Damodaran on Valuation

17.1. POSSIBILITY AND CONSEQUENCES OF FINANCIAL DISTRESS

Growth is not inevitable, and firms may not remain as going concerns. In fact, even large publicly traded firms sometimes become distressed for one reason or another and the consequences for value can be serious. In this section, we consider first how common it is for firms to become distressed and follow up by looking at the consequences of distress.

17.1.1. Possibility of Distress

Financial distress is far more common in the real world that most of us assume it to be. In fact, even casual empirical observation suggests that a very large number of firms, especially smaller and higher-growth ones, will not survive and will go out of business. Some will fail because they borrow money to fund their operations and then are unable to make these debt payments. Other will fail because they do not have the cash to cover their operating needs.

To get a measure at the probability of distress, we have to begin by defining distress. If we define it as companies that enter Chapter 11, relatively few publicly traded firms at any point in time can be considered distressed. If we define it more broadly as firms that are having trouble making interest payments and meeting other contractual commitments, distress is much more common. Kahl (2001) examined all publicly traded firms in the United States between 1980 and 1983 and found that 1,346 firms had trouble making their interest expenses from operating income in at least one year and ...