Monday, January 19, 2015

How choosing the right discount rate matters to Max Scherzer

My student Hyojung Lee sent me to a cute article about how Max Scherzer's $210 million contract is not really a $210 million contract.  Because Scherzer is getting $15 million per year over 14 years, the present value of the contract is substantially less than $210 million; it is also worth less than a contract that pays $30 million per year over the seven years he is expected to pitch.

But Dave Cameron (the author of the piece) assigns a 7 percent discount rate to the contract.  The present value of $15 million per year over 14 years at a 7 percent discount rate is about $131 million. He chose 7 percent as the discount rate because that is the expected long run return of investing in the stock market.

A contract is not, however, like a stock.  It is a bond--contracts have seniority to equity, and guarantee a particular cash flow.  I would guess the Nats (unlike the Expos) are something like a BBB company.  The current bond yield on BBB issues is currently about 3.6 percent.  Discounting the value of the Scherzer contract at 3.6 percent produces a present value of $163 million.  Not that $131 million isn't nothing, but $163 million is a lot more.

[Update: Adam Levitin says that MLB teams are more like AAA (in bond rating, not playing quality, except, perhaps for the Diamondbacks last year), because all of baseball backs team contracts (when the Rangers went bankrupt, all players got paid).  That would drive the discount rate to 2.8 percent, and raise the value of the contract to $172 million.]


The Oriole Way said...

The 'right' discount rate also depends on Scherzer's own preferences and opportunity costs. He may view this annuity as preferable to $130 million today that he can then invest in some portfolio of assets which will provide X rate of (expected) return. It's that breakeven point that is 'right' for Scherzer, but good luck finding that out.

ProGrowthLiberal said...

Isn't this source giving an even lower AAA effective yield?

The Federal Reserve notes that the Moody's series for these yields are higher. But this all gets into the term of the bond. And with the current steep term structure, that matters.

ProGrowthLiberal said...

This source provides a lower AAA effective yield than 2.8%:

The Federal Reserve (using a long-term Moodys series) gives higher rates for both AAA and BBB. Given the steepness of the current term structure, this is not surprising.