WARWICK MSc FINANCE

IB9Y70
CORPORATE FINANCE

AUTUMN 2024

Lecturer: Andrea Gamba

Warwick Business School
University of Warwick

Phone: 024 765 24 542

E-Mail: andrea.gamba@wbs.ac.uk
Office Hours: Tuesday, 16.00-18.00, Room 2.110
or by appointment

Teaching assistant: Ozan Akbas

E-Mail: Ozan.Akbas@warwick.ac.uk
Office Hours: Monday, 16.30-18.30, Room TBD

This is an overview of the forthcoming “Corporate Finance” MSc Finance module, covering:

• a brief description of the module and its learning outcomes,

• the lecture timetable,
• details on module delivery and assessment,
• the required textbook and pre-readings.

Please read this document carefully before the beginning of the module and make sure to complete
any required pre-reading.
 INTRODUCTION
Corporate Finance is the study of financial decision-making processes at the corporate level. In
other words, Corporate Finance deals with questions such as the following:

1. What are the decisions that financial managers are required to make?
2. What are the objectives that (should) govern these decisions?
3. What are the constraints and frictions imposed by the economic and regulatory
framework?
4. Can conflicts of interest distort the manager's incentives to pursue their goals?
5. How can the different available choices be evaluated and ranked?
6. How will the above decisions, constraints, and frictions impact the price of corporate
securities?

Of these, only the first question has a relatively simple answer: The key decisions made by the
financial manager of a corporation are the following:

• Capital budgeting decisions:

What real assets (or projects) should the firm invest in?
Examples include opening new facilities to increase production capacity, investing in
research and development (R&D) to expand the product line or reduce production costs, and
determining when to shut down unprofitable production lines. To make these decisions,
potential investment opportunities and their associated flexibilities must be assessed and, if
alternatives exist, ranked accordingly.

• Financing decisions:
How should the firm raise the funds to finance its investment activity?
The manager can choose between using internal funds, borrowing by issuing debt, or raising
capital by issuing equity. This decision shapes the firm’s capital structure, which carries
significant implications, such as its impact on bankruptcy risk and the incentives of both
equity holders and managers to pursue the firm’s objectives.

• Risk management decisions:

How can a firm insure against its business hazards and other sources of risk? And why?
Interestingly, the primary reason a corporation hedges against interest rate, commodity, and
exchange rate risks is not merely to reduce risk itself. We will explore the objectives of
hedging and insurance for non-financial corporations, along with the common strategies
used to manage risks—such as derivatives, insurance contracts, operational hedges, and
corporate liquidity management.

• Payout policy decision:

What fraction of its profits should the firm pay out to its shareholders?
This question explores the trade-off between enhancing shareholder wealth through higher
cash disbursements and retaining earnings to fund investment and growth during favorable
conditions, as well as to mitigate financial distress during adverse conditions, which
increases the value of shareholder’s equity.

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With the first question addressed, the goal of this course is to provide answers to the remaining five
questions using modern finance theory, particularly the Law of One Price, to evaluate the impact of
these decisions on the pricing of corporate securities (both equity and debt) and, ultimately, the
firm’s value. The study is compelling because these decisions are influenced by “frictions” or
“imperfections” within the economic environment, financial markets, and the institutional structure
of corporations. Indeed, Corporate Finance is often seen as the study of how these “frictions” affect
the firm decisions and the prices of corporate securities.

This graduate-level course introduces the tools and concepts of Corporate Finance, offering a
framework for understanding and analyzing corporate financial decisions. It provides both a
theoretical and empirical examination of key Corporate Finance topics crucial for understanding
firm value and security pricing. The course emphasizes fundamental principles and quantitative
tools, ensuring a rigorous and analytical approach.

Our objective is to equip students with the advanced concepts of modern finance theory and
quantitative tools necessary for addressing the challenges faced by CFOs and business executives.
This includes making investment, financing, risk management, and payout decisions while
considering flexibility, discretion under uncertainty, tax implications, and financing effects .
Students will also learn to evaluate how factors such as corporate and personal taxes, bankruptcy
costs, information signaling, and conflicts of interest influence investment and financial structure
decisions. Additionally, students will gain proficiency in using option-pricing techniques to assess
corporate securities and investment projects.

LEARNING OUTCOMES

After completing this module, students will ...

• be able to define the role of the financial manager, the types of decisions (s)he is required to
make, the objectives and constraints that apply, and the potentially distorted incentives (s)he
may have and the related remedies offered by corporate governance;
• be able to evaluate and rank different investment opportunities or the decision to sell firm's
assets, taking into consideration issues of accounting practice, taxation, understanding how
the uncertainty of future cash flows, and the flexibility of the decision maker affect the
investment appraisal process, and how to adjust the process to take these effects into
account;
• be familiar with the different ways in which the firm can raise funds to finance investment,
and understand the implications of the firm's debt/equity mix on its value, tax burden, risk of
bankruptcy, and the influence of the type of financial contracts used to finance the firm on
agency conflicts and information asymmetry and how these may affect the choice of an
"optimal" financing mix;
• understand the reasons why a corporation should manage its risk, and be able to assess what
are the risks that the firm should hedge, and the main risk management tools, including
derivatives, insurance policies, and cash management;
• understand the implications of the firm's cash retention/payout policy on shareholder wealth
and long-term growth prospects, and how these may determine an "optimal" policy;
• understand the channels through which all these decisions impact the price of corporate debt
and equity, and ultimately, the value of the firm.

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 A WORD ABOUT MATHEMATICS

Finance is inherently a quantitative subject, and as such, a certain amount of mathematics is

unavoidable. However, we will strive to keep the level of mathematical complexity to a minimum.
New concepts will be introduced from first principles, accompanied by clear economic intuition and
practical numerical examples. For the most part, we will rely on basic calculus (such as addition,
multiplication, percentages, and functions of one or two variables, including their derivatives and
integrals) and foundational statistics (including probability, expected value, variance, covariance,
and correlation).

READINGS

The core reading for this module consists of selected chapters from:

Berk, J., and P. DeMarzo

“Corporate Finance,” 6th (global) edition available online, 2023,
Pearson

For a lower level preparatory reading (for those who have not taken any Corporate Finance before)

Hillier, D., S. Ross, R. Westerfield, J. Jaffe, and B. Jordan

“Corporate Finance,” (European) edition, 2016
McGraw Hill

Other materials, including lecture notes, case study materials, and papers, will be made available to
participants in the week preceding the relevant sessions of the module.

ASSESSMENT

Assessment for this module is based on the following two components:

• 25% of your mark is based on a 1-hour in-person closed book class test on the material
covered in Weeks 1-5, on 6 November 2024, at 12.00;
• 75% of your mark is accounted for by the final 3-hour in-person closed book (written)
examination, on the entire course material, in the w/c 6 January 2025.

The structure of the final exam and tests will be announced in class. We will provide a mock test
paper and a mock exam paper to familiarize with the structure. Both the test and the exam are based
on open-answer problems, all comprising of quantitative as well as theory sub-questions.

PRE-CLASS PREPARATION

To get the best learning experience from this module, it is essential that you complete any assigned
reading by the time indicated. We expect you to not only “skim through” the relevant pages of the
book, but rather to develop a familiarity and some understanding of the concepts covered before
you come to class. This will greatly enhance the benefit you derive from attending the lectures and
the workshops, since you can concentrate on the “finer points” rather than waste your time
struggling to grasp notation and basic ideas.
Before the module begins, please READ CHAPTERS 1, 3, 10, 20, and 21.1-21.3 in your textbook
and study the Week 0 material posted in the module’s page on my.wbs.

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 CODE OF CONDUCT
The teaching faculty is committed to delivering a module of the highest standard and creating an
engaging and productive learning experience for you.

Just as you expect your instructors to be well-prepared, it’s important to hold yourself to the same
standard. To maximize your learning, you should actively engage with the course material. Before
attending lectures, read the essential chapters of the textbook and review the lecture notes. During
the lecture, don’t hesitate to ask questions if anything is unclear. Afterward, supplement your
understanding by watching additional videos and materials, and test your comprehension by
working through related questions. Make sure to complete each week’s problem set before
attending the workshop. This preparation is crucial for both your learning and exam readiness.

Your workshop experience will be much more valuable if you are familiar with the material in
advance. You will be better equipped to understand the solution explanations and ask insightful
questions, leading to a deeper grasp of the content and the retention of key details that might
otherwise be missed.

We hope you find the module enjoyable and that it provides a productive learning experience!

TEACHING FACULTY
Dr Andrea Gamba is Professor of Finance. Andrea joined Warwick Business School in 2010. He
has been Visiting Professor of Finance at the George Washington University School of Business
from 2008 to 2010, Associate Professor of Mathematical Finance at the University of Verona (Italy)
from 2000 to 2010. Before then, he has been Assistant Professor at University Ca’ Foscari (Italy)
from 1996 to 2000. He had visiting and research appointments at NYU, Purdue University, Calgary
University, University of Maryland, and London Business School. His primary research interest is
currently corporate finance, with secondary fields in banking, derivatives, financial contracting. He
has published in major finance journals, including the Journal of Finance, Review of Financial
Studies, Journal of Financial Economics, Management Science, Review of Corporate Finance
Studies, Financial Management, Journal of Economic Dynamics and Control, Energy Economics,
Finance Research Letters, and Applied Mathematical Finance. He has also presented his research
in numerous international conferences in finance. Andrea has been associate editor of the Journal of
Corporate Finance since 2018 and of Decisions in Economics and Finance since 2022. He has been
member of the scientific committee of several major international conferences in finance, including
SFS Finance Cavalcade, European Finance Association, Western Finance Association, Financial
Intermediation Research Society. His teaching expertise covers a wide range of topics including
corporate finance, derivative pricing, and investments taught at all levels. Andrea served as a
consultant on real options valuation for SwissCom and Cable & Wireless and BHP Billiton, and on
derivative pricing for banks (Unicredit, UBS, Lehman Brothers) and insurance companies
(Cattolica Assicurazioni).

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 LECTURE TIMETABLE

WEEK 0: w/c 23 September 2024

§ Preliminary concepts to the upcoming Corporate Finance course

o No-arbitrage and The Law of One Price
o Risk premium and CAPM
o Risk-neutral valuation
o Options

§ Readings:
o Chapter 3: "Financial decision making and the Law of One Price"
o Chapter 10: "Capital markets and the pricing of risk"
o Chapter 20: "Financial options"
o Chapter 21: "Option valuation" (only sections 21.1 and 21.3)

§ Problem Set 0 posted on my.wbs. Solutions will be posted during Week 1.

WEEK 1: w/c 30 September 2024

§ Module Outline
o Description of the module: lecture topics, assessment, textbook, readings, etc.

§ Financing and capital structure

o M-M irrelevance propositions in perfect capital markets
o Leverage and risk-return
o WACC
o Leverage and beta

§ Readings:
o Chapter 14: “Capital structure in a perfect market”

§ Recommended readings:
o J. R. Graham and C. Harvey, 2001, The Theory and Practice of Corporate Finance:
Evidence from the Field, Journal of Financial Economics, 60(2-3): 187-243

§ Problem Set 1 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

WEEK 2: w/c 7 October 2024

§ Capital structure and taxes

o Corporate taxes and tax shield
o M-M propositions with corporate taxes
o The role of personal taxes
o Miller (1977): equilibrium and capital structure irrelevance with personal taxes
o Empirical evidence: the low leverage puzzle

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§ Readings:
o Chapter 15: “Debt and taxes”

§ Recommended readings:
o M. H. Miller, 1977, Debt and Taxes, Journal of Finance, 32(2), pp. 261-275
o J. R. Graham, 2000, How Big are the Tax Benefits of Debt?, Journal of Finance, 55(5),
pp. 1901-1941
o A. Korteweg, 2010, The Net Benefits to Leverage, Journal of Finance, 64(6), pp. 2137-
2170

§ Problem Set 2 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

WEEK 3: w/c 14 October 2024

§ Capital structure, financial distress and default risk

o Corporate securities as contingent claims
o M-M proposition II and default
o The cost of bankruptcy and of financial distress
o Trade-off theory of capital structure
o Debt-equity agency conflicts

§ Readings:
o Chapter 16: “Financial distress, managerial incentives, and information” (only sections
from 16.1 to 16.7)

§ Recommended readings:
o M. C. Jensen and W. H. Meckling, 1976, Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure, Journal of Financial Economics, 3(4), 305-360.
o S. C. Myers, 1977, Determinants of Corporate Borrowing, Journal of Financial
Economics, 5(2), 147-175.

§ Problem Set 3 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

WEEK 4: w/c 21 October 2024

§ Capital structure and incentives

o Agency costs of debt and agency costs of equity
§ Empirical evidence on capital structure
§ Capital structure and information
o Information content of a security and underpricing
o Pecking order hypothesis

§ Readings:
o Chapter 16: “Financial distress, managerial incentives, and information” (only sections
from 16.8 to 16.9)

§ Recommended readings:

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 o R. Rajan and L. Zingales, 1995, What Do We Know about Capital Structure? Some
Evidence from International Data, Journal of Finance, 50(5): 1421-1460.
o J. Fan, S. Titman and G. Twite, 2012, An International Comparison of Capital Structure
and Debt Maturity Choices, Journal of Financial and Quantitative Analysis, 47, 23-56.
o S. C. Myers and N. S. Majluf, 1984, Corporate Financing and Investment Decisions
when Firms have Information that Investors do not have, Journal of Financial
Economics, 13(2), 187-221.

§ Problem Set 4 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

WEEK 5: w/c 28 October 2024

§ Capital Budgeting
o Separation theorem
o Net present value (NPV)
o Leverage and taxes
o WACC and CAPM

§ Readings:
o Chapter 7: “Investment decision rules” (pre-requisite reading, not covered in class)
o Chapter 8: “Fundamentals of capital budgeting” (only sections 8.1-8.4)
o Chapter 12: “Estimating the cost of capital” (only sections from 12.4 to 12.7)
o Chapter 18: “Capital budgeting and valuation with leverage” (only sections 18.1 and
18.2)

§ Problem Set 5 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

WEEK 6: w/c 4 November 2024

§ Advanced topics in capital budgeting

§ Capital Budgeting: alternative valuation methods for levered projects

o NPV with WACC
o Adjusted Present Value (APV)
o Flow-to-Equity method

§ Capital budgeting valuation and leverage policies

§ Other effects of financing on project valuation

§ Readings:
o Chapter 18: “Capital budgeting and valuation with leverage” (from section 18.3 to 18.8)

§ Problem Set 6 includes the Case Study: “Sneaker 2013” posted on my.wbs. Case discussion
during the workshop, on Monday in the following week.
§ The class test takes place on TBD.

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WEEK 7: w/c 11 November 2024

§ Real options
o Limitations of traditional valuations methods
o Decision Tree Analysis and its limitations
o Typical real options in capital budgeting
o Valuation of real options

§ Readings:
o Chapter 22: “Real options”

§ Recommended readings:
o L. Trigeorgis, 1993, Real Options and Interactions with Financial Flexibility, Financial
Management, Autumn: 202-224.
o L. Trigeorgis, 1993, The Nature of Option Interactions and the Valuation of Investments
with Multiple Real Options, Journal of Financial and Quantitative Analysis 28(1): 1–20.

§ Problem Set 7 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

WEEK 8: w/c 18 November 2024

§ Corporate Risk Management

o Irrelevance and motivations
o Insurance
o Types of risk
o Hedging with financial derivatives
o Other risk management tools
o Empirical evidence

§ Readings:
o Chapter 30: “Risk management”

§ Recommended readings:
o Froot, Kenneth A., David S. Scharfstein, and Jeremy C. Stein, 1993, Risk management:
coordinating corporate investment and financing policies, Journal of Finance 48: 1629–
1658.
o W. Guay and S. P. Kothari, 2003, How much do firms hedge with derivatives?, Journal
of Financial Economics 70(3): 423-461.
o T. W. Bates, K. M. Kahle, and R. M. Stulz, 2009, Why do U.S. firms hold so much more
cash than they used to?, Journal of Finance 64: 1985–2021.

§ Problem Set 8 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

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WEEK 9: w/c 25 November 2024

§ Payout Policy
o Dividends and share repurchases
o Irrelevance proposition in perfect capital markets
o The role of personal taxes
o Asymmetric information and signaling
o The value of share repurchases
o Empirical evidence

§ Readings:
o Chapter 17: “Payout policy”

§ Recommended readings:
o Ikenberry, D. L. and T. Vermaelen, 1996, “The Option to Repurchase Stock”, Financial
Management 25(4): 9-24.
§ Problem Set 9 posted on my.wbs. Solutions will be provided during the workshop, on Monday
in the following week.

WEEK 10: w/c 2 December 2024

§ Corporate Governance
o Incentive and compensation
o Empirical evidence
o Other corporate governance mechanisms

§ Readings:
o Chapter 28: “Mergers and acquisitions” (Section 28.5 and 28.6)
o Chapter 29: “Corporate governance”
o D.K. Denis and J.J. McConnell, 2003, International Corporate Governance, Journal of
Financial and Quantitative Analysis 38, 1-36.

§ Recommended readings:
o L. Bebchuk, A. Cohen and A Ferrell, 2009, What matters for corporate governance? Review
of Financial Studies 22, 783-827, (read up to section 2).
o S.N. Kaplan, 2013, CEO pay and corporate governance in the US: Perceptions, facts and
challenges, Journal of Applied Corporate Finance 25 (2), 8-25.

§ Problem Set 10 posted on my.wbs. Solutions will be provided on my.wbs.

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