Newbury Inc. has retained $2 million in earnings this year. It can borrow up to $1.5 million at a rate of 8% and sell the same amount of new stock at a cost of 17%. Newbury's 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

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According to pecking order theory, a firm will first use internal funds, such as retained earnings, to finance its capital budget. In this case, Newbury Inc. has $2 million in retained earnings and a capital budget of $2.5 million, so it can fully finance its capital budget using its retained earnings. This is the most cost-effective option since the cost of common equity without selling any new stock is 16%, which is lower than the cost of new equity (17%) or new debt (8%). Therefore, the best choice is to use $2 million in retained earnings and $0.5 million in debt.