According to the Pecking Order Theory of financing, which source is preferred first by firms?

• A. External equity
• B. Debt
• C. Internal financing
• D. Government subsidies

Answer: (C)

In the Pecking Order Theory, firms prioritize internal funds before seeking external financing. This happens because using retained earnings or other internal resources avoids the costs and signaling problems that come with external funds. Internal financing carries no flotation costs, no need to raise new capital from outside investors, and it avoids conveying to the market that the firm is in need of cash or that its stock is overvalued. Issuing debt is preferred over equity when external funds are needed, because debt can be cheaper and provides tax advantages, but it still signals leverage and introduces default risk. Issuing new external equity is the least favored because it often sends negative signals about the firm’s prospects and incurs higher issuance costs. Government subsidies are not part of the standard hierarchy. Therefore, the first source firms turn to is internal financing.