League Expansion, Interest Rates, and Other Fun Friday Topics by Ben Clemens January 15, 2021 Earlier this week, Ken Rosenthal reported that owners are unlikely to pursue expansion plans in the near future. At first, that sounds strange. Why would owners who are experiencing a cash crunch turn down a quick cash infusion, reportedly nearly $70 million per team? As it turns out, the math is straightforward. Let’s talk about perpetual cash flows, debt equivalence, and other fun stuff like that. Per Rosenthal’s reporting, owners would stand to make an aggregate $2 billion from expansion fees, or $1 billion per new team. Split 30 ways, that amounts to $66.7 million per team, which would go a long way for clubs who are acting phenomenally cash-light. In exchange, however, they’d give up a small share of a lucrative enterprise that makes owning a baseball team a cash cow. Again per Rosenthal, the league projected to make $2.4 billion in central revenue in 2020 before the pandemic laughed in the face of advance planning. Central revenue is everything generated by MLB rather than by individual teams — national TV contracts, national sponsorships, streaming revenue, consumer product sales, and assorted other line items, with TV contracts comprising the lion’s share of the money. That works out to $80 million per team, and adding two teams to the mix would dilute teams’ share of the pie. With 32 teams, each team would only get $75 million in central revenue per year. That might not sound like much — $5 million over time weighed against $67 million in cold hard cash right now — but big enterprises like baseball teams don’t need to act to maximize their liquidity. They instead seek to maximize net present value, which is a financially stylized way to consider the value today of money you might receive in the distant future. This is going to get annoyingly math-y, but I’ll try to keep it in somewhat relatable terms, so bear with me. Say your friend offers you the choice of $100 today or $200 in a year. Presumably, you’d prefer the $200 — it’s twice as much money! Things get trickier, however, if it’s a choice between $100 today or $110 in a year, or between $100 today and $200 in 20 years. Finance deals with this through the use of interest rates. Consider this: let’s say that your local bank will pay you 5% interest if you deposit money with them. That rate is wildly out of line with current savings rates — which currently sit below 1% — but 5% is a nice round number, and we’re using it, so nuts to you, reality. How much is your $100 worth in a year in this case? Easy — $105. How much is it worth in 20 years? In the interest of not boring you, I’ll skip the formula, but 5% compound interest over 20 years comes out to $265. In this world, $100 today beats $200 in 20 years. We can apply that same math, with a few modifications, to work out the net present value of the revenue share that teams would sacrifice in the event of expansion. Since these central revenues have no expiration date, we’ll consider them a growing perpetuity. Why perpetual? Again, no end date. Why growing? Central revenue increases over time, naturally enough. TV deals might not go up forever, but they do tend to increase over time. For the purposes of this analysis, I’m going to make a few assumptions. First, we’ll assume a 5% discount rate. Second, we’ll assume central revenues grow at 2.5% annually. Using those assumptions, the present-day value of the revenues that each team would be sacrificing — the perpetual right to receive a cash flow that starts at $5 million per year and grows by 2.5% annually — comes out to $200 million. In other words, the league would need to collect $6 billion in expansion fees — $200 million times 30 teams — to make expansion worth it to the existing owners. This isn’t the exact number, of course — a lot depends on your assumptions — but it’s probably in the right vicinity. In everyday life, plenty of things pop up that would make you pick a suboptimal side as judged by net present value. Take our original example, $200 in a year against $100 now. You’d probably prefer the $200, but if you need to pay your cell phone bill next week, a bird in the hand might be worth two in the bush. That sounds a lot like what teams are saying about their own finances. If you’ll recall, Tom Ricketts described the scale of losses as “biblical” this summer. The league claimed $1 billion in cash losses in 2020. Sure sounds like they might like some money to pay their cell phone bills. Teams don’t work like regular people, though. They have the ability to take on debt if they have some unforeseen expenses in the present day that line up poorly with future money coming in. Consider our first example again. If you need $100 in one week, and someone offers you either $100 now or $200 in a year, debt would work this way: you take the $200 in a year, then borrow $100 dollars from a bank, promising to pay them back $110 in a year. Now when you have your expenses is less important than taking the better deal in terms of net present value. Instead of saying that teams value the expansion share of central revenues at $200 million and leaving it at that, we can do some fancy math. If you think about it, trading expansion fees for future revenues isn’t so different from borrowing money. The team gets cash now, but they lose money in every future year. Sure, it’s foregone revenue instead of paid interest, but aside from that, the cashflow looks exactly like issuing a perpetual bond. Money in today, money out every year after today. Let’s ask a new question, then. If teams needed to get cold, hard cash this offseason, one way or another, they could either expand and receive fees or issue debt. Through creative replacement of the perpetuity formula, we can figure out the interest rate that would make teams indifferent between borrowing from capital markets or accepting expansion and the fees that go along with it. Again, I’ll spare you the actual nitty-gritty math; the answer comes out almost exactly to 10% — again assuming a 2.5% growth rate on central revenues. In other words, if a team had the choice between borrowing $67 million at a 10% interest rate or adding two new teams to the league to receive their $67 million, they’d be indifferent between the two options. In reality, major league teams can borrow at far more favorable terms. The league’s trust, which functions on behalf of all 30 teams, received an ‘A’ rating from Fitch this July. Bonds with that rating yield around 2% at the moment. Teams can’t all borrow at that level, but interest rates are hilariously low at the moment — high yield bonds (a polite term for junk bonds), rated CCC, yield around 8%, and every baseball team is a far better credit than that. What does this all mean? It’s entirely possible that teams need cash to cover their obligations. They tend to take profits and reinvest them from year to year, which leaves them without much cash on hand. They just went through a pandemic that devastated their gate revenue. It would hardly be surprising if they were cash constrained. For a multi-billion dollar corporation (true of every team), though, cash now or cash in the future is merely a matter of transformation. Negative cash balance? Borrow it! Positive cash balance? Invest it! That doesn’t work infinitely — the Cardinals couldn’t go out and borrow $5.6 billion or anything — but for the amounts that cover operating expenses, the only real constraint on issuance is MLB’s own guidance on how much debt each team can run. Why won’t there be expansion? Under the current terms, it doesn’t make sense for owners to dilute the value of their future cashflows. If someone came to you and offered you $20 for something you think is worth $50, you’d say no. It doesn’t need to be more complicated than that. Are owners experiencing a cash crunch? Certainly. If they wanted it, though, there are always a few places they can generate cash. When you put expansion in that context, passing on expansion in the middle of a pandemic makes a little more sense.