You are a bank loan officer. ABC Corporation has requested a $2.1 million loan. The corporation has $2 million in retained earnings and an existing debt obligation that calls for a repayment of $4 million one period hence. The firm has existing assets that will be worth $6 million with probability 0.7 and nothing with probability 0.3 one period hence.

These are the future values of the assets in place if the firm does not make any investment at present. The firm also has the choice of investing in one of two mutually exclusive projects (A or B). Project A will yield $4 million with probability 0.7 and $2 million with probability 0.3 one period hence. Its cash flows are uncorrelated with (and in addition to) those from the assets in place. Project B will yield $13 million with probability 0.2 and nothing with probability 0.8. Its cash flows are also uncorrelated with those from the assets in place. Assume that everybody is risk neutral and that there is no discounting. Moreover, ABC’s existing debt has seniority over any new bank loan. Compute ABC’s project choice and your pricing of the bank loan in two cases: (i) ABC has $2 million in retained earnings that will be kept within the fi rm for one period, (ii) ABC has already announced that the retained earnings will be paid out as dividends right now and hence unavailable to augment ABC’s cash flows one period hence. Assume that your bank’s cost of funds is zero and the bank is competitive (prices the loan to earn zero expected profit).