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

The expected taxable earnings are calculated as the average of the three scenarios: $(100,000 + 50,000 + 0) / 3 = $50,000. For the first $50,000, the tax is 15%, which is $7,500. For earnings above $50,000 (which only applies to the $100,000 scenario), the additional $50,000 is taxed at 25%, which is $12,500. So, the total tax on $100,000 is $7,500 + $12,500 = $20,000, leaving $80,000 after tax. The expected after-tax earnings are the average of the three scenarios: $(80,000 + 42,500 + 0) / 3 = $40,833.

The MakeStuff Company's Earnings Stream Is Highly Dependent on the Cost