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Theory and practice

wish to spend, there will be more available to them (their wealth will be maximised)

provided that the investment policy outlined in Proposition 1 (above) is followed.

This is because individual shareholders can use borrowing or lending to adjust the

dividends from the business to match their personal tastes. Put another way, the

pattern of dividends does not affect the wealth of the shareholders.

3 The financing method does not affect the shareholders’ wealth. Provided that the invest-

ment policy outlined in Proposition 1 (above) is followed, it does not matter

whether the investment is financed by the shareholders or by borrowing.

These may be summarised as the separation theorem, which says that investment

decisions and financing decisions should be made independently of one another. This

proposition was first identified by Irving Fisher in the 1930s and was formally set out

by Hirshleifer (1958).

These propositions may seem like not-too-subtle glimpses of the obvious, yet when

they were first formally propounded they met with quite a lot of scepticism, not

entirely because of the lack of reality of some of the assumptions that we have made.

Much of the scepticism was due to the fact that the propositions were in conflict with

widely held views on these aspects of business finance.

The assumptions

Our consideration of Projects X and Y, and indeed of the separation theorem gener-

ally, is based on four major assumptions:

1 Investments last for only one year.

2 Returns from investments are known with certainty: for example, there is no doubt

that if Project X is undertaken, £120,000 will flow in next year.

3 All individuals prefer more wealth to less.

4 Borrowing and lending rates are equal as between one another, and as between

individuals and businesses.

Clearly, some of these assumptions are unrealistic, particularly the first two.

Whether this seriously weakens the separation theorem and its implications is prob-

ably impossible to assess directly. Even if the theorem does not strictly hold true in

practice, it does give some insights about the relationship between shareholders and

managers in the context of investment productive assets, as well as into how those

investments might be financed. The theorem certainly provides a foundation for sev-

eral major financial theories that we shall encounter later in this book.

The formal derivation of the separation theorem by Hirshleifer is reviewed in the

appendix to this chapter.

2.5 Theory and practice

We have discussed what business finance is about and what financial decisions are

intended to achieve. We have also considered some theoretical propositions of how

we should make financing and investment decisions. In the remainder of this book we

shall explore how such decisions should be made in theory, and how they appear to

be made in practice, and we shall try to reconcile the differences between theory and

practice where they occur.

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