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A natural gas producing firm is exposed to fluctuations in market prices of natural gas. If market conditions are favorable (high gas prices) the firm will realize a pre-tax operating profit of $300 million. If market conditions are unfavorable, then the firm will realize a pre-tax operating loss of $175 million. Suppose that the two possible market states (favorable and unfavorable) are expected to occur with equal probability. The firm can enter into a forward contract to offset its risk, and the forward contract is worth either -$175 million if conditions are favorable or $175 million if conditions are unfavorable. The cost of the forward contract is $3.5 million. Suppose that the firm is only concerned about expected operating profit and cannot carry its losses forward or backwards for tax purposes. The firm is subject to a 35% tax rate.
a) What does expected operating income equal if they do not hedge?
b) What does expected operating income equal if they hedge?
c) What should the company do, hedge or not hedge?
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