Problem 8 - Accounting

Question

Metro-Goldwyn-Mayer Studios Inc. (MGM) is a major producer and distributor of theatrical and television filmed entertainment. Regarding theatrical films, MGM states, "Our feature films are exploited through a series of sequential domestic and international distribution channels, typically beginning with theatrical exhibition. Thereafter, feature films are first made available for home video generally six months after theatrical release; for pay television, one year after theatrical release; and for syndication, approximately three to five years after theatrical release." Assume that MGM releases a film during early 2009 at a cost of \(\$ 115\) million, and releases it halfway through the year. During the last half of 2009 , the film earns revenues of \(\$ 140\) million at the box office. The film requires \(\$ 45\) million of advertising during the release. One year later, by the end of 2010 , the film is expected to earn MGM net cash flows from home video sales of \(\$ 36\) million. By the end of 2011 , the film is expected to earn MGM \(\$ 19\) million from pay TV; and by the end of 2012 , the film is expected to earn \(\$ 4\) million from syndication. a. Determine the net present value of the film as of the beginning of 2009 if the desired rate of return is \(20 \%\). To simplify present value calculations, assume all annual net cash flows occur at the end of each year. Use the table of the present value of \(\$ 1\) appearing in Exhibit 1 of this chapter. Round to the nearest whole million dollars. b. Under the assumptions provided here, is the film expected to be financially successful?

Step-by-Step Solution

Answer

The NPV is $25 million, so the film is financially successful.

Step 1: Calculate Initial Investment

The initial investment is the sum of the production cost and advertising cost. The cost of production is $115 million, and the advertising cost is $45 million, resulting in a total investment of $115 + $45 = $160 million.

Step 2: Identify Cash Flows

List the expected cash flows from various distribution channels: - 2009 Box Office: $140 million - 2010 Home Video: $36 million - 2011 Pay TV: $19 million - 2012 Syndication: $4 million.

Step 3: Determine Present Value Factors

Using a discount rate of 20%, find the present value factors from the table of present value of $1: - Present value of cash flow in Year 0 (2009): 1 (since it's at the start) - Present value of cash flow in Year 1 (2010): 0.833 - Present value of cash flow in Year 2 (2011): 0.694 - Present value of cash flow in Year 3 (2012): 0.579.

Step 4: Calculate Present Value of Cash Flows

Multiply each cash flow by its respective present value factor to find the present value: - Box Office (2009): $140 million × 1 = $140 million - Home Video (2010): $36 million × 0.833 = $29.988 million - Pay TV (2011): $19 million × 0.694 = $13.186 million - Syndication (2012): $4 million × 0.579 = $2.316 million.

Step 5: Sum Present Value of Cash Flows

Add up all the calculated present values:\[PV = 140 + 29.988 + 13.186 + 2.316 = 185.49\text{ million} \].

Step 6: Determine Net Present Value (NPV)

Subtract the initial investment from the total present value of cash flows to find the NPV:\[NPV = 185.49 - 160 = 25.49\text{ million}\]. Round this to the nearest whole million: $25 million.

Step 7: Evaluate Financial Success

If NPV > 0, the investment is considered financially successful. Based on the calculated NPV of $25 million, the film is financially successful.

Key Concepts

Initial Investment

The initial investment is a crucial starting point for any financial evaluation. It refers to the total amount of money required to start a project or investment. In the case of releasing a film, there are typically substantial upfront costs. For MGM, the initial investment included both the production cost and the advertising cost, totaling $160 million.
Understanding initial investment is essential because it sets the foundation for all subsequent evaluations. Without knowing how much has been invested, it is impossible to accurately determine the profitability or success of the venture. This total cost must be recovered through subsequent revenues for the project to be considered fruitful.

Present Value Factors

Present value factors are used to determine the current worth of a sum of money that will be received in the future. The logic is based on the time value of money principle, which asserts that a dollar today is worth more than a dollar in the future due to its potential earning capacity.
To calculate present value, you multiply the future cash flow by its corresponding present value factor. These factors are derived from a discount rate, which is the rate of return desired or expected from an investment. In the MGM example, a discount rate of 20% was used. This means that future earnings are less valuable today. Different years have unique factors:

• 2009: 1
• 2010: 0.833
• 2011: 0.694
• 2012: 0.579.
  Each presents the fraction of the future value that is equivalent to the present value today, allowing investors to make informed decisions about future cash flows.

Cash Flows

Cash flows represent the money that comes in and goes out of a project during specific periods. For projects like films, understanding cash flows is vital to assessing whether initial investments can be recouped and profits can be made. Cash flows can occur at different stages as the project progresses through its lifecycle.
In MGM's scenario, cash flows came from multiple channels:

• Box Office earnings in 2009 after the release
• Home Video sales in 2010
• Pay TV revenues in 2011
• Syndication earnings in 2012.
  Each of these streams provides a different amount at different times, impacting the overall financial assessment. Accurately predicting these flows is key in the calculation of net present value and ultimately determining the project's success.

Financial Success Evaluation

Evaluating financial success is a multi-step process that fundamentally relies on the net present value (NPV) calculation. NPV represents the difference between the present value of cash inflows and the initial investment. It's a primary metric for assessing whether an investment or project is likely to be profitable.
In straightforward terms, if the NPV is positive, the investment is expected to generate more cash than was invested, indicating financial success. For MGM's movie, with an NPV of $25 million, the film is expected to be financially viable. This measure helps stakeholders understand the potential return on their investment and decide whether to proceed or halt further projects.
A consistently positive NPV across projects can signal effective strategic planning and valuable decision-making within an organization.