NPV of Existing Contract
Brown Company has an existing contractual arrangement to administer vehicle registration and license plate distribution in the southeastern region for State of Ohio. The current arrangement breaks the state into seven districts and each district has a different private sector service provider. The Brown Company contract with the State of Ohio has 10 years remaining. A cost-savings study sponsored by Governor Kasich’s office found that consolidation of the seven districts into one central office would lead to significant cost savings in program administration. The study also found consolidation would address existing disparities in service quality and reduce error rates in license plate issuance and registration in underperforming districts.
The State of Ohio has approached Brown Company to discuss buying out the contract. Mr. Brown is a prominent democratic party activist and donor. He has a great deal of animosity toward the Kasich administration and is playing hardball on the contract buyout. You have been tasked to represent the State of Ohio in negotiation with Mr. Brown and the Brown Company to reach a reasonable contract buyout price.
The remaining ten years of the contract are valued at $250,000 in annual net revenue. Mr. Brown is demanding a contract buyout price of $2.5 million dollars to account for the lost revenue of $250,000 per year for 10 years. For all questions below, assume that the contract execution (i.e. buyout) will take place today, but will take effect next year (i.e. year 1) and the current revenues this year (i.e. year 0) are not impacted by the contract buyout.
Provide a brief explanation for why Mr. Brown’s demands for a $2.5 million buyout are unreasonable from a financial perspective.
The Kasich administration had instructed that a standard discount rate of 5% be used to determine the NPV of all contracts. In an excel file, show the NPV of the annual cash flows and the total contract. Remember that the contract buyout will occur now, but not take effect until next year, so start with year 1 (not year 0) when you discount. What buyout offer should be made to Mr. Brown?
Mr. Brown has reconsidered his position and made another counteroffer. He is insisting that the Kasich administration pay $2 million to buyout the contract. The Kasich administration has decided to allow for a discount rate of 4% to avoid political fallout. Can the two parties reach an agreement now? Why?