Present Value of Strasburg’s Contract
August 21, 2009 at 3:14 pm by Capitol Avenue Club under Draft, Front Office, Washington Nationals
With the help of one of my economics major friends, I’d like to present a break-down of the Present Value of Strasburg’s contract. For those of you unfamiliar with the concept, since money has a time-value (i.e. a dollar today is worth more than a dollar tomorrow), Strasburg’s $15.1 million, to be paid in certain increments, does not equal $15.1 million if he were to recieve a lump sum today. Here’s how it breaks down.
The deal is a 4-year deal with a signing bonus. This year, 2009, Strasburg gets a pro-rated portion of the MLB league minimum (~$400,000, so ~$100,000 for him) and a $2.5 million dollar portion of his signing bonus. Since he’s making that money right now, we’re assuming he gets it today. So the present value of his $2.6 million for 2009 is $2.6 million.
In 2010, Strasburg receives a $2 million salary and a $2.5 million dollar portion of his signing bonus. This $4.5 million does not equal $4.5 million 2009 dollars. Assuming a 12% rate of return (and daily compounded interest), the present value of Strasburg’s 2009 earnings is $3,991,221–over half a million less than what he would receive if he’d gotten paid today.
In 2011, Strasburg receives a $2.5 million salary and the final $2.5 million portion of his signing bonus. Again, assuming a 12% rate of return compounded daily, Strasburg’s 2011 earnings in 2009 dollars equals $3,933,216.
And in 2012, the final year of Strasburg’s deal, he receives a $3 million salary. This salary, in 2009 dollars, equals $2,093,070.
Adding it all together, Strasburg’s deal is worth, in 2009 dollars, $12,617,507. Nearly $2.5 million gets lost due to the time value of money.
My methods and assumptions are rather crude and this is more of an estimate than anything else.
That’s the advantage signing a MLB deal rather than just a bonus has for the club.
Of course, the main disadvantage is you have to place the player directly on your 40-man roster (i.e. you begin using his options immediately and don’t have those first 3-4 years of MiLB development). But with a player like Strasburg, he supposedly won’t need to develop in MiLB very much. So I think doing a MLB deal was the correct path for the Nationals.
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Peter, I am trying out my first “cover it live” at my site if you want to join. I know that you have your own game to worry about though :)
Peter,
Though I’m not sure this was your major point, I think this subtely demonstrates a point about backloaded contracts in general. All too often when people analyze contracts they focus on the “average” salary per year the player will get without regard to the usual backloading of the contract. When you consider the discount rate (which admittedly varies), teams that lockdown the most predictable years to lower salaries arguably come out a winner. At the same time, the argument can be made that placing the most “absolute” monetary value into the most unpredictable years is a mistake. I think it’d be a fascinating, and most time consuming, study to look at unbalanced contracts to see whether accounting for PV and the discount rate whehter teams come out winners or losers on multi-year deals based on this concept. A great case study might be someone like Derek Lowe who we ridicule for the total value 4 yr./$60 million. His contract is in fact $15 million a year, so the questions become 1) Was his expected performance this year worth $15 million and 2) would his expected performance in year four be worth $15 – the proper adjustment (sorry, too lazy to consider this right now). In other words, guys like him who have completely balanced deals can provide a great benchmark to compare to players with unbalanced contracts. Unfortunately, much of this would be 20/20 hindsight, but I love the notion of using these types of economic concepts to possibly evaluate the true value of past contracts.
Interesting. Though the 12% risk free rate is probably not accurate given the current market. But it wouldn’t change the analysis that much. Good stuff.
In today’s economy, you can never assume anything with regards to risk free rate of return. But 12% used to be the assumption (before the economy went down the toliet) and since nobody else knows what the hell you’re supposed to assume, I just thought keeping it simple was the way to go. But you are right. You CAN’T assume a 12% rate of return.