Question

Critically evaluate the assumptions upon which the Fisher Seperation Theorem is based and assess the extent to which these limit its usefulness in financial decsion-making

Answer 1

Fisher Separation Theorem:

• The significance of the theorem is that the firm and its shareholders are separate.
• The firm's policy should aim to maximize the utility of all shareholders.
• The firm doesn't consult each shareholder before it makes its decision to invest.
• The company should invest up to the point where the return on the marginal investment equals the interest rate in the capital market.
• It separates the 'investment decisions' of management from the 'consumption decision', of shareholders.

Underlying assumptions of theorem:

• It is two period model, the present time and a future time.
• There is no uncertainty and the outcome of all decisions is known to everybody.
• There are no imperfections in the market.
• All decisions makers are rational
• No transaction costs and no taxes.

These limits its usefulness in financial decisions-making, the theorem assumes that the capital markets are perfect and the information that is floating out is clear and known to everyone. This helps the managers to take the financial decisions and create the investment decisions for the firm, the theorem also assumes that there are only two periods (present and future); this clearly confirms that the firm should always focus on the current and long-term objectives. The theorem also clearly talks about investment decisions that are made by the firm shouldn't focus in satisfying the shareholders objectives, but it should focus on its core business which in turn increase the firms NPV and will be helpful to the shareholders to increase their returns. The theorem also help to evolve another theorem call M and M approach, which talks about how effective is giving the dividends to the shareholders or not giving dividends.