Wallace E. Carroll School of Management
MF891: Doctoral Seminar in Corporate Finance
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.
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%
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
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 on two topics of current corporate finance research
In this part of the course, we will review in some detail several recent papers in two areas of current research in finance.
Topic Nine: Cheap Talk, Reputation, and Financial Analysts in Games of Information Transmission
Crawford, V. and J. Sobel, 1982, “Strategic Information Transmission,” Econometrica, Vol. 50, No. 6 (Present this paper in conjunction with pages 210-218 of the game theory book by Gibbons).
Sobel, J., 1985, “A Theory of Credibility,” Review of Economic Studies, pages 557-573.
Benabou, R., and G. Laroque, 1992, “Using Priveleged Information to Manipulate Markets: Insiders, Gurus, and Credibility,” The Quarterly Journal of Economics.
Krishna, V., and J. Morgan, 2001, “A Model of Expertise,” The Quarterly Journal of Economics.
Morgan, J., and P. Stocken, 1998, “An analysis of stock recommendations,” Princeton University Working Paper.
Cheng, Y., M. Liu, and J. Qian, 2002, “Buy-side analysts, Sell-side analysts, and Information Transmission: Theory and Evidence,” Boston College Working Paper (to be presented by Mark Liu).
Topic Ten: Auction Theory with Applications to Financial Economics
(i) Fundamentals of auction theory (Each concept below to be presented by one student):
Concept one: Mechanism design and the Revelation principle.
Datta, P., Strategies and Games, Chapter 22, “Mechanism Design, The revelation principle, and Sales to an unknown buyer,” (pages 348 to 352).
Present the above chapter in conjunction with:
Pages 164 to 168 of the game theory book by Gibbons.
Concept Two: The Standard Auctions, the Revenue Equivalence Theorem,
and Optimal Auctions
Datta, P., Strategies and Games, Chapter 23, “An Application: Auctions,” (pages 367 to 377).
To be presented in conjunction with:
Klemperer, P., 1999, “Auction Theory: A Guide to the Literature,” Journal of Economic Surveys, Vol 13, No. 3 (To be presented: Sections: 1.2 to 1.5; Section 4; Appendix A: “The revenue equivalence theorem”; the proof of this theorem in Appendix A is also required).
Students presenting the above two concepts (as well as other students)
may also refer to the following useful article (NOT TO BE PRESENTED):
Wolfsetter, E., "Auctions: An Introduction," Journal of Economic Surveys, Vol. 10, No. 4. (section 4 is useful for the student presenting concept 1 and section 2 is useful for the student presenting concept 2).
(ii) Applications to financial economics (each article below to be presented by one student):
Bias, B., and A. Faugeron-Crouzet, 2002, "IPO Auctions: English, Dutch, French and Internet.," Journal of Financial Intermediation, Vol 11, No. 1.
Bias, B., Bossearts, P., and J. C. Rochet, 2002, "An optimal IPO mechanism," Review of Economic Studies.
Bhattacharyya, S., and R. Singh, 1999, "The resolution of bankruptcy by auction: allocating the residual right of design," Journal of Financial Economics, 269-294.
Rhodes-Kropf, M., and S. Viswanathan, 2001, “Financing Auction Bids,“ Duke University Working Paper (to be presented by Mark Liu).