The Value of Deferred Money in the Chris Davis Deal

On Saturday, the Orioles agreed to re-sign star first baseman Chris Davis, and the price tag was staggering given his limited market: $161 million over seven years. Except, they aren’t really paying him $161 million over the next seven years; as part of the deal, the Orioles have deferred about a quarter of the contract, pushing $6 million per year of his annual salary into the years after the contract has expired, and pushing some of it way into the future. Under the terms of this deal, Baltimore will now be sending Davis checks for the next 22 years, with the $42 million in deferred money being paid out from 2023 through 2037.

So while the $161 million number is a headline-grabber, the actual value of this deal is quite a bit lower than that, since money loses value over time. We talked about this last year with the Max Scherzer deal, and not surprisingly, Davis and Scherzer are both represented by Scott Boras; he’s clearly willing to create long-term payment structures in order to get a larger total payout numbers when the deals are announced. And for the owners, these types of deals help them acquire (or retain) star players while potentially pushing the future costs of the deal onto another ownership group; Peter Angelos is 86 years old, and will probably not be alive for the entire duration of Davis’ payments.

But to compare these deferred-money contracts to deals signed where the money is paid out during the time the player is actually under contract, we need to use some accounting techniques to create apples-to-apples comparisons. Using net present value (NPV) calculations, we can measure just how much money the Orioles saved by deferring $42 million of Davis’ contract, and see what an equivalent contract without deferrals would have been.

In last year’s post on Scherzer, I used a 7% discount rate, but that was too aggressive on my part; the league and the MLBPA have agreed to use a 4% discount rate for calculating the present value of long-term deals. Since that’s what they’ve agreed upon, and they have better access to future cash flow numbers than we do, it’s probably best for us to accept their discount rate calculations than argue for some other number. So, using that 4% number, we can calculate not only the net present value of Davis’ deal, but also the equivalent value of different payment structures.

Because of the deferred money in the deal, the NPV of Davis’ contract at a 4% discount rate is $126.8 million; that’s the equivalent lump-sum payment that would have the same value as the payment structure he accepted. And this number lines up almost exactly with the number Buster Olney was given by a management source about the value of the deal from their perspective.

@DCameronFG $42 million deferred with no interest over 22 years. Management valuation of deal is at $127.5m.

— Buster Olney (@Buster_ESPN) January 18, 2016

Clearly, $127 million is a lot lower than $161 million, and if we just stopped there, it’d be much easier to defend this outlay on the Orioles part. After all, $127 million is almost exactly what I predicted Davis would get back before the off-season began, and that was on a five-year contract, not a seven-year deal. But we don’t want to just take the NPV of this deal and compare it to other total contract numbers, since teams aren’t making lump-sum payments on those deals either. The numbers that really matter are the ones in the other columns; the NPVs of the alternate payout structures, and the total dollars that the team would have had to pay to come up with an equal NPV to this deal.

As you can see from looking at those columns, the NPV of a seven year, $161 million contract with a flat payout structure, paying $23 million per season from year one through year seven, is $138 million. In other words, the Orioles saved about $11 million in long-term value by deferring the $42 million well down the road. The savings is more like $9 million if we think they could have heavily backloaded the deal instead, starting the contract at $17 million but ending up at $28 million in the final two years of the contract; the NPV on that kind of structure would be $136 million.

But the fourth column is probably the one we care about the most. Generally, we care about contract values because we’re using them to answer the question of what else the team could have done, and we want to know the currency value of this contract; what they could have spent on someone else if they wanted to use this money to sign another player, perhaps one less open to deferrals. So, by fixing the NPV at that $126.8 million figure, we can come up with an equivalent total contract number. Using that 4% discount rate on a seven-year deal, a $147.8 million contract with a flat payout structure would have the same value as the contract Davis just signed.

So, realistically, the deferred money in this deal makes this contract equal to a seven year, $148 million deal that was paid out over the time that Davis is required to play for the team. That’s the real value of this deal when comparing it to other contracts signed this winter. Of course, the fact that he didn’t get an opt-out also has to be factored in as a positive for the Orioles, but he did get a no-trade clause, which has some additional value to Davis. No contract comparison is as simple as what we did above, but when looking at the total dollar figures being bandied about, it’s better to think of Davis’ contract as a $148 million deal. That’s the non-deferred equivalent.