The Hotshots are a professional basketball team with a long tradition of winning. However, over the last 3 years the team has not won a major championship, and attendance at games has dropped considerably. A large basketball manufacturer is the team’s major corporate sponsor. Carl Cliff, president of the basketball company, is also the president of the Hotshots. Cliff proposes that the team purchase the services of a star player, Bob Jackson. Jackson would create great excitement for Hotshots fans and sponsors. Jackson’s agent notifies Cliff that terms for the superstar’s signing with the Hotshots are a signing bonus of $8 million payable now and a house in the foothills near Sabino Canyon at a cost of $5 million. The annual salary and cost of living adjustments are under negotiation.

Cliff’s initial reaction is one of shock. However, he decides to examine the cash inflows expected if Jackson is signed for a 4-year contract. Net gate receipts would most likely increase by $2 million a year, corporate sponsorships would increase $2.5 million per year, television royalties would increase $0.5 million per year, and merchandise income (net of costs) would increase $1 million per year. Cliff believes that a 12% discount rate is appropriate for this investment. The Hotshots’ marginal tax rate is 20%. The signing bonus including house purchase can be amortized (depreciated) over the 4-year period for income tax purposes, providing an annual tax deduction of $3.25 million.

REQUIRED

A. Create a timeline showing the relevant cash flows for this problem.

B. Assuming that he is not willing to lose money on the contract, what is the maximum amount per year that Cliff would be willing to pay Jackson? You will need to set up a spreadsheet for this calculation and through trial and error find an amount that brings the NPV to zero, or use an algebraic approach and annuity factors.

C. Identify possible additional factors that Cliff should consider when deciding whether to sign Jackson to the 4-year contract. List as many factors as you can.

D. For each of the relevant cash flows in this problem, discuss why Cliff cannot be certain about the dollar amount of the cash flow.

E. If Cliff decides to enter into the contract, explain how he could monitor the success of the investment as part of a (1) diagnostic and (2) interactive control system.