Wallace E. Carroll School of Management
MF891: Doctoral Seminar in Corporate Finance
This course has the 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 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: (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:
a. Class presentation: 15%
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.
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 on three topics of current corporate finance research
In this part of the course, we will review several recent papers in three areas of current research in corporate finance. The first topic deals with the effect of competition in the banking industry on a bank's relationships with borrowers and their effectiveness in screening them. The second topic deals with the effect of the presence of group of investors who are not completely rational (example, investors who are unduly optimistic) on the financial decisions of a corporation. The third topic deals with the effect of governments and legal systems in various countries on the financial decisions of corporations in these countries. These three areas are 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).
Presentation Guidelines: In the following, unless otherwise indicated, all papers are theoretical (T) papers; papers marked with a (+) are empirical papers, survey papers or simply "talk" pieces; (+/T) indicates papers which are both theoretical and empirical. 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. Most of the papers are "main (M)" papers, which should be presented in some detail. However, papers with an (S) against them are "supplementary," which need to be presented briefly in one or two slides, focussing on their relationship with the body of work represented by the main paper. If several adjacent papers have an (S/M) marking against them, they are to be presented jointly, with students having discretion on the relative importance given to these papers (i.e., students can present one of these in detail, with the other(s) presented briefly as supplementary papers).
Topic Nine: Bank Lending and Interbank Competition
Sharpe, S., "Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships," Journal of Finance.
Broecker, T., 1990, "Credit-worthiness tests and Interbank Competition," Econometrica.
Petersen, M., and R. Rajan, 1995, "The Effect of Credit Market Competition on Lending Relationships," Quarterly Journal of Economics.
Villas-Boas and Schmidt-Mohr, 1999, "Oligopoly with Asymmetric Information: Differentiation in Credit Markets," Rand Journal of Economics.
Dell'Ariccia, Friedman, and Marquez, 1999, "Adverse Selection as a Barrier to Entry in the Banking Industry," Rand Journal of Economics.
(+/T)(S) Shaffer, S., 1998, "The winner's curse in banking," the Journal of Financial Intermediation.
Topic Ten: Near-Rational Investors and Corporate Finance
Heaton, J. B., 1998, "Managerial optimism and corporate finance," working paper
De Meza, D., and C. Southey, 1996, "The borrower's curse: Optimism, Finance, and Entrepreneurship," The Economic Journal.
Manove, M., 1998, "Entrepreneurs, optimism, and the competitive edge."
Manove, M., and J. Padilla, 1999, "Banking (conservatively) with optimists," Rand Journal of Economics
Bernardo, A., and I. Welch., 2000, "On the evolution of overconfidence and entrepreneurs."
Topic Eleven: Law, Government, and International Corporate Finance
(+/T) Lombardo, D., and M. Pagano, 2000, "Legal Determinants of the return on Equity," working paper.
(+/T) Du, J., 2000, "Government Business Relationship and International Corporate Finance," working paper.
Shleifer, A., and R. Vishny, 1994, "Politicians and Firms," Quarterly Journal of Economics.
(S/M)(+) La Porta, R, F. Lopez-de-silanes, A. Shleifer, and R. Vishny, 1997, "Legal Determinants of External Finance," Journal of Finance.
(S/M)(+) La Porta, R, F. Lopez-de-silanes, A. Shleifer, 1999, "Corporate Ownership around the world," Journal of Finance.
(S/M)(+) La Porta, R, F. Lopez-de-silanes, A. Shleifer, and R. Vishny, 1998, "Law and Finance," Journal of Political Economy.
Doctoral Seminar in Corporate Finance