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

Prashanth Mahagaonkar and Jianying Qiu
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Prashanth Mahagaonkar: Max Planck Institute of Economics, EGP Group, Jena, Germany

No 2008-056, Jena Economics Research Papers from Friedrich-Schiller-University Jena

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.

Keywords: Modigliani-Miller Theorem; Experimental Study; Decision Making under Uncertainty; General Equilibrium (search for similar items in EconPapers)
JEL-codes: C91 D53 G12 G32 (search for similar items in EconPapers)
Date: 2008-07-08
New Economics Papers: this item is included in nep-exp
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Related works:
Working Paper: Testing the Modigliani-Miller theorem directly in the lab: a general equilibrium approach (2009) Downloads
Working Paper: Testing the Modigliani-Miller theorem directly in the lab: a general equilibrium approach (2009) Downloads
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