IDEAS home Printed from https://ideas.repec.org/p/jrp/jrpwrp/2011-021.html
   My bibliography  Save this paper

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 Economics Research Papers 2011-021, Friedrich-Schiller-University Jena.
    • Handle: RePEc:jrp:jrpwrp:2011-021
    as

    Download full text from publisher

    File URL: https://oweb.b67.uni-jena.de/Papers/jerp2011/wp_2011_021.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Enrique R. Arzac & Lawrence R. Glosten, 2005. "A Reconsideration of Tax Shield Valuation," European Financial Management, European Financial Management Association, vol. 11(4), pages 453-461, September.
    2. Masulis, Ronald W. & Korwar, Ashok N., 1986. "Seasoned equity offerings : An empirical investigation," Journal of Financial Economics, Elsevier, vol. 15(1-2), pages 91-118.
    3. Horowitz, John K. & McConnell, Kenneth E., 2002. "A Review of WTA/WTP Studies," Journal of Environmental Economics and Management, Elsevier, vol. 44(3), pages 426-447, November.
    4. Dann, Larry Y., 1981. "Common stock repurchases : An analysis of returns to bondholders and stockholders," Journal of Financial Economics, Elsevier, vol. 9(2), pages 113-138, June.
    5. International Monetary Fund, 2010. "Risk and the Corporate Structure of Banks," IMF Working Papers 2010/040, International Monetary Fund.
    6. Charles R. Plott & Kathryn Zeiler, 2005. "The Willingness to Pay–Willingness to Accept Gap, the "Endowment Effect," Subject Misconceptions, and Experimental Procedures for Eliciting Valuations," American Economic Review, American Economic Association, vol. 95(3), pages 530-545, June.
    7. Jason F. Shogren & Laura O. Taylor, 2008. "On Behavioral-Environmental Economics," Review of Environmental Economics and Policy, Association of Environmental and Resource Economists, vol. 2(1), pages 26-44, Winter.
    8. repec:bla:econom:v:38:y:1971:i:150:p:136-62 is not listed on IDEAS
    9. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
    10. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, vol. 92(5), pages 1644-1655, December.
    11. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
    12. Stiglitz, Joseph E, 1969. "A Re-Examination of the Modigliani-Miller Theorem," American Economic Review, American Economic Association, vol. 59(5), pages 784-793, December.
    13. Sayman, Serdar & Onculer, Ayse, 2005. "Effects of study design characteristics on the WTA-WTP disparity: A meta analytical framework," Journal of Economic Psychology, Elsevier, vol. 26(2), pages 289-312, April.
    14. Shleifer, Andrei & Vishny, Robert W, 1997. "The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
    15. Levy, Haim & Levy, Moshe, 2002. "Experimental test of the prospect theory value function: A stochastic dominance approach," Organizational Behavior and Human Decision Processes, Elsevier, vol. 89(2), pages 1058-1081, November.
    16. Timothy N. Cason & Daniel Friedman, 1997. "Price Formation in Single Call Markets," Econometrica, Econometric Society, vol. 65(2), pages 311-346, March.
    17. Chu, Yun-Peng & Chu, Ruey-Ling, 1990. "The Subsidence of Preference Reversals in Simplified and Marketlike Experimental Settings: A Note," American Economic Review, American Economic Association, vol. 80(4), pages 902-911, September.
    18. Pinegar, J Michael & Lease, Ronald C, 1986. "The Impact of Preferred-for-Common Exchange Offers on Firm Value," Journal of Finance, American Finance Association, vol. 41(4), pages 795-814, September.
    19. Smith, Vernon L, et al, 1982. "Competitive Market Institutions: Double Auctions vs. Sealed Bid-Offer Auctions," American Economic Review, American Economic Association, vol. 72(1), pages 58-77, March.
    20. Giovanni Dell'Ariccia & Robert Marquez, 2010. "Risk and the Corporate Structure of Banks," Journal of Finance, American Finance Association, vol. 65(3), pages 1075-1096, June.
    21. Cason, Timothy N. & Friedman, Daniel, 2008. "A Comparison of Market Institutions," Handbook of Experimental Economics Results, in: Charles R. Plott & Vernon L. Smith (ed.), Handbook of Experimental Economics Results, edition 1, volume 1, chapter 33, pages 264-272, Elsevier.
    22. Stewart C. Myers, 2001. "Capital Structure," Journal of Economic Perspectives, American Economic Association, vol. 15(2), pages 81-102, Spring.
    23. Viscusi, W Kip, 1989. "Prospective Reference Theory: Toward an Explanation of the Paradoxes," Journal of Risk and Uncertainty, Springer, vol. 2(3), pages 235-263, September.
    24. Andrea Isoni & Graham Loomes & Robert Sugden, 2011. "The Willingness to Pay—Willingness to Accept Gap, the "Endowment Effect," Subject Misconceptions, and Experimental Procedures for Eliciting Valuations: Comment," American Economic Review, American Economic Association, vol. 101(2), pages 991-1011, April.
    25. Masulis, Ronald W., 1980. "The effects of capital structure change on security prices : A study of exchange offers," Journal of Financial Economics, Elsevier, vol. 8(2), pages 139-178, June.
    26. John H. Kagel, 2004. "Double Auction Markets with Stochastic Supply and Demand Schedules: Call Markets and Continuous Auction Trading Mechanisms," Palgrave Macmillan Books, in: Steffen Huck (ed.), Advances in Understanding Strategic Behaviour, chapter 9, pages 181-208, Palgrave Macmillan.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Neugebauer, Tibor & Shachat, Jason & Szymczak, Wiebke, 2023. "A test of the Modigliani-Miller theorem, dividend policy and algorithmic arbitrage in experimental asset markets," Journal of Banking & Finance, Elsevier, vol. 154(C).
    2. Te Bao & Edward Halim & Charles N. Noussair & Yohanes E. Riyanto, 2021. "Managerial incentives and stock price dynamics: an experimental approach," Experimental Economics, Springer;Economic Science Association, vol. 24(2), pages 617-648, June.
    3. Jieyi Duan & Nobuyuki Hanaki, "undated". "An experimental analysis on cross-asset arbitrage opportunity and the law of one price," ISER Discussion Paper 1257, Institute of Social and Economic Research, Osaka University.
    4. Arturo Macias, 2022. "Capital structure irrelevance in the laboratory: an experiment with complete and asymmetric information," Experimental Economics, Springer;Economic Science Association, vol. 25(5), pages 1418-1440, November.
    5. Jacob LaRiviere & Matthew McMahon & William Neilson, 2018. "Shareholder Protection and Agency Costs: An Experimental Analysis," Management Science, INFORMS, vol. 64(7), pages 3108-3128, July.
    6. 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.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Yixin Chen & Junrui Zhang, 2019. "The Interdependence of Debt and Innovation Sustainability: Evidence from the Onset of Credit Default Swaps," Sustainability, MDPI, vol. 11(10), pages 1-24, May.
    2. Isabel Marcin & Andreas Nicklisch, 2014. "Testing the Endowment Effect for Default Rules," Discussion Paper Series of the Max Planck Institute for Research on Collective Goods 2014_01, Max Planck Institute for Research on Collective Goods.
    3. Anton Miglo, 2012. "Managers versus Students: New Approach in Improving Capital Structure Education," Journal of Education and Vocational Research, AMH International, vol. 3(11), pages 353-369.
    4. Drouvelis, Michalis & Sonnemans, Joep, 2017. "The endowment effect in games," European Economic Review, Elsevier, vol. 94(C), pages 240-262.
    5. Miglo, Anton & Liang, Shuting & Lee, Zhenting, 2014. "Capital Structure of Internet Companies: Case Study," MPRA Paper 56330, University Library of Munich, Germany.
    6. Henrik Andersson & Nicolas Treich, 2011. "The Value of a Statistical Life," Chapters, in: André de Palma & Robin Lindsey & Emile Quinet & Roger Vickerman (ed.), A Handbook of Transport Economics, chapter 17, Edward Elgar Publishing.
    7. Marcin, Isabel & Nicklisch, Andreas, 2014. "Testing the Endowment Effect for Default Rules," WiSo-HH Working Paper Series 10, University of Hamburg, Faculty of Business, Economics and Social Sciences, WISO Research Laboratory.
    8. Lindsay, Luke, 2019. "Adaptive loss aversion and market experience," Journal of Economic Behavior & Organization, Elsevier, vol. 168(C), pages 43-61.
    9. Lunn, Pete & Lunn, Mary, 2014. "A Computational Theory of Willingness to Exchange," Papers WP477, Economic and Social Research Institute (ESRI).
    10. Stefano DellaVigna, 2009. "Psychology and Economics: Evidence from the Field," Journal of Economic Literature, American Economic Association, vol. 47(2), pages 315-372, June.
    11. Oben K Bayrak & Bengt Kriström, 2016. "Is there a valuation gap? The case of interval valuations," Economics Bulletin, AccessEcon, vol. 36(1), pages 218-236.
    12. Babl, Christian & Fausel, Andreas & Kuhlman, Leonard & Schiereck, Dirk, 2014. "Werteffekte auf Anleiheemissionen: Eine Note für deutsche Emittenten," Die Unternehmung - Swiss Journal of Business Research and Practice, Nomos Verlagsgesellschaft mbH & Co. KG, vol. 68(1), pages 8-22.
    13. Yushu Zhu, 2017. "Call it good, bad or no news? The valuation effect of debt issues," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 57(4), pages 1203-1229, December.
    14. Buckley, Neil J. & Cuff, Katherine & Hurley, Jeremiah & McLeod, Logan & Mestelman, Stuart & Cameron, David, 2012. "An experimental investigation of mixed systems of public and private health care finance," Journal of Economic Behavior & Organization, Elsevier, vol. 84(3), pages 713-729.
    15. Drichoutis, Andreas C. & Lusk, Jayson L. & Pappa, Valentina, 2016. "Elicitation formats and the WTA/WTP gap: A study of climate neutral foods," Food Policy, Elsevier, vol. 61(C), pages 141-155.
    16. Steffen Andersen & John Fountain & Glenn Harrison & E. Rutström, 2014. "Estimating subjective probabilities," Journal of Risk and Uncertainty, Springer, vol. 48(3), pages 207-229, June.
    17. Susan Chilton & Michael Jones-Lee & Rebecca McDonald & Hugh Metcalf, 2012. "Does the WTA/WTP ratio diminish as the severity of a health complaint is reduced? Testing for smoothness of the underlying utility of wealth function," Journal of Risk and Uncertainty, Springer, vol. 45(1), pages 1-24, August.
    18. Jesús Martín-Fernández & Gloria Ariza-Cardiel & Luz Mª Peña-Longobardo & Elena Polentinos-Castro & Juan Oliva-Moreno & Ana Isabel Gil-Lacruz & Héctor Medina-Palomino & Isabel del Cura-González, 2017. "“Gaining or losing”: The importance of the perspective in primary care health services valuation," PLOS ONE, Public Library of Science, vol. 12(12), pages 1-14, December.
    19. Farsi, Mehdi, 2010. "Risk aversion and willingness to pay for energy efficient systems in rental apartments," Energy Policy, Elsevier, vol. 38(6), pages 3078-3088, June.
    20. Simon Gächter & Eric J. Johnson & Andreas Herrmann, 2022. "Individual-level loss aversion in riskless and risky choices," Theory and Decision, Springer, vol. 92(3), pages 599-624, April.

    More about this item

    Keywords

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

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:jrp:jrpwrp:2011-021. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Markus Pasche (email available below). General contact details of provider: http://www.jenecon.de .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.