Testing the Modigliani-Miller theorem directly in the lab

We present an experiment designed to test the Modigliani-Miller theorem. Applyinga general equilibrium approach and not allowing for arbitrage among firmswith different capital structures, we find that, in accordance with the theorem, participantswell recognize changes in the systematic risk of equity associated with increasingleverage and, accordingly, demand higher rate of return. Yet, this adjustment is notperfect: subjects underestimate the systematic risk of low-leveraged equity whereasthey overestimate the systematic risk of high-leveraged equity, resulting in a U-shapedcost of capital. A (control) individual decision-making experiment, eliciting severalpoints on individual demand and supply curves for shares, provides some support forthe theorem.