(2 sub-questions) Calcstar, Inc., a software development firm financed by both debt and equity, is undertaking a new project. (Project A) If the project is successful, the value of the firm in one year will be $125 million but if the project is a failure, the firm will be worth only $75 million. The current value of Calcstar assets is $100 million, a figure that includes the prospects for the new project. Calcstar has outstanding zero coupon bonds due in one year with a face value of $80 million, and this is the only debt the firm has. Risk free rate is currently 5% per year. Calcstar pays no dividends.

a. Find the current value of Calcstars debt and equity using binomial option pricing.

b. Suppose that in place of the above project, Calcstars management can select a riskier project success $150 million vs. failure $50 million. If Calcstars managers are mostly compensated by salaries and pension plans, would the managers select the riskier project? Explain.