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Testing the Modigliani-Miller theorem directly in the lab: a general equilibrium approach

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Author Info
Prashanth Mahagaonkar (Max Planck Institute of Economics, EGP Group, Jena, Germany)
Jianying Qiu () (Max Planck Institute of Economics, EGP Group, Jena, Germany)

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Abstract

In this paper, we experimentally test the Modigliani-Miller theorem. Applying a general equilibrium approach and not allowing for arbitrage among firms with different capital structure, we are able to address a question fundamental to the valuation of firms: does capital structure affect the value of the firm? If so, how? We find that, consistent with the Modigliani-Miller theorem, experimental subjects well recognized the increased systematic risk of the equity with increasing leverage and accordingly demanded higher rate of return. Yet, this adjustment was not perfect: subjects underestimated the systematic risk of low leveraged equity whereas overestimated the systematic risk of high leveraged equity, resulting in a U shape weighted average cost of capital.

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Publisher Info
Paper provided by Friedrich-Schiller-University Jena, Max-Planck-Institute of Economics, Thueringer Universitaets- und Landesbibliothek in its series Jena Economic Research Papers in Economics with number 2008-056.

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Date of creation: 08 Jul 2008
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Handle: RePEc:jrp:jrpwrp:2008-056

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Related research
Keywords: Modigliani-Miller Theorem; Experimental Study; Decision Making under Uncertainty; General Equilibrium;

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Find related papers by JEL classification:
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Davenport, Michael, 1971. "Leverage and the Cost of Capital: Some Tests Using British Data," Economica, London School of Economics and Political Science, vol. 38(150), pages 136-62, May. [Downloadable!] (restricted)
  2. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March. [Downloadable!] (restricted)
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  3. Masulis, Ronald W., 1980. "The effects of capital structure change on security prices : A study of exchange offers," Journal of Financial Economics, Elsevier, vol. 8(2), pages 139-178, June. [Downloadable!] (restricted)
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