Fundamental Analysis

Fundamental Analysis

Arundel Partners is an investment group, set up to purchase sequel rights associated with films produced by one or more major U.S. major studios. By owning such rights, Arundel will be able to wait and see if the movie was successful, before deciding whether to exercise its right and produce a second film based on the story or character of the first.

However, Arundel's profit margin would depend on how much it has to pay to purchase such a portfolio of sequel rights, and this problem would be analyzed in our report.

1. Why do the principals of Arundel Partners think they can make money buying movie sequel rights? Why do the partners want to buy a portfolio of rights in advance rather than negotiating film-by-film to buy them?

The principals of Arundel believe that they can make money with the purchase of the movie sequel rights due to the volatility associated with a movie's success. Such volatility is precious in an option and therefore, the principals think that they can make use of such unpredictability in the movie industry to their advantage. Furthermore, the principals have the right not to exercise the option if the movie was not successful, and therefore not produce any sequel. Therefore, the loss associated with such a movie with bad response from the public would be limited to the premiums paid by Arundel for the option. However, the gain on the upside can be unbounded and this provides Arundel with the opportunity to make money. Furthermore, Arundel can also sell the rights to the highest bidder if it does not want to produce the sequel itself. This is also another method where Arundel can make money with the purchase of the rights.

It is of critical importance that Arundel buy the portfolio of rights in advance rather than negotiating film-by-film as once production starts, the studio would gradually form an opinion about the movie, and Arundel would be placed at a disadvantaged position by having to bargain over individual projects. Furthermore, there is also the

presence of informational asymmetry, where the studio holds more information about each individual film than Arundel. Such negotiation held for film-by-film also takes up more time and efforts, and may not even be successful in the end. Therefore, it is in Arundel's best interest that they buy the portfolio of rights before production starts.

2. Estimate the per-film value of a portfolio of sequel rights such as Arundel proposes to buy. [There are several ways to approach this problem, all of which require some part of the dataset in Exhibits 6-9. You may find it helpful to consult the Appendix, which explains how these figures were prepared.] Using the Discounted Cash Flow method:

Discount rate = 12%

PV of Net inflows were discounted back 4 years.

PV of Negative costs were discounted back 3 years.

Movie value of the positive NPV sequels = $490.87 million for 26 movies Per-film value = $490.87m / 99 = $4.96 million

Using the Black-Scholes option-pricing model with figures taken from Table B of Exhibit 9

Length of time in which cash outflow for hypothetical sequel may be deferred (t)

= 3 years

Discount rate (tf,)

= (1.06^2) - 1

= 0.1236

Present value of cash inflows from hypothetical sequel (S) = (28.2 / (1.1236^4) )

= $17.693 miillion

Present value of cost to produce hypothetical sequel (X)



= (31.3 / (1.1236^3) ) = $22.065 million

Standard deviation per year on present value of cash inflows

= $29.3 million

= (29.3 / 28.2) * 100% = 103.901%

NPV

= 17.693 / 22.065

= 0.802

σ√t

= 1.03901 X √3

= 1.80

3. What are the primary advantages and disadvantages of the approach you took to valuing the rights? What further assistance or data would you require to refine your estimate of the rights' value?

DCF Model

Advantages:

The DCF model is easy to understand as it just requires two variables (cash inflows and discount