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ACCA · Question 21.5 · Business Finance

Section B - Case 2: Quantum Mesh Inc

Scenario: Quantum Mesh Inc is a tech startup developing AI-driven satellite mesh networks. A venture capital firm is considering a buyout. Quantum Mesh has an operating profit (EBIT) of $5m, depreciation of $1m, and a corporate tax rate of 20%. Capital expenditure for the year was $1.5m, and working capital increased by $0.5m.

Question 5: If Quantum Mesh decides to raise further capital independently, the CFO suggests following the Pecking Order Theory.

According to the Pecking Order Theory, what is the preferred sequence of financing?

Answer options:

A.

New equity, then debt, then retained earnings.

B.

Debt, then retained earnings, then new equity.

C.

Retained earnings, then debt, then new equity.

D.

Retained earnings, then new equity, then debt.

How to approach this question

Remember the logic of the Pecking Order Theory: managers prefer financing that requires the least amount of external scrutiny and has the lowest issuance costs.

Full Answer

C.Retained earnings, then debt, then new equity.✓ Correct
The Pecking Order Theory suggests that firms prioritize their sources of financing based on the principle of least effort/cost and information asymmetry. The order is: 1) Internal funds (retained earnings) because there are no issuance costs or external scrutiny. 2) Debt, because it is cheaper than equity and less sensitive to information asymmetry. 3) New equity as a last resort.

Common mistakes

Confusing the pecking order with the traditional view of WACC, or thinking equity is preferred over debt because it doesn't require mandatory interest payments.
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