You are the manager of a company that has an equal chance of earning either $20,000 or $40,000 before taxes.Your firm is subject to a 20% tax rate on the first $30,000 and 35% on all income earned beyond that point.If you are offered a costless hedge to achieve guaranteed before tax earnings of $30,000,what is the expected benefit to hedging?

Question

Quizplus · Accepted Answer

Earnings before tax with hedging: 30,000
After-tax earnings by hedging: 30,000 ´ .8 = 24,000
After-tax earnings with 20,000 pre-tax earnings: 20,000 ´ .8 = 16,000
After-tax earnings with 40,000 pre-tax earnings: (30,000 ´ .8 = 24,000)+ (10,000 ´ .65 = 6,500)= 30,500
After-tax expected earnings from not hedging: .5(16,000)+ .5(30,500)= 23,250
Benefit from hedging: 24,000 - 23,250 = 750

You Are the Manager of a Company That Has an Equal