Question

When a firm needs to raise additional funds, it can potentially obtain them from 3 different sources: external debt, external equity, and internal sources of cash. Based on the pecking order theory, in what order would a firm raise money from these three sources? Why?

Answer 1

As per Pecking Order Theory, a firm should first raise money from its internal sources of cash because it implies that the company is in a good position and is generating enough cash to fund its operations. There is also fees involved in raising capital from external sources due to less information available about the firm to external parties. The managers of the firm are well aware of the position of the company and therefore there is less risk which reduces the cost of the capital. It is also more convenient and less time consuming as the management doesn't have to deal with external parties.

After internal sources of cash, a firm should raise money from external debt as it is cheaper than raising external equity. A firm does not have any further obligations to the lender once the external debt is fully repaid whereas the firm has to share future profits with the equity holder. Also, external debt is less risky as lenders usually have first claim on the assets of the firm whereas equity holders have residual claim on the firm's assets once all the obligations of the firm are satisfied. So, it the firm is expected to be profitable in the future, it will have to forego more profits in case of external equity funding whereas in case of external debt funding, the firm has to only pay the interest and repay the loan.

External Equity should be the last option for raising money as it could mean that the company is not confident to raise external debt and fulfill its obligations. It could also mean that the the firm thinks that the its stock is overpriced and wants to take benefit of the higher stock price before it decreases. Also, external equity leads to dilution which is not in the interest of existing shareholders of the firm.