Question

Provide a detailed explanation of fishers’ theorem

Answer 1

The question is asking about Fisher's famous separation theorem which says that investment decisions of the company is different from the investment decisions of its investors, financing decisions of the company and finance mix of the company Let us understand it with the help of numbers.

Let say company wants to in a project and it can either invest or pay dividend from this money. So let say there are five projects A ,B ,C ,Dand E which provide different returns 10% 15 % 25% 50% and 75% company will check at which level market is providing capital ( basically it is known as the trade off between capital market line (CML)and potential opportunities frontier(POF) let say market is providing $1000 @10% and since it is capital market then investment and borrowing is freely allowed for everyone,so this $1000 point will be the tradeoff point or tangent point(in graph) between CML and POF let say company choses project which provides 25% and requires investment of $600 so it would give $400 as dividend now and 600×1.25=$750 in future,this decision is irrespective of the decisions of the investors but it won't make any difference to them let see how

Let us assume there are two investors X and Y

X doesn't want 400 it only needs 150$ now would company have done if it was influenced by X  

It would have  given $150 to X now and and invested $250 in capital markets @10% now X would have received $750 + 250(1.1)=1025$ in future. Now as per Fisher's theory company doesn't need to change its decision it can simply give $400 to X and ask him to use $150 now invest 250$in capital market ( as everyone can invest in capital markets freely) now X will get $750 from the company in future, 275 from his own invest i.e. 1025 in total. Which means that X has achieved his goal and company didn't meed worry about X's decision.