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FE 620: FINANCIAL THEORY WITH CORPORATE APPLICATIONS Charles S. Tapiero Lecture periods: Laboratory periods: Recitation periods: Credits: 2 ½ hours 0 hours 0 hours 3 This course prepares students with an understanding of financial theory and how modern finance is used by firms for strategic and tactical decision making. The course is divided into two parts. The first part applies scientific principles to financing, valuation, investment and capital budgeting decisions. The critical issue of how these decisions impact market value and return on assets is addressed. The scientific tools used are primarily mathematical, but only a modest level of mathematics is required to understand the primary concepts. In today’s fast-pace, growth-driven business arena, students must understand that the most valuable investment opportunities often involve risk. Investors need a flexible and a risk sensitive strategy, yet many current financial assessment tools frustrate this type of decision making because they fail to identify what individuals need to capitalize on unexpected events. Financial engineering and the use of contingent claims analysis offer an innovative and disciplined approach to these problems and how to mitigate the negative effects of risk. The second half of the course applies derivatives (options) thinking — the theory behind financial options valuation, risk neutral pricing and complete markets is elaborated on. Real options, options on real (nonfinancial) assets, bringing the financial market discipline to the valuation and evaluation of companies’ opportunities. Using real options theory, decision makers can more effectively target crucial opportunities to finance, re-focus, delay, modify, or even abandon their projects as events unfold. The realm of applications includes the following. • Evaluation of investments in R&D, information technology, start-up ventures, and product design • Licensing • Product development • Mergers and acquisitions Throughout the course, problems and exercises are used to highlight the techniques and the theory of financial decision theory to corporate decision making and management. Prerequisites Students will use mathematical concepts from calculus, probability and statistics in this course. Students will be supplied basic lecture notes for each of the mathematical topics used. Grading Midterm Final Homework Class Participation 40% 40% 10% 10% Textbook(s): Tapiero Charles S., Lectures Notes to be distributed on selected topics Tapiero Charles S., Risk and Financial Management: Mathematical and Computational Methods, Wiley 2004 Breasley and Myers, Corporate Finance, Mc-Graw-Hill, latest edition Software: @RISK, Student Version, Palisade Corporation. 1 Additional Readings: Ross, Westerfield and Jaffe, Corporate Finance, Fourth Edition, Irwin Timothy A. Luehrman. Investment Opportunities as Real Options: Getting Started on the Numbers. Harvard Business Review, July 1998. Timothy A. Luehrman. Strategy as a Portfolio of Real Options. Harvard Business Review, September 1998. 2 Syllabus: Topics 1 2 3 4 5 6 7 8 9 10 11 12 13 Topic and Assignment Introduction and overview of the course What is Financial Theory, What is Corporate Finance and how does one support the other. Corporate Firms: organization, objectives and financial instruments Techniques and outline of selected for financial Corporate problems. Value, Risk, Discounting, yield, Interest Rates and Term structure of interest rates Fixed income securities and Bonds, traditional valuation, NPV valuation Corporate and Rated Bonds Selected problems: Cash flows valuation, Capital budgeting, Case Problems Exercises and Solutions Review of Probability Theory and the Random Walk Review of Utility, risk, Expected utility and valuation Case studies, Problems and exercises Principles of Asset Pricing, The Capital Asset Pricing Model The CAPM and the CCAPM (SDF) Case Studies and Problems of Corporate Finance and Asset Pricing Exercises Financial Theory: Arbitrage, Risk neutral pricing and complete markets defined Arbitrage Pricing Theory: Theory and Practice Models of Asset Dynamics Basic Forwards, Futures and Options Theory RNP and Corporate Finance Selected Problems: Miller-Modigliani; Capital Structure; Dividend Policy; Investment Management Read Lecture Notes Midterm Examination Applied Corporate Risk Finance Risk, Finance and Corporate Financial Risk Management in Practice Options and Derivatives Products: Theory and Data based. Corporate Rated Bonds Management; Real Options and Credit Risk Real Options Practice: Four-Step Solution Process: Calculating Option Values and Adjusting for Leakage in Value Corporate Financial Management Discussion of selected Case Problems: Theory and Practice Review Case Studies: Case Study 1: Valuing a Start-Up Firm Case Study 2: Investing in a Start-Up Firm CASE STUDIES on Options and Real Options Case Study 1: Buying Flexibility Case Study 2: Combining Real and Financial Flexibility Case Study 3: Strategy as a Portfolio of Real Options Covers the Teaching Notes (Product Number 294109) Real Options: Valuing Managerial Flexibility by Michael E. Edleson. These notes have a description and taxonomy of real options followed by several examples of valuing and using real options to make better value-enhancing decisions. Covers Teaching Notes (5-295-117) Corporate Financial Management: Options Exercises, by Timothy A. Luehrman. Final Examination 3