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. By disregarding the preferences of its shareholders in favor of maximizing company value, the company will ultimately succeed in providing greater long-term prosperity for both management and the shareholders.
- Fisher's separation theorem says that the main goal of a corporation should be to increase the company's value to the maximum extent possible.
- The theorem argues that the need to maximize company value trumps the priorities of shareholders, who are looking to benefit from dividend payouts or the selling of shares.
- The theorem is named after Irving Fisher, a neoclassical economist, and Yale Professor, who developed it in 1930; his books and philosophies have influenced many economists.
- He argued that shareholders have different goals than management and also lack the understanding of what the business needs to make the decisions that will benefit the company in the long-term.
- As such, management would do better to focus on productive opportunities, which will ultimately maximize profits and therefore help both managers and 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 the preferences of shareholders 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 is also known as the portfolio separation theorem.
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 being equal, the value of the firm does not vary depending on whether it primarily uses 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. Neoclassical economics looks at supply and demand as the primary drivers of an economy. 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.