Finance: What is Fisher's Separation Theorem?

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Transcript

00:21

corporate decision making so a bit about how running a

00:24

big corporation works While a corporation has two sets of

00:28

bosses you've got the owners and then you've got the

00:30

manager In small companies these were often the same people

00:33

The guy who owns the Sneaker Repair Pagoda at the

00:37

mall probably owns 100% of the stock in that company

00:40

and works full time as the manager and probably is

00:43

the only employee to butt in large corporations A separation

00:46

comes into play There are shareholders right people who on

00:49

the common stock And there are the managers People like

00:51

the CEO CFO CEO ahead of technology and so on

00:55

The people who run the Company day today there can

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be overlap like managers often own stock but for the

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most part the rules operate separately Fisher's separation serum deals

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with the fact that a corporation has run by the

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manager's acts separately from the wishes of its shareholders like

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they're not perfectly parallel The best thing for the company

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is often different than the best thing for shareholders at

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least in the short term Each entity the shareholders and

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the corporate managers responds to different forces and thinks differently

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about the best uses of the company's precious resource is

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or assets or money Will the fissure separation Throughem says

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these differences don't really matter at least in terms of

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making corporate decisions The theory states that a corporation should

01:36

maximize its present value regardless of what its shareholders want

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You run treat not Trick Ink a company that makes

01:47

tiny X ray devices to check Halloween candy for razor

01:50

blades You made 10,000,000 box in profit last year You

01:53

have two fundamental choices You can use that money to

01:56

invest in the business things like expanding your X ray

01:59

mine or running in R and D Yet to make

02:01

a better caramel density ofthe center Or you can give

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the money to shareholders in the form of a special

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dividend which means giving them cash as a reward for

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well holding the stock So what do your shareholders think

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you should do with your 10,000,000 bucks in profit Well

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one of your shareholders Polly Favor is sitting pretty Her

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other investments are going well Her second trust fund just

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vested and she miraculously just won the national lottery in

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Mozambique She doesn't need the money She tells you to

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invest the full $10,000,000 in the company to grow it

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Meanwhile another shareholder Artie Loot Flush isn't doing so well

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He got divorced last year and owes a lot of

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child support both to his ex wife and his former

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mistress Meanwhile his other investments have all gone south and

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he lost a ton of money in an unsuccessful attempt

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Teo Rig the National Lottery of Mozambique He really needs

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the money The cash Today baby He asks you to

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turn the full $10,000,000 a profit into a special dividend

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The fissure separation throughem suggests that you'll ignore them both

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that you'll figure out what projects makes sense to invest

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in and commit whatever profit is needed to run those

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programs Whatever's leftover well then you'll give it out as

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a dividend so your staff crunches the numbers and decides

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that well If you buy another Ray excrete ER for

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1,000,000 bucks it'll have a return on investment of 25%

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next year like 250 grand And meanwhile if you invest

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$4,000,000 in developing a new product for checking Valentine's Day

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candy for poison it'll show a return of 15% Every

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other possible project has unexpected return of only 7% or

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less Well meanwhile your nerd crew determines that capital markets

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would return 8% over the coming year And all this

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means that if you borrow money you'll have to pay

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8% interest on that loan Or if you loaned money

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out while you'd get a return of 8% right so

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there's your cut off If you can't get more than

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8% return on your money well you might as well

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just loan the money out or give in to your

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shareholders as a dividend So that's what you do You

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invest 1,000,000 box in a ray excrete er it has

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a 25% of year return for a long time I

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mean it gets you 250 grand by the end of

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the year and then another 200 50 grand then next

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year in 2 50 the next In the meantime you're

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Ray X Streeter has all kinds of other values for

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it However you do the calculation It's a really good

04:15

return 25 per cent away better than eight You also

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invest 4,000,000 box in the Valentine's Day Poison prevention project

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the VD three p As you call it you expect

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it to return 15% meaning you'll wind up with 600

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grand in profits next year and then 600 next and

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600 than next And then the value will go up

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and however you do the math at 15% is way

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better than 8% kind of returns you invested then 5,000,000

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ofyour 10,000,000 in high yield high return projects You have

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5,000,000 bucks left Well what do you do with it

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You give that out in dividends So Polly is a

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little disappointed because she wanted to keep the money and

04:52

invested But she takes the extra money you give her

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and loans it out on her own at 8% interest

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It therefore gives her the same return as she would

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have gotten from keeping the money with your company You

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already invested in all your high return projects The best

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the company could have done with that money is earned

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8% at least return in the capital markets The same

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thing that Polly is going to get returned to her

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with her investing it in the capital markets It doesn't

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matter whether she has the money or the company has

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the money Meanwhile already is bummed He needed that extra

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money bad but he still has access to the money

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he needs He can go into the capital markets and

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borrow it at 8% interest He can just give Holly

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a call and Violet from her like why not Okay

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but how is already gonna pay the money back Wealthy

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company that he invests in took $5,000,000 turned it into

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a 5.8 5,000,000 in a year Right That's the 1,000,000

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invested A 25% return and the 4,000,000 invested A 15%

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return What blended together That's a 17% return on the

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$5,000,000 investment Much more than that 8% interest or 8%

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return would have returned to them had they invested it

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in a lesser return project So next year come dividend

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time he'll get that additional amount paid out which he

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can use to pay down debt Unless the company can

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invested at a higher rate than the vanilla capital market

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rate at which point then already will just roll over

06:09

his loan or his investment turn he'll sell for another

06:12

year and let the company or in a higher return

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again So that's the math behind the fissure separation serum

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The company will take a CZ much profit as it

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needs to run its high return projects anything more than

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it could get by just loaning out the money at

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interest rates or investing it in some analogous project Everything

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else then goes to shareholders with shareholders Stay happy because

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they can just use the capital markets to make up

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the difference in investment returns If they wanted less money

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they could loan out the extra if they wanted more

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than they can borrow what they need Meanwhile if company

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needs more money it can borrow it as well Like

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say next year you bring in 7,000,000 in profit in

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the capital markets are paying 8% again but you have

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$10,000,000 in projects that can make more than a 15%

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return For that extra 3,000,000 bucks you'll borrow the funds

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at 8% interest and pay it back after the investments

07:01

return At least 15% right borrow it ate Earn it

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15 You end up pocketing 7% on the plus side

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So in that year shareholders won't get any dividends All

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the money plus extra that's been borrowed gets reinvested in

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the company But shareholders don't mind because they can also

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borrow money if they need it Meanwhile the money invested

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with you makes an above market return and a key

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here is that it makes no difference how the firm's

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investments are finance whether by dead or cash or stock

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whatever it is they have in their coffers And if

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things get too bad for Artie well he can always

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sell his stock and treat not trick ink right Well

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the sale will give him plenty of money for child

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support and for legal costs related to the charges of

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lottery tampering he faces in Mozambique But that's a separate

07:43

story