Question

When is the present value of distress costs likely to exceed the present value of the tax shield from debt?

Answer 1

At high levels of debt, the present value of distress costs is likely to exceed the present value of the tax shield from debt.

What is Distress Cost?

• Distress cost is the additional expense, such as a higher cost of capital, that a company in financial distress must pay.
• Companies that are struggling often have a harder time paying their debts, which increases the likelihood that they will default. In order to meet urgent needs, assets may need to be sold fast and at a loss due to distress costs.
• Other costs associated with distress include diminished staff morale and productivity.
• Ex-ante expenses—those incurred before the event—and ex-post costs—those incurred after the event—such as bankruptcy—are the two categories of distress costs.

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