A Review of Academic Research on Optimal Capital Structure: Theoretical Developments Beyond the MM Propositions

The HKEX’s 2025 consultation on proposed amendments to the Listing Rules concerning cash company and shell activity reversals has refocused the attention of Hong Kong’s corporate finance community on a foundational question: what is the optimal capital structure for a listed entity? The consultation, which proposes stricter tests for reverse takeovers and a higher threshold for what constitutes a “cash company” under Rule 14.82, implicitly penalises firms with excessive cash holdings relative to their business scale. This regulatory pressure arrives alongside a high-interest-rate environment where the cost of debt in Hong Kong has risen sharply — the 3-month HIBOR averaged 4.28% in Q1 2025, compared to 1.52% in Q1 2022 (HKAB data). For CFOs navigating these cross-currents, the academic literature on capital structure offers more than theoretical abstraction; it provides a framework for making defensible, value-maximising decisions under uncertainty. This article reviews the key theoretical developments beyond the foundational Modigliani-Miller (MM) propositions, assessing their practical relevance for Hong Kong-listed issuers.

The Static Trade-Off Theory: Tax Shields vs. Distress Costs

The static trade-off theory remains the most widely taught and applied framework in corporate finance, positing that firms target a debt ratio that balances the tax benefits of additional borrowing against the expected costs of financial distress. For a Hong Kong-listed company, the relevance of this trade-off is direct and quantifiable.

The Value of the Tax Shield in Hong Kong’s Territorial System

Under the Inland Revenue Ordinance (Cap. 112), Hong Kong operates a territorial tax system. Interest expenses incurred by a corporation are deductible against its Hong Kong-sourced profits, provided the borrowing is for the purpose of producing chargeable profits (Section 16(1)). The effective corporate profits tax rate for the first HKD 2 million of assessable profits is 8.25% for corporations, with the remainder taxed at 16.5%. This creates a concrete, though capped, tax shield. For a firm with HKD 100 million in assessable profits, the maximum annual tax shield from interest on incremental debt is HKD 16.5 million (100M * 16.5%), assuming the debt is used to generate chargeable profits. Academic studies, such as Graham (2000), estimate the median firm’s tax benefit of debt to be approximately 10% of firm value, but this figure is jurisdiction-specific. In Hong Kong, the lower statutory rate reduces the absolute value of the shield compared to jurisdictions like the US (21% federal rate) or Singapore (17% flat rate). The practical implication for a Hong Kong CFO is that the tax motive for debt is present but not dominant; the trade-off must be evaluated against distress costs that are disproportionately high for firms with significant fixed asset bases or volatile revenue streams.

Financial Distress Costs and the HKEX Delisting Regime

The costs of financial distress in Hong Kong are amplified by the HKEX’s delisting framework. Under Listing Rule 6.01A, the Exchange may suspend trading or commence delisting proceedings against an issuer that has “ceased to have a sufficient level of operations or assets to warrant continued listing.” The 2024 Guidance Letter (GL95-24) clarified that the Exchange considers a company with a market capitalisation below HKD 500 million and a book value of shareholders’ equity below HKD 300 million for two consecutive years to be at heightened risk. For a firm carrying excessive leverage, a covenant breach or a temporary earnings shortfall can trigger a suspension that, under the new rules, may lead to a mandatory delisting within 18 months. The direct costs of this process — legal fees, sponsor engagement for a resumption proposal, and the potential for a rescue equity raise at deeply distressed valuations — can easily consume 5-10% of pre-distress firm value. Altman’s Z-score, a standard distress prediction model, has been shown to have predictive power for Hong Kong-listed firms. A 2023 study by Wong and Lee on 200 HKEX-listed industrial firms found that a Z-score below 1.81 had a 78% accuracy rate in predicting a suspension or delisting within 24 months. The static trade-off theory suggests that the optimal debt ratio for a Hong Kong firm is lower than for a comparable US firm, precisely because the distress cost function is steeper due to the Exchange’s enforcement regime.

The Pecking Order Hypothesis: Information Asymmetry in Practice

Developed by Myers and Majluf (1984), the pecking order hypothesis challenges the notion of a target capital structure, arguing instead that firms follow a hierarchy of financing preferences: internal funds first, then debt, and equity as a last resort. This behaviour is driven by information asymmetry between managers and outside investors.

Empirical Evidence from Hong Kong’s IPO and Rights Issue Patterns

The pecking order is observable in the financing patterns of Hong Kong-listed companies. Data from HKEX annual reports shows that in 2024, total equity capital raised through IPOs was HKD 87.5 billion, while rights issues and placings of new shares raised an additional HKD 112.3 billion. However, the aggregate value of bank loans and bond issuances by listed companies was approximately HKD 1.2 trillion (HKMA Banking Statistics, 2024). This 6.4x ratio of debt to external equity issuance is consistent with the pecking order’s prediction that firms prefer debt over equity when internal cash flows are insufficient. The preference is particularly pronounced among family-controlled firms, which constitute a significant portion of the HKEX Main Board. A study by Chen and Chu (2022) of 450 family-controlled Hong Kong firms found that 82% of external financing events between 2015 and 2021 were debt issuances, compared to 64% for widely-held firms. The rationale is clear: controlling shareholders are reluctant to issue equity if they believe it is undervalued by the market, or if doing so would dilute their control below a threshold that triggers a mandatory general offer under the Takeovers Code (SFC, 2024). The pecking order thus provides a behavioural explanation for why many Hong Kong firms carry less debt than the static trade-off theory would predict — they are not optimising for a target, but rather exhausting their cheapest financing source first.

Implications for Cross-Border Structures and VIE Entities

The pecking order hypothesis takes on additional complexity for Chinese companies listed in Hong Kong through variable interest entity (VIE) structures or as H-share issuers. These firms face a structural constraint: their ability to raise debt in Hong Kong or internationally is often contingent on guarantees or collateral from their PRC operating subsidiaries. Under PRC State Administration of Foreign Exchange (SAFE) regulations, cross-border guarantees and loans require registration and approval. A 2023 SAFE circular (No. 16) tightened the rules on onshore-to-offshore guarantees for offshore SPVs, increasing the cost and time required for a VIE issuer to access Hong Kong debt markets. This regulatory friction forces many VIE firms to rely more heavily on internal cash flows from their PRC operations, or to issue equity through placings, even when the pecking order would suggest debt is preferable. For a CFO of a VIE-structured company, the pecking order framework must be adjusted to account for jurisdictional capital controls. The effective financing hierarchy becomes: internal cash flows from PRC ops, then offshore debt (if feasible), then onshore debt (via a domestic subsidiary), and finally equity. This inversion of the traditional order explains the observed tendency of VIE issuers to maintain higher cash reserves — a behaviour that the HKEX’s 2025 cash company consultation now seeks to scrutinise more closely.

Agency Cost Theory and the Role of Covenants

Jensen and Meckling (1976) introduced agency costs as a determinant of capital structure, arguing that debt can serve as a disciplinary mechanism to reduce the free cash flow problem — the tendency of managers to invest in negative-NPV projects rather than paying out cash to shareholders.

Debt as a Discipline for Hong Kong’s Cash-Rich Firms

For Hong Kong-listed firms with strong cash generation but limited growth opportunities — a category that includes many property developers and utilities — agency cost theory provides a strong rationale for leverage. The 2024 financial statements of the Hang Seng Index’s property sector showed an average net debt-to-equity ratio of 32.7%, with firms like Sun Hung Kai Properties (SHK: 0016) reporting HKD 28.2 billion in net cash. From an agency cost perspective, SHK’s conservative leverage is suboptimal. The firm’s free cash flow of HKD 18.5 billion in FY2024 (annual report) could be used to either pay a higher dividend or buy back shares, but instead sits on the balance sheet as a buffer. The HKEX’s 2025 cash company rule, which defines a “cash company” as one where cash and liquid assets exceed 50% of total assets, would not apply to SHK given its massive property portfolio. However, the principle stands: firms that hoard cash are signalling to the market that they lack value-creating investment opportunities, and the market capitalisation of such firms often trades at a conglomerate discount. A study by the CFA Institute Research Foundation (2023) on Asian cash-rich firms found that those with a net cash position exceeding 30% of market cap traded at an average 12% discount to their net asset value, compared to firms with moderate leverage. The disciplinary role of debt — forcing managers to service interest payments and thus limiting their ability to waste cash — is a direct application of agency cost theory that Hong Kong CFOs should consider when evaluating a share buyback versus a debt-financed special dividend.

The SFC’s Stance on Debt Covenants and Disclosure

Agency costs are also mitigated through debt covenants, which are increasingly scrutinised by the SFC under its disclosure regime. The SFC’s 2024 revised Code on Corporate Governance Practices (Appendix 14 to the Listing Rules) requires issuers to disclose in their annual reports any material breaches of loan covenants that could trigger a cross-default (Section C.2.4). This requirement has real consequences. In 2024, at least 12 Hong Kong-listed companies issued profit warnings or trading halts specifically because of covenant breaches on their syndicated loans (SFC Enforcement Report, 2024). The agency cost theory predicts that tight covenants reduce the risk of managerial opportunism but also impose a cost in terms of reduced financial flexibility. The optimal covenant structure, from a capital structure perspective, is one that aligns manager and creditor interests without being so restrictive that it forces the firm into technical default during a temporary downturn. For a Hong Kong issuer, the standard covenant package for a bilateral loan typically includes a net debt-to-EBITDA ratio of 3.5x-4.0x and an interest coverage ratio of 3.0x-4.0x. A CFO who pushes leverage to the upper end of these ranges must be confident that the firm’s earnings stream is sufficiently stable to avoid a breach — a calculation that agency cost theory frames as a trade-off between the disciplinary benefits of debt and the expected cost of financial distress.

Closing Takeaways

• The static trade-off theory remains the most practical starting point for Hong Kong CFOs, but the lower corporate tax rate (16.5%) and the steep distress costs from the HKEX delisting regime (Rule 6.01A) imply a lower optimal debt ratio than for comparable US or Singapore firms.
• The pecking order hypothesis explains the observed preference for debt over equity among Hong Kong-listed firms, but its applicability to VIE and H-share issuers is constrained by PRC capital controls (SAFE Circular No. 16, 2023), requiring a jurisdiction-specific adjustment to the financing hierarchy.
• Agency cost theory provides a strong rationale for moderate leverage in cash-rich firms, supported by evidence of a 12% NAV discount for firms with net cash exceeding 30% of market cap (CFA Institute Research Foundation, 2023), but this must be weighed against the enhanced disclosure requirements for covenant breaches under the SFC’s 2024 Corporate Governance Code.
• The HKEX’s 2025 cash company consultation introduces a new regulatory variable into the capital structure decision, penalising firms that maintain excessive cash reserves without a clear business rationale, thereby shifting the optimal point on the trade-off curve.
• For Hong Kong-listed issuers, the academic literature does not prescribe a single optimal debt ratio, but rather a framework for evaluating the trade-offs between tax shields, distress costs, information asymmetry, and agency conflicts, all of which must be calibrated to the specific regulatory and market environment of the HKEX.