16. Application of Time Value of Money Skills

Salem Swingman has been playing baseball since he was five years old and has always dreamed of playing in the big leagues. Last season, he was a starting pitcher for a double-A (A)-level baseball team, the Ketchum Baldies; last year, he was the first runner-up for the Minor League Player of the Year award. Using his 93 mph fastball, an impeccable curve ball and slider, and a reliable change pitch, he achieved a 15-2 win-loss record, an earned run average (ERA) of 2.76, and 123 strikeouts in 99.1 innings pitched. He is also your best friend.

A

Two weeks ago, on his three-year anniversary with the team, Salem received the following email from his agent, Steven Sign'em-Now, indicating that he is being called up to the Springfield Dusties, the Baldies's corresponding Major League Baseball (MLB) team. Moreover, Salem's contract is being revised to reflect his new status. The email describes the general terms and conditions of Salem's revised contract.

From: Steven Sign'em-Now

To: Salem Swingman

Subject: New Team, New Contract Proposal

Saleem,

Congratulations! You've been called up to the Springfield Dusties. Below are the offered terms and conditions of your new contract. After you review them and think about the offer, call me and we'll discuss your options. Congrats again!

Salary and Incentives:

Salem Swingman hereafter referred to as the "Player," is offered a four-year contract with an annual salary of $594,000 per year, to be paid at the end of each month in the contract term.

Salary and Incentives:

• Salem Swingman hereafter referred to as the "Player," is offered a four-year contract with an annual salary of $594,000 per year, to be paid at the end of each month in the contract term.
• Under the league's 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 Player's 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 pertormance.
• 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 Ryan's 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 Player's 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.

A local car dealer has offered you a contract that will pay $750 per month for two years. This contract is contingent on your accepting the contract with the Dusties and will take effect immediately upon signing your MLB contract. In return for these payments, you will participate in the dealer's promotional events, such as signing autographs and allowing photographs as requested.

I've also attached a worksheet that you can use to analyze the deal. I'm in negotiations for the rest of the day, so let's discuss your thoughts on the contract proposal tomorrow. I'm proud of you!

Take care,

Steven

Steven Sign'em-Now

Sports Agent, R&R Talent Management Inc. | Springfield

Salem is so excited! According to Steven, the contract is worth $3,272,400-assuming receipt of all possible bonuses. After rereading the email twice and calling his family, Salem called you to review the terms of the contract and verify Steven's calculations. After an extended conversation about what he'll do with his newfound wealth, you and Salem have agreed that any funds received could be invested to earn 5.00%, compounded monthly.

Contract Evaluation Worksheet

Complete the following worksheet by inserting the appropriate values to evaluate the contract and answer the related questions.

Note: To clarify possible sources of confusion and simplify your calculations:

Salem is so excited! According to Steven, the contract is worth $3,272,400-assuming receipt of all possible bonuses. After rereading the email twice and calling his family, Salem called you to review the terms of the contract and verify Steven's calculations. After an extended conversation about what he'll do with his newfound wealth, you and Salem have agreed that any funds received could be invested to earn 5.00%, compounded monthly.

Contract Evaluation Worksheet

Complete the following worksheet by inserting the appropriate values to evaluate the contract and answer the related questions.

Note: To clarify possible sources of confusion and simplify your calculations:

• 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.

Salem Swingman's Contract Evaluation Worksheet

c

D

2

3

Assumptions and

Calculated Values

Bank Rate Information:

Salem's Bank Account

Rate (compounded monthly)

Monthly Bank Rate

Assumptions and

Calculated Values

Bank Rate Information:

Salem's Bank Account

Rate (compounded monthly)

Monthly Bank Rate

Effective Annual Interest Rate

Salar and BonUs

8

9

10

Information:

Annual Salary (4% COLA)

Monthly Salary

Discount factor (based on

Cell B4 above)

Discounted Annual Salary

11

12

13

Time-in-League Bonus

14

Discount factor (based on

Cell B4 above)

15

Discounted Time-in-

Leaque Bonus

16

17

18

Milestone Bonus

Discount factor (based on

Cell B5 above)

19

Discounted Milestone

Bonus

20

B

%

%

Year 1

11.681222004

S

$10.000

0.9754

0.9513

c

Year 2

11.11267639

0.9050

S] Valuation of Stock

D

Year 3

$

10.571802890

0.8610

Year 4

10.057254654195

21

Performance Bonus

22

Discount factor (based on

Cell B5 above)

23

Discounted Performance

Bonus

24

25

Monthly Endorsement

Contract Payment

26

Discount factor (based on

Cell B4 above)

27

Discounted Monthly

Endorsement Payment

28

29

30

0.9513

11.6812

0.9050

11.1127

S

S Valuation of Stock

0.8610

0.8191

Contract's Total Nominal

Value

Contract's Total Discounted

Value

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

• It is appropriate and necessary to discount the performance bonus using the bank account's effective annual interest rate because of differences in the timing of the compounding of the bank account and that of the payments for the performance bonus.
• Steven's estimate of the value of Salem's contract is incorrect on a nominal basis, and the error is $80,389.

Related Question: The local car dealer creating Salem'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 Salem 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.]