All posts by jgarven

How Cash-Strapped Chicago Snagged a Triple-A Rating for Its New Bonds

Since the city of Chicago is apparently no longer considered to be insurable by the bond insurance industry (cf., it has had to turn to other means for making its debt attractive to investors. The latest scheme involves issuing new bonds through a new (and separate) legal entity called the Sales Tax Securitization Corporation (STSC). The bonds offered by STSC are collateralized by a dedicated first claim to the city’s sales-tax revenue. Apparently similar strategies have been employed two years ago by the city of Detroit, throughout the past decade by Puerto Rico and 40-some years ago by New York City.

Interestingly, the bond rating agencies are somewhat split about the extent to which a so-called “dedicated first claim” to Chicago’s sales-tax revenues would obtain in the event of default; this divergence of opinion is reflected by the ratings given on these bonds; e.g., Fitch and Kroll gave STSC a AAA rating, whereas S&P scores it two grades lower.

Chicago has created a new company to sell the debt, offering a tempting pledge to investors: a dedicated first claim to the city’s sales taxes.

Preparation for tomorrow’s Final Exam review for Finance 4335

Here are some suggestions for preparing for tomorrow’s Final Exam review for Finance 4335:

1. Be sure to read and review my blog posting entitled “Hints about the final exam in Finance 4335… from earlier today.

2. I have posted the final exam formula sheet which will appear as part of the final exam booklet. Furthermore, the Standard Normal Distribution Function (“z”) Table will also appear as part of the final exam booklet.

3. Read and review the Finance 4335 Fall 2017 course synopsis.

4. For tomorrow’s review session, review problem sets 3-11 (solutions for which are available at and the Spring 2017 Final Exam Booklet and Solutions and come to class with any questions you may have concerning any of this material.

See y’all tomorrow!

Hints about the final exam in Finance 4335…

The final exam for Finance 4335 is scheduled for Tuesday, December 12, 2:00 p.m. – 4:00 p.m. in Foster 402. The exam consists of two parts:

  • The first part features five multiple-choice questions worth 5 points each. The questions are mostly on the topic of decision theory; e.g., risk neutrality, risk aversion, risk loving, maximizing expected utility, calculating expected payoffs on gambles, etc.
  • The second part consists of three problems worth 24 points each. The topics covered include demand for insurance, applying the Black-Scholes-Merton option pricing formula to evaluate risk of default by a limited liability corporation, and evaluating whether the firm should hedge, given tax asymmetries.

The “good” news is that you automatically receive 3 points for signing your name on this exam booklet; thus, the total points possible for this exam are 100.

Later today, I will post the formula sheet which will appear as part of the Final Exam booklet; it may help you study for the exam by looking over the various formulas.

Is Da Vinci’s ‘Salvator Mundi’ Worth $450 Million or $454,680?

Fascinating geometric mean return calculation for Da Vinci’s ‘Salvator Mundi’; at its recent $450 million sales price, the annual rate of return for this artwork over the course of five centuries comes out to around 1.35%.

“Salvator Mundi” sold at Christie’s for more than $450 million. If we were to regard this work of art as an investment, has the Leonardo generated a good return since the master painted it?

Original source for our coverage of the underinvestment problem

For what it’s worth, our discussion last Thursday concerning how corporate risk management “fixes” the underinvestment problem is based upon the following journal article:

Garven, James R. and Richard D. MacMinn, 1993, “The Underinvestment Problem, Bond Covenants and Insurance,” Journal of Risk and Insurance, Vol. 60, No. 4 (December), pp. 635-646. (cited 84 times according to Google Scholar)

No class on Tuesday, November 21

I have decided to cancel class on Tuesday, November 21.  On Tuesday, November 28, we will complete our coverage of the Why is Risk Costly to Firms? lecture note (specifically, the asset substitution and managerial incentives topics which appear on pp. 26-43).

The final problem set for the semester (Problem Set 11) is now due on Tuesday, November 28 (instead of Tuesday, November 21).  The final scheduled class meeting for Finance 4335 is Thursday, November 30; class on that day will be devoted primarily to a review session for the final exam, which is scheduled for Tuesday, December 12, 2:00 p.m. – 4:00 p.m. in Foster 402.

Happy Thanksgiving!

Some hints for Problem Set 10

The classic capital budgeting model (such as you learned in Finance 3310) implicitly assumes that the firm has unlimited liability and faces linear taxes. When these assumptions hold, then the net present value (NPV) of a project is calculated by estimating expected values of future incremental after-tax cash flows and discounting them at an appropriate risk-adjusted discount rate. However, we showed during yesterday’s class meeting how limited liability and nonlinear taxes imply that the net present value of a project depends upon the manner in which incremental after-tax cash flows interact with cash flows from existing assets. Consequently, the after-tax value of equity is equal to the difference between the pre-tax value of equity and the value of the government’s tax claim (both of which we model as call options on the firm’s assets). Furthermore, project NPV corresponds to the difference in after-tax value of equity (assuming the project is undertaken), minus the after-tax value of equity (assuming the project is not undertaken).

Problem Set 10 provides an opportunity to apply these concepts.  Here are some hints for parts A through E of Problem Set 10 :

  1. In part A, apply the option pricing framework to determine the pre-tax value of equity (V(E), where V(E) = V(Max(0,F-B)), the value of debt (V(D), where V(D) = V(B – Max(0,B-F)), and the value of taxes (V(T), where V(T) = \tauV(Max(0,F-TS)), assuming that this investment is not undertaken.  Helpful hint: we performed these same calculations in class yesterday for the problem described on pp. 17-18 of the teaching note.
  2. In order to determine whether the project should be undertaken, in part B you need to  after-tax equity value (i.e., V(E) – V(T)) which obtains under the assumption that the investment is undertaken. Once you obtain that result, the net present value (NPV) of the project is the difference between the after-tax value of equity (V(E) – V(T)) in part A (which you have already calculated) and the after-tax value of equity which obtains if the investment is undertaken. The decision to invest or not to invest depends upon whether the NPV of the investment is positive (in which case you undertake the project) or negative (in which case you do not undertake the project).
  3. An investment tax credit (ITC) is quite literally a check sent by the U.S. Department of the Treasury to the company; thus, the NPV when there is an ITC is equal to the NPV that you calculated in part B plus the value of the ITC.  At that point, whether you invest or don’t invest depends upon whether NPV is positive or negative (as in part B).  The ITC in this case increases project NPV by $1 million.
  4. In order to answer part D, you need to redo the calculation described in the first paragraph above using a 20% tax rate rather than a 35% tax rate.
  5. In order to answer part E, you can figure out the tax rate at which the firm is indifferent about making the investment by trial-and-error, or better yet, adapt the Tax Options spreadsheet located on the lectures notes page to the parameters upon problem set 10 is based and use Solver.