Answer to Question #131481 in Financial Math for Naeem Ebrahim

Question

The financial manager (FM) of Toys Ltd. is faced with a decision regarding its
capital structure composition. Currently, the structure consists of R50m in debt
and R20m in equity, which is higher than the target D/E ratio. The FM can access
either more equity, or more debt, to finance future projects, however, it is
expected that the cost of debt will increase if more debt is incurred. Analyst
reports indicates that the company’s current share price is in line with
expectations and that the company has little in the way of retained earnings. The
FM chooses to issue equity to fund future projects. Which of the following theories
best describes the action taken in the given scenario?

A. Market timing
B. Pecking order
C. M&M
D. Trade-off

Answer 1

The correct answer is C.

C . Pecking order

The pecking order theory states that managers display the following preference of sources to fund investment opportunities: first, through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort.