Arundel Partners: The Sequel Project
Question 1: Arundel Partners thinks they can make money by buying the rights to sequels because of the possible arbitrage opportunity between the price they would pay for an option to sequels and the sequels’ real value. Therefore, valuing the option correctly takes great importance.
The partners want to buy a portfolio of rights in advance rather than negotiating film-by-film to buy them because it is of critical importance to Arundel that a number of films and a price per film are agreed upon before either Arundel or the studio knows which films would generate the option of a sequel. If not, once production starts the studio would inevitably have more information on the likeliness that a sequel would be possible. This would put Arundel at a disadvantage, because they would then have to negotiate the price for sequel rights on each film produced while knowing much less than the production studio about the film. For example, if the studio knew that obtaining the rights for the literary work the first movie is based upon took a lot of haggling and work, and that the script has gone through fifteen revisions with six different writers, then the studio may be keen to get rid of the sequel rights. While a film’s profitability is always a gamble, there are often early signs such as these that a movie is going to be a jumbled mess that cost the studio way too much money to produce in the first place. These films tend to do poorly in the box office and not get sequels.
Without a prior agreement, the studio could thus try to sell Arundel options for the less-successful properties and keep the potentially more lucrative ones for itself. While Arundel’s financing does help the studio fund its work, if the studio knows they have a hit and the sequel will likely be very profitable, the studio would be more willing to finance the sequel itself and keep all the rights (and profits).
Question 2: In order to assess the per-movie value of a portfolio of sequel rights, and ultimately the profitability of the novel business proposition, we performed both a DCF and Black-Scholes analysis. Using a DCF analysis, we determined the average per-movie value across the entire selection of 99 films to be $4.96M (Exhibit A). Using the hypothetical sequel nominal cash flows given in Exhibit 7 discounted at the 12% cost of capital, we were able to determine which movies from each studio’s portfolio had positive NPVs. Assuming that each studio would only choose to produce sequels with positive NPVs (they would let the options on the negative NPV projects expire), we were then able to sum the value of each portfolio and divide that by the number of movies purchased to calculate the average value per movie.
After reviewing the data to assess the best investment opportunities, we recommend that Arundel Partners pursue an opportunity with MCA Universal and Disney, which would provide an average per-movie value for the two firms combined of $8.28M. These two studios have high average values per movie, low standard deviations of returns, and positive average returns: SUMMARY | | MCA | Paramount | Sony | TC Fox | Warner | Disney | Sum of Exercised Options | $93.71 | $26.84 | $98.39 | $19.56 | $139.19 | $113.18 | Average Value per Movie | $6.69 | $2.68 | $2.89 | $1.78 | $7.33 | $10.29 | Average Return | $4.58 | -$4.68 | -$7.71 | -$4.84 | -$0.48 | $6.21 | Standard Deviation of NPVs | 10.75 | 10.46 | 15.89 | 8.52 | 25.90 | 18.42 |

Purchasing these two portfolios would also be in-line with their specification range of purchasing 15 to 30 films.
Question 3: Both the DCF and Black-Scholes valuation approaches have advantages and disadvantages. The advantages of a DCF analysis include that fact that the analysis is forward-looking and dependent more on future circumstances rather than past history as well as the allowance for varying discount rates across different years of analysis. In addition, the DCF analysis allows us to use the internal projections generated by Arundel Partners to determine a value for each sequel portfolio. If Arundel Partners is confident in its assumptions, we can be confident in our per-movie sequel value.
Disadvantages of the DCF analysis include the fact that predicting cash flows accurately is extremely difficult, and our DCF does not account for potential volatility in the cash flows, which could be substantial and vary greatly by company. In addition, our DCF analysis does not include the value of the option to make follow-on investments, which could be of significant value with a successful movie.
In order to refine our DCF analysis, it would be helpful to have a sample set of projected cash flows over a several year period. This would allow us to account for trends in the industry and better understand the long-term profitability and volatility of each studio. In addition, it would be helpful to complete analysis regarding the required rate of return for the investment to verify the 12% cost of capital. Since this is a new investment idea, Arundel Partners may not have a clear idea of the risk associated with the project, and a riskier project would increase our required rate of return while decreasing the value of the investment.
Question 4: There are many possible disagreements and problems between Arundel and a major studio should they enter into a relationship involving sequel options. One important such disagreement could stem from pricing. Arundel and the studio will need to come to a price both find fair. Valuation of the project is important to ensure Arundel sets the price low enough to increase the likelihood of a profit, and but also high enough to give the studios a realistic bid. If Arundel can come to the table offering $2M per film, especially at Disney or MGM where the predicted per-movie profitability is higher than other studios, then the studio will hopefully be more open to negotiation. Coming in with a lower bid could offend the studio and get the pricing debate off to a bad start.
Another issue Arundel and the studio may face is how to address third or fourth films in a series. As these films tend to have decreasing returns compared to the first one and its sequel, we would recommend that Arundel let the rights return to the studio for the third and fourth films. Perhaps Arundel could use this gesture of goodwill to bargain for a lower price per film for the sequel package.
A third problem they may encounter would be choosing films. If Arundel is purchasing a set number of films and the studio produces more than that number, there will need to be a stipulation in the contract that explains how the contract’s films will be chosen. The studio will likely want to decide but that would not be beneficial for Arundel. Even an arbitrary measure such as month of release could have negative consequences if the studio withholds a film or releases it early in order to keep the sequel rights. We recommend that Arundel buy all the films a studio produces, and includes a stipulation in the contract with a price per film for any films over that number.
Arundel should insist that any contract with a studio includes a number of films and a price per film that is set before either party knows which films will be produced. An expiration date for the sequel rights would also help Arundel from a tax perspective. They should set it at somewhere between three and five years. Three years should suffice to know whether or not a sequel should be made, but five would give Arundel more time and also allow for the possibility of a cult hit on video (the timeline for this is slower than for a normal hit but a sequel could be profitable if the fan base is big enough).
Arundel should also insist on the contract explicitly outlining Arundel’s financial obligations to the production of the sequel. If they want their financial contribution to end at the price paid per film in the contract, then they need to ensure they won’t be on the hook for more of the production costs later should the sequel go into production. Also, the percentage of the profits from the sequel that Arundel is entitled to should be clearly spelled out – in our calculations we assumed 100% but actors or crew involved in profit-sharing for the film would eat into that return. The contract should stipulate how that type of situation would be handled. If Arundel takes these factors into account and does its best to mitigate potential conflicts with the studio, this could be a profitable venture for them.