WHY DO PROFITABLE FIRMS USE LESS DEBT?

Jianzhou Zhu
University of Wisconsin – Whitewater
Ye Yuan
Southern Illinois University at Carbondale
ABSTRACT
In this study, the authors find that a positive earnings shock causes a firm’s equity debt
spread to narrow while a negative earnings shock causes a firm’s equity debt spread to widen.
When a cross sectional observation is taken, it is found that more profitable firms tend to face a
smaller equity premium over its own debt relative to their less profitable counterparts. Firms in
the former group are less reluctant to raise external equity compared to the less profitable firms.
This finding provides one of the potential explanations to the “under-leverage puzzle”
documented in corporate finance literature.