Investing Feeds

Irving Fisher’s Separation Theorem is the bedrock of modern financial theory. Essentially it asserts that in the modern, listed, business entity there is a divestiture of ownership (Shareholders) and control (The Board) and as such, this separation produces the need for the control to maximize the present value (see article on NPV) regardless of the market opportunities of the owners. In simple terms, the interests of the owners of a firm are always served by utilizing NPV as a tool of investment appraisal. It’s main assumptions are therefore that:

1) The Firms investment decision is independent of the preferences of the owner, and

2) The investment decision is independent of the financing decision.

Making the tradeoff between mutually exclusive investments, a firm utilizing NPV, will by proxy of that methodology, maximize the market position of the stock, regardless of the financing decision (whether to utilize debt or equity to fund projects), and regardless of the owners opinions. The mathematical proof can be viewed at

http://cepa.newschool.edu/het/essays/capital/fisherinvest.htm

Fisher’s legacy to modern finance has been vast, utilizing his Theory of Interest to provide the technique of NPV analysis ushered in a new era of Financial Theory, however, as the world of finance is a conservative one, there are still decisions made without reference to the use of NPV. It is important to have a working knowledge of the Separation Theorem and the use of NPV if you are thinking of investing money in any project, be it Stocks, Future or any of the modern complex financial instruments. Indeed, if an investor’s normative function is to maximize wealth, then NPV is the only mathematically correct way in which to measure, in dollar terms, the wealth creation function.