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An Analysis of the Conditions for the Validity of Modigliani-Miller Theorem with Incomplete Markets

  • Gottardi, Piero

In this paper we investigate the consequences of the firms' financial decisions in the framework of a perfectly competitive general equilibrium model with incomplete markets. When markets are complete or there are no derivative securities (such as options, forwards or futures) written on the firms' shares, these decisions are irrelevant. This result reaffirms and qualifies the original claim by Modigliani and Miller. On the other hand, if markets are incomplete, we show that in the presence of any type of derivative security a change in the capital structure of a firm will modify, generically, both the real equilibrium allocation and the value of the firm. The reason is that the payoff of the derivative securities is affected in a non-linear way by changes in the firm's financial policy; thus the set of the agents' insurance opportunities is also modified.

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Article provided by Springer in its journal Economic Theory.

Volume (Year): 5 (1995)
Issue (Month): 2 (March)
Pages: 191-207

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Handle: RePEc:spr:joecth:v:5:y:1995:i:2:p:191-207
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