Prof. Thomas Chemmanur

Office: Fulton 440

Phone: (617) 552 3980

e-mail: chemmanu@bc.edu

Web-page: www2.bc.edu/~chemmanu

Fall 2009

**
BOSTON COLLEGE**

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 (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)

4. Camerer, C., *Behavioral Game Theory*. (This is an interesting book, in
the sense that it discusses how one would engage in experimental testing of game
theory models).

**
Books for supplementary reading:**
Unfortunately, there are not many Ph.D. level text books which covers corporate
finance comprehensively. Two Ph. D. level text books which provides at least
some coverage of the main topics are by Jean Tirole or by J. A. De Matos:

1. Tirole, Jean, *
The Theory of Corporate Finance , *
Princeton University Press, 2005**.**

This is a new book by one of the top economists working in corporate finance, game theory, and applied Industrial Organization. While it is reasonably good, I want to emphasize that I will not follow any text book, but teach directly from academic papers. If you are going to buy one Ph.D level in corporate finance, this would be a good choice.

2. J. A. de Matos, *Theoretical Foundations of Corporate Finance*,
Princeton University Press, 2002. This is an earlier Ph.D. level text book.

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:

3. Copeland, T.A., J.F. Weston, and Shastri, *Financial Theory and Corporate
Policy*, Fourth edition, Pearson Addison-Wesley Publishing Company, 2005
(this book will be referred to as CW in the outline). Although this book will
not help you with much 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.

4. 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:

5. R. A. Brealey, S. C. Myers, and F. Allen, *Principles of Corporate Finance*,
9^{th} Edition (New York, McGraw Hill-Irwin, 2008).

**
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.**

**
Papers: **

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**

**
Papers:**

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**.

**
Papers:**

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.

**
Papers:**

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:__
Brief Review of Mechanism Design and the Revelation Principle (Tentative, as
time permits)

**
Papers: **

Myerson, R., Mechanism Design, a Review, Unpublished Working paper

Myerson, R., Nobel Memorial Lecture, reprinted in the *American Economic
Review, 2008.*

__
Topic Six:__**Adverse Selection and Capital Structure; Issuing various Corporate Securities
Under Asymmetric Information; Experiments to test game theoretic models in
finance.**

**
Papers:**

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.

Cadsby and Maksimovic, “Experimental verification of the Myers and Majluf equity issue game” (precise references to be provided later).

**
Other reading: **
Matos sec 3.2

__
Topic Seven:__**Dividend Policy Under Perfect Capital Markets** **and under Asymmetric
Information**

The Modigliani-Miller Proposition on Dividends. Dividend Policy Under Asymmetric Information and Taxes.

**
Papers:**

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 Eight:__**Initial Public Offerings (IPOs): An Introduction**

**
Papers:**

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 Nine:__**Security Design/The Structure of Corporate Liabilities**

**
Papers:**

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 (this part
may be truncated depending on the availability of time).__

In this part of the course, we will review in some detail several recent papers
in several areas of current research in corporate finance. Each paper *
presented* in this part of the course 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

**
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.