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

Which of the following is a feature of the pecking order theory of capital structure?

Pecking order theory says firms prefer internal accruals first, then debt, and raise new equity only as a last resort. This is because of information asymmetry between managers and outside investors, which makes external equity the costliest source.

  1. AFirms prefer internal accruals first, then debt, and issue new equity lastCorrect
  2. BFirms prefer new equity first, then debt, and retained earnings last
  3. CFirms target an optimal debt-equity ratio by trading off tax shield against bankruptcy costs
  4. DFirms keep debt constant regardless of profitability

Explanation

Pecking order theory, based on information asymmetry, ranks internal funds first, debt second, and external equity last. The trade-off theory is the one described in the third option.

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