Titile: Pecking-Order Theory A number of corporate finance textbooks talk about

Question

Titile: Pecking-Order Theory

A number of corporate finance textbooks talk about pecking-order theory as it relates to firms seeking financing. The theory states that all things considered, firms tend to prefer the use of internal funds as their first choice for financing. What is meant by "internal funds" and why do you think firms tend to prefer the use of these funds over other funds? Finally, search the current balance sheet of any publicly traded company and determine what percentage of their assets are financed with internal funds.

Explanation / Answer

Ordinarily the company does not distribute all the profits in the form of dividend but distributes only a part of net profit and the remaining portion of profits are invested in business. So year after year the company makes sufficient funds by retaining the portion of their profits earned every year for making future investment into the business. These funds are referrred to as Internal funds.

Companies prefer internal funds over the external funds (Debt and equity) because Cost of internal funds is less than the Cost of external funds. Companies do not need to pay any interest on the use of internal funds whereas in case of use of external funds, interest is to be paid regularly on debts, loans etc. Further, Control of company's business remains in the hand of the founders of the company with the use of internal funds.

Example:- The Walt Disney Company Balance Sheet for the period ending on 02 April 2016:-

Percentage of total assets that are financed with internal funds = Retained earnings / Total assets * 100

   = 62870000 / 90264000 * 100

= 69.65 % (approx)

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