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.
