Suppose you are a bank lending officer at the Midtown National Bank considering a loan request from Miller Manufacturing company for $1.05 million. The firm currently has $1 million in equity and its existing debt repayment obligation is $2 million. Assume that this equity is in the form of retained earnings invested in a noninterest-bearing account. The firm can invest the $1.05 million it will borrow from your bank in one of two projects (the bank cannot directly control which project the firm will invest in): A or B. Project A will yield a payoff of $2 million with probability 0.8 and $1 million with probability 0.2 at the end of the period.

Project B will yield a payoff of $7 million with probability 0.2 and a payoff of zero with probability 0.8 at the end of the period.

The firm’s existing assets will yield a payoff of $3 million with probability 0.8 and a payoff of zero with probability 0.2 at the end of the period. The payoff on either project A or project B is statistically independent of the payoff on the firm’s existing assets. These payoff distributions are common knowledge. For simplicity, there is no discounting and the bank loan you will make is subordinated to the firm’s previous debt. Examine how Miller Manufacturing’s behavior and the terms of lending change depending on whether or not it has the $1 million equity mentioned earlier.