Finc3011

In: Business and Management

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FINC3011 Tutorial 8
Chapter 17 Questions 5, 6
Chapter 9 Questions 1, 2, 4, 5, 6, 7
Chapter 17 Questions
5. What does it mean for a tax code to be convex? If a country’s corporate tax rate is flat, does it make sense for a firm to hedge?
Answer: A convex tax code imposes a larger tax rate on higher incomes and a smaller tax rate on lower incomes. If a country’s tax rate is flat, a key question is how losses are treated. If losses are subsidized immediately at the same rate that gains are taxed, there is no tax advantage to hedging. But, losses are usually not subsidized, as losses are typically only allowed to be deducted against future income. These tax-loss carry-forwards usually do not grow with the time value of money; nor are they indexed to inflation. Thus, the subsidy associated with a loss is less than the tax associated with a profit, and the tax code is effectively convex. There are also other legitimate reasons to hedge that are not tax related. 6. If the tax code is convex and the forward rate equals the expected future spot rate, why would a firm prefer to pay taxes on the hedged value of a foreign currency cash flow rather than wait to pay the taxes on the realized foreign currency cash flow?
Answer: In the presence of a convex tax code and if the forward rate equals the expected future spot rate, a firm would prefer to pay tax on its expected income with certainty rather than paying its expected tax by taking the probability weighted average of the taxes on possible incomes in the uncertain future states of the world. This is because hedging allows the firm to shift income across different states of the world. Increasing income in states with losses avoids the low subsidy rates, and thus hedging reduces expected taxes.
This increases the firm’s value.

Chapter 9 Questions
1. As the vice president of finance for a U.S. firm,…...

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