Chapter 2
Consumption, Investment
and the Capital Market
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–1
Learning Objectives
•
Explain how a company’s managers can, in
principle, make financial decisions that will be
supported by all shareholders.
•
Explain how the existence of a capital market
makes this result possible.
•
Identify the company’s optimal investment/dividend
policy under conditions of certainty.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–2
Fisher’s Separation Theorem:
A Simplified Example
•
The foundation for many fundamental results of
finance theory:
–
•
Addresses the question of how management deals with
diverse preferences for dividends and investment in a
company with more than one shareholder.
Assumptions
–
–
–
Certainty.
Frictionless capital markets.
Interest rate for borrowers equals interest rate for lenders.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–3
Fisher’s Separation Theorem:
A Simplified Example (cont.)
•
Implication of theorem
–
A company can make dividend/investment decisions that
are in the best interests of all shareholders, regardless of
differences in the preferences of individual shareholders.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–4
Fisher’s Separation Theorem:
A Simplified Example (cont.)
•
Simple example (without a capital market)
Assume:
–
A company has only two shareholders (‘A’ and ‘B’),
who hold equal shares of $800 each.
–
Project Small involves $500 outlay now and cashflow
of $570 later.
–
Project Upgrade requires outlay of additional $200 and
incremental cash flow of $220.
–
Project Upgrade can only be undertaken together with
Project Small, forming Project Large.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–5
Fisher’s Separation Theorem:
A Simplified Example (cont.)
•
Simple example (without a capital market)
Assume:
–
Projects Small and Large enable dividends, of $300
and $100 respectively, to be paid now.
–
Projects Small and Large enable dividends, of $570
and $790 respectively, to be paid later.
–
Assume Shareholder A wishes to consume $150 now
and shareholder B wishes to consume only $50 now.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–6
Fisher’s Separation Theorem:
A Simplified Example (cont.)
–
Given their respective consumption preferences, A and B
will desire different dividend policies from the company.
–
A will want the company to invest in Project Small, while B
will prefer Project Large.
–
Clearly, the company cannot make a decision that will
satisfy both shareholders simultaneously. Therefore, it
is not possible to say which investment is optimal.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–7
Fisher’s Separation Theorem:
A Simplified Example (cont.)
•
Solution — introduce a capital market:
–
A solution can be found if there is a capital market in
which shareholders can borrow and lend on their
personal accounts.
–
Essentially, the shareholders can lend excess income
(dividends) in the capital market or borrow to satisfy
current consumption if current dividends are
(temporarily) insufficient.
–
A resolution is possible because the capital market
enables one of the shareholders to achieve a result that
is better than the result the company alone could provide.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–8
Fisher’s Separation Theorem:
A Simplified Example (cont.)
–
The introduction of the capital market also enables
a company to use the net present value (NPV) rule
to identify the optimal investment, thereby maximising
the value of the company, which is in the interests
of all shareholders.
–
If, for example, the interest rate is 12% in the capital
market, we can calculate the rates of return to each
project and compare.
–
Project Small returns $570 for an outlay of $500,
a return of 14%.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–9
Fisher’s Separation Theorem:
A Simplified Example (cont.)
–
Project Upgrade returns $220 for an outlay of $200, a
return of 10%.
–
The firm should invest in Project Small only, leaving $300
in dividends.
–
Shareholder A gets $150 now, as desired.
–
Shareholder B also gets $150 now, but only wants $50,
so lends $100 in the capital market at 12%, receiving
$112 later.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–10
Fisher’s Separation Theorem:
A Formal Approach
•
Fisher’s separation theorem attempts to provide a
consistent set of rules for making investment,
financing and dividend decisions.
•
While initially developed in a simplified setting, the
rules are applicable even when more realistic
assumptions are made.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–11
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
Assumptions in Fisher’s analysis:
–
There are only two points in time — the present (Time 1)
and the future (Time 2).
–
There is no uncertainty and, hence, the outcome
of all decisions (including investments) is known
now to everybody.
–
There are no imperfections in the capital market.
–
All decision makers are rational.
–
The company’s managers wish to use the company’s
resources according to the wishes of the shareholders.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–12
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
The company
–
The company is endowed with a fixed amount of resources
at Time 1.
–
Managers must decide how much to invest and how much
to pay out as dividends.
–
The level of investment at Time 1 determines:

The residual resources at Time 1, available as a dividend
at Time 1.
 The resources that will be available to be paid as dividends
at Time 2.
–
These opportunities can be summarised in a production
possibilities curve (PPC).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–13
Fisher’s Separation Theorem:
A Formal Approach (cont.)
Production Possibilities Curve
Time 2
Resources (C2)
250
Q
160
0
150
200
Time 1
Resources (C1)
Figure 2.1: Production possibilities curve
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–14
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
PPC decisions (assuming 200 units of resources
at Time 1):
–
Point (200, 0) — whole 200 paid as dividend at Time 1,
investment is zero, dividend at Time 2 is zero.
–
Point (0, 250) — no dividend at Time 1, whole of
resources invested at Time 1, resources of 250
available for distribution at Time 2.
–
Point Q (150, 160) — intermediate case. Time 1—
dividend of 150, 50 invested. Time 2— resources
of 160 available.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–15
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
The shareholders:
–
Forgo current consumption by investing in a company
at Time 1 in order to earn a return that increases
consumption opportunities at Time 2.
–
A person’s preference for consumption at Time 1 or 2 can
be represented by indifference curves — all combinations
of Time 1 and Time 2 consumption on the same
indifference curve make the consumer equally well off.
–
Convex shape of indifference curves shows that a
consumer’s desire to increase consumption at a given
time decreases as the level of consumption at that time
increases (decreasing marginal utility).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–16
Indifference Curves
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–17
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
The company’s decision
–
Bringing the company and shareholders together —
what investment/dividend decision should be made?
–
Assuming two shareholders, A and B, with indifference
curves A1, A2, A3 and B1, B2, B3.
–
As can be seen in the following diagram, Shareholder A’s
utility is maximised at point A, while Shareholder B’s utility
is maximised at point B.

For example: Shareholder A would not choose a point on
indifference curve A1 as it would make him/her worse off that
point A and any point on indifference curve A3 is infeasible.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–18
Fisher’s Separation Theorem:
A Formal Approach (cont.)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–19
Fisher’s Separation Theorem:
A Formal Approach (cont.)
–
As Figure 2.3 illustrates, there is no investment decision
that can simultaneously lead to maximum utility for both
shareholders.

If we choose point A, Shareholder B is disappointed as
he/she ends up on the lower indifference curve B1, rather
than on B2 at point B (of course, this would disappoint
Shareholder A).
–
No simple decision rule can be used to satisfy
all shareholders.
–
However, such a rule exists if there is a capital market.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–20
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
Solution: introduce a capital market
–
Capital market can be thought of as a place where
current resources may be transformed into future
resources and vice versa.
–
Assume capital market is frictionless (interest rate is the
same for borrowers and lenders).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–21
Fisher’s Separation Theorem:
A Formal Approach (cont.)
–
The market opportunity line can be used to show the
combinations of current and future consumption that an
individual can achieve from a given wealth level, using
capital market transactions:
C2
W1  C1 
1  i 
where C1 = income at time 1
C2 = income at time 2
i = interest rate per period
W1 = person's wealth at time 1
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–22
Fisher’s Separation Theorem:
A Formal Approach (cont.)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–23
Fisher’s Separation Theorem:
A Formal Approach (cont.)
–
–
Figure 2.5 (next slide) shows that a person being
offered income streams denoted by A and B can
maximise utility by:

Accepting the income streams of A and B.

Then converting stream A into A ′ and stream B into B ′
by means of a capital market transaction.
However, stream A should be chosen because it
corresponds to a higher wealth level which, in turn,
ensures higher utility (higher indifference curve),
given access to a capital market.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–24
Fisher’s Separation Theorem:
A Formal Approach (cont.)
Market Opportunity Line
Market Opportunity Line
C2
275
160
A
A′
B′
B
0
170
250
C1
Figure 2.5: Consumption opportunities offered by two wealth levels
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–25
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
Proving there is an optimal policy:
–
Figure 2.6 (next slide) shows a company, with E units of
resources, which is considering three investment policies
(P1, P2 and P).
–
Shareholders will unanimously prefer policy P because
the resulting wealth level W is the maximum achievable.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–26
Fisher’s Separation Theorem:
A Formal Approach (cont.)
C2
C
P2
P
P3
E
W1 W2 W
C1
Figure 2.6: Effect of company policy on shareholder wealth
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–27
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
Proving there is an optimal policy (cont.):
–
Figure 2.7 combines preferences of shareholders A and B
with company’s optimal choice.
–
Choices P1 and P2 provide shareholders with inferior utility
to the choice of P.
–
Shareholders do not consume at point P.
–
The capital market allows them to consume at PA
and PB respectively.
–
This is the best they can do, given the interest rate.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–28
Fisher’s Separation Theorem:
A Formal Approach (cont.)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–29
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
Identifying the optimal policy
–
The following decision rule should be used:
Accept the project if and only if
Return at Time 2
 0
1 i
where  = outlay of units of resources required
i = interest rate per period
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–30
Fisher’s Separation Theorem:
A Formal Approach (cont.)
–
The previous decision rule is called the ‘net present
value rule’.
–
The return next period is divided by the factor (1 + i )
to convert the future return to present value.
–
The investment outlay is then subtracted from the
present value to give the net present value (NPV).
–
If the NPV is positive, the project will increase the
wealth of the shareholders and should, therefore,
be accepted.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–31
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
Implications for financial decision making
–
There are implications for investment, financing and
dividend decisions:

Implications hold where there are perfect markets for
both capital and information.

Implications unaffected by the introduction of uncertainty,
provided all participants have the same expectations.

Implications unaffected by extension to the
multi-period case.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–32
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
The investment decision
–
The theorem means that a company can make investment
decisions in the interests of every shareholder, regardless
of differences between shareholders’ preferences.
–
NPV analysis can be used to identify the optimal decision.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–33
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
The financing decision
–
Fisher’s analysis uses a single market interest rate.
–
No distinction between debt and equity securities, and
cost to company of acquiring funds is independent of the
type of security issued.
–
Value of company and wealth of shareholders is
independent of the company’s capital structure.
–
Financing decision is irrelevant.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–34
Fisher’s Separation Theorem:
A Formal Approach (cont.)
•
The dividend decision
–
Dividend decision is irrelevant, provided the company
does not alter its investment decision.
–
This is possible because, unlike the situation in Fisher’s
analysis, companies can lend or borrow in the capital
market themselves.
–
For example, a company can pay a higher dividend and
still maintain the optimal level of investment by borrowing
in the capital market.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–35
Investors’ Reactions to Managers’
Decisions
supplies funds to
COMPANY
makes an investment,
funding or dividend
decision
transact in
CAPITAL MARKET
There is a
consequent effect on
the company's share
price
INVESTORS
adjust their
expectations
transmits information to
Figure 2.11
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–36
Investors’ Reactions to Managers’
Decisions (cont.)
–
A company’s managers make an investment, financing or
dividend decision.
–
Information about this decision is transmitted to investors.
–
Investors may adjust their expectations of future returns
from an investment and revise their valuation of the
company’s shares.
–
Investors compare the market price with their revised
valuation and either buy or sell shares in the company.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–37
Investors’ Reactions to Managers’
Decisions (cont.)
•
Certainty
–
If managers knew with certainty an investment’s cash
flows, they would know its NPV.
–
All investors would also know the NPV of the investment
and there would be an immediate increase in the price of
the company’s shares.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–38
Investors’ Reactions to Managers’
Decisions (cont.)
•
Uncertainty
–
In practice, there is uncertainty.
–
The effect on the share price of decisions made by
managers is no longer perfectly predictable.
–
A simplification is to assume that the share price will
adjust immediately to reflect the new best estimate of the
‘true’ value of the company.
–
Empirical evidence suggests investors react quickly to the
receipt of new information with this information being
reflected in security prices.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–39
Summary
•
How can diverse investors all be satisfied with
the decisions of management?
•
Fisher’s separation theorem tells us that if there
is a capital market, managers are able to make
decisions that will satisfy all shareholders.
•
Companies should maximise shareholder wealth
and let shareholders use the capital market to
allocate this wealth over time.
•
Company and shareholders’ decisions are
separate.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
2–40