Time value - mini cases - FINAL UNPROOFED Final Check...

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Unformatted text preview: CASE 10 Allison Boone, M.D. Allison Boone had been practicing medicine for seven years. Her specialty was neurology. She had received her bachelor’s degree in chemistry from Kent State University and her MD. from Washington University in St. Louis. She did her residency at Columbia Presbyterian Hospital in New York. Allison practiced neurology in a clinic with three other doctors in Hurst, Texas. Her husband, Samuel L. Boone, held an administrative position for Harris Methodist HMO in Arlington, Texas. Allison and Samuel had been married for five years and were parents of young twin sons, Todd and Trey. They lived in Arlington in a beautiful four—room house overlooking Lake Arlington. Allison normally left for work at 7:30 am. and closed her office at 5:30 pm. to return home. On Tuesday, July 6th, 2006 at 5:15 pm, she received an emergency call from Arlington General Hospital and immediately went to the hospital to help a patient who had suffered serious brain damage. By the time she had administered aid and helped prepare the patient for surgery it was 11:00 pm. On her way home as she passed the Ballpark in Arlington (home of the Texas Rangers baseball team), she was confronted head on by a drunken driver going over 80 miles an hour. A crash was inevitable and Allison and the other driver were killed instantly. The drunken driver was making a late delivery for Wayland Frozen Foods, Inc. Legal Considerations The families of both drivers were devastated by the news of the accident. After the funeral and explaining the situation to the children, Samuel Boone knew he must seek legal redress for his family’s enormous loss. Following interviews with a number of lawyers, he decided to hire Sloan Whitaker. Sloan was with a Dallas law firm (Hanson, Sloan, and Thomason) that specialized in plaintiffs lawsuits. He had been in practice for over 20 years since graduating from Southern Methodist University (SMU) law school in 1986. When Sloan began his investigation on behalf of Samuel Boone and his family, he was surprised to find out the driver of the delivery vehicle had a prior record of alcohol abuse and that Wayland Frozen Foods, Inc. had knowledge of the problem 40 Proposal I Proposal 2 Proposal 3 Case 10 when they hired him. It appears the driver was a relative of the owner and at the time of employment he revealed what he termed “a past alcoholic problem that was now under control”. In any event, he was acting as an employee for Wayland Frozen Foods in using their truck to make a business related delivery at the time of the accident. The fact that he was speeding and intoxicated at the time of the impact only increased the legal exposure for Wayland Frozen Foods. After much negotiating with the law firm that represented Wayland Frozen Foods (and its insurance company), Sloan Whitaker received three proposals for an out-of-court settlement to be paid to Allison Boone’s family. The intent of the proposals was to replace the future earning’s power of Allison Boone, less any of the earnings she would have personally needed for her normal living requirements. Also, the value that she provided for her family as a wife and mother, quite aside from her earning power, had to be considered. Finally, there was the issue of punitive damages that Wayland Frozen Foods was exposed to as a result of letting an unqualified driver operate its truck. If the case went to court, there was no telling how much a jury might assign to this last factor. The three proposals are listed below. An actuarial table indicated that Allison, age 37 at the time of the accident, had an anticipated life expectancy of 40 more years. Pay the family of Allison Boone $300,000 a year for the next 20 years, and $500,000 a year for the remaining 20 years. Pay the family a lump sum payment of $5 million today. Pay the family of Allison Boone a relatively small amount of $50,000 a year for the next 40 years, but also guarantee them a final payment of $75 million at the end of 40 years. In order to analyze the present value of these three proposals, attorney Sloan Whitaker called on a financial expert to do the analysis. You will aid in the process. Allison Boone, MD. Required 41 Assume a discount rate of 6 percent is used, which of the three projects has the highest present value? In analyzing the first proposal, take the present value of the 20 year $300,000 annuity. Then take the present value of the deferred annuity of $500,000 that will run from the 21St through the 40th year. The answer you get for the second annuity will represent the value at the beginning of the 21St year (the same as the end of the 20th year). You will need to discount this lump sum value back for 20 years as a single amount to get its present value. You then add together the present value of the first and second annuity. The second and third proposals are straight forward and require no further explanation. Now assume that a discount rate of 11 percent is used instead of 6 percent. Which of the three alternatives provides the highest present value? Explain why the change in outcome takes place between question 1 and question 2. If Sloan Whitaker thinks additional punitive damages are likely to be $4 million in a jury trial, should he be more likely to settle out-of- court or go before the jury? CASE 11 Billy Wilson, All American In his senior year at a major midwestem university, Billy Wilson had been the third runnerup for the fabled Heismann Trophy. The trophy goes to the outstanding football player in America and is presented annually by the New York Athletic Club. During the past football season, Wilson had run for over 1,500 yards and scored 18 touchdowns. He had also caught 41 passes coming out of the backfield. His time in running the 40—yard dash, which professional scouts consider to be extremely important, was 4.38 seconds. He was voted first team All American by the Associated Press and was a second team All American in the Coaches Poll selections. On Monday morning, his agent, Joel Weinberg, called to say that he was looking at three different proposals that a major West Coast professional football team had made for Billy Wilson’s services. The team had drafted him in the first round of the National Football League draft as the sixth player selected out of the thousands of college football players that were eligible for that year. The Edmonton, Alberta, team of the Canadian Football League was also interested in Wilson’s services. The Canadian team had called his agent over the weekend to put its offer on the table. While the NFL (National Football League) team that had drafted Billy Wilson in the first round had exclusive rights over all other US. teams to signing Billy Wilson during the current year, the Canadian team was not bound by such an arrangement and could make any offer it wished and hope the outcome would be positive. Actual Proposals The West Coast NFL team offered the following three proposals. The team’s general manager, who was in charge of contract negotiations, said his team would stand behind any of the three offers and it was up to Billy Wilson and his agent to choose which they preferred. Contract offer 1: 0 $900,000 immediate signing bonus. 0 $850,000 at the end of each year for the next five years. 44 Case 11 Contract offer 2: $200,000 immediate signing bonus. $100,000 at the end of each year for the next four years. $150,000 a year at the end of years 5 through 10. $1,000,000 a year at the end of years 11 through year 40. Contract offer 3: $1,000,000 immediate signing bonus. $500,000 at the end of year 1. $1,000,000 at the end of year 2. $1,500,000 at the end of year 3. $2,500,000 at the end of year 4. As part of the third offer, he was also promised a $200,000 bonus for any year in which he was selected to play in the Pro Bowl All Star game. His agent figured there was a 25 percent probability of that occurring in each of the next four years. The Edmonton, Alberta, team of the Canadian Football League offered the following: $1,100,000 signing bonus. $2,000,000 at the end of each year for the next three years. The Canadian contract was not guaranteed. This means that Billy was assured of his signing bonus, but if he did not make the team in any of the three years, he would not receive his salary. His agent figured there was an 80 percent probability that his contract would be picked up (paid) in each of the next three years. (The US. team's contract proposals were all guaranteed.) Bil/y Wilson, All American Wilson’s Reaction Required 45 Billy Wilson was a sociology major in college and although he was red-shirted (laid out) for one year, he would still receive his degree at the May graduation ceremonies. He was proud of the 2.75 average (out of 4.0 points) he had compiled because of the rigors of college football. He knew that only about 40 percent of athletes on scholarship ever got their degree. At some schools the average was as low as 10 percent, while Notre Dame boasted about a graduation rate approaching 100 percent. As a nonbusiness major, Billy was confused about the process for determining the actual numerical value of the offerings. For example, the second contract offer from the U.S. team had a total dollar value of over $31 million. He was astounded by such a figure. He knew that players selected as the veryfirst player in the draft in prior years had not received such a high sum. They had been the first players selected in the draft in their respective years, and he was only the sixth player chosen in the current year. His agent, Joel Weinberg, began to explain to Billy the importance of the time value of money. He said inflows in the future were not worth nearly as much as current inflows and that, therefore, they should be discounted back to the present at a 10 percent interest rate. While Billy did not fully understand how the calculations were done, he knew he could rely on his agent to do the proper analysis. 1. Calculate the present value of the three contract proposals offered by the U.S. team. Factor in any probability considerations where appropriate. Calculate the present value of the contract offered by the Canadian team. Factor in any probability considerations where appropriate. 3. Which of the four contracts offers has the highest present value? What is the amount? 4. If the discount rate used were 7 percent instead of 10 percent, how might that change your answer. You do not need to do new calculations, merely indicate what the likely impact would be. 5. Returning to your answer for question 3, assume Billy Wilson’s agent will receive 10 percent of the present value of the contract as his fee. Also, the remaining 90 percent will be taxed at 33 percent. What is the aftertax value of the present value of the proceeds that Billy will receive? 6. If Billy and his agent think tax rates are likely to be higher in the future, how might that influence the decision? 7. Using the answer fiom question 3, how large an annuity could Billy Wilson pay himself for the next 40 years at 10 percent interest? 8. What other factors should Billy Wilson consider? In ...
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