Corporate Finance and Fisher

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Corporate Finance andFishers Model

• Professor Chris Adam
• Australian Graduate School of Management
• University of Sydney and University of New South
  Wales

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INTRODUCTION

• To explain decision behaviour of firms and
  individuals over time
• Model developed by Irving Fisher
• Uses three assumptions
• Perfect certainty
• Perfect capital markets
• Rational investors

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TWO PERIOD MODEL

• Consider two periods of time (now, future)
• Decisions of individuals to allocate resources
  over time on basis of
• Tastes and preferences for present versus future
  consumption
• Investment opportunities available now and in
  future

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TWO PERIOD MODEL

• Individual tastes and preferences trade-off
  between consumption now and in future
• Investments can be in
• firm by buying shares
• capital market by lending
• Firm can produce in either or both periods,
  described by production possibility frontier

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TWO PERIOD MODEL

• Market line represents rate of substitution or
  transformation between periods
• Slope of line (1 interest rate)
• Firm invests part of endowment now up to optimum
  production point
• takes rest as dividend
• optimum point where
• 1 interest rate 1 productive return

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TWO PERIOD MODEL

• Investment now produces dividend in next period
• If firm owner wants to consume only part of
  dividend now, can invest excess in capital market
• adds to dividend from firm in next period

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TWO PERIOD MODEL

• Model works with many owners of firm
• each makes own consumption/capital market
  decisions using firms earnings and market line
• Firm needs only to make one optimum
  production/dividend (investment) decision
• This is Fishers Separation Theorem

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FIRM VALUATION

• Value of firm now
• Period 1 dividend
• Present Value of Period 2 dividend
• To maximize value of firm is to maximize
  shareholder wealth (utility)

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EXTENSIONS

• Imperfect capital markets mean lending and
  borrowing rates may differ
• no longer unique production decision to be made
  by current owner regardless of owners tastes
• Rules to find optimum production point
• Chose projects with positive Net Present Values
• Chose projects with Internal Rate of Return gt
  Required Rate of Return

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EXTENSIONS

• Borrowing can extend PPF
• Should only be undertaken if NPV(project) gt 0
• For firm valuation in perfect capital markets,
  investment decision (where funds go) matters, not
  financing decision (where funds come from)
• Dividend distribution decision not change firm
  value in perfect capital markets
• Simply a different division of value of net cash
  flows from investments