Arundel - Case Solution

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1 Real Options - A Case Study Straight from Hollywood! ! In April 1992, David A. Davis, a movie industry analyst at Paul Kagan Associates, Inc. in LA was asked to evaluate a business idea. ! The idea was to purchase sequel rights to films produced by some major movie studios. ! As owner of these rights, the client would judge the success of a movie, and then decide whether or not to produce a sequel film. ! The sequel rights would be purchased before the first film was even made. ! The client would not select the rights for particular movies based on predictions of possible sequel’s success – rather, they would purchase all of the sequel rights for a studio’s entire production during a specified period (1-2 years), and/or a specified number of films. ! The client would pay cash in advance for the rights, which would help finance production of the initial films. What were these sequel rights worth? How much should the client pay to purchase the portfolio of these sequel rights? 2 The Sequel Project ! The client would purchase sequel rights to a studio’s entire production over a number of years. ! If a particular film was a hit, the client could exercise its right by producing the sequel itself or hiring professionals to do so. ! Alternatively, it could sell the rights to the highest bidder. ! Most first films would not justify sequels, so this option would expire unexercised. ! The rights must have a specific expiration date (say 3 years from the first film’s release), by which time they would have to decide or forfeit the rights (usually, for most films, it is clear after the first few weeks whether a sequel would be profitable or not). ! It is critically important for the client to transact the deal before the studio knew which films it would produce. 3 Why this Project? ! The client doesn’t have a comparative advantage in movie production, so

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