Newbury Inc.has retained $2 million in earnings this year.It can borrow up $1.5 million at a rate of 8% and sell the same amount of new stock at a cost of 17%.Newbury cost of common equity without selling any new stock is 16%.If Newbury's capital budget is $2.5 million,pecking order theory says management will use:

Question

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According to pecking order theory, management would prefer to use retained earnings first, then debt and lastly new equity. In this case, Newbury has $2 million in retained earnings, which is enough to cover its capital budget of $2.5 million. Using debt or selling new equity would be a less preferable option for management as it would increase their cost of capital. Therefore, the best option for Newbury is to use the $2 million in retained earnings and borrow the remaining $0.5 million.