Do Stocks of Debt-Free Firms with Higher Debt Capacity Perform Better in the Long Run?

What is it about?

Some companies choose to operate without debt even though borrowing can provide important benefits. This study examines whether the ability to borrow in the future, or debt capacity, helps explain the long-term stock performance of debt-free firms. We compare debt-free firms with different levels of debt capacity and examine their stock returns over the following one to five years. We find that debt-free firms generate positive abnormal returns regardless of their level of debt capacity. However, firms with greater debt capacity experience even stronger long-term stock performance.

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Why is it important?

Companies that avoid debt give up potential benefits of borrowing, such as tax advantages, raising the question of why some firms deliberately maintain a debt-free capital structure. One possible benefit is preserving the ability to borrow when attractive investment opportunities or financing needs arise. Our findings show that debt-free firms generate positive long-term abnormal stock returns and that debt-free firms with greater debt capacity exhibit stronger performance. These results provide useful insights into why maintaining financial flexibility through a conservative debt policy can be valuable and help explain the long-term stock performance of debt-free firms.

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