Prepare a memo addressing the following questions: 1. You are a movie mogul, and you are approached with a proposal to produce and distribute a movie based on the life story of Ernest Hemingway. Your financial advisors tell you that costs and revenues are expected to parallel those for a "typical" movie in Exhibit 2 of the case. In particular, negative costs (which for the sake of simplicity can be thought of as incurred today) will be $18 M with certainty. Revenues (which are incurred one year from now) are expected to be $46.5M. However, there is uncertainty in revenues. In particular, if the movie is a hit - which occurs with probability 1/2 - revenues will be 20% above expectations (i.e., approximately $56M). Conversely, if the movie bombs - which also occurs with probabilityl /2 - revenues will be 20% below expectations (i.e., approximately $37M). Finally, distribution fees and distribution expenses (which are incurred one year from now) will be$12.5M and $15.5M, regardless of whether the movie is a hit or a flop. Assume that the discount rate is 12% and ignore taxes. Do you go ahead with the movie? 2. Suppose all the numbers are exactly the same, but instead of being about Ernest Hemingway, the movie is an adaptation of the old T.V. series Gilligan's Island. Unlike Ernest Hemingway's biography, the storyline of this movie could be continued in a sequel. Consistent with the typical timeline of Exhibit 3, assume that production of the sequel would start three years from now and revenues would be received four years from now. In addition, assume that the negative cost and revenues of the sequel would match the ratios indicated in Exhibit 4, i.e. the negative cost of the sequel is 120% of the negative cost of the initial movie, and revenues are 70% of the initial revenues. (For example, if the first movie was a success and yielded revenues of $56 M, the expected revenues of the sequel would be70% x $56M = $39.2M.) In addition, assume that distribution fees and expenses are also70% of the initial distribution fees and expenses. Is your decision any different (leaving aside your artistic preferences)? 3. In the Gilligan's Island movie, suppose the revenues are more extreme, without a change in their mean: if the movie is a hit, revenues will be80% above expectations (about $84M), while if the movie flops, revenues will be80% below expectations (about $9M). Does this added uncertainty make the project more or less attractive? 4. Now turn to the decision Arundel is facing in the case. The objective is to compute the value of a sequel right assuming that Arundel would need to purchase sequel rights on all 99 movies in Exhibit 7. As in the previous questions, you can base your calculations on revenues and costs while ignoring taxes (i.e., suppose cash flows are simply revenues minus costs), and use a discount rate of 12%. Hint: Use the information from Exhibit 7 and ask yourself which sequels would be produced in year 3. Calculate the cumulative NPV for the sequels that would be produced and divide by the total number of movies in Exhibit 7
