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

Author

Listed:
  • Prashanth Mahagaonkar

    (Max Planck Institute of Economics, EGP Group, Jena, Germany)

  • Jianying Qiu

    (Max Planck Institute of Economics, EGP Group, Jena, Germany)

Abstract

In this paper, we experimentally test the Modigliani-Miller theorem. Applying a general equilibrium approach and not allowing for arbitrage among firms with different capital structure, we are able to address a question fundamental to the valuation of firms: does capital structure affect the value of the firm? If so, how? We find that, consistent with the Modigliani-Miller theorem, experimental subjects well recognized the increased systematic risk of the equity with increasing leverage and accordingly demanded higher rate of return. Yet, this adjustment was not perfect: subjects underestimated the systematic risk of low leveraged equity whereas overestimated the systematic risk of high leveraged equity, resulting in a U shape weighted average cost of capital.

Suggested Citation

  • Prashanth Mahagaonkar & Jianying Qiu, 2008. "Testing the Modigliani-Miller theorem directly in the lab: a general equilibrium approach," Jena Economics Research Papers 2008-056, Friedrich-Schiller-University Jena.
    • Handle: RePEc:jrp:jrpwrp:2008-056
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    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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