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

In this paper, we experimentally test the Modigliani-Miller theorem. Applying ageneral equilibrium approach and not allowing for arbitrage among ¯rms with differ-ent capital structure, we are able to address a question fundamental to the valuationof 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 recognizedthe increased systematic risk of the equity with increasing leverage and accordinglydemanded higher rate of return. Yet, this adjustment was not perfect: subjects un-derestimated the systematic risk of low leveraged equity whereas overestimated thesystematic risk of high leveraged equity, resulting in a U shape weighted average costof capital.