Arundel Partners The Sequel Project Group 8 Constantino 51064265 Edward 51042814 Evelyn 97004330 Francesca 50191000 Hugo 50649257 Irin 97475858 Kenneth 51012428 Philip 51144321

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 production Production Distribution Exhibition Statistics Major studios distributed 35% of all films accounting for 93% of revenues coming from exhibitions.

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

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.

Time Scale Distribution and Exhibition Distribution and Exhibition Production Production Time (years) 1 2 3 4 5 First movie Delay Sequel 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. PV (Negative Cost) PV (Revenue)

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.

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).

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

All movies are the same (come from the same distribution of returns) 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.

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.

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.

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.