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

Which of the following best describes the 'pecking order theory' of capital structure?

The pecking order theory says firms first use internal accruals, then borrow debt, and raise fresh equity only as a last resort. The reason is information asymmetry and the higher issue costs and signalling problems linked with new equity issues.

  1. AFirms prefer internal accruals first, then debt, and issue new equity only as a last resortCorrect
  2. BFirms prefer new equity first, then debt, and use retained earnings last
  3. CFirms choose the capital structure that keeps debt and equity in a fixed 1:1 ratio
  4. DFirms raise funds only from the source whose cost is lowest at that moment, ignoring information effects

Explanation

The pecking order theory holds that, because of information asymmetry and issue costs, firms rank sources as retained earnings, then debt, then external equity. The option reversing this order is wrong because it places equity first. A fixed 1:1 ratio belongs to a target-ratio approach, not this theory.

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