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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

According to the pecking order theory of financing, how does a firm prefer to raise funds?

Under pecking order theory, firms use retained earnings first, then debt, and issue new equity only as a last resort. This ordering arises because information asymmetry makes external finance costlier, and equity issues may signal that managers think shares are overvalued.

  1. AIssue new equity first, then debt, then retained earnings
  2. BUse debt first, then retained earnings, then equity
  3. CUse retained earnings first, then debt, then new equity as a last resortCorrect
  4. DMaintain a fixed target of equity regardless of source
  5. Choose the source with the longest maturity first

Explanation

Pecking order theory says information asymmetry makes outside finance costly, so managers use internal funds first, then debt, and issue new equity last because it signals overvaluation. The other orderings reverse or mix this sequence.

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