Question

After graduation, you landed a job at a large, multinational media corporation. Your firm has been negotiating a license agreement to use a certain documentary film for a term of 2.5 years. You expect that the film will return cash flows of $2.5 million at the end of each six-month period. The company licensing the rights to use the film is asking $12.5 million. Both you and your boss LOVE this documentary film and feel that the film should be licensed. Your company's required rate of return is 3.2%/year. Should you purchase the license to show the film? Post your answer with an explanation.

Answer 1

Term of License agreement = 2.5 years

Expected cash flows at the end of each 6 month period =$2,500,000

Required rate of return = 3.2%

Step 1: Adjust the rate of return and time period.

Since, we are receiving the cash flows semiannually, we need to adjust the required rate of return & term of contract accordingly. Rate of return will be divided by 2 and the period will be multiplied by 2

Rate of Return = 3.2%/2 = 1.6%

Period = 2.5 * 2 = 5

Step 2 : Calculation of present value of the cash inflows from the film

Present Value (PV) = Cash Flow x PVAF(r,t)

where, r = required rate of return

t = time period

PV = $2,500,000 * PAVF(1.6%,5)

PV= $2,500,000 * 4.76868132

PV = 11,921,703.31

Step 3: Compare the Present value of cash inflows with the offer price

Price for licensing the rights to use the film = $12,500,000

Present value of cash inflows = $11,921,703.31

Decision: Since, the present value of cash inflows is lower than the price asked for licensing the film. The company should not purchase the license to show the film.