Question

Why does a firm likely to choose internal financing when available and choose debt over equity when external financing is required? Explain in light of the pecking order theory.

Answer 1

A firm is likely to choose internal financing when available and choose debt over equity when external financing is required. This is in the order of lowest cost to highest cost of financing.

Internal financing through retained earnings is cheaper than debt which is cheaper than equity.

So, when the free cash flow is available, and the firm is in need of financing, then it first chooses to use its own funds. If required, the firm next looks to raise money through debt. Debt is cheaper than equity because it is backed by company's assets. If further financing is needed, then the firm looks to raise money by issuing shares (equity).

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