Section A

According to the Pecking Order Theory of capital structure, companies prioritize their sources of financing based on the principle of least effort and lowest information asymmetry.

Which TWO of the following statements align with the Pecking Order Theory?

Answer options:

Firms prefer internal financing (retained earnings) over external financing.

Firms actively seek an optimal debt-to-equity ratio to minimize their WACC.

If external financing is required, firms will issue debt before issuing new equity.

Equity is preferred over debt because it does not require mandatory interest payments.

How to approach this question

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

Full Answer

The Pecking Order Theory suggests that managers have a strict hierarchy for financing: 1. Retained earnings (internal, no issue costs, no signaling issues). 2. Debt (external, lower issue costs than equity, less negative signaling). 3. Equity (last resort, high issue costs, signals that shares might be overvalued). It explicitly rejects the idea of a target optimal capital structure.

Common mistakes

Confusing Pecking Order Theory with the Traditional View which seeks an optimal WACC.

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Practice the full ACCA FM — Financial Management Practice Exam 4

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