Question

In: Finance

You are a professional athlete and recognized as one of the best in your sport. Fortunately...

You are a professional athlete and recognized as one of the best in your sport. Fortunately for you, you are currently a free agent and deciding with which team you will sign your next contract. You have received the following three contract offers:

Team A: 5-year contract. $10 million signing bonus. Annual salary of $1 million.

Team B: 5-Year contract. $2 million signing bonus. Annual salary of $3.5 million.

Team C: 10-Year contract. No signing bonus. Annual salary of $2.5 million.

The signing bonus is received right now while the first annual salary payment is paid one year from today.

Which contract would you choose and why? Explain the financial factors that would influence your decision. Please ignore all non-pecuniary factors, such as location of the team, chance of winning a championship, etc. Also for the sake of this discussion, let’s set aside the propriety of athletes making this much money.

Solutions

Expert Solution

The decision to choose a contract can be made on the basis of PResent Value of all the income.

Present Value (PV) =

where

n is no. of years to last cashflow

R is interest rate or required rate of return = *10% (Lets say)*

C0 is cashflow received today

C1 is cashflow received in year 1....

Cn is cashflow received in last year

Case 1: n = 5

C0 = $10 Million

C1 = C2 ...= C5 = $1 Million

PV =

= 10 + 0.909 + 0.826 + 0.751 + 0.683 + 0.621

= $13.79 Million

Case 2: n = 5

C0 = $2 Million

C1 = C2 ...= C5 = $3.5 Million

PV =

= 2 + 3.182 + 2.893 + 2.630 + 2.391 + 2.173

= $15.27 Million

Case 3: n = 10

C0 = 0

C1 = C2 ...= C10 = $2.5 Million

PV =

= 0 + 2.273 + 2.066 + 1.878 + 1.708 + 1.552 + 1.411 + 1.283 + 1.166 + 1.060 + 0.964

= $15.36 Million

It is clear from the above cases, the highest present value is in case 3.

Therefore, Contract 3 will be chosen if interest rate, R = 10%.

The factor deciding which contract to choose will be the required return or the interest rate, R.

For example, if R is changed to 20%, the above calculations will change and give highest value for contract 1.

Therefore, it is necessary to determine R before making any decision.

jeff jeffy answered 1 year ago

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