Firm ABC has debt with a face value of $40m (which could be considered to be the exercise price on call and put options on the firm). The standard deviation of assets is . The risk-free rate is currently 4.5% and a time to expiration of 30 years is sufficiently long to use for option valuation. The market value of the firm is $80m.

a. Find the market value of debt and equity using the Black-Scholes Option Pricing Model.

b. If the firm decides to increase the volatility of its assets to by investing in riskier assets, what will happen to the market values of debt and equity? Find the new values.

c. Briefly explain the conflict between shareholders and bondholders for a firm.

d. Is this approach consistent with the roles of financial markets?