Question

Goose Gossage Jr., a professional baseball player, is deciding between two contract offers.   The Red Sox have offered Goose an eight-year contract that would pay $3 million per year for the first two years, and $2 million per year for the remaining six years. The Yankees have also offered Goose an eight year contract. They would pay $1.5 million per year for each of the eight years, and would also make deferred payments of $1.25 million per year for another eight years after the contract period finished.    Assume that each payment is made at the end of the year. Goose has determined that he will accept the contract with the highest present value.   Goose views these payments as essentially risk free, and will value them using treasury interest rates as discount rates.

(a) (3 points) Assuming that treasury interest rates are 2% per year, what is the NPV of each contract offer?

(b) (3 points) Assuming that treasury interest rates are 8% per year, what is the NPV of each contract offer?  

(c) (4 points) Explain why the results in part (b) differ from part (a) in the manner that they do.

Answer 1

Year	Red Sox	Yankees
1	$       3.00	$       1.50
2	$       3.00	$       1.50
3	$       2.00	$       1.50
4	$       2.00	$       1.50
5	$       2.00	$       1.50
6	$       2.00	$       1.50
7	$       2.00	$       1.50
8	$       2.00	$       1.50
9		$       1.25
10		$       1.25
11		$       1.25
12		$       1.25
13		$       1.25
14		$       1.25
15		$       1.25
16		$       1.25
PV at 2%	$    16.59	$    18.80
PV at 8%	$    13.28	$    12.50

c) The rsults differ becaus ein part b we have used a higher discount rate. As we use a higher discount rate , the payments long into future are discounted considerably and hence the value decreasaes. Yankees offer has a higher cash flows long into future hence using a larger discount rate decreases the value of tjeir offer more than the Red Sox offer.