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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Which of the following best describes the pecking order theory of financing?

The pecking order theory says firms prefer internally generated funds first, then debt, and raise new equity only as a last resort, because of information asymmetry and issue costs. It implies no single target gearing level.

  1. AFirms choose a target debt-equity ratio that minimises WACC and move towards it
  2. BFirms prefer internal funds first, then debt, and issue new equity only as a last resortCorrect
  3. CFirms prefer new equity first because it carries no mandatory payments
  4. DFirms are indifferent between sources of finance as value depends only on investment decisions
  5. Firms match the maturity of financing exactly to the life of the assets

Explanation

Pecking order theory, driven by information asymmetry and issue costs, ranks retained earnings first, then debt, then new equity. Option 1 is the trade-off theory and option 4 is Modigliani-Miller without taxes. Option 5 is the matching principle.

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