Part A: Real options analysis

Sequel rights to the first hit novel authors:

Digital Plus Novels Inc. (DPN) is a rather successful online publisher focusing on new talents in science fiction novels. To emphasize on the new talents, it constantly spin off its rights to publish subsequent works by authors within its portfolio. In the beginning of 2020, it is offering to sell the rights to publish subsequent works by a portfolio of 60 first hit sci-fi authors under its umbrella (hits identified as 100,000 copies or more @ about $20 price each e-copy). The range of e-copies sold for these 60 authors range from 100,500 e-copies to as high as 900,000 e-copies (few extreme runaway hits) while the average number of e-copies sold is 200,000 e-copies. DPN sets the price to this exclusive right (on 60 sci-fi authors bundled together) as 50 million dollars.

Virtual Reality Entertainment Plc. (VRE) is a bigger (and rather more diversified) epublishing company that is considering DPNs proposal. The financial manager of VRE has been gathering the relevant information as follows:

-It will take time to work on and publish online the sequel novels of these 60 sci-fi authors. On average, this will lead to the cash flows received at the end of 2022 (for simplification).

- Out of the whole lot of 60 authors (one author is targeted to produce one novel), it is estimated that only 90% will be able to produce something worth publishing online at the beginning of 2022. Of these publishable works, estimated sales are 200,000 eletronic copies per novel on average. The price of one e-copy to be sold to customers is about $25, on average. The discount rate used by sci-fi e-novel industry is 10%.

- For the above to happen, decision needs to be made at the beginning of 2022. To be conservative, VRE secures a conditional offer from its e-production house and platform providers so that it will cost altogether $291.6 million for VRE to make and sell these ecopies (e.g. all costs covered regardless of the number of e-copies in the contract). This cost will incur at the beginning of 2022 ONLY if VRE decides to go forward with these sequel enovels at that point in time. Also assume that costs (cash flow) will be incurred at the beginning of year 2022 (for simplicity) if the decision is made to go on with the publishing of this lot of publishable e-novels.

- Risk free rate is 4% per year.

- Uncertainty in sci-fi e-novel industry is quite high. Variance in the sales/returns of these 60 authors as recorded by DPN was 40%. VRE believes that such estimation will also be valid for the end of 2022.

Answer the following questions:

1) Calculate the value of rights to publish sequel novels offered by DPN. Should VRE buy it? Please use annual compounding in calculating P.

First of all, what kind of real option is this?

1. Option to expand/option to invest? Call
2. Option to delay? Call
3. Option to abandoned? Put

Second, define Five variables in option pricing regardless of call or put.

P The present value (PV) of cash flows that will be generated by the considered real asset or investment at hand. P will be made up of several variables given in the case such as number of total authors, probability of these authors creating publishable works at the time of decision, average number of ecopies that can be sold on average per novel. Use annual compounding.

EX The exercise price of initial cost to pay if VRE decide to pursue publishing e novels of these authors

V Volatility of returns that would be generated by the investment in consideration. Just only be careful with the term Variance versus SD.

Rf Risk free rate

T Time to make decision for VRE about whether to go on or not with the e publishing of new scifi novels or not, if they acquire these authrs compare that time period with now and that will be t.

After five variables are defined calculate the option price. Then put or call.

Finally, should VRE buy it or not?

• What is the value of this right you just calculate from the above (e.g. how much is it worth in VRE perspective)?
• What is the offer price mentioned by DPN (e.g. how much the seller DPN ask for) ?
• Compare and make discuss whether is a good deal for VRE.

2) One of the natures of risk associated with the e-publishing industry is the ability of authors to deliver publishable (marketable) works online. Perform a sensitivity analysis on the value of rights to publish sequel e-novels on this risk factor. You can range the probability to 10% scale (e.g. 0%, 10%, 20%, up to 100%). Interpret the implication of these numbers.

3) What is the minimum target (% of publishable e-novels, and also in number of enovels) to push for VRE for these 60 authors to break even?