Financial Economics

3

CREATING WEALTH BY INVESTING IN PRODUCTIVE OPPORTUNITIES

In this chapter we study how management can invest in firms so as to create wealth and thus enhance individuals' satisfaction. We first study proprietary firms in which the owner and manager are the same person. Then we consider productive firms with many owners. In both cases the firms make investment and financing decisions that can augment the wealth positions of their owners.

We shall see that in a perfect capital market management can maximize the wealth of a firm's owners by using a rule called the market value rule. This rule requires management to make decisions that maximize the market value of the firms they operate. After studying the details of how market value is maximized, we conclude the chapter by stating important generalizations, called separation principles, that both define the task of financial management and provide insight into how that task can best be performed.

3.1 THE ENTREPRENEURIAL FIRM—PRODUCTION AND INVESTMENT DECISIONS

A firm with a single owner-manager can be regarded as a wealth-creating device capable of increasing its owner's well-being so long as the firm is properly operated. Proper operation means setting production and financing decisions in such a way as to maximize the owner's wealth. We begin by assuming the entrepreneur has knowledge of a production technology. An initial supply of resources is also available that can either be sold for cash or used in a productive process whose ...