All this is about $40? If I were in your situation I would give them the $40 refund and immediately increase my prices, $80 is way too low for that cake.
The hassle of a paypal dispute (not to mention small claims court) will cost you more in time than you would potentially save by avoiding a refund.
I would say the same thing, but I don't like giving in to jerks. I'd wait to see if she disputes the claim, send paypal all the information that you have and wait and see. They're not going to freeze your entire account, they just pull back the amount that's in dispute and hold it until the complaint is resolved.
I have a friend who had the same thing happen, and she eventually got her money back form Paypal because she showed them that everything was delivered as ordered. The problem that they run into is that they can't quantify the kind of complaints that we get, like fallen cakes, dry cakes, etc. One guy from paypal told my friend that the best way to protect ourselves would be to not take credit cards at all because with this kind of business there's too much grey area of who's responsible for problems.
This lady seems to be late to the party, anyway. Complaining about the cake to get a refund is so last year...This year's trend is for clients to ask for a discount before they even book with you.