On the Irrelevance of Financial Policy under Market Incompleteness and Trading Constraints

This paper studies the validity of the Modigliani and Miller Irrelevance proposition in the presence of incomplete markets and portfolio restrictions. If the economy is originally in equilibrium and the firm changes its financial plan, we show that there exist state-dependent trading limits under which financial policy is always irrelevant. In addition, the no short-selling constraint usually imposed on equity shares is innocuous in spite of being state-independent, whereas fixed portfolio restrictions on other assets always have real effects if they are part of the firm’s capital structure. In this case, however, we find that the quantitative effects of financial policy are relatively small, since households are typically able to almost entirely offset the firm’s actions by modifying their portfolio holdings.