FBE 432 / Korteweg

Corporate Financial Strategy

Session 18

Arundel
Real options
Today: Arundel Partners
 Real Options:
 How do you account for flexibility in decision making?
 Option to expand, shut down, wait, switch, etc.
 Recognizing the value of flexibility raises the NPV of
projects.

 Arundel: Option to produce a movie sequel

 Option to defer (wait):
 No need to produce the sequel immediately.
 Wait to see if first film is successful.

 New information can be learned and acted upon!

Key Economic Questions
 How much should Arundel pay for the movie
sequel rights?

 What is the best time to purchase the rights?

 Why would movie studios be willing to sell the

rights?

 What incentive problems should both sides be

worried about?
Arundel: Deal Structure
 Purchase sequel rights before the first films are
made.

 Contract to purchase all the sequel rights.

 Purchase entire portfolio of movies before either

party knows which specific sequels will be
produced.

 Expiration date for the sequel rights.

3 years?

 Rights to subsequent sequels?

 Timing
0 1 2 3 4

Buy sequel Movie released Sequel released

rights elsewhere  inflows generated
Start 1st film
production

US theatrical release Sequel production starts

Resolution of  costs incurred
uncertainty
What is the NPV without options?
Valuation: Standard NPV (No options)
 PV (Costs) at t = 3 for an average sequel: $22.6m
(Exh. 7)
 PV (Inflows) at t = 4: $21.6m
 Note that distribution fees and expenses are subtracted
from inflows in Exh. 7
0 1 2 3 4

0 0 0 -22.6 +21.6

Discount rate = 12.36% (appendix).

NPV = -22.6 / (1.12363) + 21.6 / (1.12364) = -2.4
Valuation: Standard NPV (No options)
 Negative NPV, no matter what
discount rate you use!

 Based on NPV analysis, reject

the purchase of sequel rights.

 BUT: Standard NPV approach ignores option:

 Resolution of uncertainty at t = 1.
 Ability to delay a decision until after t = 1.
Valuation: the Option
t=1
Produce
First Film NPV > 0
Sequel
Successful
 Projected
t=0 sequel pos. NPV
No Sequel NPV = 0

PV = ??
Produce
NPV < 0
First Film Sequel
Flops
 Projected
sequel neg. NPV No Sequel NPV = 0
NPV of Successful Sequel
 Use Exhibit 7.
 99 hypothetical sequels for 1989.
 26 were projected to be NPV>0 at t=1:
 PV (Inflows) at t = 4: $57.2m.
 PV (Costs) at t = 3: $24.5m.
 Discount rate = 12.36%.
0 1 2 3 4

0 0 0 -24.5 +57.2

NPV (at t = 1) = -24.5 / (1.12362) + 57.2 / (1.12363) = $20.9

Valuation: the Option
t=1
Produce
First Film NPV =
Sequel $20.9
Successful
 Projected
t=0 sequel pos. NPV
No Sequel NPV = 0

PV = ??
Produce
NPV < 0
First Film Sequel
Flops
 Projected
sequel neg. NPV No Sequel NPV = 0
Valuation: the Option
t=1

First Film Successful &

p=26/99
Produce Sequel:
t=0 NPV = $20.9 (at t = 1)
PV = 4.88

1-p
First Film Flops &
No Sequel:
NPV = 0

PV = 26/99 * $20.9 / 1.1236 + (1 - 26/99) * $0 / 1.1236 = $4.88

Valuation: The Option
 So for each individual movie, the right to
produce a sequel is worth $4.88m.

 For the portfolio of rights, pay up to:

99 * $4.88m = $483.2m
Black-Scholes Valuation
 Arundel is buying a portfolio of out-of-money call
options
 Can value a sequel right as a call option.
 Underlying asset is the PV of inflows from a sequel.

T This is when the uncertainty is resolved 1yr

r Risk-free rate 6%
σ Standard deviation of 1-year return on sequel 121%
X PV (Costs) at t = 1: 22.6 / 1.12362 $17.90m
S PV (Inflows) at t = 0: 21.6 / 1.12364 $13.55m

 Black-Scholes value is $5.35m (per movie).

What Volatility to Use?
Studio Volatility
MCA Universal 126%
Paramount 133%
Sony 233%
Twentieth Century Fox 94%
Warner Bros 265%
Disney 181%

 Hard to tell, but very large!

 Volatility ranges from 94% to 265%.
 “Normal” stock portfolio volatility: 15% - 30%.
How Much does Volatility Matter?
 A lot! Call value increases with the
underlying asset’s volatility

 For high enough volatility levels, the value

flattens out.

 But for our volatility range, the curve is

steeply increasing.
Implicit Data Assumptions
 The probability distribution of films is the same
as it was in 1989 (Exh. 8)
 Arethe probability of successful sequel and NPV of
sequels really constant?

 No systematic differences across studios.

 Only uncertainty is about success of first movie’s

US release.

 We make sequels to all movies.

 Some movies may be inherently non-sequelizable.
Implicit Data Assumptions (Cont.)
 We make sequels to all movies.
 Some movies may be inherently non-sequelizable.
 26 sequels for 99 movies: Seems like a lot.
 Should drop non-sequelizable movies: Can identify them at t = 0.
 If only top 10 movies sequelizable → Value per right is
10/99 * $40.8/1.1236 = $3.66m

 This year may not be representative:

 There used to be fewer sequels in the past. Might need a more
representative time period: 1980-1991? 1987-1988?
 Over 1970-91:
 Average of 147 major releases per year: 2,940 movies in total
 About 60 sequels: Only 2%.
 Then value per right is 60/2940 * $20.9 / 1.1236 = $0.38m.
Timing Issues
 Sequel right is bought at t = 0.

 Would it make sense to buy rights between t = 0

and t = 1?
 No: Lemons problem!
 After production starts, studio knows more.
 Formally this is called an adverse selection problem.

 Would it make sense to buy rights after t = 1?

 No: Arundel is useless at that point.
 At t = 1, if the movie is successful, financing will be
available.
Why does Arundel think it can make money?
 Cannot make better or cheaper sequels than studios.
 No synergies with existing businesses.
 Tax benefits? Don’t know how the options will be taxed.
 Perhaps there is a wealth transfer from studios to
Arundel:
 Do studios undervalue sequel rights (mispricing)?
 Studios seemed not to account for sequels in their decisions.

 But we should not expect mispricing to last for long.

 The deal may increase the size of the “pie”
 Arundel has comparative advantage at raising funds?
 Arundel can help relax the studios’ financial constraints, lowering
their cost of capital.
Is this a Good Way of Financing Movies?
 Risk-sharing:
 Studio bears the risk of the first movie.
 Arundel that of the sequel (and can diversify across studios).
 This might be a good idea:
 If parties have different ability in bearing / assessing risks.
 If it provides the right incentives.
 However, the arrangement might affect the studios
decisions:
 Lowers incentives for the studios to preserve the value of
sequels.
 Too few sequelizable / Too many non-sequelizable movies.
 This is a moral hazard problem: when one party takes more
risks because someone else bears the burden of those risks.
 After the contract is signed, Arundel cannot control the studios’ actions.
 Also need to worry about studios getting into financial distress.
What happened?
 The deal did not go through because of
contracting problems.
 The investors saw too many ways for a studio to
misbehave after signing a deal like this.
 Moral Hazard!
 The deal did stimulate other creative ideas for
monetizing downstream film cash flows.
 Hedge funds and private equity funds got into
creative film financing deals, such as slate
financing, beginning in the mid-90s.
 Most notably, Legendary Pictures.
Takeaways
 Real options are everywhere.
 Flexibility in decision-making is valuable.
 The NPV including real options may differ a lot from standard NPV.
 Real option value is higher when
 Uncertainty is higher.
 New information can be learned…
 … and acted upon.
 Economic value created by:
 Risk-sharing (a form of insurance).
 Resolving frictions (economic, financial, regulatory).
 Contracting is extremely important!!
 Contracts affect incentives of all parties.
 Try to preserve (or even create) real options.
 Proper contracting can increase the size of the pie that is shared
between parties.
Roadmap
 Next class:
 StartModule 2: Financing New Ventures
 Venture Capital
 Read HBS note on “Risk and Reward in Venture Capital”

 Work on Group Project Proposals (due next

Monday!)
 Name of company
 Pain point to be addressed
 What business model(s) you will explore
 Brief description of next steps, research/data requirements
 Don’t forget to include names of group members
 Turn in through Blackboard (Turn-it-in assignments)