Solved: When Alex Rodriguez moved to the Texas Rangers

in 2001

When Alex Rodriguez moved to the Texas Rangers in 2001, he received a lot of attention for his
“$252 million” contract (the total of the payments promised was $252 million). Assume the
following about the contract: Rodriguez earns $16 million in the first year, $17 million in years 2
through 4, $19 million in years 5 and 6, $23 million in year 7, and $27 million in years 8 through
10. He would also receive his $10 million signing bonus spread equally over the first 5 years ($2
million per year). His deferred payments begin in 2011. The deferred payment amounts total
$33 million and are $5 million, then $4 million, then 8 amounts of $3 million (ending in 2020).
However, the actual payouts will be different. All of the deferred payments will earn 3% per year
until they are paid. For example, the $5 million is deferred from 2001 to 2011, or 10 years,
meaning that it will actually be $6.7196 million when paid. Assume that the $4 million payment
deferred to 2012 is deferred from 2002 (each payment is deferred 10 years). The contract is a
10-year contract, but each year has a deferred component so that cash flows are paid out over
a total of 20 years. The contractual payments, signing bonus, and deferred components are
given below. Note that, by contract, the deferred components are not paid in the year they are
earned, but instead are paid (plus interest) 10 years later.

Assume that an appropriate discount rate for A-Rod to apply to the contract payments is 7% per
year.
a. Calculate the true promised payments under this contract, including the deferred payments
with interest.
b. Draw a timeline of all of the payments.
c. Calculate the present value of the contract.
d. Compare the present value of the contract to the quoted value of $252 million.
What explains thedifference?

When Alex Rodriguez moved to the Texas Rangers in 2001

ANSWER
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