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Testing the Modigliani-Miller theorem directly in the lab

Author

Listed:
  • M. Vittoria Levati

    (Max Planck Institute of Economics, Jena - Strategic Interaction Group)

  • Jianying Qiu

    () (Department of Finance, University of Vienna)

  • Prashanth Mahagaonkar

    (Max Planck Institute of Economics, Jena - Entrepreneurship, Growth and Public Policy Group)

Abstract

We present an experiment designed to test the Modigliani-Miller theorem. Applying a general equilibrium approach and not allowing for arbitrage among firms with different capital structures, we find that, in accordance with the theorem, participants well recognize changes in the systematic risk of equity associated with increasing leverage and, accordingly, demand higher rate of return. Yet, this adjustment is not perfect: subjects underestimate the systematic risk of low-leveraged equity whereas they overestimate the systematic risk of high-leveraged equity, resulting in a U-shaped cost of capital. A (control) individual decision-making experiment, eliciting several points on individual demand and supply curves for shares, provides some support for the theore

Suggested Citation

  • M. Vittoria Levati & Jianying Qiu & Prashanth Mahagaonkar, 2011. "Testing the Modigliani-Miller theorem directly in the lab," Jena Economic Research Papers 2011-021, Friedrich-Schiller-University Jena.
  • Handle: RePEc:jrp:jrpwrp:2011-021
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    References listed on IDEAS

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    Cited by:

    1. Karlo Kauko, 2016. "Does Opaqueness Make Equity Capital Expensive for Banks?," REVISTA DE ECONOMÍA DEL ROSARIO, UNIVERSIDAD DEL ROSARIO, vol. 17(2), pages 203-227, February.

    More about this item

    Keywords

    Modigliani-Miller theorem; Experiments; Decision making under risk; 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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