Introduction to the subject guide
Introduction to the subject guide
Aims and objectives
This subject guide provides you with an introduction to the modern theory of
finance. As such, it covers a broad range of topics and aims to give a general
background to any student who wishes to do further academic or practical
work in finance or accounting after graduation.
The subject matter of the guide can be broken into two main areas:
1. The first section of material covers the valuation and pricing of real and
financial assets. This provides you with the methodologies you will need
to fairly assess the desirability of investment in physical capital, and price
spot and derivative assets. We employ a number of tools in this analysis.
The coverage of the risk-return trade-off in financial assets and
mean–variance optimisation will require you to apply some basic
statistical theory alongside the standard optimisation techniques taught
in basic economics courses. Another important part of this section will be
the use of absence-of-arbitrage techniques to price financial assets.
2. In the second section, we will examine issues that come under the broad
heading of corporate finance. Here we will examine the key decisions
made by firms, how they affect firm value and empirical evidence on
these issues. The areas involved include the capital structure decision,
dividend policy, and mergers and acquisitions. By studying these areas,
you should gain an appreciation of optimal financial policy on a firm
level, conditions under which an optimal policy actually exists and how
the actual financial decisions of firms may be explained in theoretical
terms.
Recommended reading
There are a number of excellent textbooks that cover this area. However, the
following text has been chosen as the core text for this unit due to its
extensive treatment of many of the issues covered and up-to-date
discussions:
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) second edition [ISBN 0072294337].
As alternatives, you may wish to look at the following texts that are standard
for many undergraduate finance courses:
Brealey, R. and S. Myers Principles of Corporate Finance. (Boston, Mass.,
London: McGraw-Hill, 2003) seventh edition [ISBN 0071151451].
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 1988) third edition [ISBN
0201106485].
At the head of each chapter of this guide, we will indicate recommended
reading from Grinblatt and Titman (2002). As further material, we will also
give the relevant chapters in the other two texts. For certain topics, we may
also list journal articles as supplements to the additional reading.
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Corporate finance
Subject guide structure and use
You should note that, as indicated above, the study of the relevant chapter
should be complemented by at least the recommended reading given at the
chapter head.
The content of the subject guide is as follows:
• Chapter 1: here we focus on the evaluation of real investment projects
using the net present-value technique and provide a comparison of NPV
with alternative forms of project evaluation.
• Chapter 2: we look at the basics of risk and return of primitive financial
assets and mean–variance optimisation. We go on to derive and discuss
the capital asset pricing model (CAPM).
• Chapter 3: we present the arbitrage pricing theory, proposed as an
alternative to the CAPM for the calculation of expected returns on
financial assets.
• Chapter 4: here we look at derivative assets. We begin with the nature of
forward, future, option and swap contracts, then move on to pricing
derivative assets via absence-of-arbitrage arguments. We also include a
description of binomial option pricing models and end with the
Black–Scholes analysis.
• Chapter 5: in this chapter, we examine the efficiency of financial
markets. We present the concepts underlying market efficiency and
discuss the empirical evidence on efficient markets.
• Chapter 6: here we turn to corporate finance issues, treating the decision
over a corporation’s capital structure. The essential issue is what levels of
debt and equity finance should be chosen in order to maximise firm value.
• Chapter 7: we look at more advanced issues in capital structure theory
and focus on the impacts of agency costs and asymmetric information on
financial decisions.
• Chapter 8: here we examine dividend policy. What is the empirical
evidence on the dividend pay-out behaviour of firms, and theoretically
how can we understand the empirical facts?
• Chapter 9: finally we look at mergers and acquisitions, and ask what
motivates firms to merge or acquire, what are the potential gains from
this activity, and how can this be theoretically treated?
Examination structure
Important: the information and advice given in the following section are
based on the examination structure used at the time this guide was written.
Please note that subject guides may be used for several years. Because of this,
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the current Examiners’
reports where you should be advised of any forthcoming changes. You should
also carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
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Introduction to the subject guide
This unit will be evaluated solely on the basis of a three-hour examination.
Candidates will have a choice of any four out of eight questions. Although
the examiner will attempt to provide a fairly balanced coverage of the unit,
there is no guarantee that all of the topics covered in this guide will appear in
the examination. Examination questions may contain both numerical and
discursive elements. Finally, each question will carry equal weight in marking
and, in allocating your examination time, you should pay attention to the
breakdown of marks associated with the different parts of each question.
Glossary of abbreviations used in this subject guide
APT arbitrage pricing theory
ARR accounting rate of return
B–S Black–Scholes
CAPM capital asset pricing model
CML capital market line
EMH efficient markets hypothesis
IRR internal rate of return
M&A mergers and acquisitions
M–M Modigliani–Miller
NPV net present value
OTC over the counter
RWM random walk model
SML security market line
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Corporate finance
Notes