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Class 1 : Consumption-Investment Model and Fisher Separation Theorem

1. Graphically demonstrate the Fisher Separation Theorem for the case where an
individual end up lending in financial markets. Label the following points:
- Initial wealth, Wo
- Optimal production/investment (Po, P1)
- Optimal consumption (Co*, C1*)
- Present value of final wealth, Wo*
2. Graphically analyze the effect of an exogenous decrease in the interest rate on:
a) utility of borrowers and lenders
b) the present wealth of borrowers and lenders
c) the investment in real asset
3. Suppose your production opportunity set in a world with perfect certainty consists
of the following possibilities:
Project

Investment outlay

Rate of return

$ 1,000,000

8%

1,000,000

20

2,000,000

3,000,000

30

a) Graph the production opportunity set in a Co, C1 framework.

b) If the market rate of returns is 10%, draw the capital market line for the optimal
investment decision.

4. Assume a framework of one period under full certainty where transaction take place
at the beginning of the period and the firm is liquidated at the end of the period. Past
investment will give the firm income at the beginning of the period (time to) in an
amount equal to Xo = 10,000. If no additional investment takes place at time to,
then the income at the end of the period (time t 1) will be X1 = 5,000. However, if
new investment is made at time to, the income at t 1 will be X1 = 5,000 + X1 ,
where X1 is the return (at t1) on the investment that was made at to. The lending and
borrowing rate is 20%. The firm is fully equity financed and it has no liabilities. The
firm faces the following investment projects - all independent of one another:
Project
Investment at to
Return at t1

800 1,500

700

2,300

400

350

1,000

1,200 1,600

800

3,200

600

500

1,400

a) If the firm makes no investment at the current time (time to), what is the total value
of the firm?
b) Which investment projects should the firm undertake and which should it reject?
What is the total investment at t1? What is the total value of the firm after making the
investment?
c) Suppose the firm distributes all its income except amount allocated to new
investment to stockholders as dividends. If no investment is made at the current time,
what will be the current dividend (Do) and the end-of-period dividend (D 1)? Using
the PVC of dividends what is the present value of this dividend stream and how does
it compare with the market value of the firm?
d) Now suppose the firm undertakes and invest in all of the profitable investment
projects. If the firm does not engage in any borrowing, what is the current dividend
(Do) and future dividend (D1)? Using the PV of dividends what is the value of the
firm in this case?
e) It is known that stockholders prefer higher dividend at to. In order to satisfy the
stockholders the firm decides to borrow 5,000 at time to. The money will be used to
finance the investment and any-leftover will be distributed as dividends. What are Do

and D1 in this case? What is the value of the firm? Compare your answers to parts c)
and d).
f) Suppose now that the market is imperfect and the firm and stockholders cannot
borrow at all, but they can lend at 20%. The firm decides to pay out Do = 8,250.
What investment does it make? What is D1? Does the dividend policy affect the value
of the firm in this case? Why? Can you indicate the optimum dividend policy?

g) Suppose now that the firm can borrow and lend money. However, for each 100 (or
a fraction of 100) that it borrows, it also pays (as well as the 20% interest)
transaction costs (banker's fee or commission) of 10. The stockholders do not face
such a transaction cost. What projects would you suggest the firm to undertake? What
is the NPV of the firm if it pays out Do = 8,250? Is dividend policy relevant in this
case? If yes, what is the optimal dividend policy? Illustrate your answer graphically.
Assume the stockholders cannot borrow from or lend to the firm.