Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

III. Valuation of Future

Cash Flows

6. Discounted Cash Flow
   Valuation

© The McGraw−Hill^187

Companies, 2002

CHAPTER

6

6

Discounted Cash Flow

Valuation

The signing ofbig-name athletes is often accompanied by great fanfare, but the

numbers are sometimes misleading. For example, in October 1998, the New

York Mets signed catcher Mike Piazza to a $91 million contract, the richest deal

in baseball history. Not bad, especially for someone who makes a living using the

“tools of ignorance” (jock jargon for a catcher’s equipment). That record didn’t

last long. In late 2000, the Texas Rangers offered 25-year-old Alexander

Rodriguez, or “A-Rod” as his fans call him, a contract with a stated value of $250

million!

A closer look at the number shows that both Piazza and A-Rod did pretty

well, but nothing like the quoted figures. Using Piazza’s contract as an example,

the value was reported to be $91 million, but the total was actually payable over

several years. It consisted of a signing bonus of $7.5 million ($4 million payable

in 1999, $3.5 million in 2002) plus a salary of $83.5 million. The salary was to be

distributed as $6 million in 1999, $11 million in 2000, $12.5 million in 2001, $9.5

million in 2002, $14.5 million in 2003, and $15 million in both 2004 and 2005.

A-Rod’s deal was spread out over an even longer period of 10 years. So, once

we consider the time value of money, neither player received the quoted

amounts. How much did they really get? This chapter gives you the “tools of

knowledge” to answer this question.

n our previous chapter, we covered the basics of discounted cash flow valuation. How-

ever, so far, we have only dealt with single cash flows. In reality, most investments

have multiple cash flows. For example, if Sears is thinking of opening a new depart-

ment store, there will be a large cash outlay in the beginning and then cash inflows for

many years. In this chapter, we begin to explore how to value such investments.

When you finish this chapter, you should have some very practical skills. For exam-

ple, you will know how to calculate your own car payments or student loan payments.

You will also be able to determine how long it will take to pay off a credit card if you

make the minimum payment each month (a practice we do not recommend). We will

show you how to compare interest rates to determine which are the highest and which

are the lowest, and we will also show you how interest rates can be quoted in different,

and at times deceptive, ways.

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