Empirical Performance Notes:
Three ways to test these basic investment models
1.
User cost of discount rate-based tests using Jorgensonian/neoclassical
approach to investment
2.
Q theory tests
Usually impose CRS, perfect competition, quadratic adj costs
3

Discount Rates and Equilibrium
Partial equilibrium model
Not crucial to endogenize consumption (and labor/leisure) for now
But fundamental to answer the (much broader) welfare question Cash
flows are discounted with the exogenous pricing kernel
X
t+
log(M

Neoclassical Theory of the Firm Notes
Approaches to Modeling:
Different approaches to modeling firm behavior different assumptions
about the objectives and relevant constraints on the firm or manager. Three
broa

Itos Lemma:
Suppose X is an Ito process with dXt = tdt + tdBt and f : R2 R is twice
continuously differentiable. Then the process Y, defined by Yt = f (Xt, t) is an Ito
process with
dYt = fx(Xt, t)t + ft(Xt, t) + 2 fxx(Xt, t)t
dt + fx(Xt, t)tdBt
Contingen

Discrete Time Models with Financing:
Other Firm Policies:
So far weve just considered models with an investment decision
Even with costly external financing , the issuance decision was not
independent function of only the investment decision
Now consid

Structural Models In Finance Notes
METHODOLOGY
Develop stylized facts from the data
Develop a theory that can replicate key empirical features
Provide a test of the theory and additional implications
Apply a quantitative focus, not just a qualitative

Cost of Financial Leverage:
Financial leverage imposes a cost on the firm outside of bankruptcy
Leverage of b/k costs the firm a fraction f (b/k) of its revenues
where
1
f (b/ k) =
b
k
parameterizes this cost of financial leverage
We set = 3.5
f (.25)

Role of Capital Structure
What is V here?
In M&M world w/o financial frictions, debt/equity indeterminate. So we can write
qK = B + V
q= Q=
=
V+ B
K
In this general case Tobins Q indicates the market-to-book value of the firm, not
just the equity
User Cos

Optimal Investment Notes
Given the numerical methods outlined last time, we can solve the firms problem
in a neoclassical model of firm investment
For now, well ignore financing decisions and stick to a simple M&M world
We now turn to analyzing the invest

Simulated Dynamics Notes
Simulated Dynamics: Dynamic Contingent Claims Models:
Developed a dynamic contingent claims model to better match the data
Model is stationary can be compared to real data
Generates lower