International Financial Management 2nd Edition by Geert Bekaert ,Robert Hodrick

Exercise 14

Demonstrates that hedging is profitable for the Starpower Corporation. Demonstrate that the benefit to hedging is less if Starpower is more profitable. Do this by redoing Example 1 with possible exchange rates of $0.65/CHF and $0.45/CHF.
Example 1
Starpower's Swiss Project with a More Convex Tax Schedule
Suppose in Example that positive income is taxed at a rate of 45% instead of 35%, whereas losses are again refunded at the 25% rate. Then, if Starpower does not hedge, its expected after-tax income is
[0.5 × ($5,000,000) × (1 - 0.45) + [0.5 × (-$3,000,000) × (1 - 0.252)]
= $250,000
Hence, the firm now expects to pay tax of
$1,000,000 - $250,000 = $750,000
If Starpower hedges by selling CHF40,000,000 forward at $0.50/$, it will again pay taxes on the $1,000,000 of sure income, giving it an after-tax income of
$1,000,000 × (1 - 0.45) = $550,000
When Starpower hedges, it pays $450,000 of tax instead of the expected tax of $750,000 when it does not hedge. Starpower therefore saves $300,000 of expected tax payments.