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

Which of the following best describes the 'pecking order' approach to financing?

Pecking order theory says firms first use retained earnings, then raise debt, and issue new equity only as a last resort. This ordering reflects information asymmetry and the lower issue costs and signalling effects of internal funds and debt.

  1. AFirms prefer retained earnings, then debt, then new equityCorrect
  2. BFirms prefer new equity, then debt, then retained earnings
  3. CFirms choose equal proportions of all sources
  4. DFirms prefer preference shares over all other sources

Explanation

Pecking order theory says firms use internal funds first because of low cost and no signalling problems, then debt, and issue new equity last. The second option reverses this order.

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