Consider two firms,Zoe Corporation and Marley Company.Both corporations will either make $20,000 or lose $5,000 every year with equal probability.The firms' profits are perfectly negatively correlated.If the corporate tax rate is 35%,what are the total expected after-tax profits if the two firms are combined into one corporation,assuming no tax-loss carryforwards or carrybacks?
A)$15,000
B)$8,000
C)$9,750
D)$4,000

Question

Quizplus · Accepted Answer

C)Each company has expected earnings of $20,000 × 0.5 × (1 - 0.35)- $5,000 × 0.5 = $4,000.(Note they do not pay taxes on negative earnings and there are no carryforwards or carrybacks. )
Together,their earnings are 2 × $4,000 = $8,000.
If they merge,they are guaranteed $15,000 per year because one will make $20,000 and the other will lose $5,000.After taxes,the total will be $15,000 × (1 - 0.35)= $9,750.

Consider Two Firms,Zoe Corporation and Marley Company