AN ANALYSIS OF THE CONDITIONS FOR THE VALIDITY OF MODIGLIANI-MILLER THEOREM WITH INCOMPLETE MARKETS

In this paper we investigate the consequences of the firms' financial decisions in the framework of a perfectly competitive general equilibr ium model with incomplete markets. When markets are complete or there are no derivative securities (such as options, forwards or futures) wr itten on the firms' shares, these decisions are irrelevant. This resul t reaffirms and qualifies the original claim by Modigliani and Miller. On the other hand, if markets are incomplete, we show that in the pre sence of any type of derivative security a change in the capital struc ture of a firm will modify, generically, both the real equilibrium all ocation and the value of the firm. The reason is that the payoff of th e derivative securities is affected in a non-linear way by changes in the firm's financial policy; thus the set of the agents' insurance opp ortunities is also modified.