Abstract — Leverage and the Valuation of Risk Assets: An Empirical Test

Extract

A major difficulty with testing the Modigliani-Miller (M-M) theory of the effect of leverage on the firm's value arises from the existence of interfirm differences in operating risk. Based upon the Sharpe-Lintner capital asset pricing model, the present study develops a test of the M-M theory that takes cognizance of heterogeneity with respect to operating risk. The empirical results support the M-M theory: holding total systematic risk constant, there was no relationship between leverage and required rates of return on equities. That is, investors appear to demand complete compensation for the increase in systematic risk attributable to financial leverage.