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

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  • Jianying Qiu
  • Prashanth Mahagaonkar

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," Working Papers 2009-12, Faculty of Economics and Statistics, Universität Innsbruck.
    • Handle: RePEc:inn:wpaper:2009-12
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    References listed on IDEAS

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    1. Shleifer, Andrei & Vishny, Robert W, 1997. "The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
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    More about this item

    Keywords

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