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Testing the Modigliani-Miller theorem directly in the lab

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  • M. Levati
  • Jianying Qiu
  • Prashanth Mahagaonkar

Abstract

We present an experiment designed to test the Modigliani-Miller theorem. Applying a general equilibrium approach and not allowing for arbitrage among firms with different capital structures, we find that, in accordance with the theorem, participants well recognize changes in the systematic risk of equity associated with increasing leverage and, accordingly, demand higher rate of return. Yet, this adjustment is not perfect: subjects underestimate the systematic risk of low-leveraged equity whereas they overestimate the systematic risk of high-leveraged equity, resulting in a U-shaped cost of capital. A (control) individual decision-making experiment, eliciting several points on individual demand and supply curves for shares, provides some support for the theorem. Copyright The Author(s) 2012

Suggested Citation

  • M. Levati & Jianying Qiu & Prashanth Mahagaonkar, 2012. "Testing the Modigliani-Miller theorem directly in the lab," Experimental Economics, Springer;Economic Science Association, vol. 15(4), pages 693-716, December.
    • Handle: RePEc:kap:expeco:v:15:y:2012:i:4:p:693-716
    DOI: 10.1007/s10683-012-9322-z
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    Cited by:

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    2. Neugebauer, Tibor & Shachat, Jason & Szymczak, Wiebke, 2023. "A test of the Modigliani-Miller theorem, dividend policy and algorithmic arbitrage in experimental asset markets," Journal of Banking & Finance, Elsevier, vol. 154(C).
    3. Arturo Macias, 2022. "Capital structure irrelevance in the laboratory: an experiment with complete and asymmetric information," Experimental Economics, Springer;Economic Science Association, vol. 25(5), pages 1418-1440, November.
    4. Jacob LaRiviere & Matthew McMahon & William Neilson, 2018. "Shareholder Protection and Agency Costs: An Experimental Analysis," Management Science, INFORMS, vol. 64(7), pages 3108-3128, July.
    5. Karlo Kauko, 2016. "Does Opaqueness Make Equity Capital Expensive for Banks?," Revista de Economía del Rosario, Universidad del Rosario, vol. 17(2), pages 203-227, February.

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    More about this item

    Keywords

    Modigliani-Miller theorem; Experiments; Decision making under risk; General equilibrium; G32; C91; G12; D53;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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