Prof. Thomas Chemmanur
Office: Fulton 440
Phone: (617) 552 3980
e-mail: chemmanu@bc.edu
Spring 1998
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 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 discuss various other topics related to recent research in corporate finance.

Course Organization: (Tentative: subject to changes) The first part of the course will consist entirely of lectures; the second part will consist mostly of my lectures, but may also include occasional student presentations. There will be a mid-term quiz (after six or seven weeks) and a final exam. 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. The final grade will thus depend on student performance in the mid-term, final, the term paper and the other class participation exercises, including student presentations (I will assign papers for student presentations, as well as the details of other student exercises, later. I will also announce the exact split-up of the points for each of the components which go to make up your final grade later).

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 minor changes) The course will consist mostly of lectures, and a few class presentations by students. There will be a final exam. 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 (students should choose these topics in consultation with me: a one page outline of the paper is due by mid March). Each student will also be asked to make a class presentation of a paper, which should also be chosen jointly with me. Finally, students will also be asked to workout problem sets, either alone or in groups of two (maximum). The course grade is determined as follows:

a. Class presentation: 15%

b. Class participation and problem set: 15%

c. Research Project: 30 %

d. Final Exam: 40%

Ofice Hours: I have office hours specifically for this course set up on Thursday, 3-00 to 4:00 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.

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.

(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

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.

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.

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: Adverse Selection and Capital Structure; Issuing various Corporate Securities Under Asymmetric Information.

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.

Topic Six: Dividend Policy Under perfect Capital Markets. 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.

(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.)

Part II: Papers on Some Topics of More Current Research Interest in Corporate Finance

In this part of the course, I propose to review some of the more recent research in corporate finance. This part of the course will be a combination of lectures and student presentations.

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.

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.

Chemmanur, T., and P. Fulghieri (1997) "Why Include Warrants in New Equity Issues? A Theory of Unit IPOs," Journal of Financial and Quantitative Analysis, 1, 1-35.

Chemmanur, T., and K. John (1996), "Optimal Incorporation, Structure of Debt Contracts, and Limited-Recourse Project Financing," Journal of Financial Intermediation, 5, 372-408.

*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.

* ----- , "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management, American Economic Review 85:3 (June 1995), 567-85.

* ---- , "A Theory of Debt Based on the Inalienability of Human Capital, Quarterly Journal of Economics 109:4 (439, November 1994), 841-880.

*Dewatripont, M. and J. Tirole, "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence, Quarterly Journal of Economics 109:4 (439, November 1994), 1027-54.

*Allen, F. and D. Gale (1988) "Optimal Security Design," Review of Financial Studies, 1, 229-263.

*Heinkel, R., and J. Zechner, "The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives," Journal of Financial and Quantitative Analysis, 1990, 25, 1-24.

Townsend, R. (1979) "Optimal contracts and Competitive Markets with Costly State Verification," Journal of Economic Theory, 21, 265-293.

Topic Nine: Internal Capital Markets

*Gertner, R., D. Scharfstein, J.Stein,"Internal versus External capital Markets," Quarterly Journal of Economics 109:4 (439, November 1994), 1211-1230.

*Harris, M. and A. Raviv, "The capital budgeting process, incentives and information," Journal of Finance 51:4 (September 1996), 1139-74.

*Scharsfstein, D., and J. Stein, 1996, "The Dark Side of Internal Capital markets: Divisional Rent Seeking and Inefficient Investment," MIT Working Paper.

*Milgrom, P., 1988, "Employment Contracts, Influence Activities, and Efficient Organization Design," Journal of Political Economy 96, 42-60.

*Meyer, M., P. Milgrom and J. Roberts, 1992, Organizational Prospects, Influence Costs, and Ownership Changes, Journal of Economic and Management Strategy 1, 9-35.

Topic Ten: Takeovers and the Role of the Board of Directors

*Grossman, S. and O. Hart, "Takeover Bids, the Free-Rider Problem and the Theory of the Corporation," Bell Journal of Economics, Spring 1980, 11, 42-64.

*Shleifer, A. and Vishny, R. "Large Shareholders and Corporate Control," Journal of Political Economy, June 1986, 94, 461-488.

*Scharfstein, D., "The Disciplinary Role of Takeovers," Review of Economic Studies, 1988, LV, 185-199.

*Hirshleifer, D and A. Thakor, Board Dismissals, Takeovers and Managerial Performance, Indiana University Working Paper, 1990.

*V. Warther, Board Effectiveness and Board Dissent: A Model of the Board/Management Relationship, USC Working Paper, 1993.


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