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The Taxes... They are a changing...

Friday, November 5, 2004

While perusing the recently updated blogs in the "Cubs Blog Army" I came across a short entry posted at 1060 West (a new member of the army), which pointed me to Bob Verdi's article in the Sunday Tribune.

In short, the article says that professional sports owners were included in the pig roast (tons of pork!) Federal Corporate Tax cut that was passed and signed recently. Apparently, Congress has changed the tax depreciation rules for professional teams back to the way it was in the 70's when Bud Selig purchased the Brewers using a federal tax write-off.

Depreciation is spreading out the cost of something over its useful life. For example, if I buy a package of hot dogs, I don't count the whole cost of the hot dogs on my first meal, I split the cost over each meal that I eat the hot dogs... this is essentially how depreciation works.

Since most people aren't familiar with the tax depreciation rules for pro-sports teams, a quick review: In the 70's, a new owner could claim virtually the full value of their franchise as a business expense. As a result, they didn't have to pay taxes on most of their income from the team for the first few years. It used to be that those savings stretched out 15 years.

Later, Congress changed two important factors. First, the expenses could only be claimed over a 5 year span, and second, only player salaries could be deducted. This change had 2 effects. The first effect was to make it a bit more difficult to buy a team with a tax rebate, and the second effect was to encourage owners to buy a team, hold on to it for the quick tax breaks, and then sell if 5-6 years later so that another wealthy individual could take advantage of the depreciation laws.

This was/is largely the cause for the many team sales beginning in the 70's. (21 of the 30 teams have been sold at least once in the past 15 years... and all 30 teams have changed hands since 1970.) Before the 70's many teams had stayed within a single family for 40, 50, and 60 years... the Cubs had a Wrigley in ownership from 1916-1981 (65 years).)

Now, it appears that Congress has changed the rules back, allowing owners to depreciate the full value of their teams over a 15 year stretch again.

So what does this mean for the Cubs? Verdi seems to think that the franchise is worth an extra 5% more after the bill became law. However, there are some problems with his reasoning. First, depreciation is a non-cash accounting entry, meaning the only cash to result from a depreciation expense is the tax that doesn't need to be paid (called a tax shield). For most U.S. companies, this is 35% of the expense. However, this money is also stretched out over 6 or 16 years depending on pre-tax bill or post-tax bill depreciation method. (As is usual with the government, a 5 year depreciation occurs over 6 years... half a year in the first year, and half a year in the sixth year = .5 + 4 + .5 = 5... but over 6 years).

The other factor that must be taken into consideration is this: would you rather have a dollar today or tommorrow? In finance... and trust me anyone concerned about depreciating their $100+ million sports franchise is concerned with the finances... we must discount the value of the tax rebates the teams will be receiving.

Discounting cash flows is the reverse of finding out how much will be in your savings account in 1 year. Instead of saying... I put a dollar in today, and with 5% interest its worth a 1.05, its saying... I will have $1.05 next year, how much did I put in today?

Having established our facts, we now ask: So what does this tax bill do for a prospective purchaser of the team? Well, the club's value has grown at a 12.2% annual rate since the Tribune Company bought the team in 1981 for $20.5 million. (Forbes has the team valued at $276 million). Thus, this 12.2% becomes our 'discount rate.' We also know that the Cubs 2004 payroll was approximately $90,560,000 (so says USA Today's salary database). Which would allow an owner who purchased the team before the tax law change to write off these expenses at a tax savings of approximately 35%.

Thus, before the tax law changed, a new owner would have received a current value $26 million in tax breaks.

Now that the tax law has changed, and assuming the club sold for $276 million, the new owner would be able to claim $50 million in present value tax breaks.

The difference between the two values is $24 million, or 8.7% of the franchise value.

But what does this mean for the Trib company... and more importantly for Cubs fans hoping for a higher player payroll? Nothing. The Trib Co. would have to sell the team to get the added value out of the team. The tax law change will have no impact on the team (except via the Expos... see below), and thus we shouldn't expect to see a significant change in player payroll due to the new tax rules... but there is now a better incentive for the Trib to sell... I've got $100 that I could chip in to Steve Stone's ownership group! ... Fat Chance.

So, who will benefit the most from the changes in the tax law? Not suprisingly Major Leage Baseball's very own franchise, the Expos! (Wow, you mean Bud Selig finally gives Washington D.C. its own baseball team, and Congress changes the tax law increasing the resale value of all MLB teams by about 5%! Amazing! Who'da thunk it?)

The reason the Expos will benefit most from this change in tax laws is that they will be sold this winter to the highest bidder... who just got a gigantic tax break from the Federal Government... and will be expected to pass most of that along to Montreal Expos L.P.

So how much will this mean for MLB? Well, the Expos franchise value has grown about 2.89% annually since 1991 (this is a horrible rate of return), but we are going to assume at least semi-competent management... thus I'll bump the discount rate up to a nice (arbitrary) 5%. Also, if Forbes is to be trusted, the Expos are a $145 M franchise before moving to Washington, and the new location should be worth at least $35 M to MLB (thus I will assign a pre-tax change value of $180 M to the franchise).

These assumptions lead to an additional present value of $33 million for MLB. (The tax change present value has an inverse relationship with the discount rate... and the 5% is probably low-balling it, so I also computed the savings with a discount rate of 10%, and that reduces the value by $11 million to $23 million.)

The long and the short of it? I believe the Washington Franchise will sell for about $205 - $225 million dollars. This will be an increase of about $100 million for MLB owners (who bought the team in 2002 from Jeffrey Loria for $120 M.) Each owner should pocket about $3.5 million as a result.

So, what happens when you give 29 owners an extra $3.5 million a piece? The small market clubs pocket the cash (yes Tampa Bay... I'm calling you out) and the large market teams drive up the free agent market (do you really think King George will pocket $3.5 M rather than trying to buy another title?)

Finally, throw in the $2 million per team for the XM Satellite Radio deal, and I think we can all see the free agent market gravitating back towards where it was in 2000.

Being quite capable of doing the math... super-agent Scott Boras has sensed the market pendulum swinging... and now wants a 10 year deal for Carlos (Dracula) Beltran.

Posted by Byron at November 5, 2004 10:53 AM | |

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