N. R. Prabhala
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telephone 432-6030
Secretary: Elaine Okawa
Last modified March 31, 1996

MPPM 540b
Financial Management I
Spring 1996


Outline: MODULE 3

The third module of the financial Management I will cover two subjects: Options and Corporate finance.

The first portion of this module is an introduction to the use and pricing of options. We review the basic features of options and examine how they may be used for speculation or hedging. We then discuss put-call parity, early exercise features of American options and elements of option pricing theory within the context of a binomial model. Time permitting, we will touch upon the Black-Scholes option pricing model and study the analogy between options and corporate securities.

In the corporate finance portion of this module, we discuss capital structure and dividend policies, first in an abstract world of perfect capital markets and then under more realistic conditions. We begin with the MM irrelevance propositions and discuss the underlying no-arbitrage arguments in some detail. We then identify the real-world factors that drive firms' leverage and dividend policy choices. Finally, we return to the module 1 topic of capital budgeting, but now for the specific case of a levered firm. We emphasize throughout our discussion that though the topics of corporate finance and options seem fundamentally dissimilar, they share the same intellectual foundations: the theory of "No Arbitrage." Most of the material will be motivated and discussed from this perspective.

Examinations and grading policy


There will be three homeworks, one or two case analyses and one final exam. Homeworks will be assigned every Wednesday and will be due back the following Monday. Homeworks will cover typical exam material, must be submitted on an individual basis, and will count for 15% of your grade for the module. Case write-ups, to be submitted by groups of 4-5 students, will account for 10% of your module grade. The final exam accounts for the remainder of your grade for module 3. Grades from all three modules will be weighted equally to determine the overall course grade.

TA Sessions

To Be Announced Later.

The required textbook for the course is:

Ross, S.A., R.W. Westerfield, and J.F. Jaffe (1996), Corporate Finance, 4th. edition: Irwin, Homewood, IL 60430


PPM 540b Financial Management 1: Tentative Course Outline and Reading List (MODULE 3)

4/1Class 1Introduction to Options
Option Terminology
Understanding Option Price Data
Option Strategies and Payoff Diagrams
Put-Call Parity
Reading: RWJ Chapter 21, pp. 571-580.
4/3Class 2Arbitrage Bounds on Option Prices
Definition of Arbitrage
Arbitrage Bounds for European Options
Early Excercise: American Options
Reading: RWJ Chapter 21, and Class Notes
4/8Class 3Elements of Option Pricing: The One Step Binomial Tree
Specifying an Arbitrage-Free Price Process
Options as Stock-Bond Combinations
Risk-Neutral Pricing
Reading: RWJ Chapter 21, and Class Notes
4/10Class 4Topics in Options
The Multiple Step Binomial Tree
The Effect of Early Excercise and Dividend Payments
The Black-Scholes Formula
Reading: RWJ Chapter 21, and Class Notes
4/15Class 5Why Capital Structure Might be Irrelevant
Miller-Modigliani (MM) Proposition I
Corporate vs. Personal Leverage
Arbitrage Arguments in MM
Cost of Capital & MM Proposition 2
Reading: RWJ Chapter 15, pages 383-400
4/17Class 6Why Capital Structure is Relevant
Corporate Taxes
Limits to the Use of Debt
Bankruptcy Costs
Agency Costs
Personal Taxes and the Miller Equilibrium
Financial Slack and Pecking Order Theory
The Weighted Average Cost of Capital
Reading: RWJ Chapter 15, pp 400-410. RWJ Chapter 16
4/22Class 7Capital budgeting For Levered Firm
APV, FTE and WACC Methods
Reading: RWJ Chapter 17
4/24Class 8Dividend Policy
The Process of Paying Dividends
Why Dividend Policy is Irrelevant
Why Dividend Policy Might Matter
Taxes, Issuance Costs, Clientele Theories
Signalling
Reading: RWJ Chapter 18
4/29Class 9Wrap Up
Corporate Securities as Options
Financial Policy: An Overview