Pecking order theory ranks sources of finance in the order of cost of finance. Following sources of finance are arranged in increasing order of cost of finance.
Pecking order theory facilitates selection of financing methods according to cost of finance, risk, control, accessibility, tax benefits. In addition to pecking order theory, legal status of business such as sole proprietorship, partnership, private and public limited company) and attitude of business owner/managers.
Retained Earnings
Retained earnings are internally generated earnings, which are saved after payment of dividend to shareholders or earnings left after making consumer expenditure.
Cost of finance
Retained earnings are cheapest source of finance it requires no interest payment. Maximum cost of using retained earning as a source of finance will be opportunity cost of not being able to use retained earnings as a source of finance.
Risk
Retained earnings are less risky than all other sources of finance as retained earnings do not lead to legal liabilities for external reporting and payment of interest.
Retained earnings is suitable for pursuing incremental growth. Incremental growth is a low risk strategy. It allows business owner/managers to invest gradually rather than making one large investment.
Control
Use of retained earning as a source of finance prevents business owner/managers from outside interference. Even, if debt finance (see below) is used as a source of finance, then it may lead to restricted covenants, which may limit business owner/manger ability to take investment and financial decisions.
Tax benefit
Retained earning does not involve cash outflow. However, it has opportunity cost of loss of internet income. Tax rules in most jurisdiction allows only those expenses involving cash outflow. Non-cash expenses such as opportunity cost, bad debts expense, impairment of assets are not allowed for tax purpose.
Convertible Loan Notes
Convertible loan notes is a type of debt finance with a conversion option (right but not an obligation)to buy certain number of equity shares at pre-specified exercise price at maturity.
Cost of finance
Convertible loan notes are less expensive than debt finance (see below). Reduction in interest payment (expense) is take account of conversion option. Investor may agree on lower interest payments for future gains.
Risk
Use of convertible loan notes is considered less risky for business owner/manager. If conversion option is in the money, then presumably investors would exercise conversion option. However, convertible loan notes are also redeemable at maturity just as debt finance. Investor may prefer to redeem convertible loan notes rather than exercise an option (right but not an obligation) to buy equity shares.
Control
Convertible loan notes can result in transfer/dilution of control, if significant number of investors exercise conversion option. New shareholders may not have same preference for dividends, investments and risk.
Access
Convertible loan notes can only be used by publicly listed companies. Loan notes (either convertible or not) are an negotiable instrument traded in stock market/exchange.
Share is term used for equity finance in UK and stock is term used for equity finance in US.
Tax benefit
Convertible loan notes results in cash outflow in the form of interest payments. Interest payments (expense) are tax deductible expense in most jurisdictions. It reduces the cost of finance even lower by the percentage of tax rate applicable to business.
Tax benefit will cease on either redemption or conversion of loan notes into equity shares.
