Question

According to the pecking order theory of capital structure, why do firms avoid issuing equity?

Answer 1

The pecking order theory of capital structure suggests that firms avoid issuing equity due to information asymmetry, loss of control, and higher cost of capital.

Step-by-step explanation:

The pecking order theory of capital structure suggests that firms avoid issuing equity due to several reasons:

1. Information asymmetry: When a firm issues equity, it becomes responsible to shareholders who have the right to access financial information about the company. This can lead to information leakage and potential loss of competitive advantage.
2. Loss of control: By issuing equity, the firm dilutes its ownership and control as shareholders now have a say in decision-making. This may affect management's ability to make strategic decisions.
3. Cost of capital: Equity is considered a more expensive source of funding compared to debt. When firms issue equity, they may need to offer a higher return to attract investors, increasing the cost of capital.

Overall, firms prefer to avoid issuing equity in order to maintain control, minimize information leakage, and manage their cost of capital.