Tài chính doanh nghiệp - Chapter 2: Consumption, investment and the capital market

Chapter 2Consumption, Investment and the Capital MarketLearning ObjectivesExplain 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.Fisher’s Separation Theorem:A Simplified ExampleThe 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.AssumptionsCertainty.Frictionless capital markets.Interest rate for borrowers equals interest rate for lenders.Fisher’s Separation Theorem:A Simplified Example (cont.)Implication of theoremA company can make dividend/investment decisions that are in the best interests of all shareholders, regardless of differences in the preferences of individual shareholders.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.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.Fisher’s Separation Theorem:A Simplified Example (cont.)Given their respective consumption preferences, A and B will desire different dividend policies from the company.A will want the company to invest in Project Small, while B will prefer Project Large.Clearly, the company cannot make a decision that will satisfy both shareholders simultaneously. Therefore, it is not possible to say which investment is optimal.Fisher’s Separation Theorem:A Simplified Example (cont.)Solution — introduce a capital market:A solution can be found if there is a capital market in which shareholders can borrow and lend on their personal accounts.Essentially, the shareholders can lend excess income (dividends) in the capital market or borrow to satisfy current consumption if current dividends are (temporarily) insufficient.A resolution is possible because the capital market enables one of the shareholders to achieve a result that is better than the result the company alone could provide.Fisher’s Separation Theorem:A Simplified Example (cont.)The introduction of the capital market also enables a company to use the net present value (NPV) rule to identify the optimal investment, thereby maximising the value of the company, which is in the interests of all shareholders.If, for example, the interest rate is 12% in the capital market, we can calculate the rates of return to each project and compare.Project Small returns $570 for an outlay of $500, a return of 14%.Fisher’s Separation Theorem:A Simplified Example (cont.)Project Upgrade returns $220 for an outlay of $200, a return of 10%.The firm should invest in Project Small only, leaving $300 in dividends.Shareholder A gets $150 now, as desired.Shareholder B also gets $150 now, but only wants $50, so lends $100 in the capital market at 12%, receiving $112 later.Fisher’s Separation Theorem: A Formal ApproachFisher’s separation theorem attempts to provide a consistent set of rules for making investment, financing and dividend decisions.While initially developed in a simplified setting, the rules are applicable even when more realistic assumptions are made.Fisher’s Separation Theorem: A Formal Approach (cont.)Assumptions in Fisher’s analysis:There are only two points in time — the present (Time 1) and the future (Time 2).There is no uncertainty and, hence, the outcome of all decisions (including investments) is known now to everybody.There are no imperfections in the capital market.All decision makers are rational.The company’s managers wish to use the company’s resources according to the wishes of the shareholders.Fisher’s Separation Theorem: A Formal Approach (cont.)The companyThe company is endowed with a fixed amount of resources at Time 1.Managers must decide how much to invest and how much to pay out as dividends.The level of investment at Time 1 determines:The residual resources at Time 1, available as a dividend at Time 1.The resources that will be available to be paid as dividends at Time 2.These opportunities can be summarised in a production possibilities curve (PPC).Fisher’s Separation Theorem: A Formal Approach (cont.)Production Possibilities Curve Time 2Resources (C2)250 Q1600150 200 Time 1 Resources (C1)Figure 2.1: Production possibilities curveFisher’s Separation Theorem: A Formal Approach (cont.)PPC decisions (assuming 200 units of resources at Time 1):Point (200, 0) — whole 200 paid as dividend at Time 1, investment is zero, dividend at Time 2 is zero.Point (0, 250) — no dividend at Time 1, whole of resources invested at Time 1, resources of 250 available for distribution at Time 2.Point Q (150, 160) — intermediate case. Time 1— dividend of 150, 50 invested. Time 2— resources of 160 available. Fisher’s Separation Theorem: A Formal Approach (cont.)The shareholders:Forgo current consumption by investing in a company at Time 1 in order to earn a return that increases consumption opportunities at Time 2.A person’s preference for consumption at Time 1 or 2 can be represented by indifference curves — all combinations of Time 1 and Time 2 consumption on the same indifference curve make the consumer equally well off.Convex shape of indifference curves shows that a consumer’s desire to increase consumption at a given time decreases as the level of consumption at that time increases (decreasing marginal utility).Indifference CurvesFisher’s Separation Theorem: A Formal Approach (cont.)The company’s decisionBringing the company and shareholders together — what investment/dividend decision should be made?Assuming two shareholders, A and B, with indifference curves A1, A2, A3 and B1, B2, B3.As can be seen in the following diagram, Shareholder A’s utility is maximised at point A, while Shareholder B’s utility is maximised at point B.For example: Shareholder A would not choose a point on indifference curve A1 as it would make him/her worse off that point A and any point on indifference curve A3 is infeasible. Fisher’s Separation Theorem: A Formal Approach (cont.)Fisher’s Separation Theorem: A Formal Approach (cont.)As Figure 2.3 illustrates, there is no investment decision that can simultaneously lead to maximum utility for both shareholders.If we choose point A, Shareholder B is disappointed as he/she ends up on the lower indifference curve B1, rather than on B2 at point B (of course, this would disappoint Shareholder A).No simple decision rule can be used to satisfy all shareholders.However, such a rule exists if there is a capital market.Fisher’s Separation Theorem: A Formal Approach (cont.)Solution: introduce a capital marketCapital market can be thought of as a place where current resources may be transformed into future resources and vice versa.Assume capital market is frictionless (interest rate is the same for borrowers and lenders). Fisher’s Separation Theorem: A Formal Approach (cont.)The market opportunity line can be used to show the combinations of current and future consumption that an individual can achieve from a given wealth level, using capital market transactions:Fisher’s Separation Theorem: A Formal Approach (cont.)Fisher’s Separation Theorem: A Formal Approach (cont.)Figure 2.5 (next slide) shows that a person being offered income streams denoted by A and B can maximise utility by:Accepting the income streams of A and B. Then converting stream A into A ′ and stream B into B ′ by means of a capital market transaction.However, stream A should be chosen because it corresponds to a higher wealth level which, in turn, ensures higher utility (higher indifference curve), given access to a capital market.Fisher’s Separation Theorem: A Formal Approach (cont.)Market Opportunity LineMarket Opportunity LineC2275 A160 A′ B′ B0170 250 C1Figure 2.5: Consumption opportunities offered by two wealth levelsFisher’s Separation Theorem: A Formal Approach (cont.)Proving there is an optimal policy:Figure 2.6 (next slide) shows a company, with E units of resources, which is considering three investment policies (P1, P2 and P).Shareholders will unanimously prefer policy P because the resulting wealth level W is the maximum achievable.Fisher’s Separation Theorem: A Formal Approach (cont.) C C2P2P P3 E W1 W2 W C1Figure 2.6: Effect of company policy on shareholder wealthFisher’s Separation Theorem: A Formal Approach (cont.)Proving there is an optimal policy (cont.):Figure 2.7 combines preferences of shareholders A and B with company’s optimal choice.Choices P1 and P2 provide shareholders with inferior utility to the choice of P.Shareholders do not consume at point P.The capital market allows them to consume at PA and PB respectively.This is the best they can do, given the interest rate.Fisher’s Separation Theorem: A Formal Approach (cont.)Fisher’s Separation Theorem: A Formal Approach (cont.)Identifying the optimal policyThe following decision rule should be used: Accept the project if and only ifFisher’s Separation Theorem: A Formal Approach (cont.)The previous decision rule is called the ‘net present value rule’.The return next period is divided by the factor (1 + i ) to convert the future return to present value. The investment outlay is then subtracted from the present value to give the net present value (NPV).If the NPV is positive, the project will increase the wealth of the shareholders and should, therefore, be accepted.Fisher’s Separation Theorem: A Formal Approach (cont.)Implications for financial decision makingThere are implications for investment, financing and dividend decisions:Implications hold where there are perfect markets for both capital and information.Implications unaffected by the introduction of uncertainty, provided all participants have the same expectations.Implications unaffected by extension to the multi-period case.Fisher’s Separation Theorem: A Formal Approach (cont.)The investment decisionThe theorem means that a company can make investment decisions in the interests of every shareholder, regardless of differences between shareholders’ preferences.NPV analysis can be used to identify the optimal decision.Fisher’s Separation Theorem: A Formal Approach (cont.)The financing decisionFisher’s analysis uses a single market interest rate.No distinction between debt and equity securities, and cost to company of acquiring funds is independent of the type of security issued.Value of company and wealth of shareholders is independent of the company’s capital structure.Financing decision is irrelevant.Fisher’s Separation Theorem: A Formal Approach (cont.)The dividend decisionDividend decision is irrelevant, provided the company does not alter its investment decision.This is possible because, unlike the situation in Fisher’s analysis, companies can lend or borrow in the capital market themselves.For example, a company can pay a higher dividend and still maintain the optimal level of investment by borrowing in the capital market. Investors’ Reactions to Managers’ Decisions supplies funds to transact in transmits information toFigure 2.11COMPANYmakes an investment, funding or dividend decisionCAPITAL MARKETThere is a consequent effect on the company's share priceINVESTORSadjust their expectationsInvestors’ Reactions to Managers’ Decisions (cont.)A company’s managers make an investment, financing or dividend decision.Information about this decision is transmitted to investors.Investors may adjust their expectations of future returns from an investment and revise their valuation of the company’s shares.Investors compare the market price with their revised valuation and either buy or sell shares in the company.Investors’ Reactions to Managers’ Decisions (cont.)CertaintyIf managers knew with certainty an investment’s cash flows, they would know its NPV.All investors would also know the NPV of the investment and there would be an immediate increase in the price of the company’s shares.Investors’ Reactions to Managers’ Decisions (cont.)UncertaintyIn practice, there is uncertainty.The effect on the share price of decisions made by managers is no longer perfectly predictable.A simplification is to assume that the share price will adjust immediately to reflect the new best estimate of the ‘true’ value of the company.Empirical evidence suggests investors react quickly to the receipt of new information with this information being reflected in security prices.SummaryHow can diverse investors all be satisfied with the decisions of management?Fisher’s separation theorem tells us that if there is a capital market, managers are able to make decisions that will satisfy all shareholders.Companies should maximise shareholder wealth and let shareholders use the capital market to allocate this wealth over time.Company and shareholders’ decisions are separate.