Consider two firms,Blue and Berry.Both companies will either make $25 million or lose $5 million every year with equal probability.The companies' profits are perfectly negatively correlated,so that in any year,one company makes $25 million and the other loses $5 million.If the two firms merge but are run as two independent divisions,what is the change in expected after-tax profits of the combined company (BlueBerry)in any year versus the combined expected after-tax profits of the two separate companies in any year,assuming a corporate tax rate of 30% and no tax loss carryback or carryforward?

Question

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The expected after-tax profit of each firm is $10 million (0.5 * $25 million + 0.5 * -$5 million). The combined expected after-tax profit of the two separate companies is $20 million. When the two firms merge, the expected after-tax profit of the combined company is $15 million (0.5 * $25 million + 0.5 * -$5 million). The change in expected after-tax profits is $15 million - $20 million = -$5 million.

Consider Two Firms,Blue and Berry