Do No Harm: 32. Problem 5.20 (PV of a Cash Flowstream) eBook A rookie quarterbac

Question

Do No Harm: 32. Problem 5.20 (PV of a Cash Flowstream) eBook A rookie quarterback is negotiating his first NFL contract. His opportunity cost is 89%. He has been offered three possible 4-year contracts. Payments are guaranteed, and they would be made at the end of each year. Terms of each contract are as follows: Contract 1 $2,500,000 $2,500,000 $2,500,000 $2,500,000 Contract 2 $2,000,000 $3,500,000 $4,500,000 $5,500,000 Contract 3 $6,500,000 $1,500,000 $1,500,000 $1,500,000 As his adviser, which contract would you recommend that he accept? Select the correct answer O a. Contract 3 gives the quarterback the highest future value; therefore, he should accept Contract 3. O b. Contract 3 gives the quarterback the highest present value; therefore, he should accept Contract 3. O c. Contract 1 gives the quarterback the highest present value; therefore, he should accept Contract 1. O d. Contract I gives the quarterback the highest future value; therefore, he should accept Contract 1 O e. Contract 2 gives the quarterback the highest present value; therefore, he should accept Contract 2. O Type here to search 2

Explanation / Answer

Ans: (e)

The profitability of each contract can be measured by the NPV of each of them. Higher the NPV, higher is the dollar amount he is making today. Thus, the contract with the highest NPV is recommended to the rookie.

Let calculate each NPV now using a return rate(r) of 8% as the minimum return the rookie needs to make on his contract should be his cost of other opportunities which is 8%

NPV of Contract 1 = Sum of Present Values of all the 4 year cash flows

= 2,500,000/(1+8%) + 2,500,000/((1+8%)2) +  2,500,000/((1+8%)3) +  2,500,000/((1+8%)4)

=$8,280,317.1

=$ 8.28 Million

NPV of Contract 2:

= 2,000,000/(1+8%) + 3,500,000/((1+8%)2) +  4,500,000/((1+8%)3) +  5,500,000/((1+8%)4)

=$12,467,447.00

=$ 12.47 Million

NPV of Contract 3:

= 6,500,000/(1+8%) + 1,500,000/((1+8%)2) +  1,500,000/((1+8%)3) + 1,500,000/((1+8%)4)

=$9,597,819.89

=$9.6 Million

When compared, the NPV of Contract 2 is higher than the other 2.

Thus, Contract 2 gives the Quarterback the highest present value, therefore, he should accept Contract 2

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