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ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation

Zentra plc has a target capital structure and wishes to fund a new project using retained earnings before issuing new equity. Under the pecking order theory, which ordering of financing preference would management follow?

Under pecking order theory, management prefers retained internal funds first, then debt, and issues new equity only as a last resort, because information asymmetry makes external equity the most costly and the most negative signal to the market.

  1. AInternal funds, then debt, then new equityCorrect
  2. BNew equity, then debt, then internal funds
  3. CDebt, then internal funds, then new equity
  4. DInternal funds, then new equity, then debt

Explanation

Pecking order theory says information asymmetry makes managers prefer internal funds first, then debt, and new equity last because issuing equity signals overvaluation. The option putting equity before debt reverses the cost of the information signal.

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