Evaluating an investment proposal under uncertainty Serge Martin, general 7 manager of the hapless Hogtown Flyers, is considering the acquisition of Mario Flanagan to bolster his team's sagging fortunes. Mario has played the last two seasons in Europe, so there would be no compensation paid to an¬ other team if he is hired. Mario, a prolific scorer, is holding out for a 10-year contract with contract demands of (1) an immediate and one-time payment of $200,000 as a signing bonus and (2) $1,000,000 in salary in the first year. Mario is demanding that his salary increase at the rate of 10% each year.

Serge figures that hiring Mario will increase ticket sales by 35,000 per year. Tickets sell for $20 per game, and total variable costs associated with each customer per game are about $5. In addition, Serge is certain that with Mario, the Flyers will get into the playoffs each year. Getting into the playoffs means sales of at least 50,000 playoff tickets, which sell for $30 each. The variable (unit driven) cost associated with each playoff ticket is about $5. Be¬ cause the Flyers have the highest ticket prices in the league and would oper¬ ate at capacity if Mario were signed, Serge does not expect these numbers to change over the life of Mario's contract.

362 Chapter 8 Serge's only concern is that Mario is demanding a guaranteed contract; that is, he will be paid whether he plays or not. Serge is virtually certain that Mario will play for seven years. However, after that, he is uncertain of the possibilities, but certain that whenever Mario stops playing, ticket sales will revert to their current levels.

(a) Prepare a 10-year statement of cash flows associated with this opportunity.

(b) Assume that the Flyer's after-tax cost of capital is 6%. Compute the net present value of this deal if Mario plays for 7 years, 8 years, 9 years, and 10 years. Assume that the Hogtown Flyers face a marginal tax rate of 40% and that any losses on the sports operations can be used to reduce the taxes on other operations.

(c) What would you advise Serge to do?

(LO 1)