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 after-tax earnings if it can lock in the moderate price level for sure?

Question

Quizplus · Accepted Answer

If the input price is at a moderate level, taxable earnings will be $50,000. With a 15% tax rate on the first $50,000, MakeStuff will pay $7,500 in taxes. Therefore, their after-tax earnings would be $42,500 ($50,000 - $7,500). This is the best choice because it is a guaranteed outcome, with no risk involved. The other outcomes involve high levels of uncertainty and could result in significantly lower earnings or no earnings at all.

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