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Business FinanceSection BBusiness FinanceCapital StructurePecking Order Theory

ACCA · Question 24 · Business Finance

Section B - Case 2: NeuroLink Prosthetics

Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%.

NeuroLink needs to raise an additional $5 million for R&D. The CFO suggests following the Pecking Order Theory.

Question: According to the Pecking Order Theory, what is the preferred order of financing sources?

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

Recall the Pecking Order Theory, which is based on asymmetric information. Managers prefer sources of finance that require the least amount of disclosure and have the lowest issue 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, lowest cost, and minimal information asymmetry. 1. Retained Earnings: No issue costs, no market scrutiny. 2. Debt: Lower issue costs than equity, interest is tax-deductible, does not dilute ownership. 3. New Equity: Last resort due to high issue costs, dilution of control, and negative market signaling (investors might think shares are overvalued).

Common mistakes

Thinking that debt is always bad and equity is preferred, which contradicts the theory.
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