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Corporate Finance and Fisher’s Model

Corporate Finance and Fisher’s Model. Professor Chris Adam Australian Graduate School of Management University of Sydney and University of New South Wales. INTRODUCTION. To explain decision behaviour of firms and individuals over time Model developed by Irving Fisher Uses three assumptions:

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Corporate Finance and Fisher’s Model

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  1. Corporate Finance andFisher’s Model Professor Chris Adam Australian Graduate School of Management University of Sydney and University of New South Wales

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. TWO PERIOD MODEL • Model works with many owners of firm • each makes own consumption/capital market decisions using firm’s earnings and market line • Firm needs only to make one optimum production/dividend (“investment”) decision • This is Fisher’s Separation Theorem

  8. 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)

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

  10. EXTENSIONS • Borrowing can extend PPF • Should only be undertaken if NPV(project) > 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

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