Corporate Finance

Lecture 4

Corporate Finance

Lecture 4 :
Fisher Separation Theorem

Impact Consultancy & Training Pte Ltd

Fisher Separation & Optimal Decision

Making
! Fundamental assumptions
! Without investment, return cannot be generated
! Two forms of investments
Physical investment projects
Financial in nature
! Perfect capital market
Unlimited amount of borrowing & lending at the same
market interest rate
No transaction costs
Impact Consultancy & Training Pte Ltd

Corporate Finance

Lecture 4

Fisher Separation & Optimal Decision

Making
! Details about physical investments
!

Rank investments in terms of their return

Will provide a Production Opportunity Frontier (POF)

that represents one manner in which the firm can transform
its current funds into future income

Note : The greater C0 is the lesser C1 will be & vice versa

! Using the assumed utility function for the firms, an
indifference curve can be plotted to find the optimal physical
investment plan of a given firm
Impact Consultancy & Training Pte Ltd

Fisher Separation & Optimal Decision

Making
C1

Figure 1

IC

C0 is Period 0 consumption while

C1 is Period 1 consumption

Firm X

Investment increases from Point

m to Point 0

POF

Firm Y

IC
0

Impact Consultancy & Training Pte Ltd

C0
4

Corporate Finance

Lecture 4

Fisher Separation & Optimal Decision

Making
! Optimal physical policies of 2 different firms are shown in
Figure 1
! Specifics of the utility function of the firm will impact upon
the firms physical investment policy
! Implication : Shareholders must dictate to managers of the
firm the point to which it invests
Consume more leads to Invest less (m High C0)
Consume less leads to Invest more (m Low C0)

Impact Consultancy & Training Pte Ltd

Fisher Separation & Optimal Decision

Making
! In capital market, financial investment allows firms to borrow
or lend unlimited amount at rate r
! Assume the firm neither borrows or lends, current
consumption (C0) is m (ie. consume all), whereas period 1
consumption (C1) is zero
! BUT if the firm lend to (deposit in) the capital market all of
its funds then
C0 = 0 ie. No current consumption with m fully invested
C1 = (1 + r)m ie. Available for consumption in period 1
! Hence, the relationship between period 0 & period 1
consumption is
C1 = (1 + r)(m C0)
Impact Consultancy & Training Pte Ltd

Corporate Finance

Lecture 4

Fisher Separation & Optimal Decision

Making
!

The curve which represents capital market investments is a

straight line with a slope -(1 + r) called CML (Capital
Market Line)

Optimal financial investments for 2 different sets of

preferences (X & Y) are shown in Figure 2

Note : The greater C0 is the lesser C1 will be & vice versa

Impact Consultancy & Training Pte Ltd

Fisher Separation & Optimal Decision

Making
C1

IC

Figure 2

[C0, m(1 + r)]

Firm X

CML

Firm Y
IC
0

m (C0 = m, C1 = 0)

Impact Consultancy & Training Pte Ltd

C0

Corporate Finance

Lecture 4

Fisher Separation & Optimal Decision

Making
! We can now proceed to analyse optimal decision-making when
firms invest in both financial & physical assets
! Should undertake projects with greatest return
! As return on financial asset is always (1 + r), firm first
invest in all physical assets with returns greater than (1 +
r)
=> Those shown on Production Possibility Frontier (PPF)
between points m & I on Figure 3
Note : Any other point to the left of I suggests that it would be
better just to invest in financial asset as it gives a better C0
& C1 combination
Impact Consultancy & Training Pte Ltd

Fisher Separation & Optimal Decision

Making
!

Decision to physically invest up to I will be taken by all

firms regardless of the preferences of the owners (ie.
Prefer to consume more or less at Period 0 or 1)

Investments above I will be dominated by returns from

financial investments

Assume can borrow or lend in the capital market

Borrowing will move firm to south east along a line
starting at point I & with slope -(1 + r)
Lending will move firm to north west with the same
slope
Impact Consultancy & Training Pte Ltd

10

Corporate Finance

Lecture 4

Fisher Separation & Optimal Decision

Making
!

Preferences come into play when we consider how much

financial assets should be undertaken

Two possible optima are shown in Figure 3

Point X is for owners (Low C0)
Who prefer period 1 consumption &
Have lent on the capital market
Point Y is for owners (High C1)
Who prefer period 0 consumption &
Have borrowed from the capital market
Impact Consultancy & Training Pte Ltd

11

Fisher Separation & Optimal Decision

Making
! Figure 3 demonstrates the key insight of fisher separation
!

All firms, regardless of preferences of shareholders, will

have the same optimal physical investment policy, investing
to the point where the PPF & CML (Capital Market Line)
are tangent

Consumption preferences of shareholders then dictate the

firms borrowing or lending policy (financing decision)
BUT not the physical investment policy
Will shift the optimum along the CML
Impact Consultancy & Training Pte Ltd

12

Corporate Finance

Lecture 4

Fisher Separation & Optimal Decision

Making
C1

IC

Figure 3
Firm X

CML
CML

Firm Y
IC
0
m

C0

Impact Consultancy & Training Pte Ltd

13

Fisher Separation Theorem & Project

Evaluation
! Figure 3 shows a sub-optimal physical investment decision (I)
& the CML that borrowing & lending from point I would
trace out
! Clearly CML always below CML achieved through the
optimal physical investment policy
! Hence, the optimal physical investment policy should
maximise the horizontal intercept of the CML (ie. Highest C0)
on which the firm ends up

Impact Consultancy & Training Pte Ltd

14

Corporate Finance

Lecture 4

Fisher Separation Theorem & Project

Evaluation
! Chronology of the Process of Fisher Separation Theorem
! Have $m current funds
! Decide on Optimal Physical Investment (I0)
Rank projects in order of highest to lowest IRR
Invest in projects where IRRi > Required Rate of Return
(r) until IRRi = r
! Decide on Shareholders C0 Preference
! Remaining funds available to invest $m C0

Impact Consultancy & Training Pte Ltd

15

Fisher Separation Theorem & Project

Evaluation
Optimal Financial Investment
($m C0) > I0 then Invest ($m C0) - I0 into Financial
Assets
($m C0) < I0 then Borrow I0 - ($m C0) to invest up to
the Optimal Physical Investment decided earlier
! Clearly, the level of Optimal Physical Investment is
independently or separately decided & not influenced by the
firms financial decision
!

Impact Consultancy & Training Pte Ltd

16

Corporate Finance

Lecture 4

Fisher Separation Theorem & Project

Evaluation
! Assume firm decides to invest I0 from the income of m at time
0, the horizontal intercept of the CML of the firm is
where m I0 = C0
where (0) is the income at time 1 from the firms physical
investment ie. C1 & discounted by (1 + r)-1 => PV (C1)
! Re-arranging the formula will result in the following
! ! (I ) $
0
m +#
& ' I0
#" (1+ r ) &%
Impact Consultancy & Training Pte Ltd

17

Fisher Separation Theorem & Project

Evaluation
! Maximising the horizontal intercept is equivalent to
maximising

This is equivalent to maximising the net of the PV of future

income [(I0) / (1+r)] & PV of todays investment (I0) ie.
Maximising NPV
! With physical investment, the total consumption available in
todays value will then be m + Maximised NPV
!

Impact Consultancy & Training Pte Ltd

18

Corporate Finance

Lecture 4

Effects of Relaxation of Perfect Capital

Market Assumption on Fisher Separation
Theorem

! Perfect capital market assumption is vital for Fisher Separation

Theorem
!

Unlimited amount of borrowing & lending at the same market

interest rate

No transaction costs

! Example of relaxation of perfect capital market assumption

!

Realistically, Borrowing rate > Lending (Investing) rate

In Figure 4, there are 2 points at which the CML & POF are
tangential (Note : North west direction of CML now have a
lower slope as investing in financial asset yields lower r)
Impact Consultancy & Training Pte Ltd

19

Effects of Relaxation of Perfect Capital

Market Assumption on Fisher Separation
Theorem
!

This implies that agents (management) with different

consumption preferences will choose differing physical
investment decisions

Hence Fisher Separation Theorem breaks down as

illustrated in Figure 4

Agents (management) with strong preferences for future

consumption will physically invest to point X & then finally
invest to an optimum on the CML

Impact Consultancy & Training Pte Ltd

20

10

Corporate Finance

Lecture 4

Effects of Relaxation of Perfect Capital

Market Assumption on Fisher Separation
Theorem
!

Those with strong preferences for current consumption

physically invest to point Y & borrow along CML

Agents who value current & future consumption will

optimise by locating directly on the PPF & not using the
capital market at all as show at point Z

Impact Consultancy & Training Pte Ltd

21

Effects of Relaxation of Perfect Capital

Market Assumption on Fisher Separation
Theorem
C1
CML

Figure 4

Z
Y

CML

Impact Consultancy & Training Pte Ltd

C0

22

11