1. Arundel Partners The Sequel Project Group 8 Constantino Edward Evelyn Francesca Hugo Irin Kenneth Philip

2. 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.

3. 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

4. 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.

5. 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)

6. 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.

7. 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
= − = −2.4m
But this ignores the fact that Arundel can choose not to invest in NPV < 0 movies! (i.e. it is wrong).

8. 26 of the movies had a NPV > 0 for their sequels given information at t = 1.
For these 26 movies E[C3] = and E[C4] =
Therefore
NPV = − + =18.88
Note: this is NPV per successful movie. NPV/movie (if buy ex-ante):
NPV = (18.88)26/99 = 4.96m

9. 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.

10. 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:
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 % needed to use the Black-Scholes formula if other inputs
are in annual terms.
Could use 121% and normalize other inputs accordingly.

11. 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.

12. 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.