Which statement is true regarding the cost of financial distress?

Which statement is true regarding the cost of financial distress?

• A. The cost decreases with more debt.
• B. Distress costs decline with debt.
• C. Costs are independent of leverage.
• D. As the level of debt increases, the cost of financial distress increases until at some point it exceeds the earnings per share benefit from financial leverage.

Answer: (D)

The main idea is that financial distress costs rise as a firm increases its debt. As leverage grows, the likelihood and impact of distress grow too, because fixed debt obligations become harder to meet and lenders, suppliers, and customers react to greater risk. These distress costs include both direct costs (legal, administrative, restructuring) and indirect costs (lost sales, damaged reputation, tighter credit terms). The expected cost of distress is the chance of distress times the cost if it happens, and both the probability and the potential cost escalate with higher debt. At some point the marginal cost of additional debt due to distress exceeds the incremental benefit from financial leverage (the tax shield and potentially higher earnings per share). When that tipping point is reached, increasing debt reduces firm value. So the true statement is that the cost of financial distress rises with more debt, and it eventually outweighs the earnings-per-share benefit from leverage.

The main idea is that financial distress costs rise as a firm increases its debt. As leverage grows, the likelihood and impact of distress grow too, because fixed debt obligations become harder to meet and lenders, suppliers, and customers react to greater risk. These distress costs include both direct costs (legal, administrative, restructuring) and indirect costs (lost sales, damaged reputation, tighter credit terms). The expected cost of distress is the chance of distress times the cost if it happens, and both the probability and the potential cost escalate with higher debt. At some point the marginal cost of additional debt due to distress exceeds the incremental benefit from financial leverage (the tax shield and potentially higher earnings per share). When that tipping point is reached, increasing debt reduces firm value. So the true statement is that the cost of financial distress rises with more debt, and it eventually outweighs the earnings-per-share benefit from leverage.