This is not about who won and who lost (you might recall that Scott Boras entered the free agency market looking for 5 years and $150 million, but I could not possibly comment) but I think it is useful to discuss just how much Manny Ramirez is really getting.
If he stays the course under the deferred contract as signed, the net present value of the $45 million dollars is $37.66 million. If he opts out after Year 1, the net present value of the $25 million dollars is $21.82 million.
NPV compares the value of a dollar today to the value of that same dollar in the future. It is meant to account for inflation; for the risk of not obtaining the funds as promised; and for the opportunity cost.
Opportunity cost calculates what else Manny might do with the money other than lend it, tax free, to the Dodgers. Here is an example to help you understand the concept. A kid out of high school decides to go to college. He will lose four years of salary at the job he could get. He is investing that "loss" in the hope that his post-college salary will more than make up the difference in the future.
It is easy for calculate NPV, using a spreadsheet program's function menu. You input the amount the projected cash return in each of the years for as long as the contract runs and then determine the discount rate. The Excel command is:
The difficulty arises in deciding what a proper discount rate might be. There is some subjectivity involved and another analyst might well come up with a different number.
For example, I set the risk at 1%. I think there is a 99% chance that the Dodgers will be able to honor the contract. Some, would say there is no risk, others might place the risk higher.
I set the inflation rate at 2% because the current Fed target is fixed at between 1.7% and 2% and they often err to the high side.
The opportunity rate is even trickier. We have to make two simplifying assumptions. First, that Manny has enough money to invest all of the money, as it comes in, and second, that he would opt for safer investments rather than chase higher yields by absorbing more risk. Of course, there are problems with both assumptions. I have not accounted for taxes nor for the agent's commission. The whole amount would not be available for investment.
In this sort of analysis, the 10-year US Treasury bond is often used as the reference rate for the safest investment available in the market. That rate is currently 3.01% but I am using 3.5% because that is the highest annual percentage yield for a 5-year CD that I could find with a quick scan of the web.
In my next blog, I am going to try to turn the tables and see if we can work out what the contract is worth to the Dodgers. As you will see, that is quite a bit harder.
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