Pecking Order Theory in Capital Structure Decisions

Medium Capital Structure Decisions Pecking Order Theory

Smith Enterprises, a medium-sized manufacturing firm, is exploring its options for financing a new project that is expected to generate significant cash flows. The CFO, Jane, is well-versed in capital structure theories and is considering how their existing financial leverage will impact her decisions.

Given the company's history of issuing equity as a last resort, Jane is leaning towards a financing approach that aligns with the Pecking Order Theory. According to this theory, companies prioritize their sources of financing in the following hierarchy: internal funds (retained earnings) first, then debt, and lastly, equity.

Which of the following actions is most aligned with the Pecking Order Theory as described in the context of Smith Enterprises?

Smith Enterprises should utilize retained earnings to finance the new project before considering any external debt.

Smith Enterprises should issue new equity to raise funds for the project as it is the most flexible financing option.

Smith Enterprises should seek to refinance existing debt to improve its capital structure before proceeding with the project.

Hint

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