Question

The pecking order theory of capital structure predicts that firms will fund positive NPV projects first with internally generated funds, then with debt, and finally with new equity. What is the primary insight of the pecking order story theory that leads to this funding ordering in which equity is only issued as a last resort?

A.	Issuing debt is always superior to issuing equity because interest paid to debtholders is tax deductible whereas dividends paid to shareholders are not.

B.	The opportunity cost of internally generated funds is low in comparison to issuing new debt or equity because the alternative to retaining the funds and investing in new projects is to pay the funds out as dividends.

C.	Issuing equity dilutes earnings per share.

D.	Investors and managers are asymmetrically informed about the firm’s operations and value. There is an adverse selection cost of issuing equity because investors believe a firm is likely to issue equity when management believes the firm’s stock is overpriced.

Answer 1

The pecking order theory of capital structure predicts that firms will fund positive NPV projects first with internally generated funds, then with debt, and finally with new equity. What is the primary insight of the pecking order story theory that leads to this funding ordering in which equity is only issued as a last resort?

Ans:

B. The opportunity cost of internally generated funds is low in comparison to issuing new debt or equity because the alternative to retaining the funds and investing in new projects is to pay the funds out as dividends.