Innovation plays a pivotal role in establishing and maintaining a competitive advantage in the market for firms because innovation can be the source of a profit increase and growth. In addition, innovation allows firms to obtain a stable profit by constructing the entry barrier for other firms. Thus, innovation can lower the default risk of firms. However, innovation can also increase the firm’s default risk because innovation requires too much investment of the firm’s resources. The purpose of this study is to examine the effect of innovation on the default risk of firms. Our sample consists of firms listed on the Korea Stock Exchange from January 1, 2000 to December 31, 2007. Our sample excludes financial and construction firms. Firms that issued preferred equities during the sample period are also excluded. This study makes use of R&D activity as an innovation input indicator and innovation performance as an innovation output indicator. R&D activity is measured as R&D expenditure divided by sales. Innovation performance is measured as the proportion of gross profit not explained by capital stock or labor. Alternatively, the number of new product or process improvement may be employed. Yet, there are other types of innovation such as new sources of supply, new market, and so on. The innovation performance is based on the Cobb-Douglas production function and captures the contribution of all innovation activities to a firm’s gross profits. The Merton’s (1974) model is adopted to compute the default probability which proxies the default risk of firms. The Merton’s model uses the market value of a firm’s equity and take account of the volatility of a firm’s assets, while accounting models such as the Altman’s (1968) Z-score model do not. Accounting models imply that firms with similar financial ratios have similar likelihoods of default. However, in the Merton’s model, firms which have similar levels of equity and debt may have quite different likelihoods of default when the volatilities of their assets differ (Vassalou and Xing, 2004). The empirical results are as follows. First, there exists a U-shaped relationship between R&D activity and the default risk of firms. In other words, R&D activity reduces the default risk, but too much R&D activity increases the default risk. Second, innovation performance monotonically reduces the default risk of firms. These results imply that considering the industrial and technological characteristics of the firm, a manager must make decisions on the optimal level of innovation activity and a policymaker need design a policy not to push innovation activity too much.