Consider a fi rm managed by an entrepreneur. The fi rm has two kinds of debt outstanding: senior debt under which it owes $150 to bondholders, and a subordinated bank loan that requires a repayment of $1,250. The fi rm’s assets have a current liquidation value of $400, but if the fi rm continues to operate, it will be worth $1,400 with probability 0.8 and zero with probability 0.2 one period hence. To manage the fi rm for an additional period, the entrepreneur incurs a personal cost of $25. The entrepreneur has declared that he wishes to fi le for bankruptcy and has contacted both the bank and the bondholder’s trustee. The bondholders wish to liquidate the fi rm immediately. What should the bank do?

Assume universal risk neutrality and a risk-free (discount) rate of zero. The entrepreneur owns all of the fi rm’s equity.