MBA 1st Semester 2020-21 (2019)

Course: Modern Finance Theory (FIN 505)

Suggested Readings

Referred Text Books:

1. Financial Theory and Corporate Policy by Copeland , Weston, Shastri and Katz, 4th Edition (CWSK)
2. Intermediate Financial Theory by Danthine and Donaldson (DD)
3. The Theory of Finance by Fama and Miller (FM)
4. Corporate Finance Theory by William L. Megginson (WM)
5. Applied Corporate Finance/Corporate Finance-Theory and Practice by Aswath Damodaran (AD)

Unit1-2. ( Weight 40% )

A. Introduction to Financial Theory and decision making under uncertainty ((CWSK, 1; FM, Ch.
1)
General framework for decision making under certainty, axioms, models of consumption/investment
under certainty and their equilibrium conditions: i) autarchy/Robinson Crusoe 2 periods model, ii) exchange
economy/financial markets without production technology and iii) exchange economy/financial markets and
production, Fisher separation theorem

Targeted skills for assessment/exam a) the learners ability to understand and interpret the general framework
for decision making under certainty (individual preference, opportunity sets and equilibrium) b) ability to write
the constrained-optimization problem for consumption investment mentioned in (i)-(iii), solve and interpret the
results using some explicit utility function. c) the skills to explain how the existence of capital market improves
the autarchy solution

B.1 Investment/consumption under uncertainty (CWSK, Ch.3)

Essential characteristics of decision making under uncertainty, the framework for decision making
under uncertainty, axioms of choices under uncertainty, first order and second order stochastic
dominance, measuring utility from well behaved utility functions, measuring absolute and relative risk
aversion, defining and measuring risk premium/insurance premium.

Targeted skills for assessment: i) the understanding level of the decision making framework under
uncertainty ii) ability to evaluate the well behaving nature/concavity of utility functions iii) ability to
measure and interpret the risk aversion nature of utility functions iv) ability to measure the risk
premium

B.2 State preference theory (CWSK, Ch. 04 )

The concept and the role of state preference theory in economic decision making, the concept and
framework for designing pure securities, the mechanism of using pure securities’ portfolio for
managing risk, Inter temporal allocation of resources for optimization utility using pure securities.

Targeted skills for assessment: i) the ability of determining the price of pure securities and the risk-free
rate of return from the state-payoff matrix of investable risky market securities ii) the ability to
determine the quantities of market securities that can be used to construct a risk-free portfolio from the
investable wealth by using the mechanism of pure securities, iii) the analytical skills for ascertianing
optimal allocation of initial endowment/investable fund using an explicit utility function.
Unit 3-4 (Weight 15%)
Portfolio theory (Mean-Variance Analysis) & Market equilibrium/Assets pricing models (CWSK,
Ch. 5 &6 )

Deriving optimal weight for constructing minimum-variance portfolio, minimum-variance opportunity

set, capital market line, deriving the CAPM, implications for holding CAPM, Deriving beta for a
portfolio, Testing CAPM , finding summary of CAPM testing, validity of CAPM, APT theory and its
robustness over CAPM, Construction of factor mimicking portfolio, evaluating portfolio for under and
over pricing.

Targeted skills for assessment: i) the ability to derive the weight for constructing a minimum-variance
portfolio ii) the ability to derive the CAPM and explain the implication if CAPM holds iii) the ability to
construct the beta for a portfolio iv) the ability to ascertain the testing prediction that can be derived
from CAPM and ascertain the extent of validity of CAPM v) the ability to explain the robustness of APT
on CAPM vi) The ability to construct mimicking portfolio and ascertain the extent to which a portfolio
is truly priced (under/over).

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Model Exercises for Unit 1-4: Problem set 1 & 2 / you are suggested to pick the problems related to
the targeted skills (for assessment/exam) from the problem sets 1&2 selectively for practicing them
with priority.
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Unit 5. (Weight 15%)

Decision making under certainty (Advanced topics in capital Budgeting) (AD, ch.06)
project with different lives, different scale, capital rationing, capital budgeting under inflation,
implication of term structure of interest rate for capital budgeting, evaluating a project with side costs
(opportunity cost and product cannibalization), evaluate a project with side benefits (project synergies)

Targeted skills for assessment: i) the analytical skill to estimate the project cashflows over the life of a
project and use them to determine whether it should be accepted or not ii) the skill to analyze a project
with opportunity costs ( with or without alternative use) and make decision iii) the skill to analyze a
project with side benefits and make decision
*Chapter-end exercises related to the targeted skill are suggested for practice with priority.

Unit 6, 7 & 8 (Weight 30%)

Market efficiency and behavioral Finance (Class notes)

market efficiency and their forms, comparing market efficiency and perfect capital market,
implications for an informationally efficient and inefficient market for all its three forms, why
do the different stakeholders care for market efficiency.

Capital Structure Theory (WM, ch. 07 )

Importance of developing a comprehensive and accurate capital structure theory, stylized facts/
observed capital structure patterns and their implications, theoretical explanation for observed
capital structures pattern ( the agency cost/tax shield trade-off model, pecking order hypothesis,
signaling model) and the shortcomings of each theory, costs of bankruptcy and financial
distress (what makes bankruptcy cost matter, asset characterization and bankruptcy cost, asset
substitution, under investment, direct and indirect cost), the essence and the implications of the
pecking order hypothesis

Dividend policy (WM, Ch. 08)

Importance of understanding dividend policy observed dividend policy patterns and their
implications, the agency cost/contracting model, the signaling model.

Targeted skills for assessment: The skills of critical thinking related to the selected topics. For model
assessment questions, you may consult the relevant chapter-end questions.

[for any query, please send me an email: shahadat@cu.ac.bd ]