MF891: Doctoral Seminar in Corporate FinanceCourse 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.
Pre-requisites: 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 material: 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.
Course Organization: (Tentative: subject to changes) 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:
b. Class participation and problem set: 15%
c. Referee report: 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 2-00 to 3:00 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): Introduction
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.
Benveniste, L. and Spindt, "How Investment Bankers Determine the Offer Price and Allocation of New Issues," Journal of Financial Economics 24 (1989), 343-361.
Benveniste, L. and W. Wilhelm, 1990, "A Comparative Analysis of IPO Proceeds under Alternative Regulatory Environments," Journal of Financial Economics 28, 173-207.
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.
R. (1979) "Optimal contracts and Competitive Markets with Costly State
Verification," Journal of Economic Theory, 21, 265-293.
Part II: Seminar on Corporate Governance and Internal Capital Markets
In this part of the course, we will review several recent papers in two areas of current research in corporate finance: The first topic deals with the closely related areas of Corporate Takeovers, Corporate Shareholder Monitoring and Activism. The second topic deals with the related topic of Internal Capital Markets. These two areas continue to be fertile fields for current research in corporate finance, and this section of this course is aimed at acquainting students with selected current papers in these areas. (I focus on different areas of current research in corporate finance every year in this part of the course).
In the following, papers marked with a (+) are empirical papers, survey papers or simply "talk" pieces. Papers with a (*) against them are not available for selection by students; I will comment briefly about them. There is a second kind of marking against each paper, which pertains to the time and importance students should devote to the paper in their presentation. Papers with an (M) against them are "main" papers, and should be presented in some detail. Papers with a (S) against them are "supplementary," and need to be referred to only briefly. Papers with an (S/M) against them means that students have some choice in the matter; students can treat them as either main or supplemental (selectively present materials from these).
Topic Nine: Issues in Corporate Takeovers, Shareholder Monitoring, and Shareholder Activism:
(M) Grossman and Hart, 1980, "Takeover Bids, The Free Rider Problem and the Theory of the Corporation," Bell Journal of Economics, 11, 42-64.
(+) Bhagat, Shleifer and Vishny, 1990, "Hostile takeovers, in the 1980s: The return to Corporate Specialization," Brookings Papers in Economic Activity: Microeconomics, 1-84.
(M) Holmstrom and Tirole, 1993, "Market Liquidity and Performance Monitoring," Journal of Political Economy, 101, 678-709.
(M) Admati, A., P. Pfleiderer, and J. Zechner, 1994, "Large Shareolder Activism, Risk-sharing and Financial Market Equilibrium," Journal of Political Economy 102, 1097-1130.
(M) Gorton, G., and M. Kahl, 1999, "Blockholder Identity, Hostile Takeovers, and Equity Ownership Structures," University of Pensylvania working paper.
(M) Maug, E., 1998, "Large Shareholders as Monitors: Is there a trade-off between Liquidity and Control?" Journal of Finance 53, 65-98.
Topic Ten:Internal vs. External Capital Markets:
(M) Gertner, R., D. Sharfstein, and J. Stein, 1994, "Internal vs. External Capital markets," Quarterly Journal of Economics, 109, 1211-1230.
(S) Sharfstein and Stein (1998), "The Dark Side of Internal Capital Markets," MIT working paper.
(M) De Motta, A., 1999, "Managerial Incentives and Internal Capital Markets," MIT working paper.
(M) Harris, M., and A. Raviv, 1996, "The Capital Budgeting Process: Incentives and Information," Journal of Finance, LI, pages 1139-1174.
(+) Sharfstein, D., 1997, "The Dark Side of Internal Capital Markets-II: Evidence from Diversified Conglomerates," MIT Working paper.
(+) Lamont, O., 1997, Cash flow and Investment: Evidence from Internal Capital Markets," Journal of Finance, 52, 83-109.
INSTRUCTIONS FOR STUDENT PRESENTATIONS:
It is recommended that students form teams for presentations. Each team, consisting of two students, will have one and a half hours; there will be two team presentations per class. Each team can allocate work and presentation time as they please. It is NOT REQUIRED that both students constituting a team do presentations (though I expect this to be the most common arrangement); both students will get the same grade (for this part of the course) in any case. However, team members can choose to work and present individually also if they wish (in which case each person gets 45 minutes for presentation).
Most of the presentation time need to be devoted to main (M) papers. Thus, a student can devote 45 minutes (half the team time) to a single paper, if they choose to do so. However, even for (M) theory papers, you do not need to present every result (or even a majority of the results). Be free to be selective in choosing results. What I want you to do is to set-up the model structure and assumptions, and then present the main results, after setting the paper in context in the literature (briefly).
As much as possible, students should be aware of the results in the papers marked (S) in their topic, as well as the empirical results. During presentations, however, students can briefly refer to the (S) papers and the empirical (+) papers in their presentation area, but devote most of their time to the main (M) papers that they have chosen.
ON PART-II IN THE FINAL EXAM: Papers in the second part of the course
(as defined in this revised outline) will not be emphasized in the exam.
However, there will be two questions in the exam on this part of the course
(students will have to answer one of these two questions to get full credit).