SERVING THE QUANTITATIVE FINANCE COMMUNITY

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Posts: 23951
Joined: September 20th, 2002, 8:30 pm

### The most foolish theorem ever...

Yes, quality is a big issue. But can the scientist predict the quality? Can anyone predict the quality? How many people thought they were Faradays? What is the correlation coefficient between the scientist's prediction of quality and actual economic results? I'd wager it's extremely low (R^2<0.01), especially if you subtract the accumulated grant money, risk-adjusted interest payments on grants, and equity/incentive payments to the scientist.The Faraday example is a very good one on three levels. First, at what point in time did Faraday's ideas generate, say, $1 billion profits? It took decades to commercialize his inventions and more than a century to reach wide-spread adoption. Had Faraday been granted incentive payments, he'd have seen nothing (he had been dead for 13 years by the time Edison electrified a tiny part of New York City).Second, we got Faraday's results without any added incentives. If we can get more Faradays just by offering grant money, tenure-track jobs, and the occasional Nobel Prize, then why offer more?Third, if I give you$1 billion for incentivized science, then can you or anyone guarantee me a Faraday (= someone whose invention generates either: $1.5 billion of after-tax profits if I have to wait 5 years for profitability or$4.7 billion of profits if I have to wait 20 years; or $47 billion in profits if "my Faraday" gets results that take 50 years to commercialize)? And if my$1 billion doesn't buy a guaranteed Faraday, then take 1/(P(Faraday)) and multiply it by those require payoff figures. P.S. I do agree that quality matters, but it's not clear that scientific quality can be usefully increased because it's not observable until decades or centuries after the discovery.
Last edited by Traden4Alpha on January 28th, 2010, 11:00 pm, edited 1 time in total.

hamster
Posts: 216
Joined: October 12th, 2008, 3:51 pm

### The most foolish theorem ever...

QuoteOriginally posted by: daveangelQuoteOriginally posted by: BullBearQuoteOriginally posted by: daveangelso what is the problem mr bullbear ?A)1. leverage2. dumb assumptions................B)Taxes: The theorem uses the lousy regulation on corporate taxes to show how to screw the State in favor of corporations, i.e., wealth transfer from the State/individuals to Corporations!C)I can try to reformulate [metaphorically] the theorem to a more current theme, as follows:Consider 2 otherwise equally "wealthy" countries:a. Country A with no debt [e.g. China]b. Country B almost bankrupt and hence with a pile of debt [e.g. UK]Theorem: The debt/savings mix is irrelevant when an investor is deciding where to put his money / savings... So an investor should be indifferent while choosing to invest his savings in China or in the UK.I think you have a fundamental misunderstanding of M&M I (or more likely you dont and are just trying to be provocative). all this says is that the value of a firm or enterprise is independent of the way it is financed. the firm consists of assets (factories, people, brands) on the one side and liabilities and equity on the other. if there are no taxes and bankruptcy laws then the lhs (asset side) is independent of the mix of equity and debt. in most places interest expense comes above the line ie it is tax deductible meaning that there is an advantage to issuing bonds and int he limit the fim should be 100% debt financed. bankruptcy laws give the debt holders valuable rights but also give equity holders significant optionality. In reality, the conditions udner which M&M I hold cannot be observed anywhere so it is a moot theorem. however, it is a good framework to udnerstand capital structure.I agree 100% with daveangel.here is an alternative hypothesis to mm. It is about ownership and control. if you are equity holder you are owner of the firm and controls it, e.g. fire the manager. the debt and mezz holder disclaim control in exchange for fixed payments whereas rates depends on seniority. if you tell the manager to issue secured debt or some mezz you are increasing the probabilty of loosing ownership and control in exchange for higher average/exspected ROE. The residual payments to the equity fluctuates like hell, the more leverage, i.e. it is more likely you hit threshold of negative equity value. thus equity holder might feel pressured to influence manager's decision regarding buying, selling, enhancing, servicing, valuating the firm's assets. ie at the boundary equity/assets -> 0 the asset value become dependent of the capital structure. bullbearA) you might click here http://www.jstor.org/stable/1809766 and look at the date. 1958 !!! Half a century ago !!! Actually the first thoughts about worth of assets and the capital structure were made by Williams in the 30s. Whatever. the good point is that MM list all their ("dumb") assumptions. it is commonly known that assumptions are not the reality, many people spent a couple of decades relaxing them. B) you are little bit right. Why are interest payments to debt and mezz considered as costs? An accountant might explain it to you. But dont ask why. Accounting rules prefer equity holders. I suspect bcoz of historical reasons assuming equity holders are always entrepreneurs. Another reason is our monetary system which requires an incentive to borrow money. C) indeed debt/savings is irrelevant bcoz savings=debt. you have to invest savings (otherwise it's called hoarding=useless cash) what is mainly offering credit to someone else at the end of the day. even if people of one territory invest their savings somewhere around the world, they can use their capital income to pay taxes in order to serve their public debt at home. you might try the value of exspected GNP instead of savings.

quantmeh
Posts: 5974
Joined: April 6th, 2007, 1:39 pm

### The most foolish theorem ever...

QuoteOriginally posted by: hamsterhere is an alternative hypothesis to mm. It is about ownership and control. if you are equity holder you are owner of the firm and controls it, e.g. fire the manager. the debt and mezz holder disclaim control in exchange for fixed payments whereas rates depends on seniority. if you tell the manager to issue secured debt or some mezz you are increasing the probabilty of loosing ownership and control in exchange for higher average/exspected ROE. The residual payments to the equity fluctuates like hell, the more leverage, i.e. it is more likely you hit threshold of negative equity value. thus equity holder might feel pressured to influence manager's decision regarding buying, selling, enhancing, servicing, valuating the firm's assets. ie at the boundary equity/assets -> 0 the asset value become dependent of the capital structure. did you study M&M? these things are all discussed in conjunction with the theorem

exneratunrisk
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Joined: April 20th, 2004, 12:25 pm

### The most foolish theorem ever...

Last edited by exneratunrisk on January 29th, 2010, 11:00 pm, edited 1 time in total.

hamster
Posts: 216
Joined: October 12th, 2008, 3:51 pm

### The most foolish theorem ever...

QuoteOriginally posted by: jawabeandid you study M&M? these things are all discussed in conjunction with the theoremi didnt claim something new...

Posts: 23951
Joined: September 20th, 2002, 8:30 pm

### The most foolish theorem ever...

Exner,Exactly! An innovator that wants to stay independent does face challenges in financing. Most banks and other debt providers will (should!) expect substantive collateral in the form of resalable long-term assets. If banks don't do this, then the banks are de facto equity investors who has given the innovator a free call option! (That's nice for the innovator but not so good for systemic risks to the financial system.) True equity investors rightfully dilute the innovator's ownership by taking a slice of the upside in return for non-negligible risk-of-zero-recovery. Moreover, given the moral hazard and information asymmetries of the situation, any outside investor SHOULD demand an outsized claim on the assets and/or equity or the innovator.If your capital needs are modest as a percentage of near-term revenues, then tactics that modify the cash-to-cash cycle will help. Anything you can do to delay payments to suppliers or accelerate payments from customers will let your reallocate working capital to capex. Your sales of "little beautiful colored pieces of paper" are a good example of this.

hamster
Posts: 216
Joined: October 12th, 2008, 3:51 pm

### The most foolish theorem ever...

QuoteOriginally posted by: torontosimpleguyThe point is that M&M don't talk about time horizon in debt financing.When we talk about 'infinite' time horizon then cash outflow to serve the debt will eventually exceed the cash inflow from the business activity.the going concern assumption makes life easier bcoz it allows to plug perpetual into a model. e.g. you cannot reason going concern for structured products, project financing, etc... common sense ...

BullBear
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### The most foolish theorem ever...

BullBear
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### The most foolish theorem ever...

QuoteOriginally posted by: Traden4AlphaAnd I'll go a step further. The real innovations that we need are not scientific, at least not in the hard sciences. Instead, we need innovations in management. Too much of modern management practice (what those nasty MBAs do) is based on 18th and 19th century paradigms of the industrial revolution. I totally disagree. What we need is to:a. go back to the Entrepeneurial MBA paradigm.b. more real innovations in science - the kind of innovations that produce wealth for society. We'll always need this kind of innovation.What we really don't need are:a. Economists - this class is responsible for such a mess we live in. They know nothing. What's the purpose of Economists?b. Quants - we don't need quant finance. We need to get rid of quant finance and gambling. Since this is a Quant forum I'll be under attack but I'm sorry this is my view. But don't get me wrong. We really need the skills of the Quants in lots of subjects. Quantitative degrees are useful it's just that they're in the wrong place...

list
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Joined: October 26th, 2005, 2:08 pm

### The most foolish theorem ever...

With MMT it difficult to believe that M&M did not clear understand the essence of its statement.They did talk about firms cost that assume to counterparties. Buying a firm investor purchases both E + D. If firm owners agree with the buyer price then we arrive at the MMT. On the other hand firms seller price is E  D that can be either positive or negative. In such broad problem that looks even broader than setting defined by demand-surplus the market price could be thought as a settlement price between the lower and upper boundaries which are defined by the seller and buyer prices, i.e. from the interval [ E  D , E + D ].

Posts: 23951
Joined: September 20th, 2002, 8:30 pm

### The most foolish theorem ever...

Last edited by Traden4Alpha on January 30th, 2010, 11:00 pm, edited 1 time in total.

quantmeh
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### The most foolish theorem ever...

QuoteOriginally posted by: BullBeara. Economists - this class is responsible for such a mess we live in. They know nothing. What's the purpose of Economists?i bet you didn't study Economics

BullBear
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### The most foolish theorem ever...

Last edited by BullBear on January 30th, 2010, 11:00 pm, edited 1 time in total.

BullBear
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### The most foolish theorem ever...

Last edited by BullBear on January 30th, 2010, 11:00 pm, edited 1 time in total.

BullBear
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