Arundel Partner - Valuation of Sequel Rights

The proponents of the business plan 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. The value of an option can be more valuable, if the value of the underlying asset is very volatile. Purchasing sequel rights prior to release of the films makes the plan a very volatile investment.

In addition, the strategy of buying a portfolio of rights rather than negotiating film-by-film gives Arundel an advantage because it disallows a studio from negotiate higher rates of sequel rights based on the success of an individual film. Since the studio has a better idea if a movie will be successful or not, it is more advantageous for Arundel to purchase the sequel rights in advance.

Based on 1989 cash flow data, we used Black-Scholes formula to estimate the per-movie value of sequel rights. Moreover, to get a more accurate per-movie value of sequel right, we calculated the value of sequel rights of each company separately. (As shown in exhibit 1) The assumptions made to run the calculation are stated below:

a. The value of the underlying asset (S) is the NPV at year 0 of the net inflows produced from the portfolio of films produced by each company, 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 today's value by using 12% risky cash flow rate.

b. The strike price (K) is based on the negative costs necessary to produce the sequel, which is the initial investment Arundel would have to make at year 3.

c. Volatility of asset returns is the standard deviation of the expected returns from the portfolio of films produced by each company.

d. Time to maturity of the sequel rights, as given in the case, is 3 years after release of the first films to theaters.

e. Risk-free rate given in the case is 6%.

After the calculation of per-film sequel value of each company, we can determine that MCA Universal, Warner Brothers and Walt Disney are the companies providing a substantially positive per film value, with value of 6.45 million, 8.36 million and 10.54 million respectively. After deducting the initial investment (2 million) in purchasing the sequel right, the per-film return of the three companies can still be positive and add value to the project. Whereas, the rest three companies- Paramount Pictures, Sony Entertainment, and Twentieth Century Fox, are not such ideal investment destinations. The per-films value only stands at 2.52 million, 2.38 million and 0.81 million respectively. We advise that Arundel group should be careful when purchasing rights from those three companies and try its