CFA Level II ExamCorporate IssuersMedium
A company is planning to raise new capital. The firm's management believes its stock is currently undervalued by the market. According to the pecking order theory, which of the following financing sources would the company most likely prefer to use?
- AIssuing new debt.
- BRetaining earnings.
- CIssuing new preferred stock.
- DIssuing new common stock.
Show answer & explanationAnswer & explanation
Correct answer: B. Retaining earnings.
The pecking order theory states that companies prefer to finance new projects using internal funds first (retained earnings), then debt, and finally external equity (new common stock). If management believes the stock is undervalued, they would be particularly reluctant to issue new equity, as it would dilute existing shareholders at a low price. Retained earnings are the cheapest and most preferred source of financing under this theory.
Why the other options are wrong
- A. Issuing new debt is preferred over issuing new equity but comes after retained earnings according to the pecking order theory.
- C. Preferred stock is a form of equity and would be less preferred than debt or retained earnings.
- D. Issuing new common stock is the least preferred option, especially when management believes the stock is undervalued, as it would dilute existing shareholders at a low price.
Pecking Order Theory
The pecking order theory suggests that companies prioritize financing sources, preferring internal funds first, then debt, and finally external equity.
- Internal funds (retained earnings) are preferred due to no flotation costs or adverse signaling.
- Debt is preferred over equity because it has lower information asymmetry costs.
- New equity issuance is a last resort, especially when management believes the stock is undervalued (adverse selection).
Memory trick: Capital's Core: Trade-offs & Pecking.