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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, which ordering of preferred sources is correct for a profitable company with information asymmetry?

The pecking order is retained earnings first, then debt, then new equity last. Internal funds avoid issue costs and negative signals, debt is a milder signal, and a share issue may suggest the shares are overvalued to outside investors.

  1. ANew equity, then debt, then retained earnings
  2. BDebt, then retained earnings, then new equity
  3. CRetained earnings, then debt, then new equityCorrect
  4. DRetained earnings, then new equity, then debt
  5. Debt, then new equity, then retained earnings

Explanation

Pecking order theory says firms prefer internal funds first, since they avoid issue costs and signalling, then debt, and issue new equity last because managers know more than investors and an issue signals overvaluation.

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