Risk Management Question 1 - 8 Points The Pre-Tax

Risk Management question 1 8 Points the Pre Tax

The pre-tax profit of a company is uncertain and is either EUR -50 (a loss) or EUR 250 (a profit), both with a probability of 0.5. The corporate tax schedule is such that in case of a loss, there are no tax payments, and in case of a profit, the tax rate is 40 percent. The company can eliminate the risk of profits (e.g., through hedging without costs) and instead realize a certain profit of EUR 100. How much does risk management reduce the expected tax burden? Explain briefly the results. Do you find real-life examples in which tax decisions might increase firm value?

Paper For Above instruction

Risk management plays a crucial role in optimizing the financial outcomes of companies by mitigating uncertainties associated with various risk factors, including pre-tax profits. In this case, the company’s pre-tax profit is uncertain, with two possible outcomes: EUR -50 or EUR 250, each with an equal probability of 0.5. The tax implications are directly tied to these profits: no tax is payable in the event of a loss, while a 40% tax applies in the case of a profit. The company has the opportunity to hedge this risk, thereby fixing its profit at EUR 100 without incurring costs. This strategic decision affects the expected tax burden and ultimately the company's net earnings.

Initially, without any hedging, the expected pre-tax profit (E[P]) can be calculated as:

E[P] = 0.5 (-50) + 0.5 250 = -25 + 125 = EUR 100

The expected tax payments can then be determined. When the profit is EUR 250, the tax is 40% of EUR 250, equaling EUR 100. When there is a loss of EUR -50, no taxes are paid. Therefore, the expected tax (E[T]) is:

E[T] = 0.5 0 + 0.5 100 = EUR 50

Thus, the expected tax burden is EUR 50, corresponding to the expected profit and the tax schedule. Now, consider the company's ability to hedge the profit risk, fixing the profit at EUR 100, which is a certain outcome post-hedging.

With this hedged position, the company pays taxes at 40% of EUR 100, amounting to EUR 40. Since the profit is now certain at EUR 100, the expected tax burden reduces to EUR 40. The reduction in the expected tax burden due to risk management is therefore:

EUR 50 (original expected tax) - EUR 40 (hedged tax) = EUR 10

This indicates that by eliminating profit risk through hedging, the company reduces its expected tax payments by EUR 10. The primary reasoning behind this is that the company shifts from a variable profit scenario, which includes a period of loss (no tax) and high profit (high tax), to a fixed, lower profit scenario that results in consistent, predictable tax payments.

From a broader perspective, this demonstrates a key point: risk management doesn’t just stabilize profits; it can also create tax advantages when tax liabilities are linked to uncertain profits. This aligns with real-world practices where firms use financial derivatives, tax planning strategies, or operational adjustments to optimize their tax burdens and enhance value.

In real-life contexts, firms often employ tax-efficient strategies, such as loss carryforwards, strategic timing of income recognition, or specific financial structuring, to minimize taxes and increase overall firm value. For example, multinational corporations might shift profits across jurisdictions to benefit from lower tax rates or utilize debt structures that generate interest tax shields. These decisions are vital tools for maximizing shareholder value, especially within complex regulatory environments.

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