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daveangel
Posts: 17031
Joined: October 20th, 2003, 4:05 pm

### The most foolish theorem ever...

QuoteOriginally posted by: torontosimpleguyQuoteOriginally posted by: daveangelforget about the "smart" investor - we are talking about a world where M&M assumptions hold.I think I explained myself clearly. Debt can't be equal to equity since they have different "mathematical properties."One is growing exponentially, another is not (actually much slower than an exponent).P.S. It is difficult to talk with non-mathematicians though they also want to create their own "theorems." i am afraid the paucity of your argument is revealed when you have to fall back on to this sort of statement.never mind the exponential nature of debt. there is no reason why the debt issued by company B should trade away from the asset value. if it traded below then "smart" investors would buy the debt and convert to equity if the so choose. similarly, if the debt trades above asset value then many more smart entrepeneurs would set up widget factories and sell debt to finance them. its called arbitrage.
Last edited by daveangel on February 4th, 2010, 11:00 pm, edited 1 time in total.
knowledge comes, wisdom lingers

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

QuoteOriginally posted by: torontosimpleguyQuoteOriginally posted by: daveangelforget about the "smart" investor - we are talking about a world where M&M assumptions hold.I think I explained myself clearly. Debt can't be equal to equity since they have different "mathematical properties."One is growing exponentially, another is not (actually much slower than an exponent).P.S. It is difficult to talk with non-mathematicians though they also want to create their own "theorems." No one is claiming strict equivalence of debt and equity in every respect. MMT only claims equivalence debt and equity on the basis of present value on the balance sheet.Yes, debt and equity both have a distribution of outcomes. Both debt and equity have a lower-bound outcome of zero (i.e. total loss of capital). Debt's distribution has a strict upper bound, equity's distribution does not. Given that asymmetry, I'm not sure how you can claim that debt (which is upper-bounded) must grow without bounds and equity (which is not upper bounded) doesn't grow without bounds.The contractual claim that debtholders have on assets means much less than you think. In an MMT world, a company can liquidate (voluntarily or involuntarily) at any time, sell all assets at full book value, and distribute the proceeds to debtholders and equity investors (with debtholders having priority). That is, equity holders are repaid A-D.This exponential nature of debt is a red herring. You're assuming that the company perpetually rolls all interest payments into additional accumulating debt. Why can't a company borrow $1,000,000 in perpetuity and make periodic interest payments to the debtholder in perpetuity?At worst, the only issue with the so-called exponential nature of debt growing without bounds is that you've established a mechanism by which firms inevitably go bankrupt (i.e., they promise debtholders a higher rate of return than can be sustained by growth in assets and retained earnings). torontosimpleguy Posts: 1011 Joined: July 12th, 2004, 5:51 pm ### The most foolish theorem ever... QuoteOriginally posted by: Traden4AlphaI'm not sure how you can claim that debt (which is upper-bounded) must grow without bounds and equity (which is not upper bounded) doesn't grow without bounds.Actually to be precise, I should better define parameters. Due to 'accounting convention,' the company's value (V) is equal to assets (A) plus 'goodwill' (G). Company's value (V) is determined through idea of 'going concern.'So, it's not about equity per se; it's about company's value. Equity is just a residual claim (i.e., company's value minus debt).E = V - DDebt (D) is growing exponentially, company's value (V) is growing much slowly, equity (E) evaporates. torontosimpleguy Posts: 1011 Joined: July 12th, 2004, 5:51 pm ### The most foolish theorem ever... You, guys, can continue to believe in that M&M nonsense. But as I said before this "foolish" theorem is destroying the very fabric of sound economy. As a rule, companies should be financed through equity and not debt.I am better to finish here. Don't want to continue arguing with "charlatans." daveangel Posts: 17031 Joined: October 20th, 2003, 4:05 pm ### The most foolish theorem ever... Quote Don't want to continue arguing with "charlatans." Yes - I think the moral high ground is a good place to try and get to, especially if you don't have a leg to stand on. knowledge comes, wisdom lingers list Posts: 2041 Joined: October 26th, 2005, 2:08 pm ### The most foolish theorem ever... Quote--------------------------------------------------------------------------------Originally posted by: listMMT does not deal with dynamics. It is an algebra relationship and any reference on growth or exponential are irrelevant. The question is whether or not : price of a company = E + D at any t or price of a company = Cost ( t , E , D ) and nothing else.--------------------------------------------------------------------------------What is the company's value? It is determined through dynamics (a "going concern" concept). -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------I afraid that "It is determined through dynamics (a "going concern" concept). " is rather insufficient for a formal definition. From my point of view that it also could be far from perfect we first need to specify setting or broadly saying we need something assume in order to state. Price as a notion used in different senses. In more broad sense it is defined as settlement between bid and ask in other words surplus vs demand. But that implies market existence. I think that there is no real market for companies. Therefore companies price looks like a heuristic. Investors at t subjectively estimate their benefits at T rather than their future cash profit at T. Their benefits are more broad notion to embed it into pure cash over [ 0 , T ]. Traden4Alpha Posts: 23951 Joined: September 20th, 2002, 8:30 pm ### The most foolish theorem ever... QuoteOriginally posted by: torontosimpleguyQuoteOriginally posted by: Traden4AlphaI'm not sure how you can claim that debt (which is upper-bounded) must grow without bounds and equity (which is not upper bounded) doesn't grow without bounds.Actually to be precise, I should better define parameters. Due to 'accounting convention,' the company's value (V) is equal to assets (A) plus 'goodwill' (G). Company's value (V) is determined through idea of 'going concern.'Technically, goodwill is an accounting kludge used only during M&A to cover for the fact that the buyer often pays far more than the book value. Most firms have negligible "goodwill" even if their market cap is far far above their balance sheet equity levels (e.g., look at AAPL which as E =$35 billion and V = $175 billion). But if that high marketcap firm were acquired, then the discrepancy between the purchase price and the balance sheet value of E would appear as G in the merged firm.Note that I'm on your side (I think) on this aspect of this. Accounting does a really bad job of valuation. Most of the value of a firm (a going concern) is in the relationship and management of the pieces, not the pieces themselves. Accounting can tell you the value of the parts (and is great for keeping track of costs and revenues), but its utterly clueless at estimating the value of the connections.QuoteOriginally posted by: torontosimpleguyDebt (D) is growing exponentially, company's value (V) is growing much slowly, equity (E) evaporates.I have no idea where you get this idea that debt grows faster than V. What "theory" tells you that this must be so? The mathematical structure of debt implies that it grows slower than the real interest rate specified in bond. That is, the debtholder will generally earn less than the stated interest rate. Last edited by Traden4Alpha on February 4th, 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: torontosimpleguyQuoteOriginally posted by: daveangelDo you think that an investor in a world where M&M conditions hold will pay more than$1000 for the equity in A or buy the debt issued by company B for less than $1000 ?"Smart" investor wouldn't invest in company with debt structure as I said (long-term zero-coupon bond). It's because equity of this company will evaporate.forget about the "smart" investor - we are talking about a world where M&M assumptions hold.- assume a world without any economic growth, a zero sum game. there is a fixed set of business activities that generate utility, consumers are willing to pay for, thus allowing the business activities to generate operative profits and losses. on average all business activities generate profits of 0. - the business activities are bundled as "firms". the firms are allowed to issue debt and equity securities (if you like they might also issue all kind of mezz as well). the debt holder get a fixed coupon and may enforce liquidation, ie debt holder might loose some principals. and equities get all residual profits or are the loss piece in case of liquidation. - if debt holder receive coupons they are pressured to reinvest (or to consume). or the lucky equity holder who received nice dividends? what they will buy? debt or equity securities? are the desired securities available or affordable? at which unattractive security price it makes sense to consume? Last edited by hamster on February 4th, 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: torontosimpleguyQuoteOriginally posted by: daveangelforget about the "smart" investor - we are talking about a world where M&M assumptions hold.I think I explained myself clearly. Debt can't be equal to equity since they have different "mathematical properties."One is growing exponentially, another is not (actually much slower than an exponent).P.S. It is difficult to talk with non-mathematicians though they also want to create their own "theorems." you are assume that debt never defaults. you might ask gm pension funds. in case of bankruptcy the equity tranche cannot shrink less than 0, thus the rate remains 0 _____psssss_________psssss______________........... whereas the debt might continue to grow negatively. | | | . . . |\|/think about that. gardener3 Posts: 1496 Joined: April 5th, 2004, 3:25 pm ### The most foolish theorem ever... QuoteOriginally posted by: torontosimpleguyQuoteOriginally posted by: gardener3QuoteOriginally posted by: torontosimpleguyQuoteOriginally posted by: gardener3For the debtholder to reinvest the interest payments in the form of new debt they need to find new assets or companies to lend.Nope. It is a 'hidden' assumption. One can, for example, envision zero-coupon bond as a debt.What's a hidden assumption? How does envisioning a zero coupon bond make things different?Easy ... 1. It means you assumed that there are interest payments. I assume that there are none since M&M didn't list that assumption. 2. Look at my mathematical example with 2,000 years term and 5% annual interest.THis is not complicated. Interest is the same as a zero rolled over each period. The problem is you assume compounding of interest when in the M&M world there are no assets in the market with compounding cash flows. This doesn't mean that you cannot have infinite time horizon. What you will have is an annuity: 5% of$1 paid each year. If the long term disocunt rate is 2%, then your $1 debt is worth 2.5 not infinity. gardener3 Posts: 1496 Joined: April 5th, 2004, 3:25 pm ### The most foolish theorem ever... QuoteOriginally posted by: listIt is good that we begin to prove our opinion with numbers. Let me complete the above statement."For example no one will pay for the brand new car and the same car with break down$500 to fix the same price. If a buyer occurs be convinced to pay the same price it is only happened when he does not correctly interpret the notion piece"It actually how M&M probably interpret the essence of the Theorem. Indeed if a new car 30K = ( Equity + zero Debt ) is without 4 wheels which cost 1K (Debt) then we have 30K for new or 29 + 1 = ( E + D ) is a convenient illustration of the MMT from buyer point of view.Nevertheless, there does not exist a seller of the none zero debt car who thinks that without wheels he could sell the car for 30K because MMT states that his car price is E + D= 29 + 1. He thinks that the price is 29K = E based on common sense. And this is consistent with the buyer who also thinks that the price is the equity price and adding 1K he will get a brand new product. Thus the equation Price = E + D does not work for seller.This example does not perfect but it illustrates that the price 29K is the Equity and 1K does not actually the Debt. To present more accurate situation assume that seller fixed the problem but not paid yet. The E = 30 , D = 1. In contrast to above, buyer now disagrees to pay M&M price 31K = E + D and seller also understand that M&M is quite stupid price.An asset has value. Debt is a claim on an asset. On its own debt has no value. This is pretty basic that I don't see how anyone can fail to understand it.

KackToodles
Posts: 4100
Joined: August 28th, 2005, 10:46 pm

### The most foolish theorem ever...

QuoteOriginally posted by: listMMT does not deal with dynamics. It is an algebra relationship and any reference on growth or exponential are irrelevant. The question is whether or not : price of a company = E + D at any t or price of a company = Cost ( t , E , D ) and nothing else. it is also mainly an "ivory tower" idealization that has limit applicability in the real (dirty) world.

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

### The most foolish theorem ever...

the value of the equity securities E(.) is - the residual the asset value V(.) minus outstanding principal D, or E=V-D, and- given by a down and out barrier option, whereas the barrier and strike is B=0 (ie if debt is not backed by assets anymore)
Last edited by hamster on February 5th, 2010, 11:00 pm, edited 1 time in total.

torontosimpleguy
Posts: 1011
Joined: July 12th, 2004, 5:51 pm

### The most foolish theorem ever...

QuoteOriginally posted by: Traden4AlphaI have no idea where you get this idea that debt grows faster than V. What "theory" tells you that this must be so?I see that you like chess,Quote"It often happens that a player carries out a deep and complicated calculation, but fails to spot something elementary right at the first move." -- grandmaster Alexander Kotov --inscribed on gift chess sets given by Amaranth hedge fund. Here is the famous chess story that explains the power of exponential growth,QuoteWhen the creator of the game of chess (in some tellings an ancient Indian mathematician, in others a legendary dravida vellalar named Sessa or Sissa) showed his invention to the ruler of the country, the ruler was so pleased that he gave the inventor the right to name his prize for the invention. The man, who was very wise, asked the king this: that for the first square of the chess board, he would receive one grain of wheat (in some tellings, rice), two for the second one, four on the third one, and so forth, doubling the amount each time. The ruler, arithmetically unaware, quickly accepted the inventor's offer, even getting offended by his perceived notion that the inventor was asking for such a low price, and ordered the treasurer to count and hand over the wheat to the inventor. However, when the treasurer took more than a week to calculate the amount of wheat, the ruler asked him for a reason for his tardiness. The treasurer then gave him the result of the calculation, and explained that it would be impossible to give the inventor the reward. The ruler then, to get back at the inventor who tried to outsmart him, told the inventor that in order for him to receive his reward, he was to count every single grain that was given to him, in order to make sure that the ruler was not stealing from him.The amount of wheat is approximately 80 times what would be produced in one harvest, at modern yields, if all of Earth's arable land could be devoted to wheat.Wheat and chessboard problem
Last edited by torontosimpleguy on February 5th, 2010, 11:00 pm, edited 1 time in total.

GreekMartingale
Posts: 149
Joined: March 22nd, 2007, 10:08 pm

### The most foolish theorem ever...

M&M has been proven mathematically. In a simple one period general equilibrium model one can see this. In fact the contribution of M&M is not why debt policy doesn't, but why it does matter since the real world is far away from the assumptions.But my contribution to the list of stupid theorems, is the conjecture of Mr Sharpe, that everyone holds the market portfolio and the silent assumption behind any NPV, DCF etc that there is a perfectly correlated traded asset to the project under valuation and diversified equityholders holding claims to that project.