create a successful sequel from. We need a way to model this, and eliminate superfluous negative cash flows from our evaluation. This is where a decision tree method is helpful.

Using this approach, we created an inequality, stating if the NPV of a sequel is greater than 0, then take it, but it the NPV of a sequel is not greater than 0, then don’t take it. If the NPV was greater than 0, we had the inequality output the NPV value; if the NPV was not greater than 0, we had it output 0 (no gains or losses from forgoing the purchase of sequel rights). We then summed up all the values and divided them by 99 to get an average NPV of a sequel if the project was taken or not. Our newly calculated NPV is for all the sequels is 6.965981241, but when discounted back 2 years becomes 5.553237596. This value reflects a situation where Arundel would purchase sequel rights for a positive NPV project, but not for a negative NPV project.

To model a likely state in which we (and studios) are working with a limited budget, we have also made an estimation of a proposed portfolio NPV using the decision tree approach and a constraint limiting us to only ten sequels that can be produced. We took the top ten sequels because if we could only choose ten, these are clearly the ones we would wish to produce. The top ten net present value films in descending order are: