CFA Level I · CFA Level I Exam · Capital Structure
Which of the following capital structure outcomes is most consistent with the pecking order theory?
Profitable firms with plenty of retained earnings tending to have lower debt ratios best fits pecking order theory. They can fund projects internally and need little external capital, so leverage falls without any target ratio, which distinguishes this theory from the trade-off theory.
- AProfitable firms with ample retained earnings tend to carry lower debt ratiosCorrect
- BFirms issue equity whenever their share price reaches a high level
- CFirms set a fixed target debt-to-equity ratio and adjust toward it
Explanation
With no target ratio, leverage under the pecking order simply reflects financing needs. Profitable firms fund investment internally and so borrow less. Target-ratio adjustment belongs to the trade-off theory, and timing equity issues to high prices belongs to market timing arguments.
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