Billy Wilson, All American

In his senior year at a major midwestern university, Billy Wilson had been the third runnerup for the fabled Heismann Trophy. The trophy goes to the outstanding football player in America and is presented annually by the New York Athletic Club. During the past football season, Wilson had run for over 1,500 yards and scored 18 touchdowns. He had also caught 41 passes coming out of the backfield. His time in running the 40-yard dash, which professional scouts consider to be extremely important, was 4.38 seconds. He was voted first team All American by the Associated Press and was a second team All American in the Coaches Poll selections.

On Monday morning, his agent, Joel Weinberg, called to say that he was looking at three different proposals that a major West Coast professional football team had made for Billy Wilson's services. The team had drafted him in the first round of the National Football League draft as the sixth player selected out of the thousands of college football players that were eligible for that year. The Edmonton, Alberta, team of the Canadian Football League was also interested in Wilson's services. The Canadian team had called his agent over the weekend to put its offer on the table. While the NFL (National Football League) team that had drafted Billy Wilson in the first round had exclusive rights over all other U.S. teams to signing Billy Wilson during the current year, the Canadian team was not bound by such an arrangement and could make any offer it wished and hope the outcome would be positive.

Actual Proposals

The West Coast NFL team offered the following three proposals. The team's general manager, who was in charge of contract negotiations, said his team would stand behind any of the three offers and it was up to Billy Wilson and his agent to choose which they preferred.

Contract offer 1:

$900,000 immediate signing bonus.

$850,000 at the end of each year for the next five years.

Contract offer 2:

$200,000 immediate signing bonus.

$100,000 at the end of each year for the next four years.

$150,000 a year at the end of years 5 through 10.

$1,000,000 a year at the end of years 11 through year 40.

Contract offer 3:

$1,000,000 immediate signing bonus.

$500,000 at the end of year 1.

$1,000,000 at the end of year 2.

$1,500,000 at the end of year 3.

$2,500,000 at the end of year 4.

As part of the third offer, he was also promised a $200,000 bonus for any year in which he was selected to play in the Pro Bowl All Star game. His agent figured there was a 25 percent probability of that occurring in each of the next four years.

The Edmonton, Alberta, team of the Canadian Football League offered

the following:

$1,100,000 signing bonus.

$2,000,000 at the end of each year for the next three years.

The Canadian contract was not guaranteed. This means that Billy was assured of his signing bonus, but if he did not make the team in any of the three years, he would not receive his salary. His agent figured there was an 80 percent probability that his contract would be picked up (paid) in each of the next three years. (The U.S. team's contract proposals were all guaranteed.)

Wilson's Reaction

Billy Wilson was a sociology major in college and although he was red-shirted (laid out) for one year, he would still receive his degree at the May graduation ceremonies. He was proud of the 2.75 average (out of 4.0 points) he had compiled because of the rigors of college football. He knew that only about 40 percent of athletes on scholarship ever got their degree. At some schools the average was as low as 10 percent, while Notre Dame boasted about a graduation rate approaching 100 percent.

As a nonbusiness major, Billy was confused about the process for determining the actual numerical value of the offerings. For example, the second contract offer from the U.S. team had a total dollar value of over $31 million. He was astounded by such a figure. He knew that players selected as the very first player in the draft in prior years had not received such a high sum. They had been the first players selected in the draft in their respective years, and he was only the sixth player chosen in the current year.

His agent, Joel Weinberg, began to explain to Billy the importance of the time value of money. He said inflows in the future were not worth nearly as much as current inflows and that, therefore, they should be discounted back to the present at a 10 percent interest rate. While Billy did not fully understand how the calculations were done, he knew he could rely on his agent to do the proper analysis.

Required

1.Calculate the present value of the three contract proposals offered by the U.S. team. Factor in any probability considerations where appropriate.

2.Calculate the present value of the contract offered by the Canadian team. Factor in any probability considerations where appropriate.

3.Which of the four contracts offers has the highest present value? What is the amount?

4.If the discount rate used were 7 percent instead of 10 percent, how might that change your answer. You do not need to do new calculations, merely indicate what the likely impact would be.

5.Returning to your answer for question 3, assume Billy Wilson's agent will receive 10 percent of the present value of the contract as his fee. Also, the remaining 90 percent will be taxed at 33 percent. What is the aftertax value of the present value of the proceeds that Billy will receive?

6.If Billy and his agent think tax rates are likely to be higher in the future, how might that influence the decision?

7.Using the answer from question 3, how large an annuity could Billy Wilson pay himself for the next 40 years at 10 percent interest?

8.What other factors should Billy Wilson consider?