The pecking order explanation of capital structure states that a hierarchy of financing exists for firms, in which new external debt financing is employed first, followed by retained earnings and finally by external equity financing.

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The pecking order theory actually suggests that companies prioritize their sources of financing (from internal financing to equity) according to the principle of least effort, or least resistance, preferring to raise equity as a last resort. Hence, firms prefer to use internal funds first (retained earnings), then debt, and issue new equity only as a last resort.

The Pecking Order Explanation of Capital Structure States That a Hierarchy