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Change of Schedule
Please note the change of schedule for the remaining classes as follows:
Session 3: March 31
Session 4: April 7
Session 5: April 14
Session 6: April 21
All classes will take place in Meeting room A (ground floor Fuqua, west wing) from 12.15-3.15.
Materials
Some of the materials from last year have been put on this page for downloading. Please note that the content of these notes is not definite and the notes contain some errors that will be fixed before final distribution in class.
Outline
The following explains aims and objectives of the PhD seminar in corporate finance, and gives the syllabus for each class. Please note that this syllabus a framework rather than as a rigid structure, and some papers or topics may be changed for other ones at a later stage. This document covers the following topics:
Objectives What is "Corporate Finance?" Introduce the main literature Introduce the main areas of research Discuss new research What the course does not Organization of the course Pre-requisites Reading and preparation Assignments Syllabus of individual sessions Capital structure theory The optimal allocation of control rights Corporate Financing and information I : Dividend signaling Corporate Financing and information II : IPOs and adverse selection Security design Issues in the design of debt contracts Mergers and acquistions, and the integration of corporate finance and industrial organization References 0. LogisticsThe lectures are on Tuesdays, 12.15-3.15 in meeting room A. My secretary, Anne Higgs will keep a folder with the main readings, so you can save the time of locating the original articles you wish to read. I. ObjectivesThe course aims at providing participants with a thorough grounding in the modern theory of corporate finance. The main objectives are: To familiarize participants with the main areas of investigation in corporate finance To discuss the major literature of the field To introduce the major techniques of theoretical research, To introduce recent contributions in the field. 1. What is "Corporate Finance"?Most basically, corporate finance addresses the questions how companies raise financing and structure their liabilities. The major areas of research addressed in this course are: Capital structure: how do companies choose between different types of securities, particularly debt and equity? Security design: How do companies design liabilities (e. g. maturity and seniority of debt claims, call and conversion provisions) Corporate payout policy: How much do companies pay out to investors as dividends? The corporation in primary markets: why do companies go public, and why are initial public offerings (IPOs) generally underpriced? Ownership rights: how are control rights (e. g. voting rights, liquidation rights) assigned to security holders? When are these rights contingent? Mergers and acquisition and the market for corporate control: What determines the boundaries of the company? What are the costs and benefits of concentrated ownership? How is corporate control exercised? Note that the emphasis here is on positive, not on normative questions. The research discussed here generally aims at understanding observed corporate financial policies, and market price responses to these decisions. 2. What is the main literature in corporate finance?Everybody who wishes to complete a PhD in Finance should read the "Classics" in the theory of corporate finance. These articles are usually widely cited, and started completely new areas of research. All modern research and academic discussion assumes familiarity with these contributions.
Unfortunately, those papers that are path breaking in terms of ideas are not always those that contain the most general or rigorous statement of a particular result. In some cases the results stated in a fundamental paper are solely based on a numerical example, in others the statement or proof is incomplete or plainly incorrect. Hence, on several occasions we will discuss those papers during the lectures that state a certain result more generally or carefully, or restate older results in the context of modern methodology. For this reason some of the papers above will be mentioned only in passing during the lectures. However, this should not lead anybody to believe that they are not worth reading. Several of these papers contain stimulating ideas and original thoughts that were lost in the reception, and re-discovering those is sometimes a valuable contribution in its own right. 3. TechniquesOne major objective of the course is to introduce students to some of the major techniques of theoretical investigation. This means in principle that students should make themselves familiar with microeconomics and some game theory. We will then select some exemplary papers in order to study their methodology. These papers may be of lesser importance in terms of substance or impact, but show how a particular technique can be used to demonstrate certain results. In particular, we shall have a look at the following game theoretic and mathematicl concepts: Complete information games and subgame perfection Normal form games and mixed strategies Principal agent theory and mechanism design Bayesian games and signaling Equilibrium refinements Adverse selection Binomial trees Auction theory However, the course is not designed as a game theory course, and cannot substitute such a course. Hence, these concepts will be neither comprehensive nor always very detailed, and game theoretic results will generally be stated, but not proved or derived. The objective is to show how these concepts are applied in the theory of corporate finance. A more abstract discussion is beyond the scope of this course. 4. New ResearchThe last (but not least important) objective of the course is to give students some feel for the more recent research in the field. Hence, we shall discuss some working papers and recently published research that addresses new question or opens up new perspectives. The selection of these papers is naturally the most subjective, and reflects personal tastes. Here we enter the current discussion, where the dust has not yet settled. 5. What the course does notThe focus is necessarily narrow, and some important areas of the subject are excluded. We shall not address the following: Transaction costs and taxes; we shall mention this only in passing, although the subject is certainly important. Real investment decisions. We shall say little about corporate investment decisions and exclude the important (and growing) area of real option analysis. Financial intermediation; corporate finance in a broader context includes the analysis of banks, investment banks, and the price setting on exchanges. We shall bypass this area altogether. Market microstructure. The incorporation of information into prices in secondary markets is an important area of research in its own right, which has powerful (and yet largely unexplored) implications for corporate finance. Moreover, the focus of the course is on theoretical research. While we will also touch on some institutional and empirical aspects of the subject as well, these will remain on the sidelines. Students are strongly encouraged to complement the course and familiarize themselves with some institutional and legal details, results in empirical research and case studies. Indications for further reading are given throughout. I also recommend to study the relevant MBA material offered in the school, particularly for Advanced Corporate Finance. Ideally, sit in and audit this course if this is feasible.
II. Organization of the course1. Pre-requisitesThe modern theory of corporate finance relies heavily on advances in microeconomics and game theory. All students are assumed to be familiar with (list not exhaustive): Utility and expected utility theory Basic statistical concepts, stochastic dominance Risk and risk aversion, constant and relative risk aversion Optimization theory Portfolio theory and the Capital Asset Pricing Model For the first lecture some understanding of general equilibrium theory would also be useful. The course also assumes some familiarity with game theory. (see I.3 above). Although all concepts will be introduced in the course, the amount of time allocated will assume some general familiarity with: Games in strategic and normal form Definition of strategies Nash equilibrium Dominant strategies Extensive form games Students not familiar these concepts should consult the relevant textbooks. Kreps (1990) is a good introduction to microeconomics at a graduate level, with special emphasis on game theory. His chapters 11-13 cover the minimum amount of game theory required for this course, and we will use some of the later chapters as preparation for more advanced topics in the course. (see individual session descriptions below). 2. Readings and PreparationThere is no text in corporate finance, reflecting the fact that the field has not converged to a coherent set of results or a uniformly accepted methodology. Hence, there is no way to bypass the study of original papers. There are two volumes to facilitate this, and I recommend that students purchase both of them. Smith (1990) has compiled a collection of important essays, including an introduction to the field, some of the classics cited below, and some major empirical contributions. Bhattacharya and Constantinides (1989) have also collected several important contributions, trying to identify the major paper in each area, and complementing it with a survey of the research in each of them. There is no overlap between both volumes, and they also cover those areas for which we will not have any time during the course.
Students are recommended to purchase either Fudenberg and Tirole (1991), one of the major graduate texts in game theory, or Kreps (1990) (see the discussion under 6 above). Both volumes cover more material than required for this course, but it is useful to have something as a reference to fall back on. Fudenberg and Tirole's book is more detailed and more technical, but those who wish to do active research in this area should master this. 3. AssignmentsYou will receive one assignment in each of the first six lectures. The assignments are individual and due two weeks after the respective lecture. For some lectures you may choose between two different assignments. In order to receive a credit for this course you need to complete at least five assignments. If you hand in six assignments you will be graded on the basis of the best five.
III. Individual SessionsSession 1: Capital structure and the Modigliani-Miller TheoremDate: March 20
Subject: Modigliani Miller theorems, Capital structure
This session introduces the subject starting with the seminal paper by Modigliani and Miller (1958) about capital structure irrelevance. These papers identify circumstances where corporate financing decisions do not matter. Much of the subsequent research can be understood as an attempt to identify those assumptions in the MM theorems that are violated in practice and give a potential role to capital structure. This session focuses on alternative settings where the Modigliani Miller propositions hold: Economies with complete markets (Arrow-Debreu economies) Incomplete markets with suitable restrictions on the type of securities that are traded. Economies where the Capital Asset Pricing Model holds Particular focus in on the second point and the importance of short sales constraints and restrictions on the security space.
Main readings: Hellwig (1981); Modigliani and Miller (1958); Stiglitz (1969)
Many issues regarding Modigliani Miller theorems and capital structure cannot be discussed in this section. This includes in particular the tax effects of capital structure (see e. g. DeAngelo and Masulis (1980)*, Kraus and Litzenberger (1973) and Miller (1977)) and empirical studies on capital structure (here see e. g. Rajan and Zingales (1995)). I strongly recommend that everybody reads the survey article about capital structure theory by Harris and Raviv (1991). The course folder also contains a number of articles from the 1988 Journal of Economic Perspectives, where some of the authors studied here review the impact of the Modigliani-Miller Theorems after 30 years. Session 2: The optimal allocation of control rightsDate: March 27
Subject: Voting rights, ownership rights
Methodology: Subgame perfection; stochastic dominance; incomplete contracts
The literature on optimal capital structure discussed in this session is younger than that in later sessions. However, it relies on comparatively simple game theoretic concepts, hence we study it first. The main objective of this literature is to understand some qualitative features of corporate securities and addresses questions like: why does equity have voting rights and debt liquidation rights? Is it ever optimal to have non-voting shares? Which security holder should have control of the board of directors?
The main focus is on the incomplete contract approach to corporate finance, which holds that the contracts assumed in Arrow-Debreu economies are too complex, even if information is symmetric. Therefore, institutions serve as a substitute to complete contracts to structure future decision making that fills in the gaps in these incomplete contracts. We focus on two such institutions in this lecture: Voting rights determine how decisions about asset ownership are made by competing management teams. Voting rights can be allocated either equally to all shares (one share-one vote) or differently to different classes of shares, with different implications for the outcomes of future corporate control contests. Decision making rights can be allocated to different agents in different states by making use of the fact that bankruptcy shifts control from insiders to external investors contingent on the realization of the firm's cash flows. As a result, bankruptcy can also serve as a substitute for specifying complete contracts for all future contingencies under some circumstances. Preparation: Kreps (1990), chapters 11, 12
Main readings: Aghion and Bolton (1992); Grossman and Hart (1988); Hart and Moore (1995)
Further reading: Berkovitch and Israel (1996) discuss how the allocation of control rights can be important in the design of bankruptcy rules. Harris and Raviv (1988) have another discussion of the one share-one vote problem (with to some extent different assumptions and results). Aghion and Bolton (1989) contains a "bare bones" version of their RES paper, and Zender (1991) has developed some ideas similar to their approach. Session 3: Corporate Financing and Information IDate: March 31
Location: Seminar room B
Subject: Dividends
Methodology: Signaling games, non-dissipative signaling
This is the first in a sequence of sessions on the literature on asymmetric information, which relies heavily on the tools provided by Bayesian game theory. The objective of these papers is largely quantitative, and aims particularly at understanding price reactions in securities markets in response to corporate financing decisions. This session focuses particularly on dividends as an example of signaling, although almost all corporate financing decisions have been analyzed as signaling phenomena.
In some sense, all signaling models have the same underlying structure. The aim of this session is to develop a generic dividend signaling model and show how the dividend signaling papers in the literature can be understood as parameterizations of this structure. This should ultimately enable everybody to understand all other signaling equilibria as variations on a theme. We will use this opportunity also to review some equilibrium refinements.
Some authors noted the tension between the commonly accepted rationality assumption underlying the analysis, and the "burning money" assumption at the basis of (dissipative) signaling models. We shall discuss non-dissipative signaling briefly.
Preparation: Kreps (1990), chapter 17,
Main readings: Bhattacharya (1978), John and Williams (1985), Miller and Rock (1985), Bhattacharya (1980).
Further reading: Ambarish, John, and Williams (1987), Constantinides and Grundy (1989), Leland and Pyle (1977), Miller and Modigliani (1961), Williams (1988) The applications of signaling arguments to corporate financing decisions is vast. Harris and Raviv (1991) contain a bibliography of the relevant literature. Williams also had a survey of some of the literature in the volume 2 edited by Bhattacharya and Constantinides (1989) (see readings above). Session 4: Corporate Financing and Information IIDate: April 7
Location: Meeting room A
Subject: Initial Public Offerings (IPOs)
Methodology: Adverse selection and signaling
One of the most puzzling observations in corporate finance is the fact that initial public offerings of common stock appear to be underpriced. Almost all techniques have been explored to give a satisfactory answer to this question. Some explain it as a signaling phenomenon (familiar from the last session). This session focuses on adverse selection arguments. It also shows how fragile information based arguments can be: simple extensions of a model can lead to different conclusions. Dybvig and Zender (1991) ask the question why companies should use capital structure rather than managerial compensation contracts to resolve agency problems. We shall also discuss the underlying problem of making specific modeling decisions in theoretical research.
Preparation: Fudenberg and Tirole (1991), chapter 8
Main readings: Myers and Majluf (1984), Dybvig and Zender (1991), Noe (1988) , Rock (1986).
Further reading: There is also a literature on IPO signaling, e. g.Allen and Faulhaber (1989), Grinblatt and Hwang (1989), Welch (1989). An alternative approach to understand the phenomenon of "hot issue markets" is Welch (1992). Session 5: The design of optimal contracts: security design and mechanism designDate: April 14
Location: Seminar room B
Subject: Security design
Methodology: Mechanism design
In this session we go beyond the limitations of the preceding analysis which took for granted that capital structure decisions are chair between given debt and equity contracts. In most cases companies have several design parameters at their disposal. We shall see under which circumstances standard debt emerges as an optimal contract, and explore mechanism design as a powerful tool to derive optimal contracts.
Preparation: Kreps (1990), chapter 18
Main readings: Boot and Thakor (1993); Gale and Hellwig (1980).
Further reading: Benveniste and Spindt (1989) and Benveniste and Wilhelm (1990) have applied mechanism design techniques to the question of optimal IPO mechanisms. Bolton and Scharfstein (1990) solve the problem of debt design in the face of competition as an optimal security design problem. Recent contributions include DeMarzo and Duffie (1995) and Marin and Rahi (1996). See also the survey by Duffie and Rahi (19..). Session 6: Issues in the design of debt contractsDate: April 21
Location: Meeting room A
Subject: Debt contracts
Methodology: Infinite horizon games; contract renegotiation
This session takes up three issues in the design of debt contracts and capital structure decisions. Of these Anderson and Sundaresan (1986) is the most innovative, since it aims at integrating techniques from traditional valuation theory (which usually ignores the complications of corporate financing decisions) with the insights of modern corporate finance theory (which is usually conducted in terms of highly stylized, static or two-period models). Other issues are the seniority structure of debt and arrangements with multiple creditors.
Preparation: Kreps (1990), chapter 15.3
Main readings: Anderson and Sundaresan (1996), Myers (1977).
Further reading: Anderson, Sundaresan and Tychon (1996), Berglöf and von Thadden (1994), Bolton and Scharfstein (1996), Jensen (1986), Hart and Moore (1995) (see lecture 2), Lambrecht and Perraudin (1996), Leland (1994).
Mathematica Program
You can down load the file bondval.nb. This is a Mathematica notebook that does some of the calculations for the Anderson and Sundaresan model. Session 7: AuctionsDate: April 28
Location: Meeting room A
Subject: Auction theory
This session will be taught by Professor James D Wang. Please refer to the teaching note for details.
IV. ReferencesAghion, Philippe and Bolton, Patrick, 1989, The Financial Structure of the Firm and the Problem of Control, European Economic Review 33, 286-293
Aghion, Philippe and Bolton, Patrick, 1992, An "Incomplete Contract" Approach to Financial Contracting, Review of Economic Studies 59, 473-494
Allen, Franklin and Faulhaber, Gerald R., 1989, Signaling by Underpricing in the IPO Market, Journal of financial Economics 23, 303-323
Ambarish, Ramastry; John, Kose and Williams, Joseph, 1987, Efficient Signalling with Dividends and Investments, Journal of Finance 42, 321-343
Anderson, Ronald W. and Sundaresan, Suresh, 1996, Design and Valuation of Debt Contracts, Review of Financial Studies 9, 37-68
Anderson, Ronald W.; Sundaresan, Suresh and Pierre Tychon, 1996, Strategic analysis of contingent claims, European Economic Review 40, 871-881
Bagnoli, Mark and Lipman, Barton L., 1988, Successful Takeovers without Exclusion, Review of Financial Studies 1, 89-110
Benveniste, L. M. and Spindt, P. A., 1989, How Investment Bankers Determine the Offer Price and Allocation of New Issues, Journal of Financial Economics 24, 343-361
Benveniste, L. M. and Wilhelm, William J., 1990, A Comparative Analysis of IPO Proceeds under Alternative Regulatory Environments, Journal of Financial Economics 28, 173-207
Berglöf, Eric and von Thadden, Ernst-Ludwig, 1994, Short-Term versus Long-Term Interests: Capital Structure with Multiple Investors, Quarterly Journal of Economics 109, 1055-1084
Berkovitch, Elazar and Israel, Ronen, 1996, The Design of Internal Control and Capital Structure, Review of Financial Studies 9, 209-240
Bhattacharya, Sudipto, 1978, Imperfect Information, Dividend Policy, and the "Bird in the Hand" Fallacy, Bell Journal of Economics, 259-270
Bhattacharya, Sudipto, 1980, Nondissipative Signalling Structures and Dividend Policy, Quarterly Journal of Economics 95, 1-24
Bhattacharya, Sudipto and Constantinides, George M., 1989, Financial Markets and Incomplete Information (Rowman & Littlefield Publishers, Inc., Savage, Maryland).
Bolton, Patrick and Scharfstein, David, 1990, A Theory of Predation Based on Agency Problems in Financial Contracting, American Economic Review 80, 93-106
Bolton, Patrick and Scharfstein, David, 1996, Optimal Debt Structure and the Number of Creditors, Journal of Political Economy 104, 1-25
Bolton, Patrick and Scharfstein, David S., 1992, A Theory of Debt Structure, mimeo
Boot, Arnoud W. A. and Thakor, Anjan V., 1993, Security Design, Journal of Finance 48, 1349-1378
Burkart, Mike, 1995, Initial Shareholdings and Overbidding in Takeover Contests, Journal of Finance 50, 1491-1515
Burkart, Mike, Gromb, Denis and Panunzi, Fausto, 1994, Large Shareholders, Monitoring, and Fiduciary Duty, mimeo
Constantinides, George M. and Grundy, Bruce D., 1989, Optimal Investment with Stock Repurchase and Financing as Signals, Review of Financial Studies 2, 445-465
DeMarzo, Peter and Duffie, Darrell, 1995, A Liquidity-Based Model of Security Design, mimeo
Dybvig, P. and Zender, J., 1991, Capital Structure and Dividend Irrelevance with Asymmetric Information, Review of Financial Studies 4, 201-219
Fudenberg, Drew and Tirole, Jean, 1991, Game Theory (MIT Press, London and Cambridge).
Gale, Douglas and Hellwig, Martin, 1980, Incentive compatible Debt Contracts: The one-period problem, Review of Economic Studies 52, 647-664
Grinblatt, Mark and Hwang, C. Y., 1989, Signaling and the Pricing of New Issues, Journal of Finance 44, 393-420
Grossman, Sanford J. and Hart, Oliver D., 1980, Takeover Bids, The Free Rider Problem, and the Theory of the Corporation, Bell Journal of Economics 11, 253-270
Grossman, Sanford J. and Hart, Oliver D., 1981, The Allocational Role of Takeover Bids in Situations of Asymmetric Information, Journal of Finance 36, 253-270
Grossman, Sanford J. and Hart, Oliver D., 1982, Corporate Financial Structure and Managerial Incentives, in McCall, John J. (ed.), The Economics of Information and Uncertainty, Grossman, Sanford J. and Hart, Oliver D., 1988, One Share-One Vote and the Market for Corporate Control, Journal of Financial Economics 20, 175-202
Harris, Milton and Raviv, Arthur, 1991, The Theory of Capital Structure, Journal of Finance 46, 297-355
Hart, Oliver D. and Moore, John, 1995, Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management, American Economic Review 85, 567-585
Hellwig, Martin, 1981, Bankrtupcy, Limited Liability and the Modigliani-Miller Theorem, American Economic Review 71, 155-170
Holmström, Bengt, 1979, Moral hazard and Observability, Bell Journal of Economics 10, 74-91
Holmström, Bengt, 1982, Moral Hazard in Teams, Bell Journal of Economics 13, 324-340
Jensen, Michael C. and Meckling, William H., 1976, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics 3, 305-360
Lambrecht, Bart and Perraudin, William, 1996, Creditor races and contingent claims, European Economic Review 40, 897-907
Kraus, Alan and Litzenberger, Robert H., 1973, A State-Preference Model of Optimal Financial Leverage, Journal of Finance 28, 911-922
Leland, Hayne, 1994, Corporate Debt Value, Bond Covenants, and Optimal Capital Structure, Journal of Finance 49, 1213-1252
Leland, Hayne E. and Pyle, David H., 1977, Informational Asymmetries, Financial Structure, and Financial Intermediation, Journal of Finance 32, 371-387
Maksimovic, Vojislav and Zechner, Josef, 1991, Debt, Agency Costs, and Industry Equilibrium, Journal of Finance 46, 1619-1643
Miller, Merton H., 1977, Debt and Taxes, Journal of Finance 32, 261-275
Miller, Merton H., 1988, The Modigliani-Miller Propositions After Thirty Years, Journal of Economic Perspectives 2, 99-120
Miller, Merton H. and Rock, Kevin, 1985, Dividend Policy under Asymmetric Information, Journal of Finance 40, 1031-1051
Miller, Merton and Modigliani, Franco, 1961, Dividend Policy, Growth, and the Valuation of Shares, Journal of Business 34, 411-433
Modigliani, Franco and Miller, Merton, 1958, The Cost of Capital, Corporation Finance, and the Theory of Investment, American Economic Review 48, 261-443
Myers, Steward C., 1977, Determinants of Corporate Borrowing, Journal of Financial Economics 5, 147-175
Myers, Steward C. and Majluf, Nicholas S., 1984, Corporate Financing and Investment Decisions when Firms have Information that Investors do not have, Journal of Financial Economics 13, 187-224
Myers, Stewart C., 1984, The Capital Structure Puzzle, Journal of Finance 39, 575-592
Noe, Thomas H., 1988, Capital Structure and Signaling Game Equilibria, Review of Financial Studies 1, 331-355
Pagano, Marco and Roell, Ailsa, 1994, The Choice of Stock Ownership Structure: Agency Costs, Monitoring and Liquidity, mimeo
Rock, Kevin, 1986, Why New Issues are Underpriced, Journal of Financial Economics 15, 187-212
Shleifer, Andrei and Vishny, Robert W., 1986, Large Shareholders and Corporate Control, Journal of Political Economy 94, 176-216
Smith, Clifford W., 1990, The Modern Theory of Corporate Finance (McGraw-Hill, New York).
Welch, Ivo, 1989, Seasoned Offerings, Imitation Costs, and the Underpricing of Initial Public Offerings, Journal of Finance 44, 421-450
Welch, Ivo, 1992, Sequential Sales, Learning and Cascades, Journal of Finance 47, 695-732
Welch, Ivo, 1995, Equity Offerings following the IP Theory and evidence, Journal of Corporate Finance
Williams, Joseph, 1988, Efficient Signalling with Dividends, Investment, and Stock Repurchases, Journal of Finance 43, 737-747
Zechner, Josef, 1996, Financial market-product market interactions in industry equilibrium: Implications for information acquisition decisions, European Economic Review 40, 883-896
Zender, Jaime F., 1991, Optimal Financial Instruments, Journal of Finance 46, 1645-1663
Zwiebel, Jeffrey, 1995, Block Investment and Partial Benefits of Corporate Control, Review of Economic Studies 62, 161-185
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