What Is Fisher's Separation Theorem?
Fisher's separation theorem postulates that, given efficient capital markets, a firm's choice of investment is separate from its owners' investment preferences and therefore the firm should only be motivated to maximize profits. To put it another way, the firm should not care about the utility preferences of shareholders for dividends and reinvestment. Instead, it should aim for an optimal production function that will result in the highest profits possible for the shareholders.
How Fisher's Separation Theorem Works
The basic notion that managers of a firm and its shareholders have different objectives is the starting point for Fisher's Separation Theorem: shareholders have utility preferences that form individual utility function curves, but managers of the firm have no reasonable means of ascertaining what they are. Thus, managers should ignore their preferences and work to maximize the value of the firm. Managers who make these investment decisions for production should assume that, in the aggregate, owners' consumption objectives can be satisfied if they maximize returns of the enterprise on their behalf.
Fisher's separation theorem was an important insight. It served as the foundation for Modigliani-Miller theorem that, given efficient capital markets, a firm's value is not affected by the way it finances investments or distributes dividends. There are three main methods for financing investments: debt, equity and internally-generated cash. All else equal, the value of the firm does not vary depending on debt versus equity financing.
Irving Fisher (1867 - 1947) was a Yale-trained economist who made prolific contributions to neoclassical economics in the studies of utility theory, capital, investment, and interest rates. The Nature of Capital and Income (1906), The Rate of Interest (1907) and The Theory of Interest (1930) were seminal works that influenced generations of economists.