Arundel Partners Is Taking Under

¶ … Arundel Partners is taking under consideration the option of buying the movie sequel rights of one or two large studios. However, they want to acquire these rights under given circumstance: before the movies are actually produced. The alternative to buying an entire portfolio of rights would be to negotiate film-by-film and chose to acquire only some films.

The fact is that is very difficult, if not impossible to determine the success of one movie. Studios or consulting firms can only forecast a potential success rate, but there is no guarantee that the forecast will turn into reality. Arundel Partners is trying to take advantage of the uncertainty surrounding movie success and indirectly movie sequel success and negotiate lower acquiring prices.

On one hand, movie studios cannot claim that a certain movie is going to generate so much higher revenues that the industry average and the sequel rights for that movie are worth more than the average price offered for any other movie's sequel rights. In fact, if the movie turns into a blockbuster disaster, a sequel will never be made, but the studio cashes in a fixed value that is paid for its sequel rights and this value can be used in the production of the initial movie.

On the other hand, Arundel Partner is assuming a high risk by acquiring "blindly" all movies produced by one or two given studios, because according to the industry statistics, not all movies produced by a large studio have sequels. In fact sequels are made only after blockbuster successes. Moreover, even if a movie has success and the sequel is made, there is no guarantee that this latter one will be successful. The industry statistics show that a sequel costs in average 20% more than the initial movie and the rental revenues are only 70% of this one. So the sequel costs more and gains less.

Additionally, from the financial point-of-view we can assume the following:

26 out of 99 movies have a sequel with a positive net present value (NPV) average cash inflow avg CI (4) in the 4th year (U.S. rentals/no U.S. distribution costs) = $57.2 million average cash outflow avg CO (3) in the 3rd year = $24.5 million discount rate 12% (d)

Sequel's value at time 0 is:

avg CI (4) - avg CO (3) 57.2-24.5 NPV0= (1+d) = (1+0.12) = $18.91 million

1+d) 3

By discounting the sequel's NPV at a 12% rate, the company would still gain $18.91 million, from which it will have to deduct the distribution costs that are calculated as percentage of the value thus obtained (e.g. 30% of $18.91 million=$5.67 million). With a 30% distribution cost, the final value of a sequel would be $13.24 million. The one year return is 1.33>1, meaning that this option is "in the money."

Additionally, we can assume:

average negative cost in the 3rd year of 99 potential sequels is $22.6 million.

A average cash inflow in the 4th year of 99 potential sequels is $21.6 million discount rate 12% (d) avg CI (4) - avg CO (3) 21.6-22.6 NPV0= (1+d) = (1+0.12) = $-2.36 million (1+d) 3

The one year return for this option is 0.72

Despite being one of the most common option valuations, DCF is not perfect. It has been several years since experts have observed a gap between DCF valuation and market prices and alternatives to this method have been developed. One of these alternatives called ROA (the real options approach), whose popularity has increased due to the fact that NPV is properly estimated (Ochoa, 2007). DCF is trying to estimate the asset's intrinsic value, which requires a large amount of information for the valuation to be accurate. Moreover, the information can be manipulated by the valuator and the outcome of the valuation can vary a lot.

DCF has some advantages as well. DCF is less exposed to market changes than other methods because the valuation is based on the asset's fundamentals. Also, as Warren Buffet once said, DCF is the "right way to think" when buying an asset, rather than acquiring stock.

Arundel's business evaluation is based on assumptions made from market averages. Thus, the company is assuming that a given number of sequels will be made (26 in the example before). A better valuation needs more information, namely more recent data and forecast market trends for the next 5 years.

Also, the company has to detail its contractual requirements to avoid future issues that may come up. Thus, if in the future, Arundel wishes to use its right to produce a sequel, but the movie studio refuses from various reasons (e.g. no artistic justification), Arundel should have its sequel made. The making of a sequel becomes a 100% business decision and the decision belongs to the entity that owns the sequel's rights. Conversely, if the making of a sequel doesn't make business sense, Arundel reserves the right to refuse the making of this one or sell back to the studio the right to make it.

The formulation of a long-term investment strategy can be very challenging because the decision maker is faced with a wide range of choices and evaluating all options is a heavy, time-consuming process.

For instance, the decision maker has to choose whether to add a 240 basis points to a ten-year Treasury Bond or to a ten-year Treasury Inflation Protected Security (TIPS). Additionally, the decision maker knows that the 240 basis points have to be added above the ten-year government bond rate.

In a non-inflationary world, funds are loaned at a rate equal to the nominal rate of interest. When inflation is taken under consideration, the return calculated based on a nominal rate is different than the real one because the purchasing power of future cash flows is lower. It is questionable whether the interest rate increases exactly with the inflation rate, when the latter is introduced. However, inflation rate definitely exerts upward pressure on real interest rates. Some specialists have called the difference between the real and nominal interest rates "the inflation premium," although other specialists do not agree that the relationship between the real interest rate and the inflation rate is additive, but multiplicative.

In the example above, the way to "capture" the inflation effect would be to add the 240 basis points to the ten-year Treasury Inflation Protected Security that yielded $4.14%, instead of adding it to the ten-year Treasury Bond that yielded $6%. TIPS are also known as Treasury Inflation-Indexed Securities because the principal is always indexed with the inflation as measured by the Consumer Price Index (CPI).

Let us assume that we have to evaluate when the best moment to cut a 50-year-old tree is. The options are: the tree is growing at the rate of 1 inch every 5 years and 1 grade for every 2 inches or the tree is growing at the rate of 1 inch every 10 years. Initial DBH is 10 inches.

Option 1

PV5=

C0+

C0*(1+p) t*(1+k) t

10*(1+0.02)5*(1+0.01)5

PV10=

C0+

C0*(1+p) t*(1+k) t

10*(1+0.02)5*(1+0.01)5

The tree is growing 1 inch every 5 years, that means that is growing 0.2 inches/year and one grade every 2 inches, meaning that is growing 0.1 grades/year. For simplification, we assumed that 1 grade=1inch.

Option 2

PV10=

C0+

C0*(1+p) t*(1+k) t

10*(1+0.01)10*(1+0.005)10

PV5=

C0+

C0*(1+p) t*(1+k) t

10*(1+0.01)10*(1+0.005)10

The tree is growing 1 inch every 10 years, which means that is growing 0.1 inches/year and one grade every 2 inches, meaning that is growing 0.05 grades/year.

Assuming that all trees have to be cut in the same year and some grow according to the 1st option and others according to the 2nd, the year that gives the optimal value will be chosen by comparing the 2 options assuming that the number of option 1-trees is equal to option 2-trees. if, hypothetically speaking this number is 100 trees for each option, the cumulated value of both options is:

PV5 option 1 + PV5 option 2) * 100 = (21.6 + 20.78) * 100 = 4,237.9

PV10 option 1 + PV10 option 2) * 100 = (23.47 + 21.62) * 100 = 4,507.6

The comparison's results suggest that cutting the trees after 10 years maximizes the Mr. Smith's tree value. It also seems that the tree value is increasing in time and the growth rate is increasing in time, which implies that the more Mr. Smith can wait before cutting the trees the higher their value will be at the cutting moment.