Consider Marvelous Computers managed by Mr. Bill Doors. The firm has two kinds of debt outstanding: senior debt under which it owes $100 to bondholders, and a subordinated bank loan that requires a repayment of $1,000. The assets of Marvelous Computers have a current liquidation value of $200, but if the firm continues to operate, it will be worth $1,100 with probability 0.9 and zero with probability 0.1 one period hence. To manage the firm for an additional period, Mr. Doors incurs a personal cost of $5. Mr. Doors has declared that he wishes to file for bankruptcy and has contacted both the bank and the bondholders’ trustee.

The bondholders wish to liquidate the firm immediately. What should the bank do? Assume universal risk neutrality and a risk-free interest rate of zero. Mr. Doors owns all of the firm’s equity.