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

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  • Jianying Qiu

    (Department of Economics, University of Innsbruck SOWI Building, Universitaetstrasse 15 6020 Innsbruck, Austria // Max Planck Institute of Economics, ESI Group, Kahlaische Str. 10, D-07745 Jena, Germany)

  • Prashanth Mahagaonkar

    (Max Planck Institute of Economics, EGP Group, Kahlaische Str. 10, D-07745 Jena, Germany // Schumpeter School of Business and Economics, University of Wuppertal, Germany)

Abstract

In this paper, we directly test the Modigliani-Miller theorem in the lab. Applying a general equilibrium approach and not allowing for arbitrage among firms with different capital structures, we are able to address this issue without making any assumptions about individuals' risk attitudes and initial wealth positions. We find that, consistent with the Modigliani-Miller theorem, experimental subjects well recognized the increased systematic risk of equity with increasing leverage and accordingly demanded higher rate of return. Furthermore, the correlation between the value of the debt and equity is -0.94, which is surprisingly comparable with the -1 predicted by the Modigliani-Miller theorem. Yet, a U shape cost of capital seems to organize the data better.

Suggested Citation

  • Jianying Qiu & Prashanth Mahagaonkar, 2009. "Testing the Modigliani-Miller theorem directly in the lab: a general equilibrium approach," Schumpeter Discussion Papers sdp09006, Universit├Ątsbibliothek Wuppertal, University Library.
  • Handle: RePEc:bwu:schdps:sdp09006
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    Keywords

    The Modigliani-Miller Theorem; Experimental Study; Decision Making under Uncertainty; General Equilibrium;

    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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