Internal financing

In the theory of capital structure, internal financing is the name for a firm using its profits as a source of capital for new investment, rather than a) distributing them to firm's owners or other investors and b) obtaining capital elsewhere. It is to be contrasted with external financing which consists of new money from outside of the firm brought in for investment. Internal financing is generally thought to be less expensive for the firm than external financing because the firm does not have to incur transaction costs to obtain it, nor does it have to pay the taxes associated with paying dividends. Many economists debate whether the availability of internal financing is an important determinant of firm investment or not. A related controversy is whether the fact that internal financing is empirically correlated with investment implies firms are credit constrained and therefore depend on internal financing for investment.^{[1] [2]}

Advantages & Disadvantages of internal financing

Advantages

• Capital is immediately available
• No interest payments
• No control procedures regarding creditworthiness
• Spares credit line
• No influence of third parties
• More flexible
• More freedom given to the owners

Disadvantages

• Expensive because internal financing is not tax-deductible
• No increase of capital
• Losses (shrinking of capital) are not tax-deductible
• Limited in volume (volume of external financing as well is limited but there is more capital available outside - in the markets - than inside of a company)

See also

• external financing
• capital structure

External links

• Definition at investor words.

References

1. Hubbard, Kashap and Whited, "Internal Financing and Investment", Journal of Money, Credit & Banking, 1995
2. RE Carpenter, BC Petersen , "Is the Growth of Small Firms Constrained by Internal Finance?," Review of Economics and Statistics, 2002 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=259864