Pecking order theory
Pecking order theory proposes firms finance new investment first from retained earnings, then debt, and equity only as a last resort. Information asymmetry makes external equity a costly signal, so no single optimal debt ratio exists.
FrameworkCapital structure theory
See it move
Managers know more about their firm's true value than outside investors, so issuing new equity signals the shares may be overpriced, depressing the price on announcement. To avoid that penalty, firms finance investment first from retained earnings, which carry no information cost, then from debt, where lenders' priority claims reduce the asymmetry problem, and turn to external equity only as a last resort.
Check yourself
Meridian SA has sufficient retained earnings to fund its planned capital investment programme in full. According to pecking order theory, which financing choice should it prefer, and what is the primary reason?