Using the Time Value of Money Decision Tree to Calculate an Athlete’s

Contract Offers
Author: B. David Tyler
Publisher: Human Kinetics, Inc.
Publication year: 2017
Abstract
The case follows sport agent Whitney Regine as she reviews contract offers for her client, baseball
player Adam Scialomie. Regine receives four offers, and though they are all for five years of playing
time, the payments are structured in wildly different ways. Regine must use her knowledge of Time
Value of Money and the TVM Decision Tree to determine which contract will provide her client with
the largest contact in terms of PV. She will find that the contracts with the largest nominal values—
i.e., the figures that get reported in the media—are not necessarily worth the most in terms of present
value. She will also see the impact that different discount rates can have in making her decisions.
Case
CRACK! The ball shoots past the diving first baseman and heads toward the outfield corner. Adam
Scialomie rounds first and second with ease, slowing as he reaches third base with a stand-up triple.
Scialomie plays it cool, removing his batting gloves and talking strategy with his third base coach, but
his agent Whitney Regine shows show no such restraint. Watching the game at home, she pumps her
fist and grins. Her client is wrapping up his “contract year”—the final playing season before he goes
on the market as a free agent, and she gains negotiating leverage every time he gets a hit or throws
out a runner from his catcher’s spot behind home plate.

Scialomie currently plays for the Baltimore Orioles and plans to resign with this team. Regine’s task
is to get him the largest contract she can during the upcoming negotiations. The Orioles have a good
relationship with Regine, and they want to resign Scialomie; yet, like any organization, they are
looking to minimize their expenses. Their goal is to negotiate the smallest contract possible.

Both sides agree that Scialomie is a decent Major League Baseball (MLB) player and his salary should
reflect that standing. Where the sides disagree is when those payments should happen. The Orioles
are pushing to extend payments through deferred compensation, and while Scialomie and Regine are
not opposed to that idea, Regine is wary of what that means for Scialomie’s bottom line. This is her
first client where the timing of payments will be such a factor, so she mutes the TV and begins
reviewing what she knows about time value of money, deferred compensation, and planning for
different scenarios.

Time Value of Money

Time value of money (TVM) refers to the idea that the same amount of money is worth different
amounts at different time periods. Regine thinks of a few reasons why this is true. First, money tends
to have differing degrees of purchasing power at different times. Imagine if you had $1 in 1940. With
that $1, you could have purchased a loaf of bread (10¢), a gallon of gas (11¢), a ticket to the latest
movie in the theater (24¢), and still not used up half of your money (Box Office Mojo, n.d.; People
History, n.d.). In the modern United States, $1 alone would buy none of those things. This erosion of
purchasing power is known as inflation and is a natural outcome within relatively free market
economic systems (Brayley & McClean, 2008). The Bureau of Labor Statistics measures inflation
using the Consumer Price Index (CPI), which captures changes in the price for a “basket” of common
purchases within the American household. The CPI helps compare the value of money at one time
with another time.

A second reason that stagnant money loses its value is because of opportunity cost. That is, there are
alternatives for what to do with money. If Scialomie sticks $10,000 under his mattress for five years,
at the end of five years he will still have $10,000. But, if he were put that money into a savings account
that pays a 2% return, he would have $11,041. Thus, his decision to put the money under his mattress
carries an opportunity cost of $1,041.

In the savings account example above, the nominal value of the return was $1,041 (i.e., the actual
number of dollars that he gained). But, assuming there was inflation during these five years,
the real return was less; i.e., the purchasing power of $1,041 at the end of year 5 (t5) is less than the
purchasing power of $1,041 at the beginning (t0). If inflation were 1.5% during the five years, the real
rate of return would only be 0.5% (2% interest—1.5% inflation), which means Scialomie only netted
$253 in real purchasing power. Thus, if comparing the purchasing power of Scialomie’s money at
different times, it is more accurate to use the 0.5% rate.

To put it another way, if Scialomie has a present value (PV) of $10,000 now (at t0) and assumes
a compounding rate of 0.5%, the future value (FV) of his money in year 5 (t5) is $10,253. In the reverse
of that, the value at t0 (the PV) of $10,253 at t5 (the FV) is $10,000, assuming an 0.5% discount rate.
Regine remembers all these terms and concepts, but she still flips through chapters 5 and 6 of Ross,
Westerfield, and Jordan (2013), as well as Chapter 4 of Brown, Rascher, Nagel, and McEvoy (2016),
to remind herself of the details. Among the details she needs to remember are the different types of
TVM situations that she will likely encounter.

The savings account TVM calculations in the examples dealt with single payments, either
compounding them forward or discounting them backward. Regine also needs to account for a series
of payments, such as an annuity or a perpetuity. An annuity is a series of payments that occurs for a
defined number of payments, whereas a perpetuity is a series of payments that goes on forever.
A standard annuity assumes that the first payment in the annuity is made at the end of the first year
(t1), but to complicate matters further, annuities can start right away (t0, which is known as
an annuity due), or several time periods in the future (ty, known as a delayed annuity). And though
typically an annuity’s payments are constant (the same amount is paid at each time period), annuity
payments can also increase over time. Such a series is referred to as a standard growing
annuity, growing annuity due, or delayed growing annuity, depending on when the first payment is
made. As with single payments, one can calculate an annuity’s PV by discounting the series of
payments backward or its FV by compounding the payments forward.

Regine realizes that there are over a dozen formulas needed to handle these various circumstances,
and she struggles to determine which formula to use in which situation. To help make sense of it all,
she builds a decision tree wherein she can ask questions about the payments and follow the path to
find the right formula to apply.

The TVM Decision Tree

The TVM Decision Tree is printed on opposite sides of a single sheet of paper (see Appendix). On one
side are the PV formulas and the other side has the FV formulas. If she is discounting payments, she
uses the PV side; if she is compounding payments, she flips the page to show the FV side. Before
evaluating any offers from the Orioles, she first must master the TVM Decision Tree by working
through a few practice problems.
Sample Problem—Calculating the PV of a Standard Annuity
Regine starts by trying to find the PV of a series of four payments of $500,000 each that start at year
1 (y = 1), where she assumes an 8% discount rate; she abbreviates this rate as i, though she has seen
others use r. The series of payments shown on the timeline in Figure 1.

Figure 1: Timeline for Calculating the PV of a Standard Annuity

The nominal value of each payment is $500,000; in this situation, the nominal value refers to the
actual dollar amount that will be paid in a given year. Thus, the total nominal value of the series of
payments is $2,000,000 ($500,000 × four payments). Because of TVM, however, the PV of each
payment is different. If Regine were to use the single payment formula to calculate each of these
payments, she would find PVs of $462,963 for the payment at t1, $428,669 for the payment at t2,
$396,916 for the payment at t3, and $367,515 for the payment at t4. When summed these equal
$1,656,063, which is the PV for this series of payments. That is the answer Regine was trying to find,
but it took a lot of effort to get there.

Calculating the PV of each payment was repetitive, and though it did not take too long for four
payments, she imagines the tediousness of doing so for a series of 30 payments. Instead, she starts at
the upper-left of the TVM Decision Tree and starts asking questions.

• Is there one payment or a series of payments? There is a series of payments, so she branches
off of the “Series of payments” box.
• Do the payments go on forever or do they stop after a certain number of payments? They stop
after four payments, which tells her that this is an annuity; had they gone on forever, she
would have used the formulas off of the perpetuity branch.
• Are the payments variable, constant, or growing at a constant rate? The payments are the same
each year, so these are constant payments.
• Do the payments start at time period 0, time period 1, or some time period in the future (y)?
They start at year 1.
• That path ends with the standard annuity formula.
• Regine plugs her values into the standard annuity formula, where C1 = 500000, i = 0.08,
and n = 4.
This returns $1,656,063, which is the same value she calculated earlier when solving the problem,
the “long way.” She notices that the first payment was at t = 1, yet the formula calculated the PV at t
= 0 (today).

The standard annuity formula assumes that the first payment is made at the end of the first year,
thus the standard annuity formula returns the PV of the series of payments one time period before the
first payment is made. This point is so important that Regine highlights it in her notes, adds red stars
around it, and then writes it on her bathroom mirror with a dry erase marker. She considers getting
it tattooed on her forearm, but stops short of doing so due to her trypanophobia. The same idea
applies to the standard perpetuity and standard growing annuity formulas, all of which assume the
first payment is made at the end of the first year. This makes sense, of course—a payment happening
at the beginning of the first year would be happening today (t0); thus, it is already in PV and does not
need to be calculated.

Sample Problem—Calculating the PV of a Delayed Annuity

It is obvious that time has a profound effect on the value of money. Specifically, the further into the
future a payment occurs, the lower its PV. Applying this to the annuity above, Regine knows that the
same series of four payments that starts in year 15, for example, will be worth less than $1,656,063,
but by how much? She turns to the TVM Decision Tree:

• Is there one payment or a series of payments? There is a series of payments, so she branches
off of the “Series of payments” box.
• Do the payments go on forever or do they stop after a certain number of payments? They stop
after four payments, which tells her that this is an annuity.
• Are the payments variable, constant, or growing at a constant rate? The payments are the same
each year, so these are constant payments. Up to this point, she is following the same path as
before, but she will diverge in the next step.
• Do the payments start at time period 0, time period 1, or some time period in the future (y)? They
start at year 15.
• Since year 15 is not year 0 or year 1, the path ends with the delayed annuity formula.

Plugging the values into this formula returns $563,825, which is over $1 million less than if the
payments started in year 1. The nominal values of the two series of payments is still $2,000,000, but
the longer time until the payments start severely reduces the value of the annuity.

Understanding the PV of a Delayed Annuity Formula by Calculating in Two Steps

The PV of a delayed annuity formula looks complicated, but as Regine looks closer, she sees that it is
just a combination of two other formulas. The PV of a single payment formula can be rewritten as Cn /
(1 + i) n by multiplying Cn × the “1” in the numerator of 1 / (1 + i) n . Then, she substitutes the standard
annuity formula for Cn, which makes the standard annuity formula the numerator of the full delayed
annuity formula.

In this problem, she already solved for the value of the numerator ($1,656,063). She checks the
writing on her bathroom mirror and reminds herself that the standard annuity formula always
returns the PV one time period before the first payment is made. Since the first payment in this
problem was made in year 15, that means Regine has found the value of the standard annuity in year
14 (PV14). But her work is not done since she wants to know the value at t0.

She now has a single payment ($1,656,063) at t14 and she can use the PV of a single payment formula
to discount that value 14 years back to t0. For the second step of the problem, she multiples her value
by 1 / (1 + i) n , which is known as the discount factor; in this case, the discount factor is 1 / (1 +.08)14,
or 0.340461. This returns $563,825, the same value she calculated using the PV of a delayed annuity
formula.

Sample Problem—Calculating the FV of a Growing Annuity

Thinking about TVM reminded Regine of a story she had read online recently. A Hamilton Tiger-Cats
fan won a contest at a Canadian Football League game by kicking a 50-yard field goal at halftime. The
prize for the kick was a series of 10 annual payments that started at $10,000 that day and increased
by 10% per year. Assuming the fan could get a return of 6% per year, Regine wondered how much
money he would have at the time of the last payment if he just invested the money over that time.
She looked at her TVM Decision Tree, but this time started asking questions on the FV side of the
paper.

• Is there one payment or a series of payments? There is a series of payments, so she branches
off of the “Series of payments” box.
• She knows she has an annuity because it is impossible to calculate the FV of a perpetuity.
• Are the payments variable, constant, or growing at a constant rate? The payments are growing
at a constant rate of 10% each year.
• Is the interest rate the same as the growth rate? No; the interest rate is 6%, and the growth
rate is 10%. If those rates were equal, it would make the FV of a growing annuity formula
uncalculatable because its denominator has i-g and no value can be divided by zero.
Therefore, a different formula is used if these rates are the same.
• That path ends with the top growing annuity formula.

Regine plugs her values into the top growing annuity formula, where C1 = 10000, i = 0.06, and n = 10,
which returns $200,724. Using this formula was significantly easier and faster than calculating the
nominal value for each payment, then compounding each nominal value forward the right number of
years, then adding up all those values.

Now that she is confident in TVM and using the TVM Decision Tree, Regine ponders deferred
compensation and the role that it will play in Scialomie’s contract negotiations.

Deferred Compensation
Following the 1999 season, the Mets negotiated a deal with Bobby Bonilla to pay him 25 payments
of about $1.19m annually starting in 2011 (Sielski, 2010). The Mets did this to free up money to sign
other players, who eventually helped them reach the 2000 World Series (Berg, 2015). Bonilla,
meanwhile, accepted these payments in lieu of the $5.9m he would have made in the 2000 season.
That means that on July 1 of each year through 2035, the New York Mets pay Bobby Bonilla over one
million dollars, even though Bonilla has not played for the Mets since 1999 (Rovell, 2016). This
delayed annuity is just one example of deferred compensation.

Deferred compensation is found within professional sport contracts (Brown et al., 2016), but this
often results in misunderstandings about contract values since TVM effects lower the value of future
payments. By their nature, deferred compensation payments happen in the future, meaning a
deferred compensation payment of $1 million is worth less than $1 million at the time the deal was
signed. This is often lost on fans, the media, and players. For example, the media reported Bruce
Sutter’s 1984 contract with the Atlanta Braves as being worth over $44 million (6 years of playing
$750,000 per year, then 30 years of deferred compensation at $1.3 million year) (Associated Press,
1984). However, if we use a 12% discount rate—the Wall Street Journal Prime Rate at the time was
10.75% (JP Morgan Chase, n.d.)—the contract was really worth just $8.38m.
There are many reasons why a team would want to structure deals using deferred money. One such
reason might be that the owner has other ways to earn a return on his/her money. In the case of the
Mets and Bonilla, the Mets owners (the Wilpon family) were receiving 12–15% returns through their
investments with Bernie Madoff (Rovell, 2016), so investing the $5.9m with Madoff would cover the
future Bonilla payments while still providing a multimillion dollar return for the Wilpons. Of course,
in hindsight this approach failed since Madoff’s returns were the result of a Ponzi scheme, but at the
time it seemed like a smart financial decision. More often, the owner has other [legitimate] businesses
where the owner feels he/she could earn a better return on the money. For example, if the discount
rate is 4% and the owner can invest potential salary money in a different venture that will get a 7%
return, the owner may want to defer payments to the player and net 3% from the investment in the
alternative venture.

The owners may also have a better idea of how to use that money within their own team. Brown et
al. (2016) note that a team could use deferred compensation “when it needs additional cash in the
short term to sign new players, attract or retain coaching or administrative personnel, make capital
improvements, or enhance some other facet of the operation” (p. 91). Ideally, these other investments
will return more than enough to cover the impending payments owed to the player. For example, let
us assume that a team uses the savings from deferred compensation to afford better players in the
current year. This results in more team success, which in turn should be leveraged to produce more
revenue. That excess revenue, which would not have been earned if the team did not upgrade its
talent, can be used to cover the deferred player expenses. It should be stated that those plans do not
always work, however, such as when the Arizona Diamondbacks organization used deferred
compensation for 10 players on its 2001 roster, won a World Series, and yet was financially
distressed within three years (Boivin, 2014).

Another reason for using deferred compensation might be to make a contract appear larger than it
actually is. For example, during contract negotiations in 2004, the Portland Trail Blazers offered Zach
Randolph a 6-year, $72m deal. But, Randolph “felt like [he] deserved” the maximum contract
allowable by the league (which would have been $86m), and the sides agreed on a deal that paid
Randolph the larger nominal value but had 30% of the money as deferred compensation (ESPN.com,
2004). 1 Had Randolph been playing at the same time as Sutter and faced a discount rate over 9.68%,
this deferred contract would have had a lower PV than the Blazers’ initial offer.

It may seem like deferred compensation is only a bad thing for players, yet it has advantages for the
players as well. Playing careers are typically short, with baseball players averaging 5.6 years
(Witnaurer, Rogers, & Saint Onge, 2007) and even shorter careers in sports like American football
(2.66 years; Arthur, 2016). A player can ensure income beyond his or her playing career through
structuring contracts with deferred compensation. The deferred compensation revenue stream may
serve as or supplement a player’s retirement, be used by the player to fund other ventures, or provide
for the player’s family. Many athletes face severe financial hardship within a just a few years of
finishing their playing careers (Carlson, Kim, Lusardi, & Camerer, 2015; Torre, 2009), and a well-
structured deferred compensation plan can help avert a future of being destitute. That said, a
financially disciplined player could take the up-front money and invest it in secure assets that provide
a stream of income similar to that of a deferred compensation offer. This approach is often preferable
as it lowers risk exposure for the player and the investment option may deliver a better return than
would have been seen through deferred salary.

Deferred Compensation in Practice

League offices and player unions negotiate deferred compensation under the terms of each league’s
collective bargaining agreement (CBA). Regine checks the MLB’s rules to ensure the Orioles are
complying with CBA, and just for fun, she compares these with the policies in place across other major
leagues in North America. Some highlights from her notes are in Table 1.

Structuring Scialomie’s Deal

A typical contract negotiation will involve numerous factors, both financial and nonpecuniary. Regine
and the Orioles have already agreed upon many of the nonpecuniary details about Scialomie’s
contract, leaving just financial aspects to finalize. Some players’ egos dictate that they get the largest
nominal value contract, since that is what will make headlines. Fortunately, Scialomie has been smart
enough to listen to Regine and knows that the nominal value is irrelevant—he wants the highest TVM
deal.

Scialomie has also listened to Regine about not squandering his salary. Some agents counsel their
clients toward seeking deferred compensation, knowing that they need the future financial security;
Regine feels no such need. Still, Scialomie would not mind the additional supplemental income in the
future. Furthermore, Scialomie wants to play with better players and knows that taking some of his
money later will allow the Orioles to shift capital to others on the free agent market.

Table 1: Highlights of Deferred Compensation Rules in Select North American Sport Leagues

Limitations on deferred
League Funding CBA years Location in CBA
compensation

PV of deferred money must be

MLB No limitations fully funded by the club within two 2017–2021 Article XVI
years of associated playing season

No more than 25% of

NBA None specified 2017–2024 Article XXV, §1
compensation for the season.

NFL may require that by a

No more than 50% of the salary prescribed date certain, each club
Article 26, §6;
NFL up to first $2m. No more than must deposit the present value 2011–2020
Article 26, §9
75% of salary in excess of $2m. (less $2m) of deferred
compensation

Articles 50.2,
NHL No limitations None specified 2012–2022
50.4

Scialomie is a better than average player overall, and hits well for a catcher, but the risk of reinjuring
a surgically repaired throwing arm reduces his market value. The average annual salary for a catcher
is around $2.24m, though Regine argues that Scialomie’s strong hitting should allow him to make
closer to the league average [across all positions] of $4.5m (Sportrac, 2017). With that range in mind,
the Orioles prepared four possible contract offers that would work with their strategic plans and
other salary commitments (see Table 2). All offers are for five years of playing with the team.

Table 2: Contract Offers From the Orioles (All Dollar Figures Are in Millions)
 Signing Playing Total Average salary
Offer bonus (paid salary per Deferred compensation nominal reported in
at t0) year (t1-t5) value media

#1 $2.75 $2.75 None $16.5 $3.3

$3 annually, for 5 years, starting in

#2 None $1.5 $22.5 $4.5
year 8 (t8-t12)

A 10-year growing annuity that starts

#3 None $1.5 with $1 in year 9 (t9-t18) and grows at $23.4 $4.7
10% per year

A lump sum (single payment) or $25

#4 None $1.1 $30.5 $6.1
at t20

Regine studies the four offers and consults her TVM Decision Tree. For the purposes of keeping things
simple and focusing just on the differences among the deals, she assumes Scialomie receives all
payments at the end of each year (e.g., the salary for year 1 is received at the end of year one) and she
does not consider any tax implications. She draws a timeline of payments for each of the contract
offers, which is an absolutely necessary step for visualizing the payment timings and making TVM
problems easier. After realizing how helpful the timeline is in solving even simple TVM problems, she
uses her dry erase marker to add “Draw a timeline!” to her bathroom mirror reminders.

Regine completes her initial TVM calculations using a discount rate of 5.5%, which is the most likely
rate based on macroeconomic factors and alternate investments available to Scialomie. Her skills as
an agent do not include perfect clairvoyance, however, and thus she wants to examine other scenarios
in case the rate is higher or lower than she expects. She repeats the calculations using rates of 3.0%
and 8.0%. She closes her laptop once the calculations are complete and puts it in her bag for the
morning—she is ready to head to the Oriole front office and settle on Scialomie’s extension.

Questions to be addressed:

• 1. What do the timelines look like for each of Scialomie’s contract offers? That is, what is the
nominal value of each payment and when is each payment happening?
• 2. What is the total PV of each contract offer assuming the most likely discount rate of 5.5%?
What if the rate is 3.0%? Or 8.0%?
o a. Based strictly on obtaining the highest PV contract for her client, which offer should
Regine accept at each of the different rates?
• 3. Offer #4 has a lump sum payment of $25m happening at t20. The Orioles may want to
prepare for that payment by investing a little money in advance rather than needing to find
all the money to handle this large expense in year 20. In fact, the CBA mandates that deferred
money is fully funded within two years of the associated playing year (see Table 1). Regine
was surprised to see that baseball is the only league with such a rule. If the baseball CBA were
like those of other leagues—i.e., the Orioles had freedom to fund their future obligations in
however they wanted—how much would the Orioles have to invest in each of the following
four scenarios to fully fund the account? That is, how much do they need to put away in
 present value dollars to have $25m when the deferred compensation obligation comes due?
Assume a 5.5% discount rate for each of the different funding approaches.
o a. The Orioles make a single deposit today (t0).
o b. The Orioles invest a small amount into an account each year, making constant
payments annually starting at t1 and ending at t20.
o c. The Orioles make nine constant payments starting at year 5 (t5—t13).
o d. The Orioles make 15 payments starting in year 6 (t6—t20) and growing the payment
amount at 8% each year. For this scenario, Regine only needs to determine the
payment amount in year 6.
• 4. Regine believes the Orioles might have some hesitation about locking in Scialomie for five
years, so she thinks about proposing a four-year contract instead of the five-year deal. In such
an offer, she knows that there needs to be enough deferred compensation so that Scialomie’s
salary over the four years of playing does not overly burden team payroll. Design two contract
counteroffers for Regine to present to the Orioles. They must be structured differently from
each other—to give the Orioles some options—and both must meet the following
characteristics:
o a. The contract has a total PV of between $15.5m and $16.0m, assuming a 5.5%
discount rate
o b. Scialomie must earn at least $0.6m (nominal value) in each of the playing years
o c. There is deferred compensation build into the contract.
• 5. Regine remembers that in 2015, Max Scherzer signed a 7-year deal with the Washington
Nationals that was reported as $210m (Associated Press, 2015). This number grabbed
headlines as pundits had predicted he would only be paid around $178m (Heyman, 2014).
However, the deal had a large amount of deferred compensation, with the entirety of his
$35m per year salary in 2019–2021 deferred to 2022–2028 (Baseball Prospectus, n.d.;
Cameron, 2015). Assuming that his income is roughly $15m per year, 2 and that the first
payment was made today (t0), what was the actual PV of Scherzer’s deal at the time of
signing?
• 6. From a player’s perspective, what are the pros and cons of using deferred compensation?
From the perspective of team managers, what are the pros and cons of deferred
compensation? Be sure to consider core financial principles, such as risk/reward and
opportunity costs, as well as sport-specific factors (e.g., salary caps for leagues like the NFL).

Notes
1. The deal was for $84m, but it included a $2m bonus for making the All-Star team in each year of
the contract.

2. The income during the playing years has been simplified slightly for the purposes of illustration.
The actual amounts varied due to bonuses.

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