Decision Making Under Uncertainty I. You are the manager of the Cleveland Cavali

Question

Decision Making Under Uncertainty I. You are the manager of the Cleveland Cavaliers (a professional basketball team in the NBA) and you are considering a trade with another team You have the opportunity to sign a great young player, Isaiah Thomas, who formerly played for the Boston Celtics. Answer the following questions. a. You expect that signing Thomas will increase your team's profits by S12 million per year, and you expect him to play for another 10 years. Assuming that the team's profits are earned at the end of each year, and that the interest rate is 6%, what is the most you should be willing to pay Isaiah Thomas today for a ten-year contract to play for your team? b. Suppose now that there is the possibility that Thomas has a serious injury. This introduces some uncertainty about how well he plays, and thus how he will impact your team's profits. There is a 25% chance that his hip injen is so severe that he will increase your profits by Just $5 million or the next five years, and then will have no impact on the team's profits during the second half of the contract. There is a 50% chance that he increases your team's profits by $12 million per year as he did in (a) above. There is a 25% chance that he does even better than expected, and he increases the eam's profits by $20 million for each of the next five years and then 310 million for the five after that. Given this uncertainty, how much should you be willing to pay for Thomas' 10-year contract if you use the expected value criterion? Assume the interest rate is still 6%.

Explanation / Answer

A. Find out peresent value when Payment = $12,000.000 , Year = 10 and Rate = 6%

PV = 12,000,000 / (1.06)^1 + 12,000,000 / (1.06)^2 ..... 12,000,000 / (1.06)^10

PV = $ 88,321,044.62

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