THE INVESTMENT DECISION OF THE FIRM UNDER UNCERTAINTY AND THE ALLOCATIVE EFFICIENCY OF CAPITAL MARKETS*

Abstract

FISHER (9) DEMONSTRATED that in a perfect capital market under certainty the optimal investment decision is to maximize the market value net of input. Value maximizing decisions are unanamimously preferred by the owners of the firm and imply a Pareto optimal allocation of resources. Debreu (3) and Arrow (1) generalized Fisher's results to complete and perfect markets under uncertainty. Sharpe (24), Lintner (16), Mossin (19) and Fama (7) developed the capital asset pricing model, and investment criteria for value maximizing firms in capital markets satisfying the assumptions of the capital asset pricing model were derived by Lintner (16), Tuttle and Litzenberger (26), Mossin (20) and Hamada (10). Recently, however, the optimality of value maximizing decisions outside perfect and complete markets, that is, outside the worlds of Fisher, Debreu and Arrow, has been questioned in a number of papers, including Stiglitz (25), Jensen and Long (12), Fama (8), Wilson (29), Ekern (5), Ekern and Wilson (6), Leland (14), and King (13). They argue that value maximizing decisions are not Pareto optimal. Furthermore it is argued that value maximizing decisions are not preferred by the owners of the firm. Instead there exist decisions different from value maximization that are unanimously preferred by all owners of the firm. In addition there are natural incentives for management to make the decisions unanimously preferred. This paper is addressed the question of whether value maximizing decisions are optimal decisions or whether there exist decisions different from value maximization that are unanimously preferred. Though many different explanations are provided for the purported non-optimality of value maximizing decisions' it is our