Distress Cost

AAA

DEFINITION of 'Distress Cost'

Costs that a firm in financial distress faces beyond the cost of doing business. Distress costs are broken down into two categories: ex ante (before the event) and ex post (after the event), with the event in this case being a bankruptcy. Ex ante distress costs include increased borrowing costs, since lenders will charge higher rates to firms in financial trouble. Ex post distress costs include the cost of filing for bankruptcy, hiring lawyers and accountants to work on bankruptcy proceedings, and other administrative costs associated with closing out a business. 

INVESTOPEDIA EXPLAINS 'Distress Cost'

Firms with rising distress costs not only face potential bankruptcy, but also a loss of profitability as management becomes preoccupied with the threat of bankruptcy, employees show lower productivity as they worry about their jobs, suppliers charge more money up front for goods and services rather than allowing future invoicing, and customers search for healthier companies to do business with. In this sense, distress costs can lead to a vicious cycle.

Analysts reviewing a company’s financials in order to assign a value typically assume that the business will be around for the foreseeable future, and that any financial distress is temporary in nature. These assumptions allow the valuation to include a discounted cash flow from relatively far into the future.

However, if the company faces financial problems that are not temporary, this can affect the company’s terminal value. Because non-temporary financial distress is less common, it can be hard for analysts to valuate a company, since it’s significantly more difficult to understand how distress will impact future cash flows.

RELATED TERMS
  1. Involuntary Bankruptcy

    A legal proceeding in which a person or business is requested ...
  2. Distress Termination

    A thinning of an employee base that takes place when a company's ...
  3. Voluntary Bankruptcy

    A type of bankruptcy where an insolvent debtor brings the petition ...
  4. Distressed Borrower

    A borrower who is unable to fully repay his or her debt due to ...
  5. Bankruptcy

    A legal proceeding involving a person or business that is unable ...
  6. Ex-Ante

    A term that refers to future events, such as future returns or ...
RELATED FAQS
  1. Does a shareholder lose all of their equity once a Chapter 11 bankruptcy is filed ...

    When a company files for Chapter 11 bankruptcy, the management of the company is still in charge of the daily operations. ... Read Full Answer >>
  2. What are the differences between chapter 7 and chapter 11 bankruptcy?

    Chapter 7 bankruptcy is sometimes also called liquidation bankruptcy. Firms experiencing this form of bankruptcy are past ... Read Full Answer >>
  3. Is tracking error a significant measure for determining ex-post risk?

    Before we answer your question, let's first define tracking error and ex-post risk. Tracking error refers to the amount by ... Read Full Answer >>
Related Articles
  1. Credit & Loans

    How To Survive A Bankruptcy Filing

    Learn how to make filing for bankruptcy less painful so you can successfully rebuild your financial life.
  2. Stock Analysis

    Will American Airlines Fall Back To Earth In 2015?

    The airline industry enjoys blockbuster profits, and American Airlines Group has been a key beneficiary of the favorable trends that have lifted stocks.
  3. Investing

    What is Equity Financing?

    Companies that are short on cash may need financing to pay for short-term needs or long-term capital expenditures.
  4. Stock Analysis

    What’s The Best Airline Stock In the Industry?

    With many airlines forced to seek bankruptcy protection, Southwest Airlines stands out as having consistently remained profitable throughout its history.
  5. Investing

    What's a Sunk Cost?

    A sunk cost was incurred in the past, is independent of future events and cannot be recouped. Economists teach that sunk costs should not be considered when making a financial decision. Rather, ...
  6. Investing

    What's a Divestiture?

    Divestiture is when a company, government or other organization sells, shuts down or otherwise eliminates a division or operating unit. Divestitures happen for many reasons. Management may decide ...
  7. Fundamental Analysis

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
  8. Investing

    What are Operating Expenses?

    An operating expense is any expenditure made for the purpose of operating a business. These expenses are the day-to-day costs that help keep the business going. Operating expenses are reflected ...
  9. Investing

    What's Overhead?

    Overhead is an accounting term used for expenses that have to be paid even if the business doesn’t earn any revenue. The business would not be able to operate without paying its overhead expenses, ...
  10. Entrepreneurship

    Alternatives To Business Bankruptcy

    Bankruptcy isn't the only alternative for a struggling business. It can try negotiating with creditors or liquidating assets outside the U.S courts.

You May Also Like

Hot Definitions
  1. Fiat Money

    Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat ...
  2. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  3. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
  4. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
  5. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  6. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
Trading Center