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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

Vidya Pharma Ltd follows the pecking order theory of capital structure. It needs funds for a new plant and has retained earnings available, can borrow from banks, and can also issue fresh shares. In which order will management prefer to use these sources?

Under the pecking order theory the firm first uses retained earnings, then borrows debt, and issues fresh equity only last. Internal funds avoid issue costs and information problems, and new equity is costliest because the market may read it as a signal that shares are overvalued.

  1. AFresh equity, then debt, then retained earnings
  2. BDebt, then retained earnings, then fresh equity
  3. CRetained earnings, then debt, then fresh equityCorrect
  4. DRetained earnings, then fresh equity, then debt

Explanation

The pecking order theory says firms prefer internal funds first because they avoid issue costs and signalling problems. They then use debt, and issue new equity only as a last resort because it is seen by the market as a negative signal. Only option C follows this sequence.

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