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

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  • Gottardi, Piero

Abstract

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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  • Gottardi, Piero, 1995. "An Analysis of the Conditions for the Validity of Modigliani-Miller Theorem with Incomplete Markets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 5(2), pages 191-207, March.
  • Handle: RePEc:spr:joecth:v:5:y:1995:i:2:p:191-207
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    Cited by:

    1. Atesagaoglu, Orhan Erem & Carceles-Poveda, Eva, 2015. "On the irrelevance of financial policy under market incompleteness and trading constraints," Economics Letters, Elsevier, vol. 136(C), pages 125-128.
    2. Yann Algan & Olivier Allais & Eva Carceles-Poveda, 2009. "Macroeconomic Effects of Financial Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 678-696, October.
    3. Dahai Yu, 1998. "Two equivalence theorems for government finance," International Finance Discussion Papers 622, Board of Governors of the Federal Reserve System (U.S.).

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