Arundel Case

Case 3: Arundel Partners

1. Arundel has an interesting idea to buy rights to movie sequels. Their theory is that they can make a profit by securing sequel rights and providing seed capital to films even before production starts, thus avoiding the asymmetric information problem that would arise as the film progresses and the studio gains more and more inside information about the film's prospects. Buying rights in advance allows Arundel to buy rights to the sequels of eventually successful movies much more cheaply than after their success is proved, and also eliminates any potential bidding wars that may arise for sequel rights to successful films. Furthermore, securing a (relatively) inexpensive option to potentially tremendously lucrative films has great upside. Films that prove successful can easily lead to sequels that see profits in the hundreds of per cent, or perhaps even over 1,000%. These outsized returns would outweigh the cost of the options not exercised for sequels to films that flop.

The attractiveness of buying an entire portfolio of films is diversification. Arundel will retain the rights to the winners and not have to pursue sequels for unsuccessful films. This strategy greatly lowers the potential risk of just committing to individual films that may not turn out to be profitable. Also, providing seed capital to a wide-array of films will be more attractive to the studios; and since the money is spent before there is any idea of whether a film will be successful or not, the price will be much lower than if Arundel tried to purchase sequels of individual films after they were made. Providing capital at this preliminary stage also gives Arundel the negotiating power when determining an agreed upon price for the option.

2. There are two approaches to coming up with a per-film value for Arundel's investment: a traditional discounted cash flow model and an option pricing model.

In using a DCF approach, we discounted future film projects at 12% using a time span of four years - one year for the production of the first movie and three years more for the estimated date of the sequel. The DCF yields an average NPV of -$2.41 million (please see Exhibit 1). Clearly this approach points to an unfavorable outcome for Arundel's investment. However, this approach assumes static information and the absence of an option to choose only good projects.

The options