Question

Justify the pecking order theory of capital structure

Answer 1

Answer-

The pecking order theory of capital structure which states that the company will prefer financing by three ways.

The financing is done first by internal funds ie. the retained earnings. It the company has not enough retained earningss then it should raise debt and finally the last option is to raise money by issuing equity which is considered the last resort.  

The pecking order theory followed by the company gives signals to the investors the way the company is going to raise the money for itself. The investor confidence is measured by which the pecking order theory the company follows and the future stock price is decided by the pecking order theory.

The internally generated funds ie reained earnings are of zero financing cost whereas the debt has higher financing cost whereas the equity has the highest financing cost for which the investor required rate of return is highest.