CAPITAL STRUCTURE | BUSINESS FINANCE | NTA UGC NET COMMERCE | 2020 OCT

Arrange the following financing choices in order of preference suggested by the pecking order theory

(1)Reinvestment of earnings

(2)New issue of equity

(3)Issue of debt

Choose the correct answer from the options given below:

• 1,2,3 (b) 3,2,1  (c) 1,3,2 (d) 2,3,1

Ans : (c)

PECKING ORDER THEORY

The pecking order theory also known as the Pecking Order Model is a theory related to capital structure. It was initially suggested by Donaldson. In 1984, Myers and Majluf modified the theory and made it popular. According to this theory, managers follow a hierarchy to choose sources of finance. The hierarchy gives first preference to internal financing. If internal financing is not enough, then managers would have to shift to external sources. They will issue debt to generate funds. After a point when it is no longer practical to issue more debt, equity is issued as a last option.

Retaining earnings > Debenture > Preference > Equity