Prof. Thomas Chemmanur
Office: Fulton 440
Phone: (617) 552 3980
e-mail: chemmanu@bc.edu
Web-page: www2.bc.edu/~chemmanu
Spring 1999
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 focus on three important related topics which have recently the focus of considerable recent research in corporate finance: Venture Capital Financing, IPOs, and Convertible Securities.

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: 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, mostly involving analytical exercises. 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. Research Project: 30 %

d. Final Exam: 40%

Office Hours: I have office hours on Wednesday 2-00 to 3:30 P.M. and also Thursday 5-00 to 7-00 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.

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.)
 

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.

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.

*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 IPOs and Venture Capital Financing/Contract Design

In this part of the course, I propose to review several recent papers in three closely related areas of corporate finance: IPOs, Venture Capital Financing, and Convertibles. These three closely related areas continue to be a fertile field for current research in corporate finance, and this section of this course is aimed at acquainting students with selected current papers in these three areas. (I plan to focus on a different area of current research in corporate finance every year).

In the following, papers marked with a (+) are empirical papers; papers with a (#) against them are either survey papers or simply "talk" pieces. 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. Papers with an (M) against them are "main" papers, and should be presented in some detail. Papers with a (S) against them are "supplementary," and need to be referred to only briefly. Papers with an (S/M) against them means that students have some choice in the matter; students can treat them as either main or supplemental (selectively present materials from these).
 

Topic Nine: Some Puzzles in the Pricing and Performance of IPOs, and Potential Explanations

(i) The Issues: (One team)

+ (M) Ritter, J., 1991, "The Long-term Performance of IPOs," Journal of Finance.

+ (S/M) Ibbotson, R..G., and Jaffe, J.F., 1975, " 'Hot Issue' Markets," Journal of Finance 30, 1027-43.

+ (S/M) Ritter, J., 1984, "The Hot Issue Market of 1980," Journal of Business 32, 215-40.

+ (S/M) Loughran, Ritter, and Rydqvist, "Initial Public Offerings: International Insights," Pacific Basin Finance Journal 2, 165-199.

+ (S/M) Chowdhry, B., and A. Sherman, 1996, "International Differences in Oversubscription and Underpricing of IPOs," Journal of Corporate Finance 2, 359-381.

+ (M) Kandel, Sarig and Wohl, "The Demand for Stocks: An Analysis of IPO Auctions," Working Paper.
 

(ii) Explanation-1: Behavioral Theories/Theories Based on Noise Traders: (One team)

# (S) Shiller, "Speculative Prices and Popular Models,"Journal of Economic Perspectives, Spring 1990.

# (S) Shiller, "IPOs: Investor Behavior and Underpricing,"Working Paper.

# (S) Shleifer and Summers, "The Noise Trader Approach to Finance,"Journal of Economic Perspectives, Spring 1990.

(M) De Long, Shleifer, Summers and Waldman, 1990, "Noise Trader Risk in Financial markets," Journal of Political Economy 98, 703-738.
 

(iii) Explanation-2: Heterogeneous Beliefs: (One team)

(M) Abel and Mailath, "Financing Losers in Competitive Markets," Working paper (appeared in Journal of Economic Theory).

(M) Allen, F., and D. Gale, "Diversity of Opinion and Financing of New Technologies," Working paper (forthcoming, Journal of Financial Intermediation, 1999).
 

(iv) Explanation-3: Asset Price Bubbles: (One team)

(S/M) Harrison, J. M., and D. M. Kreps, "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," Quarterly Journal of Economics, 322-336.

(S/M) Tirole, J., 1985, "Asset Bubbles and Overlapping Generations," Econometrica, 53, 1071-99.

(S/M) Tirole, J., 1982, "On the possibility of Speculation Under Rational Expectations," Econometrica, 50, 1163-80.

(M) Allen, F., and G. Gorton, "Churning Bubbles,"1993, Review of Economic Studies 60, 813-836.

(S) Allen, F., S. Morris, and A. Postlewaite, 1993, "Finite Bubbles with Short Sale Constraints and Asymmetric Information," Journal of Economic Theory 61, 206-229.
 

Topic Ten: Product and Financial Market Interactions and IPOs (One team)

(M) Gertner, R., R. Gibbons, and D. Scharfstein, 1987, "Simultaneous Signaling to the Capital and Product Markets," Working Paper (later published somewhere).

(M) Zechner, J., et al, "IPOs and Product Quality," 1999, Working Paper.

(S) Yosha, O., 1995, Information Disclosure Costs and the Choice of Financing Source," Journal of Financial Intermediation 4, 3-20.
 

Topic Eleven: Venture Capital Financing, Venture Capital Contract Structure, and Convertible Securities:

(i) The Issues: (one team)

+ Sahlman, W.A, 1990, "The Structure and Governance of Venture Capital Organizations," Journal of Financial Economics 27, 473-521.

+ Barry, C.B., Muscarella, C. J., Peavey, J., and Vetsuypens, 1990, "The Role of Venture Capital in the Creation of Public Companies," Journal of Financial Economics 27, 447-471.

+ Barry, C. B., 1994, "New Directions in Research on Venture Capital Finance," Financial Management, Vol 23, No 3.
 

(ii) Models of Convertibles and Venture Capital Financing/Contract Structure:

(a) Convertibles in V.C contracts and Other settings (Two teams)

(M) Stein, J., 1992, "Convertible bonds as back-door equity financing," Journal of Financial Economics 32, 3-21.

(M) Green, R. C., "Investment Incentives, Debt, and Warrants," Journal of Financial Economics 13, 115-136.

(M) Cornelli, F., and O. Yosha, 1998, "Stage Financing and The Role of Convertible Debt," Working Paper.

(M) Rapullo, R., and J. Suarez, 1998, "Venture Capital Finance: A Security Design Approach," Working paper.

*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.
 

(b) Venture Capital Contract Design in an Incomplete Contract Setting (One or two teams)

(M) Aghion, P., and P. Bolton, 1992, "An Incomplete Contracting Approach to the Theory of the Firm," Review of Economic Studies 59, 473-494.

(S/M) Berglof, E., 1994, "A Control theory of Venture Capital Finance," Journal of Law, Economics and Organization, 10, 247-267.

(S/M) Marx, L. M., 1998, "Efficient Venture Capital Financing Combining Debt and Equity," Review of Economic Design 3, 371-387.

(S/M) Hellman, T., 1998, "The Allocation of Control Rights in Venture Capital Contracts," Rand Journal of Economics, 29 (Spring), 57-76.
 
 

INSTRUCTIONS FOR STUDENT PRESENTATIONS:

In general, each team, consisting of two students, will have one and a half hours; there will be two team presentations per class. Each team can allocate work and presentation time as they please. It is NOT REQUIRED that both students constituting a team do presentations (though I expect this to be the most common arrangement); both students will get the same grade (for this part of the course) in any case.

Students with an empirical/non-technical bent of mind should select empirical or talk pieces (though such papers are in short supply in the list above!). Teams picking empirical papers (sections NINE (i) and ELEVEN (i)) will have to present three, four or more papers briefly. In empirical papers, students can be quite selective in choosing results/sections for presentations. The important point here is to highlight interesting issues and results, while commenting briefly on the methodology.

In theory papers, more time needs to be devoted per paper, especially to main (M) papers. Thus, a student can devote 45 minutes (half the team time) to a single paper, if they choose to do so. However, even for (M) theory papers, you do not need to present every result (or even a majority of the results). Be free to be selective in choosing results. What I want you to do is to set-up the model structure and assumptions, and then present the main results, after setting the paper in context in the literature (briefly).


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