Prof. Thomas Chemmanur
Office: Fulton 440
Phone: (617) 552 3980
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 (around two thirds) 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 (this part of the course changes every year; it is suggested that students look at syllabi from earlier years for references on other current topics of 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)
Books for supplementary reading: Unfortunately, there are not many Ph.D. level text books in corporate finance. A Ph. D. text book which provides at least some basic coverage of the main topics is (referred to as Matos in this outline):
1. J. A. de Matos, Theoretical Foundations of Corporate Finance, Princeton University Press, 2002.
There are many good MBA text books. 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:
2. 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.
3. 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).
Of course, the standard text book on corporate finance at the MBA level is:
4. R. A. Brealey and S. C. Myers, Principles of Corporate Finance, 7th Edition (New York, McGraw Hill, 2002).
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 my 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. 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. Students will also be asked to critique some of the papers that other students are presenting. 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/synthesis: 20 %
d. Final Exam: 40%
Office Hours: Office hours for this course will be after class 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). The best way to contact me is through e-mail (rather than by phone).
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.
Other reading: Matos sec 2.1; CW, chapters 13 and 14 respectively, provide a review (though a bit dated) of 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.
Other reading: Matos sec 2.2
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.
Other reading: Matos sec 3.1
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.
Other reading: Matos sec 3.2
Topic Six: Dividend Policy Under Perfect Capital Markets and under Asymmetric Information
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.
Other reading: Matos Chapter 4; CW chapters 15 and 16 respectively, provides some background reading, as well as a quick summary (though somewhat dated), of the large theoretical and empirical literature on dividend policy.
Topic Seven: Initial Public Offerings (IPOs): An 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.
Townsend, R. (1979) "Optimal contracts and Competitive Markets with Costly State Verification," Journal of Economic Theory, 21, 265-293.
Aghion, P., and P. Bolton, 1992, “An ‘Incomplete Contracts’ Approach to Financial Contracting,” Review of Economic Studies 59, 473-494.
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.
Harris, Milton and Artur Raviv (1989), "The Design of Securities," Journal of Financial Economics, 24, 255-287.
Allen, F. and D. Gale (1988) "Optimal Security Design," Review of Financial Studies, 1, 229-263.
Part II: Seminar on Some Current Research Topics in Corporate Finance
In this part of the course, we will review in some detail several recent papers in two or three areas of current research in corporate finance. Students will be expected to present the papers in this part of the course (to be determined later: I am currently choosing these topics). 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: Design of Firms and Other Organizations
Sah, R. K. and Stiglitz, J. E., 1986. “The Architecture of Economic Systems: Hierarchies and Polyarchies”, American Economic Review 76, 716-727.
Harris, M. and Raviv, A., 1996. “The Capital Budgeting Process, Incentives and Information”, Journal of Finance 51, 1139-1174.
Stein, J., 2002. “Information Production and Capital Allocation: Decentralized vs Hierarchical Firms”, Journal of Finance 57, October.
Aghion, P. and Tirole, J., 1997. “Formal and Real Authority in Organizations”, Journal of Political Economy 105, 1-29.
Liberti, J. M., 2003. “Initiative, Incentives and Soft Information. How Does Delegation Impact the Role of Bank Relationship Managers?”, Working paper, London Business School. (This paper is to be presented in conjunction with the previous one).
Topic Ten: Share Allocation, Trading, and Long-term Returns around IPOs and SEOs
Boehmer, Beatrice, Ekkehart Boehmer, and Raymond P.H. Fishe, 2004, Do Institutions Receive Favorable Allocations in IPOs with Better Long Run Returns?, Working paper, Texas A&M University.
Field, Laura C., 1997, Is Institutional Investment in Initial Public Offerings Related to Long-Run Performance of these Firms?, Working Paper, Pennsylvania State University.
Ellis, Katrina, Rony Michaely, and Maureen O’Hara, 2000, When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket, Journal of Finance 55, 1039-1074.
Griffin, J. M., Harris, J. H., and Topaloglu, S., 2004, IPO Underwriter Client Trading, Working paper, University of Texas.
Gibson, Scott, Assem Saﬁeddine, and Ramana Sonti, 2004, Smart Investments by Smart Money: Evidence from Seasoned Equity Offerings, Journal of Financial Economics, forthcoming.