Prof. Thomas Chemmanur

Office: Fulton 336

Phone: (617) 552 3980

e-mail: chemmanu@bc.edu

Web-page: chemmanur.org

Spring 2020

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 signaling, various aspects of non-cooperative games with and without incomplete information, and the equilibrium concepts in such games). If time permits, 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); I will decide on this later on in the course.

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. I will prescribe some reading from the book by Jean Tirole (I have also been known to base some questions in the comprehensive exam on material in the Tirole book) . The book by De Matos is closer to some of the papers we discuss in class, and will thus be good supplementary reading for some students I strongly recommend that you obtain access to both text books. (I leave it to you to decide whether to buy these or not since I am prescribing only limited material from each book, as long as you have access to the relevant parts for reading).

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

This is a relatively 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 only one Ph.D. level in corporate finance, this would be a good choice, however.

2. J. A. de Matos, Theoretical Foundations of Corporate Finance, Princeton University Press, 2002. This is an earlier Ph.D. level text book, but have some good discussions of some of the classic papers in corporate finance. So this book may sometimes be closer to some of my lectures.

Advanced MBA text books, institutional background, and the MF881 course: At the end of the day, corporate finance (even corporate finance theory) is an applied discipline: you cannot do good research without adequate knowledge of the institutional background and real world applications. My questions in the Ph. D. comprehensive exam, while applying what we learned in this class, will tend toward real world applications (some questions). While I will only mention these in passing in this class (due to time limitations), Boston College doctoral students are expected to be conversant with these before they start doing research. One way to acquire this knowledge is to read up by yourself on these from some of the advanced MBA level (and other) text books I list below, which summarize the ideas behind some of the earlier theory papers, illustrate real-world applications, and also put the theory in the context of the empirical literature in corporate finance. Alternatively, they can sit in (audit) on the MF881: Corporate Finance Theory MBA/MSF class I teach on Tuesady, 7:00 to 9:30 PM. This would be a good idea especially if you want to do dissertation research in corporate finance. However, the choice of reading up institutional and real world applications of the theory by yourself or auditing a class like MF881 is completely up to you: I hasten to add that the MF881 class is absolutely NOT required this year for you to take the comprehensive exam.

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 (though at a somewhat lower level than the two books above, especially the Copeland et al book) is:

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

Required course materials: Most of the lectures will be based on academic papers. Since I give the references under each topic, you can download these as we go along from your school library e-journals web site (links are also given on the course website). 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. There will also be some required reading (specified below) from the Corporate Finance text book by Jean Tirole and/or De Matos.

Course Organization: The first part of the course will consist entirely of my lectures; the second part (if time permits) 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 participation: 15%

b. Problem set, referee report(s) and research project(s): 20%

c. Research Proposal/Review Article: 25%

d. Final Exam: 40%

Office Hours: Office hours for this course will be right after class Tuesday 5:30 to 6:00 P.M (right after class). 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).

GENERAL INTEREST READINGS RELATED TO FINANCE (NOT REQUIRED FOR THE EXAM):

• Paul Krugman: "How Did Economists Get It So Wrong?"

• John Cochrane: "How did Paul Krugman get it so Wrong?"

• Efficiency and beyond

• Five Zombie Economic Ideas That Refuse to Die

• Advanced Video: Robert Shiller Nobel Prize Lecture on Stock Valuation

• Advanced Video: Eugene Fama Nobel Prize Lecture on Market Efficiency

• Report of the Commission on Inclusive Prosperity

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

Other reading: Tirole Chapter 2 gives a nice overview of corporate financing, including a discussion of financial instruments, and the institutional background and some evidence relevant to the setting of the whole course.

Review: 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

Homework: Problem Set I - Part A

Review Articles and Empirical Papers (Not to be discussed in class):

Miller, M. H., 1988. The Modigliani-Miller propositions after thirty years. The Journal of Economic Perspectives, 2(4), pp.99-120.

Graham, J. R., 2000. How big are the tax benefits of debt?. The Journal of Finance, 55(5), pp.1901-1941.

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.

Holmstrom, B., "Moral Hazard and Observability," The Bell Journal of Economics, Spring 1979, 74-91.

Other reading: Matos Sec 2.2

Other reading: Tirole, Chapter 3.1 to 3.3 (Myers, 1977, Debt Overhang).

Homework: Problem Set I - Part B

Empirical, Practitioner Oriented and Review Articles Not to be Discussed in Class:

Gompers, P., Kaplan, S. N. and Mukharlyamov, V., 2016. What do private equity firms say they do?. Journal of Financial Economics, 121(3), pp.449-476.

Frank, M. Z. and Goyal, V. K., 2007. Trade-off and pecking order theories of debt.

Topic Four: Introduction to the Economics of Asymmetric Information and Signaling; Non-cooperative game theory.

Introduction to the Economics of Asymmetric Information and Signaling. 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.

Rothschild, M. and Stiglitz, J., "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information", Quarterly Journal of Economics, 1976 (not to be discussed in class)

Spence, M., "Job Market Signaling," Quarterly Journal of Economics, 1973, 355-374.

Spence, M., "Competition in Salaries, Credentials, and Signaling Prerequisites for Jobs", Quarterly Journal of Economics, 1976, 51-74.

Spence, M., "Signaling in Retrospect and the Informational Structure of Markets", American Economic Review, 2002, 434-459.

Myerson, R. B., 1985. An introduction to game theory. Working paper, Northwestern University.

Cho, I. and D. Kreps, "Signaling Games and Stable Equilibria," Quarterly Journal of Economics, May 1987, 179-221.

Kreps, D. M. and Wilson, R., 1982. Sequential equilibria. Econometrica, pp.863-894.

Fudenberg, D. and Tirole, J., 1991. Perfect Bayesian equilibrium and sequential equilibrium. Journal of Economic Theory, 53(2), pp.236-260.

Notes on the Mechanics of Identifying Nash Equilibria: Pure Strategy & Mixed Strategy

Other reading: 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).

Link: Game Theory. net

Homework: Problem Set II & Problem Set III

Additional Background Article on Game Theory in Economics and Finance Not to be Discussed in Class:

Samuelson, L., 2016. Game theory in economics and beyond. Journal of Economic Perspectives, 30(4), pp.107-30.

Topic Five: Adverse Selection and Capital Structure; Issuing various Corporate Securities Under Asymmetric Information; Experiments to test game theoretic models in finance. Summary of capital structure choice by firms taking into account various market imperfections that we discussed in class, including taxes, agency costs, and asymmetric information, as well as imperfections that we did not discuss in class: deadweight bankruptcy costs; heterogeneous beliefs.

Papers:

Ross, S., "The Determination of Financial Structure: The Incentive Signalling Approach," Bell Journal of Economics, Spring 1977, 23-40.

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.

Giammarino, R. M. and Lewis, T., 1988. A theory of negotiated equity financing. The Review of Financial Studies, 1(3), pp.265-288.

Galai, D. and Masulis, R. W., 1976. The option pricing model and the risk factor of stock. Journal of Financial Economics, 3(1-2), pp.53-81.

Cadsby, Frank, and Maksimovic, “Pooling, Separating, and Semiseparating Equilibria in Financial Markets: Some Experimental Evidence”, Review of Financial Studies, 1990, 315-342.

Cadsby, Frank, and Maksimovic, “Equilibrium Dominance in Experimental Financial Markets”, Review of Financial Studies, 1998, 189-232. (not to be discussed in class)

Leland, H. and Pyle, D., "Information Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, 1975, 32, pp. 371-388.

Grinblatt, M., and Hwang, C., "Signalling and the Pricing of New Issues", Journal of Finance, 1989, 44(2), pp. 393-420.

Chemmanur, T., and Fulghieri, P., "Why Include Warrants in New Equity Issues? A Theory of Unit IPOs", Jounal of Financial and Quantitative Analysis, 1997, 32(1), pp. 1-24.

Other reading: Matos, Chapter 3.

Other reading: Tirole, Chaper 6, up to and including application 6; application 8 (Leland and Pyle, 1977).

Homework: Problem Set IV

Article Giving Empirical Evidence on the announcement effects of Dividend Changes, Stock Repurchases, and Equity Issues (sections V and Vi): Required Reading for Exam

Asquith, P. and Mullins Jr, D. W., 1986. Signalling with dividends, stock repurchases, and equity issues. Financial management, pp.27-44.

Review Articles and Empirical Papers (Not to be discussed in class):

Myers, S. C., 1984. The capital structure puzzle. The Journal of Finance, 39(3), pp.574-592.

Harris, M. and Raviv, A., 1991. The theory of capital structure. the Journal of Finance, 46(1), pp.297-355.

Graham, J. R. and Leary, M. T., 2011. A review of empirical capital structure research and directions for the future. Annual Review of Financial Economics, 3(1), pp.309-345.

Articles on Bankruptcy Cost and Capital Structure (Not to be discussed in class):

Branch, B., 2002. The costs of bankruptcy: A review. International Review of Financial Analysis, 11(1), pp.39-57.

Senbet, L. W. and Wang, T. Y., 2010. Corporate financial distress and bankruptcy: A survey. Foundations and Trends in Finance, 5(4).

Chemmanur, T. J., Cheng, Y. and Zhang, T., 2013. Human capital, capital structure, and employee pay: An empirical analysis. Journal of Financial Economics, 110(2), pp.478-502.

Articles on Heterogeneous Beliefs and Capital Structure (Not to be discussed in class):

Bayar, O., Chemmanur, T. J. and Liu, M. H., 2015. A theory of capital structure, price impact, and long-run stock returns under heterogeneous beliefs. The Review of Corporate Finance Studies, 4(2), pp.258-320.

Articles on Theoretical Models related to Banking (Not required for the exam):

Diamond, D.W. and Dybvig, P.H., 1983. Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91(3), pp.401-419.

Diamond, D.W., 1984. Financial intermediation and delegated monitoring. The Review of Economic Studies, 51(3), pp.393-414.

Chemmanur, T.J. and Fulghieri, P., 1994. Reputation, renegotiation, and the choice between bank loans and publicly traded debt. Review of Financial Studies, 7(3), pp.475-506.

Articles with Signalling Models of Corporate Debt Maturity and Seniority Structure (Not required for the exam):

Flannery, M.J., 1986. Asymmetric information and risky debt maturity choice. The Journal of Finance, 41(1), pp.19-37.

Diamond, D.W., 1993. Seniority and maturity of debt contracts. Journal of Financial Economics, 33(3), pp.341-368.

Articles with Signalling Models of Convertible Debt (Not required for the exam):

Stein, J.C., 1992. Convertible bonds as backdoor equity financing. Journal of Financial Economics, 32(1), pp.3-21.

Mayers, D., 1998. Why firms issue convertible bonds: the matching of financial and real investment options. Journal of Financial Economics, 47(1), pp.83-102.

Topic Six: Dividend Policy Under Perfect Capital Markets and under Asymmetric Information. Choice between Cash Dividend and Share Repurchase (Brief discussion)

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

Papers:

Modigliani, F. and M. Miller, "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, October 1961, 411-433.

Bhattacharya, S., "Imperfect Information, Dividend Policy, and the 'Bird in the Hand' Fallacy," Bell Journal of Economics, Spring 1979, 259-270. (not to be discussed in class)

John, K. and J. Williams, "Dividends, Dilution, and Taxes: A Signalling Equilibrium," Journal of Finance, September 1985, 40, 1053-1070.

Riley, J. G., Informational Equilibrium, Econometrica, March 1979, 47, 331-359.

Miller, M. and K. Rock, "Dividend Policy Under Asymmetric Information," Journal of Finance, September 1985, 40, 1031-1051.

Other reading: De Matos, Chapter 4; and Chapter 3.2.4 (stock repurchase as a signal); Appendix B.2 (Informational Equilibrium).

Other reading: Tirole Chapter 7, application 7 (payout policy)

Homework: Problem Set V

Review Articles and Empirical Papers (Not to be discussed in class):

Fama, E. and K. French, "Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?" Journal of Financial Economics 60 (2001): 3-43.

Theoretical and Empirical Papers on Firms' Choice Between Dividends and Repurchases (Not Required for the Exam):

Vermaelen, T., 1984. Repurchase tender offers, signaling, and managerial incentives. Journal of Financial and Quantitative Analysis, 19(2), pp.163-181.

Ofer, A.R. and Thakor, A.V., 1987. A theory of stock price responses to alternative corporate cash disbursement methods: Stock repurchases and dividends. The Journal of Finance, 42(2), pp.365-394.

Constantinides, G.M. and Grundy, B.D., 1989. Optimal investment with stock repurchase and financing as signals. The Review of Financial Studies, 2(4), pp.445-465.

Brennan, M.J. and Thakor, A.V., 1990. Shareholder preferences and dividend policy. The Journal of Finance, 45(4), pp.993-1018.

Vermaelen, T., 1981. Common stock repurchases and market signalling: An empirical study. Journal of Financial Economics, 9(2), pp.139-183.

Asquith, P. and Mullins Jr, D.W., 1986. Signalling with dividends, stock repurchases, and equity issues. Financial management, pp.27-44.

Ikenberry, D., Lakonishok, J. and Vermaelen, T., 1995. Market underreaction to open market share repurchases. Journal of Financial Economics, 39(2-3), pp.181-208.

Peyer, U. and Vermaelen, T., 2009. The nature and persistence of buyback anomalies. The Review of Financial Studies, 22(4), pp.1693-1745.

Topic Seven: 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.

Chemmanur, T., and P. Fulghieri, A Theory of the Going Public Decision, Review of Financial Studies, 1999. (not to be discussed in class)

Other reading: De Matos, Chapter 5

Other reading: Tirole, Chapter 7, application 9 (underpricing)

Homework: Problem Set VI

Review Articles and Empirical Papers (Not to be discussed in class):

Ritter, J. R., 1991. The Long-Run Performance of Initial Public Offerings, Journal of Finance, 46 (1), pp. 3-27.

Chemmanur, T. J. and Paeglis, I., 2005. Management Quality, Certification, and Initial Public Offerings, Journal of Financial Economics, 76(2), pp.331-368.

Chemmanur, T. J., Hu, G. and Huang, J., 2010. The Role of Institutional Investors in Initial Public Offerings, The Review of Financial Studies, 23(12), pp.4496-4540.

Bajo, E., Chemmanur, T. J., Simonyan, K. and Tehranian, H., 2016. Underwriter Networks, Investor Attention, and Initial Public Offerings, Journal of Financial Economics, 122(2), pp.376-408.

Article on Insitutional Details and Emprical Evidence on IPOs (Required reading for the Exam):

Ibbotson, R.G., Sindelar, J.L. and Ritter, J.R., 1994. The market's problems with the pricing of initial public offerings. Journal of Applied Corporate Finance, 7(1), pp.66-74.

Topic Eight: Brief Review of Mechanism Design and the Revelation Principle

Papers:

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

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

Benveniste, L., and P. Spindt, How Investment Bankers Determine Offer Price and Allocation of New Issues, Journal of Financial Economics, 1989.

Other reading: De Matos, Appendix B.3 (Revelation Principle)

Homework: Mechanism Design Problem Set

Topic Nine: Security Design/The Structure of Corporate Liabilities (Not to be taught in class in the academic year 2018-19)

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.

Other reading: De Matos, Chapter 5

Other reading: Tirole, Chapter 10

Homework: Problem Set VII

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 (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.