Harvey Alexander, an all-league professional football player, has just declared

Question

Harvey Alexander, an all-league professional football player, has just declared free agency. Two teams, the San Francisco 49ers and the Dallas Cowboys, have made Harvey the following offers to obtain his services:

49ers: $1 million signing bonus payable immediately and an annual salary of
$1.5 million for the five-year term of the contract.

Cowboys: $2.5 million signing bonus payable immediately and an annual salary of
$1 million for the five-year term of the contract.

With both contracts, the annual salary will be paid in one lump sum at the end of the football season.

Required:
You have been hired as a consultant to Harvey's agent, Phil Marks, to evaluate the two contracts. Write a short letter to Phil with your recommendation including the method you used to reach your conclusion. Assume that Harvey has no preference between the two teams and that the decision will be based entirely on monetary considerations. Also assume that Harvey can invest his money and earn an 8% annual return.

Explanation / Answer

Hi,

Please find the detailed answer as follows:

The letter to Phil would include a recommendation to use the Present Value Method for evaluating 2 contracts. Under this methid, we judge the suitability of any project based on the cash inflows/outflows generated from it. The relevant calculations showing on how to calculate the Present Value and take the decision have been shown below for this case:

Alternative A (49ers):

Present Value = 1000000 + 1500000/(1+.08)^1 + 1500000/(1+.08)^2 + 1500000/(1+.08)^3 + 1500000/(1+.08)^4 + 1500000/(1+.08)^5 = 6989065.06

Alternative B (Cowboys):

Present Value = 2500000 + 1000000/(1+.08)^1 + 1000000/(1+.08)^2 + 1000000/(1+.08)^3 + 1000000/(1+.08)^4 + 1000000/(1+.08)^5 = 6492710.04

Decision:

Since the Present Value of all the Inflows + Signing Bonus is higher for 49ers, we would select the same.

Thanks.

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