Financing Frictions and the Substitution Between Internal and External Funds*

Ample evidence points to a negative relation between internal funds (profitability) and the demand for external funds (debt issuance). This relation has been interpreted as evidence supporting the pecking order theory. We show, however, that the negative effect of internal funds on the demand for external financing is concentrated among firms that are least likely to face high external financing costs (firms that distribute large amounts of dividends, that are large, and whose debt is rated). For firms in the other end of the spectrum (low payout, small, and unrated), external financing is insensitive to internal funds. These crossfirm differences hold separately for debt and equity, and are magnified in the aftermath of macroeconomic movements that tighten financing constraints. We argue that the greater complementarity between internal funds and external finance for constrained firms is a consequence of the interdependence of their financing and investment decisions.