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A natural gas producing firm is exposed to fluctuations in the market price 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 (each has a probability of occurring of .5). The firm can enter into a forward contract to offset its risk, and the loss or gain on the forward contract position 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 after-tax operating income equal if they do not hedge?
b) What does expected after-tax operating income equal if they hedge?
c) What should the company do, hedge or not hedge based upon the criteria of maximizing expected after tax operating profit?
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