Second Weekend

Day 1: Options review; valuing growth opportunities as options

Arundel Partners

Assignment: Review your notes on options from your earlier finance classes. Also read

the HBR article The Options Approach to Capital Investment. Finally, read the case

and focus on understanding the optionality in the project.

Day 2: Putting it together: DCF + Real Options

MW Petroleum (A)

Assignment: This is a tough case. But its very real. Well spend the whole day working

it through. At first well focus on the strategic issues. Then well take a first cut at the

valuation problem. Next well elaborate the valuation to take account of differences

between probable and possible reserves, for example and work out ways to identify

option pricing parameters from the data we are given. Finally, well put it all together:

the value of the assets in place, plus the value of the growth options provided by the

reserves.


Arundel Partners:

Why do the principals of Arundel Partners think they can make money buying movie sequel
rights?
What value can they add to earn the money?

Why do the partners want to buy a portfolio of rights in advance rather than negotiating film-
by-film to buy them?

Consider the following facts about the 26 filme (out of 99) whose hypothetical sequels have a
positive NPV:
Average cash inflow (US theater rentals net of US distribution costs) at time 4 = $57.2
million
Average cash outflow at time 3 (negative cost) = $24.5 million
Discount rate for investments of comparable risk = 12%
Based on this information, what is the value per sequel right at time 0?

Consider the following facts about the 99 hypothetical sequels
The average negative cost ("exercise proce") at time 3 of the 99 hypothetical sequels is $22.6
million
The average cash inflow of the 99 films ("the asset") at time 4 = 21..6 million.
The current value of the aset is 22.6 million discounted at the risk adjusted free rate of
12&
The standard deviation of the asset price is 1.21 over the one year until the first film is
released.
So NPVq = (21.6*/(1.12^4))/(22.6/(1.06^3)) = 0.72 < 1 so the option is "out of the money"
Cumilative standard deviation only cumulates for one year since that's when the uncertainty
that gets resolver at all gers resolved, so cumulative standard deviation = 1.21.
Black scholes table gives a factor that is closer to 35.5% than it is to 39.3%
A bigger table gives a value of 36.3%
Based on this information, what is the value per sequel right at time 0?

Since you'd actually be buying rights for some later year than the one the data are for, you'd
want to do sensitivity analysis for changes in the distribution of costs and revenues.
Which method would best support this?

What are some other pros and cons of the two methods?

What problems and disagreements would you expect Arundel and a mojor studio to
encounter is the course of a relationship like that described in the case?\
What contractual terms and provisions should Arundel insist on>



Arundel : Options Case
Arundel Partners The Sequels Project
After evaluation of the proposed acquisition of the movie sequel rights, we recommend to
offer movie studios as a per-movie price to purchase the sequel rights for their entire portfolio
of movies the studios are going to produce over the next year.
Arundel should make an offer to buy sequel rights as the average NPV (on a per film basis )
is $5.51 mn (this is the value calculated using real options method).
Hence, we should pay a price below $5.51mn. As per informal inquiries made by us, the
studios would be tempted to accept the price of $2mn or more and would not even consider a
price below $1mn.
We propose that we should negotiate for the price of $2mn. This would give us a profit of
$3.51 mn per film.
The movie studio might (or might not) be willing to sell these rights at this price because it
helps the studios mitigate the risk associated with producing the sequel. Also, the fact that
there is no liquid market for rights to produce sequels will also drive the price lower on
account of lack of demand.
Average value of Sequel rights per film using DCF Analysis
Average value of sequel rights per film across all studios
1. There are 99 films in the portfolio. Arundel Partners will only produce films for which
hypothetical NPV is greater than zero. Hence, we calculate NPV of each film at Year 0. Since
the exhibits state that the values are already preset values, we have not rediscounted them.
NPV (At year 0) = (PV of Net Inflows at Year 4a) (PV of Negative Cost at Year 3)
2. 28 films have NPV > 0 at t=0. The total NPV of these films at t=0 is 852.3. The average
NPV for a film is 852.3/99= $8.61mn.
Note: Since the exhibits state that the values are already preset values, we have not
rediscounted them for all the calculations
Average value of sequel rights per film per studio
By following an approach similar to the analysis above for average value of sequel rights per
film across all studios, we calculate the average value of sequel rights per film per studio.
The results are as below
Studio | Average value of sequel rights per film( in $mn) |
MCA UNIVERSAL | 12.3 |
PARAMOUNT PICTURES | 5.12 |
SONY PICTURES ENTERTAINMENT | 4.89 |
TWENTIETH CENTURY FOX | 3.33 |
WARNER BROTHERS | 12.17 |
THE WALT DISNEY COMPANY | 17.68 |
All Studios | 8.61 |
Drawbacks and improvements of the DCF analysis method
DCF models underestimate the value of investments where there are embedded options to
follow up with a second investment if the first one does well (follow-on option)
1. Discount rate: The analysis assumes that the discount rate is the same for the complete
throughput time of the project. This can be countered by using different discount rates for
different years, in case required.
2. Static model: Once the decision to go for the project has been made, possible future
changes are not taken into account anymore. It does not account for future decisions (such as
hold or abandon a part of the project) based on better information or change in scenario. The
NPV of the project should be split in multiple projects whereby the decision is postponed
until more information is known about a particular part of the project
Valuation of Sequel rights using Real Options model
Reason to use options model
The valuation of sequel rights involves contingency. This makes options model a better tool
for this analysis since it is dynamic. Using the options method firstly provides us the
flexibility to defer, contract, expand or abandon an investment. With an options model,
Arundel Partners gets a right but not an obligation to produce the sequel. This is based on the
success of the first film.
Secondly the options model helps us get a gauge of the probability of the first film (if we use
the returns of first film in the option price) before taking a decision on the sequel. We are
given how the sequel is expected to perform based on cash flows of previous sequels. From
here we can get the expected net payoff of the sequel. However, if we used the DCF model,
we would have to settle down with this net payoff as the value of the sequel. In contrast, the
options model gives us the opportunity to calculate a probability of success of the first film,
and multiply this probability with the net payoff of the sequel. Thus, options model is bound
to give us a more accurate value of the sequel.
Black Scholes Model
It makes more sense for Arundel Partners to buy a European call option on the sequel than an
American call option. This is because Arundel Partners can invest in a sequel only in Year 3,
while the success factor of the first film will be known by the end of Year 1. Therefore, there
is no advantage for exercising an option to make a sequel earlier than Year 1.
In theory, Valuation of Sequel Rights = probability that first film is a hit * net payoff of
sequel
Probability that first film is a hit = European call option price
The parameters of this European call option on sequel rights are (Please note: we have used
all values from Exhibit 7 since they represent estimated expected present value based on
historical data from exhibit 6):
1. Underlying = first film
2. S = forward (stock) price = average first film one year return = 0.67
This is because the underlying of the call option is the first film. For ease of calculation, we
have decided to use the portfolio of first film as a reference. Since the forward price of an
option is a mean, we take it to be the average of the one year return for first film.
3. K = strike price = 0
Since our forward price is a return, the strike needs to be 0, to make sure that we exercise the
call option only when the stock price is positive. This is theory would mean that the first film
has made positive one-year returns.
4. Volatility = standard deviation of first film one year return = 2.07
The forward price needs to move over the tenor of the call option in order to settle at a final
level at the option expiry date. This movement in the forward price is determined based on its
volatility. Since, we have taken the forward price to be the first film one year return, we will
take the standard deviation of the first film return as the volatility of our option.
5. Tenor = 1 year = 365 days
The call option is based on the success of the first film. Since we will already know the
success of the first film by the end of Year 1, we will buy this call option only until this
uncertainty ends.
6. Risk-free rate = r = 6%
For options pricing, we always use the risk-free return. This value is given in the question.
7. Dividend Cont yield = 0%
The percentage of returns the company pays out as dividends. It is measured as annual
dividend per share/ stock price per share. In this case, since there are no dividends, the rate is
assumed as 0.
Value of the call option
As per the Black Sholes method, the price of the above European call option is 0.64. This
value is a percentage, i.e. 64% since our forward price and strike price were all percentages
(i.e. returns). In other words, we can also term this price as the probability of the success of
the first film.
We arrived at the value using the following Black Scholes formula
C=SNd1-KertN(d2)
d1=(ln(SK)+(r+(2/2))T)/(T)
d1=0.67+(.06+(2.072/2))1)/(2.071)=1.74
d2=1.74-2.081
C=0.670.9599= 0.64
Note: ln(S/K) is approximately equal to (S-K)/K, i.e. the one-year return. Thus, we have used
the average value of one-year return here in place of ln(S/K).
The probability derived above in the form of the call option price now needs to be multiplied
by the net payoff of the positive NPV sequels. Here we use the following considerations:
1. We calculate the net payoff of each sequel film = PV of inflows in year 4 of sequel PV of
cost in year 3 of sequel
2. We select only the sequels that have a positive net payoff, since we assume here that
Arundel Partners will not be interested from the very outset to invest in sequels that do not
have an estimated expected negative NPV. There are 26 films out of 99 that have a positive
NPV.
3. We then sum up all the positive net payoffs. This comes out to $852.3m.
4. We then divide this sum by the total number of sequel films, i.e. 99 to arrive at a per-film-
sequel-payoff. We do this because our option price is also based on the average of films. This
comes out to $8.609m.
5. We then multiply the resulting per-film-sequel-payoff from above with the call option
price of 0.64 that we calculated above. The result if $5.51m.
This final result represents the Valuation of Sequel Rights = $5.51m.
Note: Since the exhibits state that the values are already preset values, we have not
rediscounted them for all the calculations
Drawback of using options model
The options pricing model assumes that there will an options house that Arundel Partners will
be able to find that trades in options on sequel rights. However, options on sequel rights is not
an active or liquid market and Arundel Partners might not even find a counterparty to buy this
call option from. This is a drawback of using the options pricing model.