If Arundel Partners were to utilize the traditional DCF methods to happen the value of the subsequence rights, the NPV would be – $ 8.42M loss per-film ( see Appendix 1 ) .
We assume that Arundel Partners will buy a portfolio of movies similar to one used in the analysis. The mean conjectural net influx of the subsequence ( $ 21.57M ) is used to calculate out the value of the province variable for the existent options theoretical account. The province variable is the mean conjectural net influx of the subsequence, discounted utilizing a WACC of 12.36 % back to 1989. Dismissing back to 1989 is of import because this is the clip of the first film’s release. Within several hebdomads of release, the film’s success is known. This get downing point value is $ 13.53M.
Constructing the Binomial Tree for Asset Values
The binomial theoretical account is used to see how the province variable evolves over clip, specifically over a clip period of 12 months ( see Exhibit 1 ) . The adulthood or termination day of the month of the subsequence rights option is set for 12 months. Within the first twelvemonth, Arundel Partners will cognize whether it will desire to exert the subsequence rights. We build the binomial tree for the net influx values utilizing the Cox-Ingersoll-Ross theoretical account. This attack approximates a lognormal distribution for the plus values ( net influx values ) . We assume that continuously compounded returns on the plus are usually distributed and volatility remains changeless. We use the termination day of the month as one twelvemonth from the purchase of the subsequence rights and the clip interval of 1/12 ( 1 month ) . We use the standard divergence on the one twelvemonth return of the portfolio as an estimation for volatility ( Ïƒ=121 % ) .
Risk-Neutral Probabilities in the Lognormal Model
Once we have the binomial tree, we replace the plus values with the final payment in each province, so value the option utilizing backward initiation or dynamic scheduling. To make the rating, we calculate the risk-neutral chances. These are weights on the hard currency flow that allow us to dismiss by continuously compounded riskless rate. We use the 10-year US Treasury bond rate in 1991 as the riskless rate. The 10-year clip period is chosen because the accessory influxs from non-US markets and post-theatre leases ( pay Television, web Television, DVD, etc ) can be important for 10 old ages. We use the lognormal theoretical account to get at the risk-neutral chance of an up move of 0.422. The final payment takes is calculated by dismissing the mean conjectural negative costs of the subsequence to 1992 ( twelvemonth 2 ) by the riskless rate ( 7.03 % ) . The discounted mean conjectural negative costs is $ 19.79M. We assign the final payments and work backwards to value the existent option utilizing risk-neutral chances and discounting by the riskless rate. We arrive at an option monetary value of $ 5.12M per movie ( see Exhibit 2 ) .
Further considerations for Real Options Valuation attack
Real options ratings recognise that the spouses at Arundel obtain valuable information after the subsequence rights have been purchased and the first movies are released in the theaters. This extra information allows the spouses to do informed actions in response, based on dynamic determination devising. This attack allows for valuing existent assets with some grade of operating flexibleness, integrating the value of the flexibleness into the option monetary value. It values the option to exert but non the duty to do future investings. It is based on the jurisprudence of one monetary value ( the monetary value of two portfolios with the same hard currency flows in every province of the universe must be the same ) .
Option value increases with great uncertainness ( see Exhibit 3 ) . The major uncertainnesss are Arundel Partners’ WACC and volatility of return on assets. A sensitive analysis shows the grade of alterations with the altering uncertainnesss. The major disadvantage of this attack is that it frequently requires alterations in concern procedure. In Arundel Partners’ instance, the footings and commissariats in the contract will extenuate some of the disadvantages.
Extra footings and commissariats for the subsequence rights portfolio The footings and commissariats for the subsequence rights for one or more studios’ full production: The adulthood or termination rate of exerting the subsequence rights is 1 twelvemonth. This will let Arundel adequate clip to do a determination about doing a subsequence and enable it to more rapidly compose off its investing in rights it chose non to exert. Arundel Partners can take to bring forth the subsequence or engage another house to make so. Arundel Partners will allow right of first refusal to the studio on any rights it planned to sell. If the studio is non interested, Arundel Partners can sell the rights to the highest bidder. Arundel Partners will pay out the payments for the subsequence rights over 12 months in the first twelvemonth of production. This gives the studio the hard currency flow to bring forth the first movie but mitigates Arundel Partner’s hazard in instance there are issues with the production of the first movie. Arundel Partners can keep back the staying payment if the studio abandons the production of the first movie.