The maximum per-film price for the sequel rights that Arundel Partners should pay is $5.12M.
If Arundel Partners were to use the traditional DCF methods to find the value of the sequel rights, the NPV would be -$8.42M loss per-film (see Appendix 1).
Calculation Details
We assume that Arundel Partners will purchase a portfolio of films similar to one used in the analysis. The average hypothetical net inflow of the sequel ($21.57M) is used to figure out the value of the state variable for the real options model. The state variable is the average hypothetical net inflow of the sequel, discounted using a WACC of 12.36% back to 1989. Discounting back to 1989 is important because this is To do the evaluation, we calculate the risk-neutral probabilities. These are weights on the cash flow that allow us to discount by continuously compounded risk-free rate. We use the 10-year US Treasury bond rate in 1991 as the risk-free rate. The 10-year time period is chosen because the ancillary inflows from non-US markets and post-theatre rentals (pay TV, network TV, DVD, etc) can be significant for 10 years. We use the lognormal model to arrive at the risk-neutral probability of an up move of 0.422. The payoff takes is calculated by discounting the average hypothetical negative costs of the sequel to 1992 (year 2) by the risk-free rate (7.03%). The discounted average hypothetical negative costs is $19.79M. We assign the payoffs and work backwards to value the real option using risk-neutral probabilities and discounting by the risk-free rate. We arrive at an option price of $5.12M per film (see Exhibit 2).
Further considerations for Real Options Valuation approach
Real options valuations recognise that the partners at Arundel obtain valuable information after the sequel rights have been purchased and the first films are released in the theatres. This additional information allows the partners to make informed actions in response, based on dynamic decision making. This approach allows for valuing real assets with some
