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Lecture Business finance (9/e) - Chapter 2: Consumption, investment and the capital market

Chapter 2 introduces you to consumption, investment and the capital market. After completing this unit, you should be able to: 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. | Chapter 2 Consumption, Investment and the Capital Market 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 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. 2 2 2 2 2 2 2 2 2 2 3 3 3 3 3 3 3 3 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. 3 3 3 3 3 3 3 3 3 6 13 13 13 13 13 13 13 13 Fisher’s Separation Theorem: A Simplified Example (cont.) Implication of theorem A company can make dividend/investment decisions that are in the . | Chapter 2 Consumption, Investment and the Capital Market 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 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. 2 2 2 2 2 2 2 2 2 2 3 3 3 3 3 3 3 3 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. 3 3 3 3 3 3 3 3 3 6 13 13 13 13 13 13 13 13 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. 4 4 4 4 4 4 4 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. 5 5 5 5 5 5 5 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. 5 5 5 5 5 5 5 5 Fisher’s .