Perfect Markets and the Separation Theorem

Since a company's retained profits for new capital projects represent alternative consumption and investment opportunities foregone by its shareholders, the corporate cut-off rate for investment is termed the opportunity cost of capital. And:

If management vet projects using the shareholders' opportunity cost of capital as a cut-off rate for investment:

- It should be irrelevant whether future cash flows paid as dividends, or retained for reinvestment, match the consumption preferences of shareholders at any point in time.

- As a consequence, dividends and retentions are perfect substitutes and dividend policy is irrelevant.

Remember, however, that we have assumed shareholders can always sell shares, borrow (or lend) at the market rate of interest, in order to transfer cash from one period to another to satisfy their needs. But for this to work implies that there are no barriers to trade. So, we must also assume that these transactions occur in a perfect capital market if wealth is to be maximised.

Perfect markets, are the bedrock of traditional finance theory that exhibit the following characteristics:

- Large numbers of individuals and companies, none of whom is large enough to distort market prices or interest rates by their own action, (i.e. perfect competition).

- All market participants are free to borrow or lend (invest), or to buy and sell shares.

- There are no material transaction costs, other than the prevailing market rate of interest, to prevent these actions.

- All investors have free access to financial information relating to a firm's projects.

- All investors can invest in other companies of equivalent relative risk, in order to earn their required rare of return.

- The tax system is neutral.

Of course, the real world validity of each assumption has long been criticised based on empirical research. For example, not all investors are risk-averse or behave rationally, (why play national lotteries, invest in techno shares, or the sub-prime market?). Share trading also entails costs and tax systems are rarely neutral.

But the relevant question is not whether these assumptions are observable phenomena but do they contribute to our understanding of the capital market?

According to seminal twentieth century research by two Nobel Prize winners for Economics (Franco Modigliani and Merton Miller: 1958 and 1961), of course they do.

The assumptions of a perfect capital market (like the assumptions of perfect competition in economics) provide a sturdy theoretical framework based on logical reasoning for the derivation of more sophisticated applied investment and financial decisions.

Perfect markets underpin our understanding of the corporate wealth maximisation process, irrespective of a firm's distribution policy, which may include interest on debt, as well as the returns to equity (dividends or capital gains).

Only then, so the argument goes, can we relax each assumption, for example tax neutrality (see Miller 1977), to gauge their differential effects on the real world. What economists term partial equilibrium analysis.

To prove the case for normative theory and the insight that logical reasoning can provide into contemporary managerial investment and financing decisions, we can move back in time even before the traditionalists to the first economic formulation of the impact of perfect market assumptions upon the firm and its shareholders' wealth.

The Separation Theorem, based upon the pioneering work of Irving Fisher (1930) is quite emphatic concerning the irrelevance of dividend policy.

When a company values capital projects (the managerial investment decision) it does not need to know the expected future spending or consumption patterns of the shareholder clientele (the managerial financing decision).

According to Fisher, once a firm has issued shares and received their proceeds, it is neither directly involved with their subsequent transaction on the capital market, nor the price at which they are traded. This is a matter of negotiation between current shareholders and prospective investors.

So, how can management pursue policies that perpetually satisfy shareholder wealth?

Fisherian Analysis illustrates that in perfect capital markets where ownership is divorced from control, dividend distributions should be an irrelevance.

The corporate investment decision is determined by the market rate of interest, which is separate from an individual shareholder's preference for consumption.

So finally, let us illustrate the dividend irrelevancy hypothesis and review our introduction to strategic financial management by demonstrating the contribution of Fisher's theorem to the maximisation of shareholders' welfare with a simple numerical example.

Review Activity

A firm is considering two mutually exclusive capital projects of equivalent risk, financed by the retention of current dividends. Each costs £500,000 and their future returns all occur at the end of the first year.

Project A will yield a 15 per cent annual return, generating a cash inflow of £575,000, whereas Project B will earn a 12 per cent return, producing a cash inflow of £560,000.

All individuals and firms can borrow or lend at the prevailing market rate of interest, which is 14 per cent per annum.

Management's investment decision would appear self-evident.

- If the firm's total shareholder clientele were to lend £500,000 elsewhere at the 14 per cent market rate of interest, this would only compound to £570,000 by the end of the year. - It is financially more attractive for the firm to retain £500,000 and accumulate £575,000 on the shareholders' behalf by investing in Project A, since they would have £5,000 more to spend at the year end.

- Conversely, no one benefits if the firm invests in Project B, whose value grows to only £560,000 by the end of the year. Management should pay the dividend.

But suppose that part of the company's clientele is motivated by a policy of distribution. They need a dividend to spend their proportion of the £500,000 immediately, rather than allow the firm to invest this sum on their behalf.

Armed with this information, should management still proceed with Project A?

Summary and Conclusions

Based on economic wealth maximisation criteria, corporate financial decisions should always be subordinate to investment decisions, with dividend policy used only as a means of returning surplus funds to shareholders.

To prove the point, our review activity reveals that shareholder funds will be misallocated if management reject Project A and pay a dividend.

For example, as a shareholder with a one per cent stake in the company, who prefers to spend now, you can always borrow £5,000 for a year at the market rate of interest (14 per cent).

By the end of the year, one per cent of the returns from Project A will be worth £5,750. This will more than cover your repayment of £5,000 capital and £700 interest on borrowed funds.

Alternatively, if you prefer saving, rather than lend elsewhere at 14 per cent, it is still preferable to waive the dividend and let the firm invest in Project A because it earns a superior return.

In our Fisherian world of perfect markets, the correct investment decision for wealth maximising firms is to appraise projects on the basis of their shareholders' opportunity cost of capital.

Endorsed by subsequent academics and global financial consultants, from Hirshliefer (1958) to Stern-Stewart today:

- Projects should only be accepted if their post-tax returns at least equal the returns that shareholders can earn on an investment of equivalent risk elsewhere.

- Projects that earn a return less than this opportunity rate should be rejected.

- Project yields that either equal or exceed their opportunity rate can either be distributed or retained.

- The final consumption (spending) decisions of individual shareholders are determined independently by their personal preferences, since they can borrow or lend to alter their spending patterns accordingly.

From a financial management perspective, dividend distribution policies are an irrelevance, (what academics term a passive residual) in the determination of corporate value and wealth

So, now that we have separated the individual's consumption decision from the corporate investment decision, let us explore the contemporary world of finance, the various functions of strategic financial management and their analytical models in more detail.

Selected References

Jensen, M.C. and Meckling, W.H., "Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure", Journal of Financial Economics, 3, October 1976.

Ang, J.S., Rebel, A. Cole and Lin J.W., "Agency Costs and Ownership Strus3cture" Journal of Finance, 55, February 2000.

Special Issue on International Corporate Governance, (ten articles), Journal of Financial Quantitative Analysis, 38, March 2003.

Miller, M.H. and Modigliani, F., "Dividend policy, growth and the valuation of shares", The Journal of Business of the University of Chicago, Vol. XXXIV, No. 4 October 1961.

Modigliani, F. and Miller, M.H., "The cost of capital, corporation finance and the theory of investment", American Economic Review, Vol. XLVIII, No. 3, June 1958.

Miller, M.H., "Debt and Taxes", The Journal of Finance, Vol. 32, No. 2, May 1977.

Fisher, I., The Theory of Interest, Macmillan (New York), 1930.

Hirshliefer, J.," On the Theory of Optimal Investment Decisions", Journal of Political Economy, August


Stern, J and Stewart, G.B. at

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