Question

Q1- Use your own words to explain the following regarding the Higgins 5-Factor Model:

1. Tax benefits
2. Financial distress and bankruptcy
3. Flexibility
4. Market signaling
5. Management incentives

Answer 1

The Higgins 5-factor mode indicate how the methods of financing selected by the company will affect its cash flow.The five factors are tax benefits ,financial distress and bankruptcy,flexibility ,market signalling and management incentives.

Tax benefits:Tax benefits refer to the tax deductions associated with the interest payments.Tax deductible interest payments accompany debt financing and as a result of such tax benefits there will be an increase in the cash flow (income)

Financial distress and bankruptcy:As the amount raised by the company through debt financing increases the company runs a higher risk of bankruptcy.And as a result the expected distress costs or the bankruptcy costs such as legal expenses would be high.

Flexibility:The firm will always be in a better position to handle costs arising in the future,if the firm manages to maintain a debt level that is not above the specified level.This is because once the firm hits the specified level it will then have to resort to equity financing.

Market Signalling:If the firm resorts to additional equity it would give the investors an impression that there is some uncertainty pertaining to the future of the firm,this will negatively impact the share prices.So in order to avoid such signalling the firm always resorts to internal financing as its primary option.

Management incentives:If the firm resorts to debt financing,the the firm then becomes liable to make mandatory interest payments,this would act as an incentive to the management to increase the cash flows so that the firm would be able to meet such interest payment obligations and avoid going into a financial crisis.