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Individual Stock Price Implications

most adverse of cash flow circumstances. Third, the firm must not have increased its debt service burden from the level prevailing under that adverse time. Investors must envision no worse circumstances occurring in the future. If all of the above three judgments converge, investors assign limited financial risk.

Investors also judge a firm’s leveraged position in comparison to the historical industry norm leveraged position. The debt/equity and the debt/total capital ratios are measures often used. The common stock price of an over-leveraged firm, by this judgmental standard, sells at a lower price for the expected earnings than an identical firm with an industry norm leverage position.

The leverage buyout of Federated Department Stores during the height of the LBO craze is an example of over-leverage. It caused the common stock price of Federated Department Stores to fall. The sequence of events started in the traditional LBO fashion. Large borrowings financed the acquisition of this conservatively managed and well-established chain of department stores. Debt was ambitiously sought in all forms and from all sources and became an extremely high percentage of the capital structure. The cash-flow-oriented debt service coverage measure, based on earnings before interest, taxes, depreciation, and amortization (EBITDA), was about one. This meant that all internally-generated cash flow had to be used to meet current debt service. There was no room for error. A debt service coverage ratio below one means the firm does not have sufficient internally-generated cash flow to meet its interest and principal payments on a timely basis. Federated Department Stores had no reserve borrowing capacity to meet a cash flow shortfall. All the money that could be borrowed had been borrowed. The firm was extremely over-leveraged. The lenders owned the firm at that point. Equity value was minimal.

The Federated Department Stores LBO hoped that future, internally-generated cash flow would service its debt. With no margin for error, error occurred. A relatively mild recession, which would normally have been survived by Federated Department Stores, slightly reduced total earnings and cash flow. The firm could not meet its debt service and went bankrupt. Components of Federated Department Stores that had survived the Great Depression of the 1930s could not survive a mild recession. Federated Department Stores went bankrupt under the weight of its own over-leverage.