The Saskatchewan Benders are a professional baseball team that has enjoyed considerable success in recent years. As a result, the team has accumulated $10 million to spend on its further development. The board of directors is currently considering two mutually exclusive options for spending the funds available.
The first option is to acquire another player. The team manager has expressed a keen interest in acquiring Basil (Bazza) Ramsey, a pitcher, who currently plays for a rival team. The rival team has agreed to release the player immediately for $10 million if required. A decision to acquire Bazza Ramsey would mean that the existing pitcher, Vinnie Smith, could be sold to another team. The Benders have recently received an offer of $2.2 million for this player. This offer is still open but will only be accepted if Bazza Ramsey joins the Benders. If this does not happen, Vinnie Smith will be expected to stay on with the team until the end of his playing career in five years' time. During this period, Vinnie will receive an annual salary of $400,000 and a loyalty bonus of $200,000 at the end of his five-year period with the team.
Assuming Bazza Ramsey is acquired, the team manager estimates additional gate receipts of $2.5 million in the first year and $1.3 million in each of the four following years. There will also be an increase in advertising revenues of $1.2 million for each of the next five years if the player is acquired. At the end of five years, the player can be sold to a baseball team for $1 million. During his period with the Benders, Bazza will receive an annual salary of $800,000 and a loyalty bonus of $400,000 after five years.
The second option is for the baseball team to improve its ground facilities. The west stand could be extended and executive box seating could be built for businesses wishing to offer corporate hospitality to clients. These improvements would also cost $10 million and would take one year to complete. During this period, the west stand would be closed, resulting in a reduction of gate receipts of $1.8 million. However, gate receipts for each of the following four years would be $4.4 million higher than current receipts. In five years' time, the team has plans to sell the existing stadium and to move to a new one nearby. Improving the stadium is not expected to affect its value when it comes to be sold. Payment for the improvements will be made when the work has been completed at the end of the first year. Whichever option is chosen, the board of directors has decided to take on additional stadium staff. The additional wage bill is expected to be $350,000 a year over the next five years.
The team has a cost of capital of 10%. Ignore taxation.
Required:
(a) Calculate the incremental cash flows arising from each of the options available to the Saskatchewan Benders.
(b) Calculate the net present value of each of the options.
(c) On the basis of the calculations made in part (b) above, which of the two options would you choose and why?
(d) Discuss the validity of using the net present value method in making investment decisions for a professional baseball team.