What it means
Finance splits these costs into two groups. Direct costs are the cash bills of a formal process, including insolvency practitioners, lawyers, advisers and court fees, and they typically consume a few per cent of asset value; indirect costs are the lost business, and they are usually far larger.
The indirect costs bite before any formal filing. Customers stop signing multi-year contracts with a supplier they think may disappear, suppliers shorten payment terms and tie up working capital, the best employees take calls from recruiters, and lenders reprice or withdraw facilities.
Distress costs are the reason the tax advantage of debt does not run forever. Interest is deductible, which makes debt cheaper than equity, but past a certain point the rising chance of distress costs more than the tax saving is worth, and the standard trade-off theory of capital structure sets the optimal debt level exactly where those two effects balance.
The costs are also asymmetric across industries. A commercial property company can be highly geared because its assets are tangible and its tenants do not care about its balance sheet, whereas a software firm selling five-year contracts, or an airline selling tickets months in advance, suffers heavily from a distressed reputation.
A further and often overlooked cost is distorted decision-making. Managers of a distressed firm tend to cut research, maintenance and marketing to preserve cash, and may take excessive risk because shareholders have little left to lose, which destroys value even if the company ultimately survives.
In practice
Real-world examples.
Example
An airline reports weak liquidity and immediately sees forward bookings fall, because travellers hesitate to buy tickets for flights six months out. The lost revenue dwarfs the advisory fees it later pays.
Example
A specialist manufacturer breaches a covenant and its three largest suppliers move it from 60 day terms to payment on delivery. The change absorbs $4,000,000 of working capital in a single quarter, worsening the exact problem that triggered it.
Example
A software company in a public restructuring loses two enterprise renewals worth $2,600,000 a year because procurement teams flag supplier viability risk. Both customers say privately that they preferred the product.
Formula
Calculation
Expected distress cost = probability of distress x cost of distress if it occurs
Net benefit of debt = present value of the interest tax shield - expected distress cost
A group with an enterprise value of $200,000,000 estimates that if it entered distress, the direct and indirect costs together would erode 25% of that value, which is $200,000,000 x 25% = $50,000,000.
At moderate gearing, the probability of distress is estimated at 8% and the present value of the interest tax shield is $12,000,000.
Expected distress cost: 8% x $50,000,000 = $4,000,000
Net benefit of debt: $12,000,000 - $4,000,000 = $8,000,000
At higher gearing, the tax shield rises to $16,000,000 but the probability of distress rises to 20%.
Expected distress cost: 20% x $50,000,000 = $10,000,000
Net benefit of debt: $16,000,000 - $10,000,000 = $6,000,000
The extra borrowing adds $4,000,000 of tax shield but $6,000,000 of expected distress cost, so the moderate level is better by $8,000,000 - $6,000,000 = $2,000,000.Case study
Seen in the real world.
Larkfield Appliances is a fictional manufacturer created for this illustrative example. It carried $90,000,000 of debt against an enterprise value of about $200,000,000, and when a weak trading update pushed its interest cover close to the covenant limit, the trouble started long before any lender acted.
Within one quarter, two national retailers cut Larkfield from their spring ranges rather than risk supply gaps, costing roughly $18,000,000 of annual revenue. Its component suppliers withdrew credit terms, pulling about $6,000,000 of cash out of working capital, and the head of product design left with four engineers. Adviser and legal fees for the refinancing came to $2,400,000, a figure the board found almost trivial next to the commercial damage.
The refinancing succeeded and Larkfield survived, but the illustrative lesson was about sequencing. Nearly all the value lost had gone before the company was ever in genuine danger of failing, which is precisely why distress costs are counted from the moment failure becomes plausible rather than from the moment it happens.
Watch out
Common mistakes.
- Counting only legal and adviser fees as distress costs, when lost customers, tighter supplier terms and staff departures are usually much larger.
- Assuming distress costs only arise once a company formally files, when most of the damage occurs while it is still trading.
- Applying the same tolerance for debt to every industry, when asset-heavy businesses can carry far more gearing than reputation-sensitive ones.
Questions
People also ask.
How do analysts estimate the probability of distress?
Usually from credit ratings, interest cover and gearing ratios, or from statistical models built on the characteristics of companies that previously failed.
Are distress costs recorded in the accounts?
Only the direct ones, such as adviser and legal fees, since the indirect costs appear as lost revenue and thinner margins rather than as an identifiable line item.
Can a profitable company face distress costs?
Yes, because distress is about the ability to meet obligations as they fall due, so a profitable business with a refinancing cliff can suffer the same customer and supplier reaction.
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