Answer to Question #299498 in Management for Shiro

Question

Discuss the principles of Pecking Order theory in respect to fundraising for capital investment.

Answer 1

The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity. In corporate finance, pecking order theory is used to help explain how companies decide where to source their financing, and thus it helps explain what drives optimal capital structure, or the ideal balance of debt and equity financing. This pecking order is important because it signals to the public how the company is performing.

If a company finances itself internally, that means it is strong. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations and finally if a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling. Firms can decide what the ideal capital structure is between cash coming in from sales, stock sold to investors, and debt sold to bondholders. Accurate analysis of capital structure can help a company by optimizing the cost of capital and hence improving profitability.