Question

There is evidence to suggest that firms have a financing hierarchy, with more preferred and less preferred sources of financing. Please rank the following sources of finance from most preferred to least preferred in alignment with the hierarchy preferred by managers: debenture, retained earnings, new stock issues and convertible debt. You need to provide a rationale for your answer.

Answer 1

The ranking – from most preferred to least preferred – are:

Retained earnings, debentures, convertible debt and new stock issues.

Retained earnings are the most favorable form of financing as it is a form of extra money lying with a company. Retained earnings are nothing but accumulated profits and this source is readily available with a company.

Next in line are debentures and convertible debt. It should be noted that these forms of debt financing costs more than retained earnings and there are costs like interest payments.

Last in line are new stock issues. This is because cost of equity tends to be high and so companies use this as the last resort.