CAT / FIA FFM Syllabus D. Financing Decisions - Internal funds - Notes ^{6 / 6}

Managers usually choose to finance new projects or investments by making use of the following sources in the order shown:

1. Internal funds (retained earnings)

2. Debt

3. Equity

The above sequence is referred to as the “pecking order theory” and is based on observations of business behaviour.

The first choice is a natural one: retained earnings are already at the disposal of the company without involving costs or formalities.

They are not considered to be a free (costless) form of finance, however, they are available for distribution to the shareholders.

As along as they are retained by the firm, management is expected to earn a cost of equity return on such funds.