Value of Leverage.

A) Hanson PLC was an all equity firm until yesterday. They are very profitable and so face a marginal corporate tax rate of 30%. The market value of their equity was $6.1B yesterday. Today they issued $1B in debt (market value and face value) with a coupon rate of 7% and repurchased $1B of equity. The bond has a one-year maturity. Since the promised return is greater than the risk-free rate of 4%, is the bond more likely to default in booms or recessions? Explain briefly.

(B). The expected rate of return on the debt is 5%. How much does the present value of Hanson's taxes fall when they levered up the firm? Assume that investors receive only 86 cents on the dollar in default. Explain