Magazine article Strategic Finance

Using Real Options to Make Decisions in the Motion Picture Industry

Magazine article Strategic Finance

Using Real Options to Make Decisions in the Motion Picture Industry

Article excerpt

Managers often face problems regarding whether to continue a project or scrap it. Traditional capital budgeting frameworks aren't particularly helpful in this regard because they assume a static investment decision-making process in which managers consider projects as do-it-now-or-never propositions. That is, traditional capital budgeting approaches assume that managers undertake "discrete" investments rather than investments that unravel in stages. The applied discounted cash flow (DCF) or net present value (NPV) methods need a beginning and ending time, suggesting that a project will produce cash flows without cessation from start to end. These stylized characterizations of investments are questionable, particularly in situations of high uncertainty, because the logic of DCF and NPV may lead to flawed decisions.

Real options, however, provide an alternative approach to thinking about capital investments by taking into account that companies can postpone a business decision, either to continue or abandon projects, based on how future uncertainty unfolds. A real option is the right, but not the obligation, to undertake a business decision. Essentially, a real options approach recognizes that managers invest in projects in stages based on new information that more closely reflects the realities of firms' rapidly changing operational and competitive environments.

Table 1 summarizes the key differences between traditional DCF methods and a real options approach to major capital outlays. As the table shows, DCF assumes investment projects as now-or-never decisions, whereas real options consider investment decisions as dynamic and staggered. In addition, DCF methods aren't tailored to flexibility, but the real options approach incorporates the flexibility of when and how much to invest. Furthermore, DCF considers volatility as a negative factor in determining project value and suggests that managers should expect--and set--higher discount rates for projects with more volatile cash flows. On the other hand, mathematical models of option valuation illustrate that the value of any option increases when volatility goes up. Thus, a real options approach values volatility positively. In sum, a real options approach is more relevant when a project contains staged investments whose outcomes are uncertain.

Real Options Research

Though real options are intuitively appealing, few studies have documented their use in practice. In this article, we'll summarize findings of a study that we conducted under the auspices of the IMA Research Foundation. The context for our study is the U.S. motion picture industry--an industry that's notoriously risky and, therefore, especially conducive to embracing the features of real options logic. Indeed, the major firms (studios) regularly introduce a number of very costly new products (movies) whose success is difficult to predict. Our research for the IMA Research Foundation involved two stages.

In the first stage, we gathered information about the production and marketing costs of movies from published sources as well as in-depth interviews with a number of professionals working in the motion picture industry. As our prior articles have outlined (see "The Movie Industry in the Spotlight," p. 59), any movie project has several key stages of decision making, such as property acquisition, script development, greenlighting of production, releasing on opening weekends, and postopening marketing support.

In the second stage of our research, we conducted statistical analyses of how real options manifest themselves at two junctures in the decision-making process of a motion picture--at the time of initial investment ( production) and at the point when executives decide how many marketing dollars to spend. Specifically, the first real option is a growth option, which is the right to make additional investments if the initial investment is successful. The growth option in the movie industry is to produce sequels after a successful original movie. …

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