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

Answer

Option 1 Cash Flow 0 1 Present value of 1 at 8% Present Value 1.000 0 0.926 416,700 1 0.857 385,6502 0.794 357,300 3 1,159,650 450,000 450,000 450,000 1,350,000 2 3 Present Value Option 2 0 1 Cash Flow 100,000 350,000 350,000 350,000 2 3 4 5 6 7 8 Present Value Present value of 1 at 8% for first 5 years & thereafter 10% Present Value 1.000 100,0000 0.926 324,1001 0.857 299,950 2 0.794 277,9003 0.735 4 0.681 5 0.564 6 0.513 7 0.467 116,750 8 1,118,700 250,000 1,400,000 Option 3 0 Cash Flow 150,000 250,000 250,000 250,000 150,000 150,000 2. 3 4 5 6 7 8 Present Value Present value of 1 at 8% for first 5 years & thereafter 10% Present Value 1.000 150,0000 0.926 231,5001 0.857 214,2502 0.794 198,5003 0.735 110,2504 0.681 102,1505 0.564 6 0.513 7 0.467 140,1008 1,146,750 300,000 1,500,000 Option 1 1,159,650 Option 2 1,118,700 Option 3 1,146,750 Present Value Since the present value is highest in case of Option 1 the same should be accepted i.e. i) a guaranteed three-year contract, calling for an annual salary of $450,000 per year