Fox Searchlight Pictures recently purchased a script for a new movie about a poker player. The movie will cost $40 million to produce. Following the production of the movie today, the cash flow to be generated in year 1 from the movie will be $40 million with 25% chance or $10 million with 75% chance. From year 2, the movie will generate $5 million and decline by 5% per year forever.
Given the growing popularity of the game, the producer believes that it may be better to delay the start of production. Delaying the production until year 1 will resolve the uncertainty about the first cash flow ($40 million or $10 million) that will be generated from the movie in one year after production. The remaining cash flows will be the same as above (that is, the second cash flow will be $5 million, which will decline by 5% per year forever).
The opportunity cost of capital is fixed at 15% over time and the risk-free rate is 5%.
(a) What is the NPV of the project if it needs to decide today whether to invest in the project?
(b) What is the embedded option in this project? Is the project worthwhile when considering the option?
(c) What should they do?