Question

While arranging capital for their business some managers follow the pecking order theory, can you explain what pecking order theory is and why managers choose such a theory to raise capital?

Answer 1

Let us first understand the pecking order theory

Pecking order theory tries to explain why companies prefer one type of financing over the other.

The main reason is that the cost of financing tends to be different for different sources.

It states that the cost of financing increases as companies use sources of funding where the degree of information asymmetry is higher.

The pecking order states that companies will prefer to use internal finances, then external debt and then finally fresh equity.

The main reasons why managers follow the pecking order is to reduce their overall cost of capital, which will directly impact the valuation of the project. Hence to minimize the cost of capital, the pecking order is followed