Prof. Thomas Chemmanur
Office: Fulton 440
Phone: (617) 552 3980
Spring 2003

Wallace E. Carroll School of Management

MF891: Doctoral Seminar in Corporate Finance

Course Objective
 This course has the objective of introducing doctoral students to theoretical research in corporate finance. The emphasis will be on incomplete information models, though a few models driven by other considerations will also be studied. The first part of the course will examine the fundamentals of corporate finance theory (e.g., the theory of the firm's choice of its capital structure and dividend policy under alternative assumptions), as well as various tool areas in corporate finance (e..g, the notion of moral hazard and agency problems, adverse selection and signalling, various aspects of non-cooperative games with and without incomplete information, and the equilibrium concepts in such games). The second part of the course will focus on two or three important related topics which are the focus of recent research in corporate finance.

Since many of the models in corporate finance make use of tools from information economics/game theory, some knowledge of these tools is required. But those who do not have these tools but are willing to catch up with some reading on their own should not have too many problems, since many ideas in corporate finance are quite intuitive, and I will try to emphasize intuition over mere technical detail wherever possible. For game theory, there have been numerous excellent and easily accessible text books written in the last four or five years. I will mention only three of these below:

1. Eric Rasmusen, Games and Information: An introduction to game theory, Basil Blackell. (A basic book)

2. Gibbons, R., Game Theory for Applied Economists, Princeton University Press, Princeton, New Jersey (intermediate level).

3. Fudenberg, D., and J. Tirole, Game Theory, M.I.T Press, Cambridge Massachusetts. (Fairly advanced)

A book for supplementary reading: Unfortunately, there are really no good Ph.D level text books in corporate finance. The best I can do here is to recommend two advanced M.B.A text books which summarizes the ideas behind some of the earlier theory papers, and also much of the empirical literature in corporate finance:

1. Copeland, T.A., and J.F. Weston, Financial Theory and Corporate Policy, third edition, Addison-Wesley Publishing Company (this book will be referred to as CW in the outline).
Although this book will not help you with any of the current research, it will give you a quick introduction and a summary of the earlier theoretical and empirical research in corporate finance, thus allowing you to place the current literature in perspective.

2. Grinblatt, M., and S. Titman, Financial Markets and Corporate Strategy, Irwin/McGraw-Hill, 1998. Chapters 17, 18 and 19 of this book provide a useful discussion of issues of financing strategy facing the firm arising from asymmetric information and agency relationships (the discussion is, however, only at the M.B.A level, and thus serves only as a starting point, at an intuitive level, for Ph.D students).

Other course materials:
Most of the lectures will be based on academic papers. I plan to make these available to you as we go along. The papers directly relevant for class discussion on each topic are mentioned under that topic in the outline below; however, the discussion will not be confined to these papers, and additional papers may be added as we go along. I will also be giving out copies of my class notes for every lecture.

Course Organization:
The first part of the course will consist entirely of lectures; the second part will be a combination of my lectures and student presentations. Each student will be required to write a short paper, either synthesizing the literature in a certain area, or, for the more ambitious, a paper which constitutes original research, which will be due approximately one month after the end of the course. Students will be asked to work out hand-in problem sets, and also do a referee's report on a paper of my choosing (I will discuss the format for this later on). Each student will also be asked to make a class presentation of one or more papers (in the second part of the course), which should also be chosen jointly with me. There will also be a final exam. The final grade will thus depend on performance in the problem sets, final exam, the research paper, and student presentation and other class participation exercises.

The course grade is determined as follows:
a. Class presentation: 15%
b. Class participation and problem set: 15%
c. Critiques of papers: 10%
c. Research Paper/syntheis: 20 %
d. Final Exam: 40%

Office Hours:
I have office hours specifically for this course (as well as other Ph.D related matters) set up on Wednesday 5:30 to 6:30 P.M. However, Ph.D students are welcome to drop by at other times as well, or to set up an appointment for some other convenient time (send me e-mail if you wish to make an appointment).

Outline of Topics

Part I: Fundamentals and Tools

  The main papers that will be used in the discussion of each topic are listed below.

Topic One: Corporate Finance under Perfect Capital Markets: The Modigliani-Miller propositions on capital structure.


Modigliani, F. and M. Miller "The Cost of Capital, Corporation Finance and the Theory of Investment"  American Economic Review, June 1958, 261-297.

(CW, chapters 13 and 14 respectively, provides some background reading on the large theoretical and empirical literature on capital structure.)

Topic Two: Taxes and Capital Structure


Modigliani, F. and M. Miller "Corporate Income Taxes and the Cost of Capital" American Economic Review, June 1963, 433-443.

Miller, M., "Debt and Taxes," Journal of Finance, June 1977, 32, 261-276.

Topic Three: Agency problems and capital structure.


Jensen, M. and W. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," Journal of Financial Economics, October 1976, 3, 305-360.

Myers, S.C. "Determinants of Corporate Borrowing"  Journal of Financial Economics, November 1977, 147-176.

Jensen, M., "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, May 1986, 76, 323-329.

Topic Four:  Adverse Selection, Signaling, and Non-cooperative game theory.
Static and Dynamic Games of complete information: pure and mixed strategies; Iterated Dominant Strategy Equilibrium; Nash Equilibrium; Sub-game Perfect Nash Equilibrium. Static and Dynamic Games of Incomplete information; Equilibrium refinements: Bayesian Nash Equilibrium, Perfect Bayesian Equilibrium, Sequential Equilibrium, and the Cho-Kreps Intuitive Criterion.


Ackerlof, G. A., "The market for lemons: Quality Uncertainty and the Market Mechanism," The Rand Journal of Economics.
Spence, M., "Job Market Signaling," Quarterly Journal of Economics 87, 355-374.

Cho, I. and D. Kreps, "Signaling Games and Stable Equilibria," Quarterly Journal of Economics, May 1987, 179-221.

The various text books I have mentioned above on game theory will be directly useful for this part of the course (as well as for the other parts as reference books for various tools from game theory applied to corporate finance).

Topic Five: Adverse Selection and Capital Structure; Issuing various Corporate Securities Under Asymmetric Information.


Ross, S., "The Determination of Financial Structure:  The Incentive Signalling Approach," Bell Journal of Economics, Spring 1977, 23-40.

Leland, H. and D. Pyle, "Information Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, 32, 1975 371-388.

Myers, S. and N. Majluf, "Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have," Journal of Financial Economics, June 1984,187-221.

Topic Six: Dividend Policy Under perfect Capital Markets.
The Modigliani-Miller Proposition on Dividends. Dividend Policy Under Asymmetric Information and Taxes.


Bhattacharya, S., "Imperfect Information, Dividend Policy, and the 'Bird in the Hand' Fallacy," Bell Journal of Economics, Spring 1979, 259-270.

John, K. and J. Williams, "Dividends, Dilution, and Taxes:  A Signalling Equilibrium," Journal of Finance, September 1985, 40, 1053-1070.

Miller, M. and K. Rock, "Dividend Policy Under Asymmetric Information," Journal of Finance, September 1985, 40, 1031-1051.

(CW chapters 15 and 16 respectively, provides some background reading, as well as a quick summary, of the large theoretical and empirical literature on dividend policy.)

Topic Seven: Initial Public Offerings (IPOs):


Rock, K., 1986, Why new issues are underpriced, Journal of Financial Economics 15, 187-212.

Chemmanur, T., 1993, The pricing of initial public offerings: A dynamic model with information production, Journal of Finance 48, 285-304.

Chemmanur, T., and P. Fulghieri, Investment bank reputation, information production, and financial intermediation, Journal of Finance, 1994.

Allen, F. and G. Faulhaber, 1989, Signaling by underpricing in the IPO market, Journal of Financial Economics 23, 303-23.

Topic Eight: Security Design/The Structure of Corporate Liabilities


Gale, David and Martin Hellwig (1985), "Incentive Compatible Debt Contracts:  The One Period Problem," Review of Economic Studies, 52, 646-663.

Harris, Milton and Artur Raviv (1989), "The Design of Securities," Journal of Financial Economics, 24, 255-287.

Bolton, P. and D. Scharfstein, "Optimal debt structure and the number of creditors," Journal of Political Economy 104:1 (January 1996), 1-25.

Hart, O. and J. Moore (1989), "Default and Renegotiation: A Dynamic Model of Debt," mimeo, 1989.

Allen, F. and D. Gale (1988) "Optimal Security Design," Review of Financial Studies, 1, 229-263.

Townsend, R. (1979) "Optimal contracts and Competitive Markets with Costly State Verification," Journal of Economic Theory, 21, 265-293.

Part II: Seminar in Behavioral Finance and Behavioral Corporate Finance
 In this part of the course, we will review in some detail several recent papers in these two areas of current research in finance. Students will be expected to present the papers in this part of the course. Each paper presented should also be critiqued by two students (thus, each student will have to turn in multiple critiques). Students have to hand in their written critiques of each paper on the day of its presentation. Critique-writers, as well as presenters of various  papers, should come to class prepared to answer questions arising in class discussion regarding these papers.

Presentation Format: Each presentation must adhere strictly to the following format (1) Statement of the problem studied; (2) Brief survey of the literature; (3) Concise, intuitive, explanation of the argument producing the major results (for theory papers) or empirical methodology; (4) Summary of main  results;  (5) Critical examination of the paper;  (6) Sketch of major extensions to the paper with specific suggestions about possible solution techniques (for theory) or empirical methodology/data for these extensions (students who can effectively accomplish the last point will get extra credit).  Most important, each presentation must be both informative and entertaining.

Critique Format: Critiques must be between three to six pages in length (depending on the paper). The format of the critiques should be roughly along the following lines: (1) Statement of the problem studied; (2) Brief survey of the literature; (3) Concise, intuitive explanation of the argument producing the major results (for theory papers) or empirical methodology; (4) Summary of results; (5) Critical examination of the paper.

Topic Nine   Behavioral Finance: Overview

Barberis, Nicholas and Richard Thaler, 2001, “A Survey of Behavioral Finance,” University of Chicago (No critique)

Rashes, Michael, 2001, “Massively Confused Investors Making Conspicuously Ignorant Choices
(MCI-MCIC),” Journal of Finance, Vol 56(5), 1911-1927.

Andrei Shleifer, “Inefficient Markets.” Oxford University Press, 2000. Chapter 1 (Not to be presented)

Topic Ten:  Behavioral Finance:  Limited Arbitrage

Andrei Shleifer, “Noise Trader Risk in Financial markets.” (Inefficient Markets; Oxford University Press, 2000, Chapter 2)

Andrei Shleifer, “The Closed End Fund Puzzle,” (Inefficient Markets, Oxford University Press, 2000. Chapter 3)

Mitchell, Mark, Todd Pulvino, and Erik Stafford, 2002, “Limited Arbitrage in Equity Markets,”
forthcoming, Journal of Finance, Vol 57(2).

Baker, Malcolm, and Savasoglu, Serkan, 2002, “Limited Arbitrage in Mergers and Acquisitions,”
forthcoming, Journal of Financial Economics, Vol.64(1).

Topic Eleven:  Behavioral Finance:  Investor Sentiment, Under- and Overreaction, and Positive Feedback Trading

Andrei Shleifer, “A Model of Investor Sentiment,” (Inefficient Markets, Oxford University Press, 2000. Chapter  5)

Daniel, K,  D. Hirshleifer, and A. Subrahamanyam, Investor Psychology and Security Market Under- and Over-reactions, Journal of Finance, 1999.

Andrei Shleifer, “Positive Feedback Investment Strategies,” (Inefficient Markets, Oxford University Press, 2000. Chapter 6)

Topic Twelve: Behavioral Corporate Finance.

Stein, Jeremy, 1996, “Rational Capital Budgeting in an Irrational World,” Journal of Business, 69, 429-455
Baker, Malcolm, Jeremy Stein, and Jeffrey Wurgler, 2001, “When Does the Market Matter?
Stock Prices and the Investment of Equity-Dependent Firms.”

Dorn, Daniel, 2002, “Does sentiment drive the retail demand for IPOs?” Job market paper

Baker, Malcolm and  Wurgler,  Jeffrey , 2002, “A Catering Theory of Dividends” Working Paper