Archive for December 8th, 2010

The Cliff Lee sweepstakes has turned into a guessing game over which mystery teams have supposedly offered the ace lefthander a seven-year contract. Although no confirmations have been forthcoming, the addition of a seventh year seems to be a major sticking point, at least for the Yankees, who, again according to unsubstantiated rumors, are unwilling to go beyond six.

On his Twitter account, columnist John Heyman reported that although the Yankees intend on sticking to six years, they would try to “steal” Lee with an inflated offer of $140-150 million. Aside from the fact that a thief isn’t supposed to come away lighter in the pockets, the biggest problem with Heyman’s exclusive is the Yankees’ supposed logic doesn’t really make much economic sense (or cents, for that matter).

All long-term contracts carry heightened risk because of the increased uncertainty that comes from peering too far into the future. For many, the burden of carrying a star player past his prime at an inflated salary seems like a fate worse than being a fan of the Pittsburgh Pirates. However, we can sometimes get too carried away with the length of a contract, especially when what we should be focusing upon is the overall value.

Back loading a contract is one way teams seek to defray the exorbitant cost of long-term deals. Even though that goes completely against the misplaced logic summarized above (now, the star player is paid even more as he gets further from his prime), the economic reasoning is very sound. Why? Because money has time value. In other words, $1 in the present is not the same as $1 in the future ($1 in the present is usually worth more). Factors such as inflation, interest and tax rates can all have an impact on the value of money as time passes, which, brings us back to the Yankees’ reported aversion to giving Lee a seven-year deal.

Let’s assume that Heyman is correct and the Yankees are willing to pay Lee $150 million over the next six years. Instead of dismissing the notion of a seven-year deal out of hand, our next question should be at what terms would such a contract be equivalent? One way to determine that is to consider the present value of two different contracts and see how they compare.

Present Value Comparison of Two Contracts

  Deal 1: $150mn / 6 years   Deal 2: $164.5mn / 7 years
Year Salary Present Value   Salary Present Value
1 $25,000,000 $25,000,000   23,500,000 $23,500,000
2 $25,000,000 $22,186,231   23,500,000 $20,855,057
3 $25,000,000 $19,689,153   23,500,000 $18,507,804
4 $25,000,000 $17,473,124   23,500,000 $16,424,736
5 $25,000,000 $15,506,510   23,500,000 $14,576,120
6 $25,000,000 $13,761,240   23,500,000 $12,935,566
7 NA NA   23,500,000 $11,479,658
Total $150,000,000 $113,616,258   $164,500,000 $118,278,941

Note: Based on a nominal interest rate of 12% compounded monthly. Assumes salary paid in full each year (which favors shorter-term deal).

Source: zenwealth.com

At this point, it might be worthwhile to take a quick diversion and explain what present value means. Basically, in this instance, it refers to the amount of money the Yankees need today to pay off a debt tomorrow (think about Wimpy and hamburgers). Of course, the concept assumes that the money is invested wisely, not spent frivolously (think Carl Pavano). With that in mind, let’s assume the Yankees invested $22,186, 231 on day one of the rumored contract and received a 12% annual rate compounded monthly. At the end of the year, the Yankees initial investment would amount to $25,000,000 (principal plus interest of just over $2.8 million). As a result, with a discounted initial sum, the Yankees could pay Cliff Lee’s salary in the following season.

Now, let’s fast forward back to the comparison. Although it does look as if the Yankees’ shorter deal is less expensive, we aren’t finished yet. In addition to calculating the present value of each term year, we also need to consider the opportunity value of the $1.5 million “saved” under the longer contract. Once again, assuming that the Yankees invested the saving (125,000 per month) at an annual rate of 12%, they would end up with just over $4 million in return. When subtracted from the present value of the deal, the two terms presented in the chart above become near equivalent. For the Yankees, however, there is also the issue of luxury tax. Assuming the team’s payroll would hover around the same level regardless of either deal, it would enjoy a luxury tax savings of $3.6 million (or more, if the Yankees also invested that sum) over the first six years of the seven-year deal. When these factors are also considered, the seven-year deal comes in almost $3 million cheaper than the shorter version.

Normalization of Hypothetical Seven-Year Deal

Variables Total
Present Value $118,278,941
Interest on Lower AAS* $4,088,741
Luxury Tax Savings# $3,600,000
Final Cost $110,590,200

* Based on a nominal interest rate of 12% compounded monthly
# Based on luxury tax rate of 40% charged in years one to six of the contract.

At this point, it should be noted that there are more variables that need to be considered in order to increase the accuracy of the comparison. For starters, we’d need to determine the rate of return that the Yankees expect on their investments (it could be much more or less than 12%). Also, we’d need to have a better understanding of the team’s cash flow (i.e., does paying Lee compromise their liquidity to the point that they can not invest elsewhere). There is also the issue of taxes, which could mitigate the Yankees’ return on investment (although, considering the amount of debt held by the team as well as the favorable tax treatment it enjoys under the terms of its financing, that really might not be much of an issue), as well as inflation, which in a baseball sense would refer to the future direction of salaries (i.e., how much will star pitchers be paid 6-7 years from now). Having noted these caveats, the analysis still illustrates there are very sophisticated ways to evaluate long-term contracts that go well beyond how much an aged All Star is making during the final years of his deal.

Should the Yankees go to seven years with Lee? Or should six be the limit? It doesn’t really matter. What the Yankees need to do is decide upon a limit in terms of present day dollars, not contract years. Only after factoring in all the variables, can such a limit be determined. Then again, there probably is one other variable that also needs to be considered….the competitiveness of Hal Steinbrenner. We know how it would have factored into a negotiation with his father, but it remains to be seen how it will influence the son.

Read Full Post »