(The following is being syndicated from The Captain’s Blog).
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.
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16 Responses to Six Years or Seven? An Apples-to-Apples Look at the Cliff Lee Sweepstakes
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TIQ IQ
So, I think that I disagree with your logic. Baseball teams and the Yankees don’t approach contracts this way. If they did, they would follow your process – take the marginal benefit that a Lee contract would return, and calculate how much they would be willing to invest to make that return. Instead, general managers are given a budget from those in charge of the business end of things, and told to go spend it and not a penny more.
In that case, the real question under your framework would be, “What percentage of the payroll should we devote to Cliff Lee in order to maximize our return?”, which I think is a very different thing.
If the question is what percentage of payroll do we invest in Lee then I think the real question becomes is Cliff Lee as good as Sabathia?
If he is then you can give him the same percentage you gave CC just a difference in years but if you don’t believe Cliff is as good or better than Sabathia as a team can you really give him the same slice of pie as CC?
The analysis has nothing to do with marginal benefit. Whether Lee has a great seven years or gets injured and never pitches is irrelevant. Instead, it is a look at the cost side of the equation, which I’d like to think every team considers. You can’t convince me that teams (at least the well run ones) ignores the real value of contracts and instead opt to make their decisions based on self-imposed constructs like budgets (especially when the simple solution is to simply allocate saved money to future years). For example, if Lee provides $30 million in value this year, but only $10 million in 2016, it makes no sense to pay him accordingly in each season. Instead, it is much better to pay the average, or, even better, pay less upfront and more at the end.
It’s kind of like having more money taken out of your paycheck so you get a bigger tax return. If you are disciplined, it’s much better to keep your money and invest than lend it to the government and have it paid back without interest. I can see the psychological benefit to an individual, but if teams are operating this way, well, they need to reevaluate.
The real question is what do you think Will? Is it worth signing him to a 6 year deal say 150 million?
I think he is worth it, considering the alternatives, but only the Yankees really know the right price because they are privy to those hidden variables I mentioned.
Ok, I understand what you’re saying a bit more now, but I think you’re leaving out the other side of the equation. All of what you said also factor’s into Cliff Lee’s decision making. Any money that comes in the future is money that isn’t turning up as interest in Cliff Lee’s bank account. He’d factor that into his compensation.
Right…this analysis is purely from the Yankees side, although I would note both examples do not involve back loading. Instead, the factoring differences are based on the total value of the contract and the length. From Lee’s standpoint, his biggest variables would be income taxes and cost of living, both of which favor Texas, as well as marketing opportunities, which would favor New York.
The concept of the analysis is perfect, but the nominal interest rate is way too high. Use 3% and rerun the numbers. Baseball teams surely do look at it this way, but not at 12%.
3% is a rock bottom rate that seems way to low. 12% might be too high, but then again, maybe not, especially in a recovering economy. Also, by investment, I don’t necessarily mean a financial instrument, but instead what ever other way the Yankees use their cash flow.
I think 6% is way more realistic than 12%. It is not 1998 and noone is getting rich off internet stocks and its not 2006 where you can securitize your mother…
And i think teams definitely take this into consideration in negotiating contracts (TVM is eco 101), although different teams will use different discount rates, but i cannot beleive that anyone in this market is using a double digit discount rate.
As I was saying below, you are confusing types of analysis in your choice of discount rate. If you are doing an IRR calculation in which you are including all the costs and benefits associated with an investment to make a go/no go decision, you’d use their required rate of return as a discount rate. It’s highly possible that their required rate of return is above 12%. That’s not what you are doing though. You are taking to cashflow streams and comparing them based on their NPV. Their required rate of return is irrelevant. You just want to measure the time value of money which is best estimated by the risk free rate (eg long term treasury).
That’s not really true. The discount rate used doesn’t have to be “risk free” in a NPV calculation. Some applications of NPV may be based on a risk free rate, but it is perfectly justifiable to use one that is higher and lower. I usually use 12% because that is the approximate historical rate of return for the S&P 500, but the best rate to use can only be known by the Yankees.
I agree in general with what you are trying to do but not completely with your methodology. What you are trying to do is compare two cashflow streams from an NPV basis but you are confusing your analysis with other things that aren’t relevant (Yankee required rate of return on investments and potential interest income from the savings in annual payroll from a longer term contract).
I’d use a long term treasury rate as the discount factor (probably more like 4-5%) rather than the 12% you used. You are really just trying to measure the time value of money not whether this meets a internal required rate of return. Similarly, I don’t think you can really assume that there will be an additional $1.5 million annually to invest or that they would achieve a 12% return on it. If you want to assume that the Yankees would either increase their debt by $1.5MM more each year in a six year contract than a 7 year year contract that is probably reasonable but their cost of capital is probably more in the 8-10% range, and whatever interest burden you added on in the 6 year scenario should also be discounted back rather than subtracted as a lump sum. You maybe be doing this but if you aren’t, the luxury tax savings also need to be discounted back.
And I have no answer for how you would model this but a big missing element is the cost to insure the contracts. I remember reading a while back that a big reason why no teams like long term contracts are because of how much they cost to insure. I don’t know how you could come up with a reasonable comparison without inside information or doing more research than I’d care to do but on its face, it seems to me that I’d take an extra year of Lee for an extra $14 million in nominal cost. The Yankees paid $13 million for a $38 year Pettitte. Chances are that salaries are only going up over the next 7 years and Lee will probably be worth that at 39 plus there are all the luxury tax and time value of money issues that make it even a stronger case.
I’ll disagree with EJ though. I think teams do analysis of this sort, any business the size of the Yankees would.
Repeating from above, it is perfectly justifiable for you to prefer a safer rate, but that certainly isn’t required. I am not interested in a base case scenario, however. I am more concerned about what the present value of the money means to the Yankees, and that is best determined by using a rate of return relevant to their investment activity, which admittedly, I really don’t know.
I also don’t agree with your comments on the interest earned from the differential, which is an opportunity cost question. All other things being equal, the Yankees would have the opportunity to invest the $1.5mn not being paid in salary to Cliff Lee (although you could argue that they would simply spend it elsewhere), and I don’t think it is outlandish to assume a rate as high as 12% (especially if you think the economy is poised for sustained growth coming out of a deep recession). The same thing is true of the luxury tax savings, which would be money the Yankees get to keep. I don’t see why you are suggesting that either needs to be discounted (that would be like reversing the process of calculating the interest). If anything, I should have taken the extra step to compound the luxury tax savings at an invested rate of return, which would have yielded a higher figure.
As for insurance, I believe coverage is restricted three year policy terms, so the only difference between the two options is the team would have to decide whether it wanted to take out a third policy on the seventh season. Otherwise, the premiums should be lower in the seven-year deal because a lesser amount would presumably be covered.
Does anyone else feel like Lee’s agent is dragging this proccess out by not letting the Yankees make a bid because he likes the attention coming along with having the hottest name on the market? Agents usually aren’t known by name to fans with the exception of Boras and I have often gotten a feeling that other agents resent him for being the one guy who always has his name in the papers and maybe just maybe this is Lee’s agents chance to be on that level and he’s going to ride it out as long as he can.
Little things like him walking out of a meeting with Cashman and being asked if he was given a deal yesterday and only having a response of a smile and no comment it just makes you feel like he likes the attention, you know what you do and say (in this case not say to reporters is going to be reported, if you make it feel like a no big deal prelim meeting they go away treat it like a National secret and everyone wants to keep digging.
12% is ridiculous.
3-6% depending on your point of view as to where the economy is heading.