16. Application of Time Value of Money Skills

Harry Hurler has been playing baseball since he was five years old and has always dreamed of playing in the big leagues.Two weeks ago, on his three-year anniversary with the team, Harry received the following email from his agent, Steven Signem-Now, indicating that he is being called up to the Wichita Wizards, the Mountain Goatss corresponding Major League Baseball (MLB) team. Moreover, Harrys contract is being revised to reflect his new status. The email describes the general terms and conditions of Harrys revised contract.

From: Steven Signem-Now

To: Harry Hurler

Subject: New Team, New Contract Proposal

Salary and Incentives:

	Harry Hurler hereafter referred to as the Player, is offered a four-year contract with an annual salary of $474,000 per year, to be paid at the end of each month in the contract term.
	Under the leagues collective bargaining agreement, the Player will receive a 4% cost-of-living adjustment (COLA) to his annual salary at the beginning of every other year. This means that the Players annual salary will increase at the beginning of year 2 and year 4, as applicable.
	In addition, the Player will receive a one-time $10,000 time-in-league bonus after six months of participation with an MLB team. This bonus will be paid immediately on completion of the six-month period.
	The Player is offered a performance-based bonus, as well as a milestone bonus. Both are intended to encourage outstanding performance.
	The Player is offered the following award-based performance incentive: a 15% bonus payable at the end of the operating year if he is selected to play in the All-Star game. The Player is also offered the following milestone bonus: a $125,000 bonus if he ties Nolan Ryans 1973 single-season strikeout record (383 strikeouts).
	The Player is eligible for each potential bonus each year that the contract is in effect and, if expressed as a percentage, will be based on the value of the Players base annual salary for the corresponding year. If earned, the performance and milestone bonuses will be distributed in a single payment at the beginning of the next contract year. Although this proposal describes only one milestone, the actual contract contains several progressive milestones. Exceeding one milestone creates the opportunity to exceed another.

In addition to the proposal offered by the Wizards, A local car dealer has offered you a contract that will pay $3,000 per month for two years. This contract is contingent on your accepting the contract with the Wizards and will take effect immediately upon signing your MLB contract. In return for these payments, you will participate in the dealers promotional events, such as signing autographs and allowing photographs as requested.

Ive also attached a worksheet that you can use to analyze the deal. Im in negotiations for the rest of the day, so lets discuss your thoughts on the contract proposal tomorrow. Im proud of you!

Take care,

Steven

Steven Signem-Now ; Sports Agent, R&R Talent Management Inc. | Wichita

According to Steven, the contract is worth $2,720,400assuming receipt of all possible bonuses. After rereading the email twice and calling his family, Harry called you to review the terms of the contract and verify Stevens calculations. After an extended conversation about what hell do with his newfound wealth, you and Harry have agreed that any funds received could be invested to earn 9.00%, compounded monthly.

Harry Hurler's Contract Evaluation Worksheet

-Assume that all bonuses are earned in each of the years for which they are available and are paid at the end of the corresponding year(s), unless specifically stated differently. Their value should be based on the salary in effect at the time the bonuses were earned.

-The endorsement proceeds are paid in accordance with the terms of the deal.

-Remember that the timing of a cash flow affects the interest rate that is used to discount the cash flow. For example, annual interest rates should be used to discount annual cash flows, and monthly interest rates are used to discount monthly cash flows. Therefore, it may be necessary to compute the appropriate interest rate that should be used in a discounting calculation.

-Round all dollar amounts to the nearest whole dollar and carry out all interest rate factors to four decimal places.

-When entering intermediate values as answer choices, be sure to round them to the nearest dollar, however when using those same values to calculate another answer, do not round.

	A				B	C	D	E	F
2	Bank Rate Information:
3	Harry's Bank Account Rate (compounded monthly)				9.00%
4	Monthly Bank Rate				? %
5	Effective Annual Interest Rate				? %
7	Salary and Bonus Information:				Year 1	Year 2	Year 3	Year 4	Total value
8	Annual Salary (4% COLA)				474,000	?	?	?	?
9	Monthly Salary				?	?	?	?
10	Discount factor (based on Cell B4 above)				11.4349	10.4542	9.5577	8.7380
11	Discounted Annual Salary				?	?	?	?
13	Time-in-League Bonus				?				?
14	Discount factor (based on Cell B4 above)				0.9562
15	Discounted Time-in-League Bonus				?				?
17	Milestone Bonus				?	?	?	?
18	Discount factor (based on Cell B5 above)				0.9142	0.8358	0.7641	0.6986
19	Discounted Milestone Bonus				?	?	?	?	?
21	Performance Bonus				?	?	?	?	?
22	Discount factor (based on Cell B5 above)				0.9142	0.8358	0.7641	0.6986
23	Discounted Performance Bonus				?	?	?	?	?
25	Monthly Endorsement Contract Payment				?	?			?
26	Discount factor (based on Cell B4 above)				11.4349	10.4542
27	Discounted Monthly Endorsement Payment				?	?			?
29	Contracts Total Nominal Value								?
30	Contracts Total Discounted Value								?

1. Given your worksheet calculations, which of the following statements is accurate? Is Stevens estimate of the value of Harrys contract accurate on either a nominal or discounted basis? Check all that apply.

-Stevens estimate of the value of Harrys contract is incorrect on a nominal basis, and the error is $58,088.

-Stevens estimate of the nominal value of Harrys contract is correct.

-It is appropriate and necessary to discount the endorsement contract using the bank accounts effective annual interest rate because of differences in the timing of the compounding of the bank account and that of the payments on the endorsement contract.

Related Question: The local car dealer creating Harry's endorsement opportunity can earn 6% (compounded quarterly) on his deposited funds. She would have to deposit $_________ each quarter, starting exactly two years before the day Harry signs his contract, to fund her endorsement contract. [Note: The future value interest factor of 6% compounded quarterly for eight quarterly periods is 8.4328.]