Questions:
What is the Pecking Order Theory for capital structure?

Alex is a manager in LMN Limited's finance department. LMN is expanding its operations into a new city, and Alex is responsible for raising $10 million in order to execute this project. The company has taken loans in the past and has a good credit history, with an effective interest rate of 8%. The company's Beta is 1 with a risk free rate in market of 5% and a market risk premium of 12%, while their corporate tax rate is 25%. How should Alex finance the company's expansion project?

Note: The company has $2.5 million in retained earnings.

Reference answers:
Pecking Order Theory states that managers follow a hierarchy when selecting the sourcing of funding. Managers first consider internal retained earnings to fund investment opportunities followed by debt and then equity in the last. 

Equity financing involves the raising of funds through sale of company's shares. Selling of shares means to provide ownership to investors in exchange of funds. Companies undergo Initial Public Offering (IPO) when they go public and offer to sell shares for the first time. Investors earn dividend payments for their shares when companies declare them.

Debt financing on the other hand involves raising capital by selling debt instruments to investors. In exchange for borrowing the money the companies pay fixed payments (principal + interest) to lenders/investors.  

When a company considers external source of funding  they frequently prefer debt over equity due to the lower overall cost. The issuance of debt often signals an undervalued stock and confidence that the board believes the investment is profitable. On the other hand, the issuance of equity sends a negative signal that the stock is overvalued and that the management is looking to generate financing by diluting shares in the company. Debt is often "cheaper" than Equity because interest paid on debt is tax-deductible, and lenders’ expected returns are lower than those of equity investors (shareholders).

Alex needs to raise an additional $7.5 million since the company already has $2.5 million in retained earnings. The retained earnings will exhaust first and then based on information provided can estimate the cost of debt and equity here as follows,

Cost of debt = effective interest rate * (1 - tax rate)
                    = 0.08 * (1 - 0.25) 
                    = 0.06 0r 6%

Cost of equity = Risk free rate + Beta (Market risk premium - risk free rate)
                       = 0.05 + 1(0.12 - 0.05)
                       = 0.12 or 12%


With this in mind, Alex should opt to fund the remaining $7.5 million with debt rather than equity.