University of Arizona FIN 601: Finance Decision Making (Ph.D. level) Spring Monday, 4pm 5:15pm & Tuesday, 8-9:15am

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1 Lubo Litov University of Arizona FIN 601: Finance Decision Making (Ph.D. level) Spring 2014 Class Schedule: Class Location: Office Hour: Monday, 4pm 5:15pm & Tuesday, 8-9:15am McClelland Hall Finance Department Conference Room Monday & Tuesday 11:15am-12:15pm & appointment (McClelland Hall, 315D) Phone: Website: Course description: This course will discuss the four areas of corporate finance. We would start with an introductory part, whereas we would review the Black-Scholes work, real options and the cost of capital. We would then follow with a second part, where would review the practice of mergers and acquisitions from a practitioner s perspective with an emphasis on the deal design, driven by tax issues. A third part, in which we would cover the fundamental theory to support modern corporate finance. And a fourth part, where we shall cover empirical research that is complementary to the one reviewed in FIN 620, the course taught by Professor Sandy Klasa. The course will highlight the areas importance for finance research, discuss existing empirical evidence, and highlight some important open questions for future research. This course is designed for PhD students who are looking for research topics and the empirical tools necessary to implement them. The course will not have a pre-specified textbook (although recommendations of relevant chapters from preselected textbooks are included below). Instead, we will discuss four research papers in detail for each class. Students will be expected to read these papers in advance and take turns leading the in-class discussion. The main objective of the course is to provide students a strong background in the mainstream areas of modern corporate finance and related areas of banking at an advanced level. Providing the students an opportunity to develop modeling skills for doing research in corporate finance/banking is another important purpose of the course. Another objective is to train the students to recognize and use recurring model structures to read and understand corporate finance. In addition to discussing the theoretical papers, we will discuss a large number of empirical papers as they are relevant. For topics, see the attached readings list. 1

2 Administrative Matters: 1. Since the objective of the course is to read and understand the major articles in corporate financial theory, participants are expected to spend adequate time preparing the assigned readings before coming to class, and working through assigned problems sets. 2. The students will be required to do a project that involves modeling a problem/ replicating existing empirical work in corporate finance. Details will be spelled out in class. 3. The grade in the course will be based on six referee reports, three presentations, research proposal, and class participation, described below. 4. Although several books containing material in corporate finance are listed below the primary course material will be journal articles. The books and the relevant material from them will be discussed in class. All of the journal articles are available on Blackboard. Grading: Your grade would be determined by five referee reports, one research proposal, due two weeks past the last class (i.e., due by May 15 th ) and three in-class presentations. The distribution of grade weights is given below: - Seven referee reports (assigned paper + subsequent research; each report 5%) 35% - Research Paper Proposal 35% - Six presentations (five empirical paper, one theoretical paper or 2-in-1 presentation, 5% each) 30% The presentations should cover the assigned papers and should last about 35 minutes each. Please submit these in advance to me, i.e., the day before the class. The research proposal is due a week past the last class, i.e., on May 16 th. The detailed guidelines on the proposal are specified at the end of this document. The referee reports would be 2-3 pages critical assessment of the contributions and methodology of the paper that is assigned to review. This assessment should also look into subsequent work that builds upon the reviewed paper. Recommended Texts: For most of the material we shall rely on research papers (published or Working Papers) that will be handed out. The following books will be useful for certain material and will be referred to in class. For the first part of the course (introduction & review) the following textbook is recommended: 1. (GT) Grinblatt, M. and S. Titman, Financial Markets & Corporate Strategy, 2 nd Edition, McGraw-Hill/Irwin Publishing, For the second part of the course (mergers & acquisitions practice) the following textbooks are recommended: 2

3 1. (SWEMS) Scholes, M., M. Wolfson, M. Erickson, E. Maydew and T. Shevlin, Taxes and Business Strategy: A Planning Approach, 3 rd Edition, Prentice Hall, (B) Bruner, R., Applied Mergers and Acquisitions, 1 st Edition, Wiley Finance, For the third part of the course (corporate theory) the following textbooks are recommended. 1. (CSW) Copeland, Shastri, Weston, Financial Theory and Corporate Policy, 4th. Edition, Addison-Wesley, (T) Tirole, J., The Theory of Corporate Finance, Princeton University Press, January (MWG) Mas-Colell, A., M. Whinston, and J. Green, Microeconomic Theory, Oxford University Press, CLASS SCHEDULE Note: This is only a tentative schedule, if we need to spend more time on certain topics, rather than others, we will do so. Please note that (***) indicates an empirical paper that need to be reviewed by students. Part I: Introductory Materials 1 session (CSW 7 & 9) 2 1. Black Scholes Derivation lecture slides & additional materials & GT chapter8. 2. Real Options- lecture slides & relevant GT chapter Cost of Capital lecture slides; summary of the estimation of equity cost of capital based on the following papers: Claus, J. and J. Thomas, 2001, Equity premia as low as three percent? Empirical evidence from analysts' earnings forecasts for domestic and international stock markets, Journal of Finance 56, Gebhardt, W., C. Lee, and B. Swaminathan, 2001, Toward an implied cost of equity, Journal of Accounting Research 39, Gode, D. and P. Mohanram, 2003, Inferring the cost of equity using the Ohlson-Juettner Model, Review of Accounting Studies 8, Part II: The Practice of Mergers and Acquisitions 2 sessions (each of the items below holds 0.5 sessions) (SWEMS all chapters, B all chapters) 1. Deal Design- lecture slides & assigned Bruner and Scholes et al. chapters 2. Deal Valuation - lecture slides & assigned Bruner chapters 3. Taxes - lecture slides & assigned Scholes et al. chapters 4. LBOs- lecture slides & assigned Bruner chapters 1 The relevant chapters from this book, Chapters 12 through 15 are scanned and presented in the course Blackboard site. 2 A session is two 75 minutes classes. 3

4 Part III: Corporate Finance Theory 4 sessions (note 1: this session may get truncated depending on the time it takes to cover the fundamental topics; you would nonetheless need to cover all) (note 2: relevant chapters CSW: 12, 13, 14, and 15.) 1. Perfect Capital Markets 1 session (CSW 15) 1. F. Modigliani and M. Miller, "The Cost of Capital, Corporation Finance and The Theory of Investment," American Economic Review, June 1958, Miller, M.H., "The Modigliani Miller Propositions After Thirty Years," Journal of Economic Perspectives, Vol 2, No 4, Fall 1988, p Stiglitz, J.E., "Why Financial Structure Matters," Journal of Economic Perspectives, Vol 2, No 4, Fall 1988, p Ross, S.A., "Comment on the Modigliani-Miller Propositions," Journal of Economic Perspectives, Vol. 2, No 4, Fall 1988, p Taxes (Corporate/Personal) 1 session (CSW 14) 1. F. Modigliani and M. Miller, "Corporate Income Taxes and the Cost of Capital: A Correction," American Economic Review, June 1963, Miller, M.H., "Debt and Taxes" Journal of Finance, May 1977, (***) 3. DeAngelo, H. and R. Masulis (1980). "Optimal Capital Structure under Corporate and Personal Taxation," Journal of Financial Economics 8, Agency Theory, Incomplete Contracting, and Corporate Governance 1 session (CSW 12 and ) 1. Ross, S.A., "The Economic Theory of Agency: The Principal's Problem," American Economic Review, LXII, May 1973, Holmstrom, B., 1979, "Moral Hazard and Observability," Bell Journal of Economics 10, Rogerson, W., "The First-Order Approach to Principal Agent Problems," Econometrica, 53, November 1985, Grossman, S., and J. Hart, An Analysis of the Principal-Agent Problem, Econometrica, 51, Jensen, M. and W. Meckling, 1976, "Theory of the Firm: Managerial Behavior, Agency Cost and Ownership Structure," Journal of Financial Economics 3, (***) 6. Myers, S.C., "Determinants of Corporate Borrowing," Journal of Financial Economics, November 1977, (***) 4

5 7. T. John and K. John, "Top Management Compensation and Capital Structure", Journal of Finance, July Corporate Policy under Asymmetric Information 1 session (CSW 12) 1. S. Grossman and J. Stiglitz, 1980, On the Impossibility of Informationally Efficient Markets, American Economic Review, Vol. 70, No. 3 (Jun., 1980), pp Myers, S., Majluf, N., 1984, Corporate Financing and Investment Decisions when Firms Have Information That Investors do Not Have, Journal of Financial Economics Vol. 13, (***) 3. Leland, H. and Pyle, H. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, Vol. 32, No.2 (May, 1977): J. Stiglitz and A. Weiss, Credit Rationing in Markets with Imperfect Information, American Economic Review, Vol. 71, No. 3 (Jun., 1981), pp Information Economics 1 session (MWG 13) 1. Rothschild, M. and J. Stiglitz, Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, Quarterly Journal of Economics, Vol. 90 (1976): Spence, M., Job Market Signaling, Quarterly Journal of Economics, Cho, I. and D. Kreps, Signaling Games and Stable Equilibria, Quarterly Journal of Economics, Vol. 102 (1987): Mechanism Design 1 session (MWG 23) (if time permits) 1. Laffont, J. and E. Maskin, The Theory of Incentives: An Overview in Hildebrand (ed.), Advances in Economic Theory, 1982: Cambridge University Press. 2. Myerson, R. and M. Satterthwaite, Efficient Mechanisms for Bilateral Trading Journal of Economic Theory, Vol. 29 (1983): Part IV: Empirical Work 5 sessions For the list of paper below, note that all four papers, present per session, need be presented by students. Moreover, of the papers for each session, the ones noted with (***) at the end are the ones for which students are responsible to write a referee report (i.e., two-three pages critical evaluation). 1. Payout Policy (0.5 session) Lintner, J., 1956, Distribution of Incomes of Corporations among Dividends, Retained Earnings and Taxes, American Economic Review, Vol. 46:

6 Aharony, J. and I. Swary, Quarterly Dividends: Changing and Earnings Announcements, and Stockholders Returns: An Empirical Analysis, Journal of Finance, Vol. 35: Fama, E. and K. French, 2001, Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay? Journal of Financial Economics, Vol. 60: Grullon, G. and R. Michaely, 2002, Dividends, Share Repurchases, and the Substitution Hypothesis, Journal of Finance, Vol. 57: DeAngelo, H., L. DeAngelo, and D. Skinner, 2004, Are Dividends Disappearing? Dividend Concentration and the Consolidation of Earnings, Journal of Financial Economics, (***) Brav, A., J. Graham, C. Harvey, and R. Michaely, 2005, Payout Policy in the 21 st Century, Journal of Financial Economics, Vol. 77: Diversification and Conglomerate Discount (1 session) In-class: 4 student presentations (submit your slides through Blackboard the day before) 1. Berger, Philip G., and Eli Ofek, "Diversification's Effect on Firm Value," Journal of Financial Economics, 37(1), January 1995, pages Campa, J. and S. Kedya, 2002, Explaining The Diversification Discount, Journal of Finance, 2002, Vol Gopalan, R. and K. Xie, 2011, Conglomerates and Industry Distress, Review of Financial Studies, Lamont, Owen A., and Christopher Polk, "Does Diversification Destroy Value? Evidence from the Industry Shocks," Journal of Financial Economics, 63(1), January 2002, pages (***) 5. Villalonga, Belen. "Diversification Discount or Premium? New Evidence from the Business Information Tracking Series." Art. 1. Journal of Finance 59, no. 2 (April 2004): Interaction of Financing and Real Investment Decisions (1 session) In-class: 4 student presentations (submit your slides through Blackboard the day before) 1. Two-in-one (one student presents both): Fazzari, S., R. Glenn Hubbard, B. Petersen, Financing Constraints and Corporate Investment, Brookings Papers on Economic Activity, 1988, 0(1): Fazzari, S., G. Hubbard, B. Petersen, Investment Cash Flow Sensitivities are Useful: A Comment Quarterly Journal of Economics, 2000, 115:

7 2. Gatchev, Vladimir, Todd Pulvino and Vefa Tarhan The Interdependent and Intertemporal Nature of Financial Decisions: An Application to Cash Flow Sensitivities. Journal of Finance. (***) 3. Two-in-one (one student presents both): Kaplan, S. and L. Zingales, Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints Quarterly Journal of Economics, 1997, 112: Kaplan, S. and L. Zingales, Investment Cash Flow Sensitivities are Not Valid Measures of Financing Constraint Quarterly Journal of Economics, May 2000, 115: Two-in-one (one student presents both): J. Lewellen and K. Lewellen, Investment and Cash Flow, 2010, Working Paper, Dartmouth College. J. Chen and J.Chen, Disappearing Investment Cash Flow Sensitivity, forthcoming, Journal of Financial Economics. 4. Behavioral Corporate Finance (0.5 session) 1. Baker, M., and J. Wurgler, 2002, Market Timing and Capital Structure, Journal of Finance, Vol. LVII: (***) 2. Baker, M., J. Wurgler, and J. Stein, 2003, When Does the Market Matter? Stock Prices and the Investment of Equity-Dependent Firms, Quarterly Journal of Economics, Baker, M., and J. Wurgler, 2004, A Catering Theory of Dividends, Journal of Finance, Vol. LIX: Baker, M., R. Greenwood, and J. Wurgler, 2009, Catering Through Nominal Prices, Journal of Finance, Vol. LXIV: Baker, M., X. Pan, J. Wurgler, 2012, The Effect of Reference Point Prices on Mergers and Acquisitions, Journal of Financial Economics, Vol. 106: IPOs and Capital Raising (1 session) In-class: 4 student presentations (submit your slides through Blackboard the day before) 1. J. Ritter, "The Long-Run Performance of Initial Public Offerings," Journal of Finance, Vol. 46, No. 1 (March 1991), pp (***) 7

8 2. Tim Loughran and Jay R. Ritter, "The New Issues Puzzle," Journal of Finance, Vol. 50, No. 1 (March 1995), pp Lowry, Michelle, and G. William Schwert, 2004, Is the IPO pricing process efficient? Journal of Financial Economics 71, Liungquist, A. and W. Wilhelm, "Does Prospect Theory Explain IPO Market Behavior?", Journal of Finance (2005). 6. Determinants of Financial Development (0.5 session) In-class: 4 student presentations (submit your slides through Blackboard the day before) 1. Beck, Thorsten and Ross Levine (2002) "Industry Growth and Capital Allocation: Does Having a Market- or Bank-based System Matter?" Journal of Financial Economics, 64(2), Rajan Raghuram G. and Luigi Zingales (1998) Financial Dependence and Growth, American Economic Review, 88(3), (***) 3. Guiso, Luigi, Paolo Sapienza, and Luigi Zingales (2004) The Role of Social Capital in Financial Development, American Economic Review, 94(3), La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny (1997) "Legal Determinants of External Finance," Journal of Finance, 52 (3), Business Groups, Stealing & Corruption (0.5 session) In-class: 4 student presentations (submit your slides through Blackboard the day before) 1. Burkart, Mike, Fausto Panunzi and Andrei Shleifer Family Firms, Journal of Finance 58(5), Johnson, Simon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer Tunneling, American Economic Review 90:2, pp Khwaja, Asim Ijaz and Atif Mian (2005), "Do Lenders Favor Politically Connected Firms? Rent Provision in an Emerging Financial Market," Quarterly Journal of Economics, Vol. 120 (4), November, La Porta, Rafael, Florencio Lopez-de-Silanes, and Guillermo Zamarippa (2003) "Related Lending," The Quarterly Journal of Economics, 118 (1), (***) 8

9 A note on preparing research proposal manuscript You would develop a research proposal under my guidance for the purposes of this class. The topic of choice need not be entirely focused on FIN 601 (i.e., this class), you could for example follow on a topic that you have selected for FIN 620 (the class read by Professor Sandy Klasa). You can also collaborate with other students on this project (but not with faculty). Here is the process that we would follow: By 2/18/2014: Please submit a three-four pages introduction that describes the research question and the factual and counter factual hypotheses to it. Please, try to strive to create a tension (i.e., if you are looking to defend a certain hypothesis, alone, then you are not presenting the question in a holistic manner). An important second part of this document would indicate your conjectured contributions to the literature. You must be very specific which papers do you build on, what deficiencies do you address, and why this is a top finance journal contribution. By week of 3/11/2014: Please meet with me to discuss your research proposal (above). I will give you guidelines as to structure your question, your hypotheses (are they logical, consistent, and comprehensive) and lastly would suggest additional test. It is your duty to come to that meeting with proper suggestions for all these aspects (I would only evaluate these). By 4/14/2014: Please replicate the studies upon which you build your empirical design. You must also be able to tabulate: (i) replication results; (ii) hypothesis-specific tests results. You must also show me your SAS and/or Stata code. By 5/6/2014: Please send to me an extended draft, describing the research question, discussion and motivation of hypotheses, empirical design for your tests to the hypotheses, discussion of your results and replicated results, references, tables and charts. By 5/16/2014: Please submit your revised draft. Note that I require submission of a revised draft. 9

10 Note on the course dates We would meet for the purposes of this class on the following dates. Date 1 1/21 (8am-9:15am) 2 1/27 3 1/28 (8am-9:15am) 4 2/3 5 2/4 (8am-9:15am) 6 2/10 7 2/11 (8am-9:15am) 8 2/17 9 2/18 (8am-9:15am) 10 2/ /25 (8am-9:15am) 12 3/3 13 3/4 (8am-9:15am) 14 3/ /11 (8am-9:15am) 16 3/ /25 (8am-9:15am) 18 3/ /1 (8am-9:15am) 20 4/7 21 4/8 (8am-9:15am) 22 4/ /15 (8am-9:15am) 24 4/ /22 (8am-9:15am) 26 4/ /29 (8am-9:15am) 28 5/5 29 5/6 (8am-9:15am) 10