Corporate
Finance @
EDHEC
Prof. Schroth
Corporate Finance 1
Synopsis MSc inFinance
The
shut-down
EDHEC Business School
option
Black-Scholes
The formula
Implementing
Enrique Schroth
Black-Scholes
Caveats and
Comments
Professor of Finance
EDHEC Business School
Case Study: Arundel Partners; The Sequel Project
6th November 2024
1 / 13
Contents
Corporate
Finance @
EDHEC
Prof. Schroth 1 Synopsis
Synopsis
The
shut-down
2 The shut-down option
option
Black-Scholes
The formula
3 Black-Scholes
Implementing
Black-Scholes The formula
Caveats and Implementing Black-Scholes
Comments
4 Caveats and Comments
2 / 13
The Sequel Project: Synopsis
Corporate
Finance @
EDHEC
Prof. Schroth
Synopsis The business proposition:
The • To buy movie sequel production rights;
shut-down
option
• Buy rights for sequels on ALL current films in production by ALL major
Black-Scholes
The formula
studios;
Implementing
Black-Scholes • Decide which sequels to produce;
Caveats and
Comments • Probably hire the studios themselves!
3 / 13
The Sequel Project: Timeline
Corporate
Finance @
EDHEC
Prof. Schroth
The time line of the project:
Synopsis
• date 0: Buys right to make sequel while first film is produced;
The
shut-down • date 1: first film released in the US;
option
Black-Scholes
→ box office figures known;
The formula
Implementing
• date 2: first film released into other markets
Black-Scholes
Caveats and
• date 3: sequel may or may not go into production;
Comments
• date 4: sequel released (if produced).
4 / 13
The Sequel Project: Value creation
Corporate
Finance @
EDHEC
Prof. Schroth
Why buy sequel rights at date 0?
Synopsis
• downside: not known whether first film successful, but
The
shut-down
option
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
5 / 13
The Sequel Project: Value creation
Corporate
Finance @
EDHEC
Prof. Schroth
Why buy sequel rights at date 0?
Synopsis
• downside: not known whether first film successful, but
The
shut-down
option
• upsides:
Black-Scholes
• could provide studios with cash for first film production, i.e., when money its
The formula tightest;
Implementing
Black-Scholes • Arundel would choose to produce based on the observed performance of the first
Caveats and film → flexibility!
Comments
key issue: what is the value of the sequel rights?
5 / 13
Arundel’s shut-down option
Corporate
Finance @
EDHEC
• Suppose Arundel were to produce all sequels in Exhibit 7
Prof. Schroth
Synopsis
The
shut-down
option
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
6 / 13
Arundel’s shut-down option
Corporate
Finance @
EDHEC
• Suppose Arundel were to produce all sequels in Exhibit 7
Prof. Schroth • Standard DCF analysis (that ignores the value of the shut down option)
would yield
Synopsis
• Average PV (at date 4) of cash inflows: 21.6M
The
shut-down • Average PV (at date 3) of cash outflows (”negative cost”): 22.6M
option
• At a discount rate of 12% (page 3)
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
6 / 13
Arundel’s shut-down option
Corporate
Finance @
EDHEC
• Suppose Arundel were to produce all sequels in Exhibit 7
Prof. Schroth • Standard DCF analysis (that ignores the value of the shut down option)
would yield
Synopsis
• Average PV (at date 4) of cash inflows: 21.6M
The
shut-down • Average PV (at date 3) of cash outflows (”negative cost”): 22.6M
option
• At a discount rate of 12% (page 3)
Black-Scholes
The formula
21.6 22.6
Implementing
Black-Scholes NPVdate 0 = 4
− = −2.36M.
1.12 1.123
Caveats and
Comments
⇒ The sequel rights would have negative NPV.
• But Arundel is only buying the option and not necessarily committing to
produce the sequel: the success or failure of the first film reveals which sequels
will be worth producing on date 3!
6 / 13
The shut-down option: Crude valuation
Corporate
Finance @
Suppose the distribution of revenues and costs in Exhibit 7 captures the
EDHEC
uncertainty Arundel faces at date 0
Prof. Schroth
Synopsis
The
shut-down
option
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
7 / 13
The shut-down option: Crude valuation
Corporate
Finance @
Suppose the distribution of revenues and costs in Exhibit 7 captures the
EDHEC
uncertainty Arundel faces at date 0
Prof. Schroth
⇒ 26 sequels in Exhibit 7 have positive NPV (one-year return > 12%)
Synopsis • If at date 0 Arundel expects to exercise 26 out of the 99 sequel rights, and
The
shut-down • The average cash inflow of this group is 57.2 M (date 4);
option
Black-Scholes
• The average cash outflow of this group is 24.5 M (date 3);
The formula
Implementing
Then, the average NPV per sequel in date 3 is:
Black-Scholes
Caveats and 57.2
Comments − 24.5 = 26.57M.
1.12
7 / 13
The shut-down option: Crude valuation
Corporate
Finance @
Suppose the distribution of revenues and costs in Exhibit 7 captures the
EDHEC
uncertainty Arundel faces at date 0
Prof. Schroth
⇒ 26 sequels in Exhibit 7 have positive NPV (one-year return > 12%)
Synopsis • If at date 0 Arundel expects to exercise 26 out of the 99 sequel rights, and
The
shut-down • The average cash inflow of this group is 57.2 M (date 4);
option
Black-Scholes
• The average cash outflow of this group is 24.5 M (date 3);
The formula
Implementing
Then, the average NPV per sequel in date 3 is:
Black-Scholes
Caveats and 57.2
Comments − 24.5 = 26.57M.
1.12
• The value of all the ‘winners’ is 26 × 26.57 = 691 M
→ the present value per sequel right is (691/99)/(1.12)3 = 4.98 M.
7 / 13
Black-Scholes valuation of the shut-down option
Corporate
Finance @
EDHEC
Prof. Schroth
Synopsis
• What is the distribution of of revenues and costs?
The
shut-down
option
• The Black-Scholes formula pins down the no-arbitrage prices of options
Black-Scholes
under the assumptions that
The formula • the underlying asset price has a log normal distribution, with continuous
Implementing
Black-Scholes support
Caveats and → the underlying returns are normally distributed
Comments
• generalizes the idea of risk-neutral valuation
8 / 13
Applying the Black-Scholes formula
Corporate
Finance @
EDHEC
• The price of a European Call option on a non-dividend paying asset is
Prof. Schroth √
c = S0 × N (d ) − PV (K ) × N d − σ T
Synopsis
The
shut-down where
option
• S0 is the current market price of the asset
Black-Scholes
The formula
• PV (K ) is the risk-free discounted PV of the strike price
Implementing
• T is the time to maturity (in years)
Black-Scholes
√
Caveats and • σ is the yearly volatility of the asset’s return (σ T is the cumulative volatility)
Comments
• N (.) is the cumulative normal density and:
√
ln (S0 /PV (K )) σ T
d= √ + .
σ T 2
9 / 13
Using Black-Scholes for Arundel
Corporate
Finance @
EDHEC
Prof. Schroth
• The payoff to each individual sequel right are:
Synopsis
max (0, Inflow − Outflow)
The
shut-down
option ⇒ option to buy sequel revenues with production cost as strike price;
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
10 / 13
Using Black-Scholes for Arundel
Corporate
Finance @
EDHEC
Prof. Schroth
• The payoff to each individual sequel right are:
Synopsis
max (0, Inflow − Outflow)
The
shut-down
option ⇒ option to buy sequel revenues with production cost as strike price;
Black-Scholes
The formula • spot price of underlying asset: (average) sequel revenues;
Implementing
Black-Scholes • strike price: (average) production cost;
Caveats and • maturity: 1 year (not 3, not 4; careful here!);
Comments
• volatility: from Exhibit 7, σ = 1.21;
• cumulative volatility
10 / 13
Using Black-Scholes for Arundel
Corporate
Finance @
EDHEC
Prof. Schroth
• The payoff to each individual sequel right are:
Synopsis
max (0, Inflow − Outflow)
The
shut-down
option ⇒ option to buy sequel revenues with production cost as strike price;
Black-Scholes
The formula • spot price of underlying asset: (average) sequel revenues;
Implementing
Black-Scholes • strike price: (average) production cost;
Caveats and • maturity: 1 year (not 3, not 4; careful here!);
Comments
• volatility: from Exhibit 7, σ = 1.21;
• cumulative
√ volatility
= σ × 1 = 1.21 (uncertainty is resolved in one year!).
10 / 13
Calculating the shut-down option value
Corporate
Finance @
EDHEC • PV strike price (average production cost, rF = 6%) = 22.6/ (1.06)3 = 18.98
Prof. Schroth
• PV of average sequel revenues = 21.6/ (1.12)4 = 13.73
Synopsis
The
shut-down
option
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
11 / 13
Calculating the shut-down option value
Corporate
Finance @
EDHEC • PV strike price (average production cost, rF = 6%) = 22.6/ (1.06)3 = 18.98
Prof. Schroth
• PV of average sequel revenues = 21.6/ (1.12)4 = 13.73
Synopsis • Value of a sequel right
The
shut-down
option c = 13.73 × N (d ) − 18.98 × N (d − 1.21)
Black-Scholes
The formula
Implementing
where
Black-Scholes
Caveats and ln (13.73/18.98) 1.21
Comments d= + = 0.3374
1.21 2
N (0.3374) = 0.63, N (0.3374 − 1.21) = 0.19.
11 / 13
Calculating the shut-down option value
Corporate
Finance @
EDHEC • PV strike price (average production cost, rF = 6%) = 22.6/ (1.06)3 = 18.98
Prof. Schroth
• PV of average sequel revenues = 21.6/ (1.12)4 = 13.73
Synopsis • Value of a sequel right
The
shut-down
option c = 13.73 × N (d ) − 18.98 × N (d − 1.21)
Black-Scholes
The formula
Implementing
where
Black-Scholes
Caveats and ln (13.73/18.98) 1.21
Comments d= + = 0.3374
1.21 2
N (0.3374) = 0.63, N (0.3374 − 1.21) = 0.19.
→ c = 13.73 × 0.63 − 18.98 × 0.19 = 5.043M.
11 / 13
Some caveats
Corporate
Finance @
EDHEC
Prof. Schroth
Synopsis We have assumed that
The • the sequels (cash flows) returns are normally (log normally) distributed!
shut-down
option • the sequels cash flow distribution is stationary
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and Critical: we must complement valuation with sensitivity analysis!
Comments
12 / 13
Postscript
Corporate
Finance @
EDHEC
• How was Arundel planning to create value?
Prof. Schroth
Synopsis
The
shut-down
option
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
13 / 13
Postscript
Corporate
Finance @
EDHEC
• How was Arundel planning to create value?
Prof. Schroth
• Partners have no specialized knowledge of movie business;
Synopsis • There is limited scope for synergies; but
The
shut-down
option
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
13 / 13
Postscript
Corporate
Finance @
EDHEC
• How was Arundel planning to create value?
Prof. Schroth
• Partners have no specialized knowledge of movie business;
Synopsis • There is limited scope for synergies; but
The
shut-down
option
• The sequel rights seem to be systematically undervalued by studios;
• Arundel may be better at raising money than the studios.
Black-Scholes
The formula
Implementing
Black-Scholes
Caveats and
Comments
13 / 13
Postscript
Corporate
Finance @
EDHEC
• How was Arundel planning to create value?
Prof. Schroth
• Partners have no specialized knowledge of movie business;
Synopsis • There is limited scope for synergies; but
The
shut-down
option
• The sequel rights seem to be systematically undervalued by studios;
• Arundel may be better at raising money than the studios.
Black-Scholes
The formula
• Black-Scholes often not needed to get a feel for the value of real options
Implementing
Black-Scholes
Caveats and
Comments
• it is useful here because of the large number of sequel rights in the purchase.
• quality of output of the valuation exercise will depend on methods and
assumptions.
• Critical: sensitivity analysis!
13 / 13