NARRBEGIN: MakeStuff Company
MakeStuff Company
The MakeStuff Company's earnings stream is highly dependent on the cost of a key commodity input.Management believes taxable earnings will be $100,000 if the input price is low,taxable earnings will be $50,000 if the input price is at a moderate level,but earnings will be zero if the input price is high.Management sees these outcomes as being equally likely.The company pays a 15% tax rate on the first $50,000 of taxable earnings,and a 25% rate on all earnings above $50,000.
-What is MakeStuff's expected after tax earnings if it remains unhedged?

Question

Quizplus · Accepted Answer

To calculate the expected after-tax earnings, we first determine the after-tax earnings for each scenario and then find the average, given that each outcome is equally likely. For low input price: $100,000 earnings, the first $50,000 is taxed at 15% ($7,500 tax), and the remaining $50,000 is taxed at 25% ($12,500 tax), totaling $20,000 in taxes, leaving $80,000 after tax. For moderate input price: $50,000 earnings, all is taxed at 15%, resulting in $7,500 tax, leaving $42,500 after tax. For high input price: $0 earnings, there's no tax. The expected after-tax earnings are the average: (80,000 + 42,500 + 0) / 3 = $40,833.33.

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