# 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) = $\tau$V(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 http://fin4335.garven.com/fall2017/risk_costly_chapter7.pdf 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).

# Merton: Applications of Option-Pricing Theory (shameless self-promotion alert)…

Now that we have begun our study of the famous Black-Scholes-Merton option pricing formula, it’s time for me to shamelessly plug a journal article that I published early in my academic career which Robert C. Merton cites in his Nobel Prize lecture (Merton shared the Nobel Prize in economics in 1997 with Myron Scholes “for a new method to determine the value of derivatives”).

Here’s the citation (and link) to Merton’s lecture:

Merton, Robert C., 1998, Applications of Option-Pricing Theory: Twenty-Five Years Later, The American Economic Review, Vol. 88, No. 3 (Jun. 1998), pp. 323-349.

See page 337, footnote 11 of Merton’s paper for the reference to Neil A. Doherty and James R. Garven (1986)… (Doherty and I “pioneered” the application of a somewhat modified version of the Black-Scholes-Merton model to the pricing of insurance; thus Merton’s reference to our Journal of Finance paper in his Nobel Prize lecture)…

# Midterm 2 grade statistics for Finance 4335

I have posted midterm 2 exam grades to Canvas, and I will return your exam booklets to you during next Tuesday’s Finance 4335 class meeting. In the meantime, if you haven’t already done so, I highly recommend reviewing the exam solutions.

For the second midterm exam, here are the descriptive statistics:

 Average 77.8 Standard Deviation 18.41 Minimum 18 25th percentile 70 50th percentile 79.5 75th percentile 92 Maximum 100

# Midterm exam 2 information…

Midterm 2 will be given during class on Thursday, November 2. This test consists of 4 problems. You are only required to complete 3 problems. At your option, you may complete all 4 problems, in which case I will throw out the problem on which you receive the lowest score.

The questions involve topics which we have covered since the first midterm exam. Topics covered include 1) demand for insurance, 2) moral hazard/adverse selection, 3) portfolio theory/capital market theory, and 4) financial derivatives (calls and puts specifically).

By the way, I have posted the formula sheet that I plan to use on the exam at the following location: http://fin4335.garven.com/fall2017/formulas_part2.pdf.

As I noted in my “Plans for next week in Finance 4335” blog posting, tomorrow’s class meeting will be devoted to a review session for midterm exam. If you haven’t already done so, I highly recommend that you review Problem Sets 5-8 and also try working the Sample Midterm 2 Exam (solutions are also provided) prior to coming to class tomorrow.