1. Suppose that American Eagle will have an operating income before taxes of $20

Question

1. Suppose that American Eagle will have an operating income before taxes of $200 million (state 1) or $ -100 million (state 2) with equal probability (each state has a probability of occurring of .5) if it remains exposed to oil price risk. It can enter into a forward contract agreement to offset this risk. The forward contract will result in a profit of either $-100 million (state 1) or $100 million (state 2), giving the firm a net operating income of $100 million or 0 in the two states. The cost of entering into the forward contract is $ 5 million. Assume for convenience that the appropriate discount rate equals 0. a) If the firm pays no corporate taxes, should it enter into the forward contract? (What is the expected value of the net operating income without and with the hedge?)

b) If the firm pays corporate taxes of 40% and cannot carry its losses forward or backward, should it enter into the forward contract? Assume the company only pays taxes if operating income is positive. (What is the expected value of the net operating income after taxes without and with the hedge?)

c) If tax losses can be carried forward to next year (when the firm expects to have operating income of $200 million with certainty), should it enter into the forward contract? Assume that the discount rate is 0%. If the firm has a loss this year, it can use the loss to reduce the company’s tax bill in the following year. (What is the expected value of the net operating income after taxes without and with the hedge?)

Explanation / Answer

Ans. a) If American eagle decides not to enter into forward contract:

If a firm decides to Enter into forward contract :

Decision: It is better not to take forward contract as it decreases the net benefit.

b) If the firm pays corporate taxes on income, then net income (without hedging will be):

If the firm pays corporate taxes on income, then net income (with hedging will be):

Decision: It is better to take forward contract as it increases the net benefit.

C) If a firm has loss of $100 million, and it enters into forward contract. Then net benefit in the current year would be -$100 million + 100 million = 0 and no loss is required to be carried forward and no benefit in the current year and next year taxes will be $200 million X 40% = $80 Million

If a firm doesn't enters forward contract, then loss in the current year will be $ 100 Million (no tax required to be paid) and in the next year net tax payable would be = (200-100) X 40% = $40 Million

Decision: No forward contract is required to hedge as it is not providing any benefits.

Related Questions

Navigate

• Browse (All)
• Browse 1
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.