Consider a firm managed by an entrepreneur. The firm has two kinds of debt outstanding: senior debt under which it owes $750 to bondholders, and a subordinated bank loan that requires a repayment of $2,550. The firms assets have a current liquidation value of $1,670 but if the firm continues to operate, it will be worth $2,750 with probability 0.7 and $100 with probability 0.3 one period hence. To manage the firm for an additional period, the entrepreneur incurs a personal cost of $280. The entrepreneur has declared that she 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? Why? Assume universal risk neutrality and a risk free (discount) rate of zero. The entrepreneur owns all of the firms equity.

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