The pecking order theory of capital structure implies that: I) Risky firms will end up borrowing more II) Firms prefer internal finance III) Firms prefer debt to equity when external financing is required A

Finance Dec 18, 2020

The pecking order theory of capital structure implies that:

I) Risky firms will end up borrowing more

II) Firms prefer internal finance

III) Firms prefer debt to equity when external financing is required

A. I only

B. II only

C. II and III only

D. III only

Expert Solution

The answer is C. II and III only.

The pecking order theory explains that the most desirable source of financing for a company is retained earnings. This way of financing represents internal finance as it comes from the entity itself. When the retained earnings are depleted, then a company will choose debt. The least desirable source of financing, according to this theory, is equity. Hence, as long as external financing is the only option, a firm will prefer debt to equity.

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