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IAI Actuarial Core Principles · Business Finance · Key principles of finance

In the pecking order theory of capital structure, in which order does a firm prefer to raise finance, from most to least preferred?

The pecking order is retained earnings first, then debt, then new equity last. Because managers know more than outside investors, issuing equity may signal overvaluation and be costly, so internal funds and then debt are preferred to avoid adverse information effects.

  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, based on information asymmetry between managers and investors, says firms first use internal funds, then borrow, and issue new equity only as a last resort since it signals overvaluation. The options placing new equity first or debt first contradict this ordering.

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