What is Distress Cost
Distress cost refers to the costs that a firm in financial distress faces beyond the cost of doing business, such as a higher cost of capital. Companies in distress tend to have a harder time meeting their financial obligations, which translates to a higher probability of default. Distress costs may extend to the need to sell assets quickly and at a loss to meet immediate obligations.
Breaking Down 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.
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.
Distress Cost and Valuation
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.
Distress Cost Calculation
The follows steps may be taken to calculate the distress cost of a company:
- Access the company's financial report.
- Add up the company's total amount of debt, including current debt (debt that has been entered into the books in the last year).
- Find out the average interest paid on debt by companies in the same space that are not in financial distress.
- Calculate for the weighted average cost of debt.
- Take that weighted average and subtract from it the cost of debt maintenance of an AAA-rated company.
- Figure the cost of financial distress in dollar terms by multiplying the financial distress cost (in percentage terms) by the total amount of debt.