Advanced Corporate Finance

Objectives and focus of the course
Under some conditions a firm‘s financial structure (its choice of leverage or of dividend policy) is irrelevant. The simplest set of such conditions is the Arrow-Debreu environment. The value of a financial claim is equal to the value of the random return of this claim computed at the Arrow-Debreu prices. In other words, the size of the corporate pie is unaffected by the way it is carved. In this Modigliani-Miller (MM) world, we have little to say about firms’ financial choices and governance. Rather the MM Theorems act as a benchmark whose assumptions needed to be relaxed in order to investigate the determinants of financial structures. In particular, the assumption that the size of the pie is unaffected by how it is carved has to be discarded. Following the lead of a few influential papers, the principal direction of analysis since the 1980s has been to introduce agency and informational problems at various levels of the corporate structure.The course “Advanced Corporate Finance” offers an advanced level introduction into the theoretical background of these changes (following the excellent exposition in Tirole (2006)) and also reviews the most important contributions of a large empirical literature testing these theories (using mostly scholarly articles). More precisely, we focus on the following major branches of theoretical work:
(a) Focus on the incentives of the firm‘s insiders (passive outsiders!):Insiders may have private information about the firm‘s technology or environment (adverse selection) or about the firm‘s realized income (hidden knowledge). Outsiders cannot observe the insiders‘ carefulness in selecting projects, the riskiness of investments, or the effort they exert to make the firm profitable (moral hazard). Informational asymmetries may prevent outsiders from hindering insider behavior that jeopardizes their investment.Standard themes: financial contracting, the firm‘s temptation to over-borrow, the resulting need for covenants to restrict future borrowing, the sensitivity of investment to cash flow, „debt overhang“, determinants of borrowing capacity, market breakdown, cross-subsidization of bad borrowers by good ones, negative stock price reaction to equity offerings, the „pecking order hypothesis“, why do good borrowers use dissipative signals: e.g., costly certifiers, costly collateral?
(b) Focus on both insiders‘ and outsiders‘ incentives (less passive outsiders!)Outsiders may occasionally affect the course of events chosen by insiders. E.g., the board of directors or a venture capitalist may dismiss the CEO or demand that insiders change their investment policy, raiders may, after a takeover, break up the firm and spin off some divisions, a bank may take advantage of a covenant violation to impose more rigor in management. Such possibilities destroy the simplicity of the classical agency relationship and their analysis paves the way to the study of security design.Standard themes: Social costs and benefits of passive monitoring, why are entrepreneurs and managers often compensated through stocks and stock options rather than on profits and losses? Do shareholders who are in for the long term benefit from liquid and deep secondary markets for shares? What are the costs of monitoring? Reduction in future competition in lending? Block illiquidity? Monitor‘s private benefit of control? Allocation of formal control between insiders and outsiders, takeovers.

Students will be able to analyze and solve problems that arise when corporations raise funds to finance their investments. In doing so, the students will be able to apply the major corporate finance theories and econometric techniques to decision-making under global influences. They will also be able to effectively communicate financial information by being able to present, discuss, and defend their analysis using appropriate terminology.

Detailed Overview of Topics and Readings: (++) Required ReadingOther Readings that are listed are recommended to enhance your knowledge and expertise with the topics.(a) Background(++)Tirole, Jean, 2006, Chapter 3: Outside financing capacity [Jean Tirole, 2006, The Theory of Corporate Finance, Princeton University Press.](++)Craig MacKinlay, 1997, Event studies in economics and finance, Journal of Economic Literature 35(1), 13-39.Angrist, J. D. and A. B. Krueger, 2001, Instrumental variables and the search for identification: From supply and demand to natural experiments, Journal of Economic Perspectives 15, 69-85.(b) Corporate Investment Policy and Sources of Finance(++)Jensen, M. C. and W. Meckling, 1976, Theory of the firm: managerial behavior, agency cost, and capital structure, Journal of Financial Economics 3, 305-360.(++)Myers, S. and N. Majluf, 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13, 187- 221.Fazzari, Steven M., R. Glenn Hubbard and Bruce C. Petersen, 1988, Financing constraints and corporate investment, Brookings Papers on Economic Activity, 141–195.Blanchard, Olivier J., Francisco Lopez-de-Silanes and Andrei Shleifer, 1994, “What do firms do with cash windfalls?, Journal of Financial Economics 36, 337−360.Lamont, O. 1997, Cash flow and investment: Evidence from internal capital markets, Journal of Finance 52(1), 83-109.Kaplan, Stephen N. and Luigi Zingales, 1997, Do investment-cash flow sensitivities provide useful measures of financing constraints? Quarterly Journal of Economics 112, 159−216.(c) Dividend PolicyEasterbrook, EH, 1984, Two agency-cost explanations of dividends, American Economic Review 74 (4):650-659.Gugler, K. and B.B. Yurtoglu, 2003, Corporate governance and dividend pay-out policy in Germany, European Economic Review, 47(4), 731-758.Jensen, M C, 1986, Agency costs of free cash flow, corporate finance, and takeovers, American Economic Review 76(2), 323-329.(++) Lang, L H P and R. H. Litzenberger, 1989, Dividend announcements: cash flow signaling vs free cash flow hypothesis, Journal of Financial Economics 24(1), 181-192.Lintner, J., 1956, Distribution of incomes of corporations among dividends, retained earnings, and taxes, American Economic Review 46(2), 97-113.(d) Mergers and Acquisitions(++)Stephen W. Salant, Sheldon Switzer and Robert J. Reynolds, 1983, Losses from horizontal merger: The effects of an exogenous change in industry structure on Cournot-Nash Equilibrium, The Quarterly Journal of Economics 98(2), 185-199.(++)Moeller, S.B., F.P. Schlingemann, and R. M. Stulz, 2005, Wealth destruction on a massive scale? A study of acquiring-firm returns in the recent merger wave, Journal of Finance 60(2), 757-782.Gugler, K., D.C. Mueller, B.B. Yurtoglu, and C. Zulehner, 2003, The effects of mergers: an international comparison, International Journal of Industrial Organization 21(5), 625-653.Morck, R., A. Shleifer and R. Vishny, 1990, Do managerial objectives drive bad acquisitions? Journal of Finance 45, 31−48.Shleifer, Andrei and R. Vishny, 2003, Stock market driven acquisitions, Journal of Financial Economics 70 (3), 295-489.(e) Executive CompensationRosen S., 1981, The Economics of Superstars, American Economic Review 71(5):845-58.Jensen M. and Murphy K., 1990, Performance pay and top management Incentives, Journal of Political Economy 98(2):225-264.Hartzell J. C, Ofek E., Yermack, D., 2004, What’s in it for me? Private benefits obtained by CEOs whose companies are acquired, Review of Financial Studies 17(1):37-61.Gabaix X. and Landier A., 2008, Why has CEO pay increased so much? Quarterly Journal of Economics 123(1):49-100.(f) Financial and Product Market Interactions(++) Parsons, C.A. and Titman, Sheridan, 2008, Capital structure and corporate strategy, Chapter 13 of Handbook of Empirical Corporate Finance, Volume 2, 203-233 (Ed. by B. Espen Eckbo).Brander JA and Lewis TR, 1986, Oligopoly and financial structure: The limited liability effect, American Economic Review, 76, 956-970.Chevalier, Judith A, 1995, Capital structure and product-market competition: Empirical evidence from the supermarket industry, American Economic Review 85(3):415-35.Chevalier, Judith A, 1995, Do LBO supermarkets charge more? An empirical analysis of the effects of LBOs on supermarket pricing, Journal of Finance 50(4): 1095-1112.Giroud, X., Mueller, H. Alex Stomper, and Arne Westerkamp), 2012, Snow and Leverage, Review of Financial Studies 25, 680-710.

Interactive development of main results

Discussions of major economic implications

Hands-on excercises

Grading is based on the following components:

- Class Participation (10%)

- Two Group Works: (1) Econometric Exercise (20%), (2) Case Study (20%)

- Final Exam: 50%