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Arundel Partners The Sequel Project

Group 8

Constantino 51064265Edward 51042814Evelyn 97004330Francesca 50191000Hugo 50649257Irin 97475858Kenneth 51012428Philip 51144321

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• April 1992: David Davis take a look at a unusual business idea– Arundel Partners would purchase sequel rights from major studios

• Before the first film was made• Purchase all sequel rights and not choose based on own judgment, or at least

a random selection of them• Pay upfront in cash on a “fixed price per-movie” basis, for the whole lot.

– Interesting to studios because• Provides cash when it is most needed, i.e. at the production stage• Help in reducing studio’s borrowing • A price of $2 M or more per movie would be tempting

• Steps in movie production1. Production2. Distribution3. Exhibition

» Statistics– Major studios distributed 35% of all films accounting for 93% of revenues coming

from exhibitions.

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• Cost structure– The total production cost is called “the negative cost”, including

• Pre-production costs: story acquisition, script development, set design, casting, film crew creation, costume design, location scouting, budget planning.

• Principal photography: fixed salaries of actors, directors, writers and other personnel; rent, wages for soundstages, set construction, lighting, transportation, costume making, special effects, etc…

• Post-production costs: editing, laying down sound and music, titles and credits.– Distribution costs: deducted from revenues collected by the distributor

from theaters and ancillary markets• Distribution expenses: advertising, etc…• Distribution fees: % charged by distributors on revenues perceived

– Exhibition costs:• On average 50% was remitted by the theaters to the distributors

• Net Profits= all revenues (proceeds remitted to distributors + …)

– negative cost – distribution costs – exhibition costs

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• Release for a sequel On average 3 years after the first film’s release, and most were

released with 1 to 5 years.• Profit structure

– Costs: 120% of original movie– Revenues: 70% of original movie

• Arundel Partners Sequel Project– Critical to agree on the number of movies and the price per movie

before which films would be produced.– A satisfactory method of payment should be agreed.– For tax purposes, desirable to fix an expiration date for the rights.– Arundel could grant the studios a right of first refusal on any

rights it planned to sell.– Arundel could use the original studio for distribution.

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Time Scale

Time (years)

0 1 2 3 4 5

Production

Distribution and Exhibition Production

Distribution and Exhibition

First movie

SequelDelay

PV (Revenue)

PV (Negative Cost) Production timeline: t=0: Film goes into production. t=1: First film released in US theaters. t=3: Production of sequel. t=4: Release of sequel.

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– This could be delete if don’t want– Why do the principal’s of Arundel think they can make

money buying movie sequel rights? • Not from production synergies or comparative advantage

in the movie business. • See if these rights are undervalued (or aleviate financing

constraints), i.e. the case is about Wall Street types trying to take advantage of poor Hollywood producers.

• Alleviate credit constraints. – Why do the partners want to buy a portfolio of rights

instead of negotiating film-by-film to buy them? • After t=0 the studios are in a much stronger bargaining

situation. • May try to withhold hits from Arundel.

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• From exhibit 7 estimate the per-film value of a portfolio of sequel rights such as Arundel proposes to buy, using the NPV method.

• Table 7, estimates of hypothetical sequences. • Naive NPV rule, expected cash inflows minus expected

cash outflows,• E[C3] E[C4]• NPV= +• −(1 + r)3 (1 + r)4 • 22.6 21.6 • = −1.123 +1.124 = −2.4m • But this ignores the fact that Arundel can choose not to

invest in NPV < 0 movies! (i.e. it is wrong).

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• 26 of the movies had a NPV > 0 for their sequels given information at t = 1.

• For these 26 movies E[C3] = 24.52 and E[C4] = 57.17. • Therefore • 24.52 57.17 • NPV = − + =18.88 • 1.123 1.124 • Note: this is NPV per successful movie.

NPV/movie (if buy ex-ante):

• NPV = (18.88)26/99 = 4.96m

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• All movies are the same (come from the same distribution of returns). Use “average movie” (from our sample) to compute ex-ante value of sequel rights option.

• Decide at t = 3 whether to produce sequel or not, based on performance of the original movie.

• Option inputs: • Strike: $22.6m. • Value of underlying asset today: 21.6/1.124 =

13.7.

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• Volatility: from exhibit 7 (volatility of returns for hypothetical sequence) 1.21 (121%).

• But most uncertainty disappears after t > 1 (once you know whether first movie was a hit).

• BS takes cumulative variance: • 12 1.212 • σ2 = σ2 σ2 = +0=0.488• Year1 + Year2and3 • 33 3 • In annual terms volatility is σ ≈ 70% (assuming no-risk after t =

1). For 3-years the cumulative variance is 1.212 . 70% needed to use the Black-Scholes formula if other inputs

•

• are in annual terms. • Could use 121% and normalize other inputs accordingly.

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• Using Black-Scholes: • Plug-in previous values into formula (K = 22.6,

S = 13.7, σ =0.7, t = 3, rf =0.07). • BS value: $5.14 (per movie). • Remarks: • By chance we get almost the same number as

with NPV. • With volatility as low as 0.4 value is still above

$2m.

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NPV analysis: • Assumption of 26 successful sequels out of 99 films seems

excessive • Lower success rate would lower NPV • No distinction is made between different types of sequels. • Main character dies • Differentiate between studios • Using incorrect discount rate Black-Scholes analysis: • Unlikely that returns are log-normal. • Underlying asset not traded.

– Questions underlying assumptions in BS, but there may be highly correlated assets.

• BS assumes a fixed exercise price -not the case here. – Could be accommodated.

• BS easy to use and ready to do sensitivity analysis. • Discount rate for NPV analysis not easy to adjust. • A clear example of a real option.