If internal funds are insufficient, what is the next preferred financing source in the Pecking Order Theory?

• A. External equity
• B. Debt
• C. Internal financing
• D. Leasing

Answer: (B)

In Pecking Order Theory, firms finance first with internal funds. When those are not enough, the next preferred source is debt. This choice avoids diluting ownership and typically carries lower issuance and signaling costs than selling new equity, making it a cheaper, more straightforward way to raise funds. Issuing equity can signal problems or overvaluation and comes with flotation costs and greater information costs, so it’s used only after debt has been utilized. Leasing is a way to obtain financing, but the standard hierarchy places debt ahead of external equity, with equity as a last resort.