Question

You have been hired as a financial advisor to Red Sox DH J. D. Martinez who plans to opt-out of the final 3 years and $62 million of his contract. He has received two offers, one from the Chicago White Sox for 5 years and $130 million and one from the Texas Rangers also for 5 years and $130 million and wants to select the best offer. The White Sox’s offer will pay J.D. $20 million in year 1, $20 million in year 2, and 30 million per year for years 3 through 5. The Ranger’s offer will pay J.D. $35 million in year 1, $35 million in year 2, $30 million in year 3, and $15 million per year in years 4 and 5. If the appropriate discount rate is 7.5%, which offer will you advise J.D. to choose?

Answer 1

Solution

In given question

Both Chicago White and rangers pay same amount but at different times

To choose the best, we have to calculate the present value of each cash flow @ 7.5%(Discount rate) and sum all the Present values. The deal with higher Present value will be chosen

Present value= Cash flow/ (1+r) ^n

Where n is the year for which present value is being measured

For example in case of Chicago white Year 1 cash flow= 20 million

Present value of Cash flow= 20/(1+.075)^1= 18.605

Present value for second year Cash flow Chicago white= 20/ (1+.075)^2=17.307

Similarly we will calculate all the present values of cash flows (Values have been given in table below

When we sum all the present values for each team we get the Total present value

	Chicago white	Rangers
Year	Cash flow	Present value	Cash flow	Present value
1	20	18.605	35	32.558
2	20	17.307	35	30.287
3	30	24.149	30	24.149
4	30	22.464	15	11.232
5	30	20.897	15	10.448
	Total Present value	103.421	Total Present value	108.674

Total Present value Chicago white= 103.421

Total present value Rangers= 108.67

Since PV of Rangers>Chicago white

Therefore Rangers deal is better