Social Choice Theory

and finance Allah shmoop What is Fisher's separation syrup Fisher

separation The're um like you have to keep your tuna

away from your marlin and they're not quite well The

separation serum was first proposed by economist Irving Fisher Nothing

to do with the seafood It has to do with

corporate decision making so a bit about how running a

big corporation works While a corporation has two sets of

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

manager In small companies these were often the same people

The guy who owns the Sneaker Repair Pagoda at the

mall probably owns 100% of the stock in that company

and works full time as the manager and probably is

the only employee to butt in large corporations A separation

comes into play There are shareholders right people who on

the common stock And there are the managers People like

the CEO CFO CEO ahead of technology and so on

The people who run the Company day today there can

be overlap like managers often own stock but for the

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

with the fact that a corporation has run by the

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

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

is often different than the best thing for shareholders at

least in the short term Each entity the shareholders and

the corporate managers responds to different forces and thinks differently

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

or assets or money Will the fissure separation Throughem says

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

making corporate decisions The theory states that a corporation should

maximize its present value regardless of what its shareholders want

You run treat not Trick Ink a company that makes

tiny X ray devices to check Halloween candy for razor

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

have two fundamental choices You can use that money to

invest in the business things like expanding your X ray

mine or running in R and D Yet to make

a better caramel density ofthe center Or you can give

the money to shareholders in the form of a special

dividend which means giving them cash as a reward for

well holding the stock So what do your shareholders think

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

one of your shareholders Polly Favor is sitting pretty Her

other investments are going well Her second trust fund just

vested and she miraculously just won the national lottery in

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

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

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

He got divorced last year and owes a lot of

child support both to his ex wife and his former

mistress Meanwhile his other investments have all gone south and

he lost a ton of money in an unsuccessful attempt

Teo Rig the National Lottery of Mozambique He really needs

the money The cash Today baby He asks you to

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

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

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

in and commit whatever profit is needed to run those

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

a dividend so your staff crunches the numbers and decides

that well If you buy another Ray excrete ER for

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

next year like 250 grand And meanwhile if you invest

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

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

other possible project has unexpected return of only 7% or

less Well meanwhile your nerd crew determines that capital markets

would return 8% over the coming year And all this

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

8% interest on that loan Or if you loaned money

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

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

8% return on your money well you might as well

just loan the money out or give in to your

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

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

a 25% of year return for a long time I

mean it gets you 250 grand by the end of

the year and then another 200 50 grand then next

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

Ray X Streeter has all kinds of other values for

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

return 25 per cent away better than eight You also

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

the VD three p As you call it you expect

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

grand in profits next year and then 600 next and

600 than next And then the value will go up

and however you do the math at 15% is way

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

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

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

You give that out in dividends So Polly is a

little disappointed because she wanted to keep the money and

invested But she takes the extra money you give her

and loans it out on her own at 8% interest

It therefore gives her the same return as she would

have gotten from keeping the money with your company You

already invested in all your high return projects The best

the company could have done with that money is earned

8% at least return in the capital markets The same

thing that Polly is going to get returned to her

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

matter whether she has the money or the company has

the money Meanwhile already is bummed He needed that extra

money bad but he still has access to the money

he needs He can go into the capital markets and

borrow it at 8% interest He can just give Holly

a call and Violet from her like why not Okay

but how is already gonna pay the money back Wealthy

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

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

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

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

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

return would have returned to them had they invested it

in a lesser return project So next year come dividend

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

can use to pay down debt Unless the company can

invested at a higher rate than the vanilla capital market

rate at which point then already will just roll over

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

year and let the company or in a higher return

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

The company will take a CZ much profit as it

needs to run its high return projects anything more than

it could get by just loaning out the money at

interest rates or investing it in some analogous project Everything

else then goes to shareholders with shareholders Stay happy because

they can just use the capital markets to make up

the difference in investment returns If they wanted less money

they could loan out the extra if they wanted more

than they can borrow what they need Meanwhile if company

needs more money it can borrow it as well Like

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

the capital markets are paying 8% again but you have

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

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

at 8% interest and pay it back after the investments

return At least 15% right borrow it ate Earn it

15 You end up pocketing 7% on the plus side

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

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

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

borrow money if they need it Meanwhile the money invested

with you makes an above market return and a key

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

investments are finance whether by dead or cash or stock

whatever it is they have in their coffers And if

things get too bad for Artie well he can always

sell his stock and treat not trick ink right Well

the sale will give him plenty of money for child

support and for legal costs related to the charges of

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

story