2-1

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Chapter 2

Consumption,
Investment and the
Capital Market
2-2
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Learning Objectives
Explain how a companys 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 companys optimal
investment/dividend policy under conditions
of certainty.
2-3
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Simplified Example
The foundation for many fundamental results of
finance theory:
How a company deals with diverse preferences for
dividends and investment when there is more than one
shareholder.
Assumptions under capital market:
Certainty, frictionless, and interest rate for borrowers
equals interest rate for lenders.
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.
2-4
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Simplified Example (cont.)
Example 1: Assume capital market does not exist
A company has only two shareholders (A and B),
who hold equal shares of $800 each.
Project Small involves $500 outlay now and $570 cash flow
later. But Project Upgrade requires outlay of an additional
$200 and incremental cash flow of $220.
Project Upgrade can only be undertaken together with
Project Small, forming Project Large.
Projects Small and Large enable dividends, of $300
and $100 respectively, to be paid now.
2-5
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Simplified Example (cont.)
Example 1: Assume capital market does not
exist (cont.)
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.
Note: Given A and Bs consumption preferences, 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 impossible to say which investment is
optimal.
2-6
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Simplified Example (cont.)
Solution:
Introduce a capital market (CM).
Essentially, the shareholders can lend excess income
(dividends) in the CM or borrow to satisfy current
consumption if current dividends are insufficient.
A resolution is possible because the CM enables:
One of the shareholders to achieve a result that is better
than the result the company alone could provide.
Using the net present value (NPV) rule for optimal
investment decision.
2-7
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Assume the interest rate is 12% in the CM, then
calculate the rates of return for each project and
compare.
Project Small returns 14% while Project Upgrade
returns 10%.
Hence, only invest in Project Small, 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.
Fishers Separation Theorem:
A Simplified Example (cont.)
2-8
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach
The theorem attempts to provide a consistent set
of rules to make investment, financing and dividend
decisions. Although initially developed in a
simplified setting, the rules are applicable even
when more realistic assumptions are made.
Assumptions in Fishers analysis:
Only two points in time: present Time 1, future Time 2.
There are no uncertainties or imperfections in the CM,
and all decision makers are rational.
The companys managers wish to use the companys
resources according to the wishes of the shareholders.
2-9
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
The company:
Endowed with a fixed amount of resources at Time 1.
Managers must decide how much to invest and pay 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).
2-10
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
Production possibilities curve
Time 2
Resources (C
2
)
250
Q
160
0 150 200 Time 1
Resources (C
1
)
Figure 2.1: Production possibilities curve
2-11
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
PPC decisions (assuming 200 units of resources
in Time 1) (Figure 2.1)
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.
2-12
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers 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 persons 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
consumers desire to increase consumption at a given
time decreases as the consumption level at that time
increases (decreasing marginal utility). See Figure 2.2.
2-13
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
The companys 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 As
utility is maximised at point A, while Shareholder Bs utility
is maximised at point B. See Figure 2.3.
For example: Shareholder A would be worse off at any
point on indifference curve A1 than point A, on A2 and
any point on the indifference curve A3 is not possible.
2-14
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
2-15
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
Figure 2.3: There is no simple investment
decision that can maximise both shareholders
utility simultaneously:
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).
However, a solution exists if there is a capital
market (CM).
In capital market, 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).
2-16
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers 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:

2
1 1
1
C
W C
i

1
2
1
where = income at time 1
= income at time 2
= interest rate per period
= shareholder wealth at time 1
C
C
i
W
2-17
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
2-18
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
Figure on next slide: Shows that an income
stream of 140, 121 and a capital market with
10% interest can satisfy two investors (A, B)
through borrowing and lending/investing by:
Maximising their wealth.
Maximising their utility.
See pp. 202 for a more detailed interpretation
of market opportunity line and company policy
effect on shareholders wealth.
2-19
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
Market Opportunity Line
C
A/B
A
C
B
140
2
275
242
0 160 250
1
30
121
99
250 30
1 1
242
250 160
1 1
99
250 140
1 1
121



.
: ' B
.
: ' A
.
: B / A
2-20
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
Proving there is an optimal policy:
Figure 2.7 combines preferences of shareholders
A and B with companys optimal choice.
Choices P
1
and P
2
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 maximises shareholders wealth.
2-21
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
2-22
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers 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

= interest rate per period i

2-23
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers 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.
2-24
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers 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.
2-25
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers 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.
2-26
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers Separation Theorem:
A Formal Approach (cont.)
The financing decision:
Fishers 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 are
independent of the companys capital structure.
Financing decision is irrelevant.
2-27
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Fishers 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
Fishers 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.
2-28
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Investors Reactions to
Managers Decisions
supplies funds to transact in
transmits information to
Figure 2.11
COMPANY
makes an investment,
funding or dividend
decision
CAPITAL MARKET
There is a
consequent effect on
the company's share
price
INVESTORS
adjust their
expectations
2-29
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Investors Reactions to
Managers Decisions (cont.)
A companys managers make investment,
financing and/or dividend decisions.
The information of these decisions is
transmitted to investors.
Investors may adjust their expectations of
future returns from an investment and revise
their valuation of the companys shares.
Investors compare the market price with their
revised valuation and either buy or sell
shares in the company.
2-30
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Investors Reactions to
Managers Decisions (cont.)
Certainty:
If all investors knew an investments cash flows, they would
know its NPV. Hence, share price of company would go up.
Uncertainty:
In practice, there is uncertainty.
Effect of managers decisions on the share price is no
longer predictable. A simplification is to assume that share
price will adjust immediately to reflect the true value of the
company.
Empirical evidence suggests investors react quickly to the
receipt of new information since information is reflected on
security prices.
2-31
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
Summary
How can diverse investors all be satisfied with
the decisions of management?
Fishers 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.