Equity-- Why Not Have Enough?
Why don't all publicly owned firms have a big enough equity cushion to avoid bankruptcy? They could then all pay lower interest rates. Modigliani-Miller says that evens out, but only in the absence of bankruptcy. Otherwise, clientele matters (well known?), as well as bankruptcy transaction costs.
Currently, a firm has $60M in equity and $40M in debt, with $100M invested in its business. Why doesn't it issue $200M more in equity, and invest the entire amount in index funds? Then it would have a cushion to protect the bondholders. Limited liability is good insofar as it means each shareholder doesn't have to be worried about being wiped out, but bad insofar as it means they can as a group rip off the bondholders.
The answer lies in agency costs, moral hazard by the managers and directors, I think-- mainly the directors. But it is surprising it is that big.
Maybe this is all in Michael Jensen's "equity cushion" work. No, it is not. "Free cash flow" is his 1986 idea.
Suppose investors who are daring have $20 million and inverstors who are timid have $20 million also. There are 4 investment projects, each able to use $10 million and each potentially expending it all with zero return. Ideally, we would have one big firm with $40 million in assets, owned by the daring investors and owing $20 million to the timid investors. But let us suppose that we can't have more than one project per corporation. The daring investors are fine. They will spread their funds equally among the four firms to achieve diversification. The timid investors are not fine. Even if they spread their funds equally among the four firms, they risk one of the firms going bankrupt and being unable to pay them. It does not help if the other three have massive profits, because their upside potential is fixed.
What can be done?