Chapter 2

Consumption,
Investment and the
Capital Market

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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  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 2-2
 Fisher’s 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.
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 2-3
 Fisher’s 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.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-4
 Fisher’s 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 B’s 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.
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 2-5
 Fisher’s 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.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-6
 Fisher’s Separation Theorem:
A Simplified Example (cont.)
• 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.
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 2-7
 Fisher’s 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 Fisher’s 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 company’s managers wish to use the company’s
resources according to the wishes of the shareholders.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-8
 Fisher’s 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).
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-9
 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

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-10
 Fisher’s 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.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-11
 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 consumption level at that time
increases (decreasing marginal utility). See Figure 2.2.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-12
 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. 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.

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 2-13
 Fisher’s Separation Theorem:
A Formal Approach (cont.)

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-14
 Fisher’s 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).
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-15
 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 =
C1income at time 1
C2 = income at time 2
i = interest rate per period
W1= shareholder wealth at time 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 2-16
 Fisher’s Separation Theorem:
A Formal Approach (cont.)

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-17
 Fisher’s 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. 20–2 for a more detailed interpretation

of market opportunity line and company policy
effect on shareholders’ wealth.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-18
 Fisher’s Separation Theorem:
A Formal Approach (cont.)
Market Opportunity Line
C2
121
A/B:  140  250
275 1.1
99
242 B′ A' :  160  250
1.1
242
121
A/B B' :  30  250
1.1
99 A′

0 30 140 160 250 C1

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-19
 Fisher’s Separation Theorem:
A Formal Approach (cont.)
• Proving there is an optimal policy:
– 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 maximises shareholders’ wealth.

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 2-20
 Fisher’s Separation Theorem:
A Formal Approach (cont.)

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-21
 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  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 2-22
 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.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-23
 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.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-24
 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  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 2-25
 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 are

independent of the company’s capital structure.

– Financing decision is irrelevant.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-26
 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.

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-27
 Investors’ Reactions to
Managers’ Decisions
Figure 2.11
supplies funds to transact in

COMPANY CAPITAL MARKET

INVESTORS
makes an investment, There is a adjust their
funding or dividend consequent effect on
the company's share expectations
decision
price

transmits information to

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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-28
 Investors’ Reactions to
Managers’ Decisions (cont.)
• A company’s 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 company’s shares.
• Investors compare the market price with their
revised valuation and either buy or sell
shares in the company.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-29
 Investors’ Reactions to
Managers’ Decisions (cont.)
• Certainty:
– If all investors knew an investment’s 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.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 2-30
 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  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 2-31