Section A

According to the Pecking Order Theory of capital structure, which of the following statements are TRUE regarding how a company should prioritize its sources of finance? (Select ALL that apply)

Answer options:

Internally generated funds (retained earnings) are the most preferred source of finance.

New equity issues are preferred over debt because they do not require mandatory interest payments.

Debt is preferred over new equity issues.

Companies seek to maintain a target debt-to-equity ratio at all times.

How to approach this question

Recall the hierarchy of the Pecking Order Theory: 1. Retained Earnings, 2. Debt, 3. New Equity.

Full Answer

The Pecking Order Theory suggests that firms prioritize their sources of financing based on the principle of least effort and lowest asymmetric information costs. The order is: 1. Internal financing (retained earnings) - no issue costs, no signaling issues. 2. Debt - lower issue costs than equity, tax-deductible interest. 3. New equity - last resort due to high issue costs and the negative signal it sends to the market (that management thinks the stock is overvalued).

Common mistakes

Confusing Pecking Order Theory with Trade-off Theory (Option D).

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Practice the full ACCA FM — Financial Management Practice Exam 2

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