Question

PV of cash flow stream

A rookie quarterback is negotiating his first NFL contract. His opportunity cost is 7%. 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:

1

2

3

4

Contract 1	$2,500,000	$2,500,000	$2,500,000	$2,500,000
Contract 2	$2,500,000	$3,000,000	$4,000,000	$5,000,000
Contract 3	$7,000,000	$1,500,000	$1,500,000	$1,500,000

As his adviser, which contract would you recommend that he accept?

Select the correct answer.

Contract 3 gives the quarterback the highest present value; therefore, he should accept Contract 3.

Contract 1 gives the quarterback the highest future value; therefore, he should accept Contract 1.

Contract 2 gives the quarterback the highest present value; therefore, he should accept Contract 2.

Contract 1 gives the quarterback the highest present value; therefore, he should accept Contract 1.

Contract 3 gives the quarterback the highest future value; therefore, he should accept Contract 3.

Answer 1

Present value of contracts are:

Contract 1= 2,500,000*PVAF(7%, 4 years)

= 2,500,000*3.387

= $8,467,500

Contract 2 = 2,500,000*PVF(7%, 1 year) + 3,000,000* PVF(7%, 2 year) + 4,000,000* PVF(7%, 3 year) + 5,000,000* PVF(7%, 4 year)

= 2,500,000*0.935 + 3,000,000*0.873 + 4,000,000*0.816 + 5,000,000*0.763

= $12,035,500

Contract 3 = 7,000,000*PVF(7%, 1 year) + 1,500,000* PVF(7%, 2 year) + 1,500,000* PVF(7%, 3 year) + 1,500,000* PVF(7%, 4 year)

= 7,000,000*0.935 + 1,500,000*0.873 + 1,500,000*0.816 + 1,500,000*0.763

= $10,223,000

Contract 2 gives the quarterback the highest present value; therefore, he should accept Contract 2.