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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Net present value method for a service company

 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 (online downloads) 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 produces a film during early 2018 at a cost of $340 million and releases it halfway through the year. During the last half of' 2018, the film earns revenues of $420 million at the box office. The film requires $90 million of advertising during the release. One year later, by the end of 2019, the film is expected to earn MGM net cash flows from online downloads of $60 million. By the end of 2020, the film is expected to earn MGM $20 million from pay TV, and by the end of 2021, the film is expected to earn $10 million from syndication.

a.    Determine the net present value of the film as of the beginning of 2018 if the desired rate of return is 20%. To simplify present value calculations, assume that all annual net cash flows occur at the end of each year. Use the table of the present value of $1 appearing in Exhibit 2 of this chapter. Round to the nearest whole million dollars.

b.    Under the assumptions provided here, is the film expected to be financially successful? Explain.

a.

To determine

Calculate net present value of the film.

Explanation

Net present value method: Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate desired by the business is based on the net income from the investment, and also called as the discounted cash flow method.

Calculate the net present value of film 20% rate of return as follows:

Here,

Cash flow for 2018 = $-10 (1)

Cash flow for 2019 = $60

Cash flow for 2020 = $20

Cash flow for 2021 = $10

Figure (1)

Hence, net present value of film is $50.

Working note 1: Calculate the value of cash flow for the year 2018...

b)

To determine

Explain the expected financial earnings of the Company MGM, and analyze the net present value of film.

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