Calcstar, Inc., a software development firm financed by both debt and equity, is undertaking a new project. If the project is successful, the value of the firm in one year will be $625 million but if the project is a failure, the firm will be worth only $375 million. The current value of Calcstar assets is $500 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 $395 million, and this is the only debt the firm has. Risk free rate is currently 5% per year. Calcstar pays no dividends.

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

2. Suppose that in place of the above project, Calcstars management decides to undertake a project that is riskier. What would happen to the value of the debt? First write down whether debt value will Increase/Decrease and explain why.

3. Suppose debt holders want to prevent the management of Calcstar from taking riskier projects. Write down two ways to achieve this goal and explain why they could work.