Question

It is December 29. As the agent for a professional baseball player, you are evaluating three proposed contracts submitted by the team. Your client must agree to terms by midnight December 31, or be ineligible for play until May 1. The three proposals are as follows:

i)         a guaranteed three-year contract, calling for an annual salary of $450,000 per year.

ii)        a three-year contract with a $100,000 signing bonus, an annual salary of $350,000, and a payment of $250,000 five years after the expiration of the contract:

iii)       a five-year contract, with a signing bonus of $150,000: an annual salary of $250,000 for the first three years, and an annual salary of $150,000 for the remaining two years: plus a lump-sum payment of $300,000 three years after the contract expires.

REQUIRED:

Ignoring income tax considerations, and assuming (1) that all payments are made on the last day of the year (except signing bonuses) and (2) that the market interest rates will remain constant at 8% for the next five years, rising to 10% thereafter, which proposed contract should you recommend that your client accept? Justify your choice. (SHOW ALL CALCULATIONS)

Answer 1

We need to calculate and compare present values (PV) of all 3 contracts. the contract which has highest present value should be recommended that your client accept.

present value = year 1 cash inflow/(1+interest rate) + year 2 cash inflow/(1+interest rate)² + year 3 cash inflow/(1+interest rate)³ + year 4 cash inflow/(1+interest rate)⁴ .... + year 8 cash inflow/(1+interest rate)⁸

Amounts which will be received today are already a present value. so those amounts need not be discounted by interest rate.

present values of contract i, ii and iii are $1,159,694, $1,118,611 and $1,146,568. so, contract i should be recommended because it has the highest present value among all 3 contracts.

Years	Interest rate	Contract i	PV Contract i	Contract ii	PV Contract ii	Contract iii	PV Contract iii
0				$100,000	$100,000	$150,000	$150,000
1	8%	$450,000	$416,667	$350,000	$324,074	$250,000	$231,481
2	8%	$450,000	$385,802	$350,000	$300,069	$250,000	$214,335
3	8%	$450,000	$357,225	$350,000	$277,841	$250,000	$198,458
4	8%			$0	$0	$150,000	$110,254
5	8%			$0	$0	$150,000	$102,087
6	10%			$0	$0	$0	$0
7	10%			$0	$0	$0	$0
8	10%			$250,000	$116,627	$300,000	$139,952
Total			$1,159,694		$1,118,611		$1,146,568

Calculations