Question

Any advice or recommendation would be greatly appreciated

You are the sport agent for a rising basketball star just drafted in the first round. Your client has two offers on the table option

1. $90 million dollars over 5 years or option
2. $30 million signing bonus and 40 million over the next 3 yrs.

What option do you recommend? How does the time value of money impact your decision?

Answer 1

This question can be answered by understanding the time value of money. The concept of time value of money is that a dollar today is more valuable than the same dollar obtained tomorrow. To understand what is the difference between the values of the two dollars, we need a discount factor which denotes what your expectations are from the dollar. This discount factor can be set according to what extra amount you expect to get if you are given the dollar today and you invest it somewhere where there is practically no risk or the risk is within your acceptable limits.

So, here as we see that the difference between the two options actually is the value of 50 million dollars in years 4 and 5; and 30 million dollars now. This is because we are getting 40 million dollars in the years 1,2 and 3 in both the cases. So, now to make a decision, we have to know the discount factor or the discount rate. Here, as no risk factor is involved we use the US Treasury rate as the discount rate. Currently the 5-year US Treasury rate is = 1.43%. We consider this as the rate for our calculation. Also, we make another assumption that the 50 million dollars in years 4 and 5 will be equally distributed between the two years. Hence, their present value turns out to be = 25/(1+0.0143)⁴ + 25/(1+0.0143)⁵ = 46.9064 million. This amount is clearly more than 30 million dollars. Hence, we recommend the first option.

Note that the recommendation has been given based on the different assumptions made. This answer can be different if a different set of assumptions are made.