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.
RELATED TERMS
  1. Distress Price

    A distress price is when a firm chooses to mark down the price ...
  2. Distressed Borrower

    A distressed borrower is one who is unable to fully repay his ...
  3. Distressed Sale

    A distressed sale is a situation wherein a seller attempts to ...
  4. Corporate Debt Restructuring

    Corporate debt restructuring is the reorganization of a distressed ...
  5. Asset Deficiency

    Asset deficiency is a situation where a company's liabilities ...
  6. Cancellation of Debt (COD)

    Cancellation of debt (COD) occurs when a creditor relieves a ...
Related Articles
  1. Investing

    The Pros and Cons of Distressed Debt Investing

    Distressed debt investing is suitable for professional investors. Besides heavy risk factors to consider, this investment type can provide a large ROI.
  2. Investing

    Are Distressed Homes Worth Buying?

    Here's a look at whether it is a good idea to buy a rundown home to repair for profit.
  3. Investing

    Post Election, Buy-Side Players Want Small Caps: BofA Research

    There's a shift among buy-side players toward small caps since Trump took office
  4. Investing

    Don't Go Broke Buying Bankrupt Stocks

    Don't be tricked by bankrupt companies' low stock prices; they're low for a reason.
  5. Trading

    Bear Market for Retailers Just Getting Started

    The number of retailers with distressed balance sheets continues to rise, setting the stage for high-profile bankruptcies.
  6. Financial Advisor

    Marathon Asset Management: Should You Consider Them?

    Read about the investment operations of Marathon Asset Management, a specialist in distressed and special-situation investing in global credit markets.
  7. Investing

    Should You Buy Banks' "Toxic" Assets?

    The Public-Private Investment Progam is part of the government's effort to fix the failing financial sector. But is it a good investment?
  8. Investing

    World's Top 10 Private Equity Firms (APO, BX)

    Obtain important information about the world's top ten private equity firms ranked as of 2015, including their investment focus and portfolio assets.
  9. Investing

    Equity Valuation In Good Times And Bad

    Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value.
  10. Personal Finance

    Should You File for Bankruptcy?

    Find out how to determine whether bankruptcy will help or hurt your financial situation.
RELATED FAQS
  1. How do you calculate the ratio between debt and equity in the cost of capital

    Discover how to calculate the ratio between debt and equity when making cost of capital estimations using the weighted average ... Read Answer >>
  2. How are period costs and product costs different?

    Product costs are the direct costs involved in producing a product. Period costs are all costs not included in product costs ... Read Answer >>
  3. What are the types of costs in cost accounting?

    Cost accounting aids in decision-making by helping a company's management evaluate its costs. There are various types of ... Read Answer >>
  4. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. Read Answer >>
Trading Center