Suppose that firms face a 40% income tax rate on positive profits and that net losses receive no credit. (Thus, if profits are positive, after-tax income is (1− 0.4) × profit, while if there is a loss, after-tax income is the amount lost.) Firms A and B have the same cash flow as in the previous problem. Suppose the appropriate effective annual for both firms is 10%.
a. What is the expected pre-tax profit for A and B?
b. What is the expected after-tax profit for A and B?
c. What would Firms A and B pay today to receive next year’s expected cash flow for sure, instead of the variable cash flows described above? For the following problems use the BSCall option pricing function with a stock price of $420 (the forward price), volatility of 5.5%, continuously compounded interest rate of 4.879%, yield of 4.879%, and time to expiration of 1 year. The problems require you to vary the strike prices.