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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. Last season, he was a starting pitcher for a double-A (AA)-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 97 mph fastball, an impeccable curve ball and slider, and a reliable changeup pitch, he achieved a 17-3 winloss record, an earned run average (ERA) of 2.84, and 108 strikeouts in 123.1 innings pitched. He is also your best friend.

Two weeks ago, on his three-year anniversary with the team, Harry received the following email from his agent, Noah Never-Enough, indicating that he is being called up to the Boston Back Bay Boys, the Baldiess 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: Noah Never-Enough

To: Harry Hurler

Subject: New Team, New Contract Proposal

Harry,

Congratulations! Youve been called up to the Boston Back Bay Boys. Below are the offered terms and conditions of your new contract. After you review them and think about the offer, call me and well discuss your options. Congrats again!

Salary and Incentives:

	Harry Hurler hereafter referred to as the Player, is offered a four-year contract with an annual salary of $564,000 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 if he is selected for consideration of a major awardsuch as the Cy Young Award (for outstanding pitching). The Player is also offered the following milestone bonus: a $100,000 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 Back Bay Boys, Ive also been able to secure the following endorsement opportunity:

A local car dealer has offered you a contract that will pay $2,750 per month for two years. This contract is contingent on your accepting the contract with the Back Bay Boys 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,

Noah

Noah Never-Enough

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

Harry is so excited! According to Noah, the contract is worth $3,034,400assuming 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 Noahs 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 6.50%, 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.

Harry Hurler's Contract Evaluation Worksheet

	A	B	C	D	E	F
1	Assumptions and Calculated Values
2	Bank Rate Information:
3	Harry's Bank Account Rate (compounded monthly)	%
4	Monthly Bank Rate	%
5	Effective Annual Interest Rate	%
6
7	Salary and Bonus Information:	Year 1	Year 2	Year 3	Year 4	Total value
8	Annual Salary (4% COLA)
9	Monthly Salary
10	Discount factor (based on Cell B4 above)	11.5880	10.8606	10.1789	9.5400
11	Discounted Annual Salary
12
13	Time-in-League Bonus
14	Discount factor (based on Cell B4 above)	0.9681
15	Discounted Time-in-League Bonus
16
17	Milestone Bonus
18	Discount factor (based on Cell B5 above)	0.9372	0.8784	0.8233	0.7716
19	Discounted Milestone Bonus
20
21	Performance Bonus
22	Discount factor (based on Cell B5 above)	0.9372	0.8784	0.8233	0.7716
23	Discounted Performance Bonus
24
25	Monthly Endorsement Contract Payment
26	Discount factor (based on Cell B4 above)	11.5880	10.8606
27	Discounted Monthly Endorsement Payment
28
29	Contracts Total Nominal Value
30	Contracts Total Discounted Value

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

It is appropriate and necessary to discount the performance bonus 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 for the performance bonus.

Noahs estimate of the nominal value of Harrys contract is correct.

Noahs estimate of the value of Harrys contract is incorrect on a nominal basis, and the error is $74,814.

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.]

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