Question 4: Real Options

Your friend is a movie producer and is considering investing in a movie today. The movie would cost $75 million to produce today and could either be a hit or a flop. If the movie is a hit, your friend will receive $30 million per year for four years starting next year, and if it is a flop she will receive only $10 million per year for four years starting next year. The movie will be a hit or a flop with equal probability.

Also suppose that your friend can invest in a sequel next year. The sequel costs the same to produce as the original movie ($75 million to be paid one year from now). If the original movie was a hit, then your friend believes that there is a 90% chance that the sequel will also be a hit and generate $30 million per year for four years starting two years from today, versus a 10% chance that the sequel will be a flop and produce $10 million per year for four years starting two years from today. If the original movie was not a hit, though, then the sequel will generate no revenue.

Your friend’s opportunity cost of capital is 5% annually. What is the value, to your friend, of the option to produce the sequel?