A STUDY OF CAPITAL STRUCTURE

MANAGEMENT OF COMMERCIAL BANKS

(With reference to NABIL Bank Ltd, Himalayan Bank Ltd
and
Nepal Investment Bank Ltd.)

By: ANUPAMA
SHRESTHA Shanker
Dev Campus
T.U. Regd. No: 7-2-503-10-2002
Exam Symbol No. 6188/2063

A Thesis Submitted to:

Office of the Dean
Faculty of Management
Tribhuvan University

In partial fulfillment of the requirement for the Degree of

Master of Business Studies (M.B.S)

Kathmandu, Nepal
March, 2010
 RECOMMENDATIO
N
This is to certify that the Thesis

Submitted by:
ANUPAMA SHRESTHA

Entitled:
A STUDY OF CAPITAL STRUCTURE MANAGEMENT
OF COMMERCIAL BANKS
(With reference to NABIL Bank Ltd, Himalayan Bank Ltd
and
Nepal Investment Bank
Ltd.)
has been prepared as approved by this Department in the prescribed format of the
Faculty of Management. This thesis is forwarded for examination.

………..……..…….……… .……………....……………. ….…….….……….………

Shree Bhadra Neupane Prof. Bisheshwor Man Shrestha Prof. Dr. Kamal Deep
Dhakal
(Thesis Supervisor) (Head of Research Department)
(Campus Chief)

………..……..…….………
Rabindra Bhattarai
(Thesis Supervisor)
2
 VIVA-VOCE SHEET

We have conducted the viva –voce of the thesis presented

by
ANUPAMA SHRESTHA

Entitled:
A STUDY OF CAPITAL STRUCTURE MANAGEMENT
OF COMMERCIAL BANKS
(With reference to NABIL Bank Ltd, Himalayan Bank Ltd
and
Nepal Investment Bank
Ltd.)

and found the thesis to be the original work of the student and written according
to the prescribed format. We recommend the thesis to be accepted as partial
fulfillment of the requirement for the Degree of
Master of Business Studies (MBS)

Viva-Voce Committee

Head, Research Department …………………….

……… Member (Thesis Supervisor) …..

……………………….. Member (Thesis Supervisor)

…..……………………….. Member (External Expert)

…..………………………..
 TRIBHUVAN

UNIVERSITY Faculty of

Management Shanker Dev

Campus

DECLARATION

I hereby declare that the work reported in this thesis entitled “A STUDY OF
CAPITAL STRUCTURE MANAGEMENT OF COMMERCIAL BANKS
(With reference to NABIL Bank Ltd, Himalayan Bank Ltd and Nepal
Investment Bank Ltd.)” submitted to Office of the Dean, Faculty of
Management, Tribhuvan University, is my original work done in the form of partial
fulfillment of the requirement for the Degree of Master of Business Studies (MBS)
under the supervision of Shree Bhadra Neupane and Rabindra Bhattarai of
Shanker Dev Campus.

……………………………
… ANUPAMA
SHRESTHA Researcher
T.U. Regd. No: 7-2-503-10-
2002
Exam Symbol No.
6188/2063
 ACKNOWLEDGEMENT

The Study “A Study of Capital Structure Management of Commercial Banks

(With Reference to NABIL Bank Ltd, Himalayan Bank Ltd and Nepal Investment
Bank Ltd.)" has been carried out in partial fulfillment of the Master’s
Degree in Business Studies(MBS).

I would like to thank all of those who helped me by sharing ideas, giving suggestions
and encouraging me in writing this thesis.

I would like to express special gratitude to thesis supervisors Shree Bhadra Neupane
and Rabindra Bhattrai of Shanker Dev Campus, without whose proper advice,
guidance and supervision; this study could not be completed. I am equally grateful
to all my respected teachers of SDC for their kind support and valuable suggestions.

I have taken considerable help from several well known books, articles of Nepalese
and foreign writers while preparing this study. I owe great intellectual debt to college
library, Shankar Dev Campus, Central Library of Tribhuvan University, Security
Board of Nepal and the staff members of my sampled banks.

At last, I would like to thank my family, friends and all those who helped me directly
and indirectly in course of this study preparation.

Anupama
Shrestha
 ABBREBRIATION
S

B = Value of Debt
CB = Commercial
Bank CE = Capital
Employed DA = Debt Asset
Ratio DE = Debt Equity
Ratio
DF = Degree of Financial
Leverage DPR = Dividend Payout
Ratio DPS = Dividend per share
EAT = Earning after
Tax
EBIT = Earning Before interest and
Tax
EBT = Earning Before
Tax EPS = Earning per
Share F/Y = Fiscal years
HBL = Himalayan Bank
Ltd
I= Interest
ICR = Interest Coverage
Ratio
JVB = Joint Venture
Bank
K = Cost of Capital K=
Overall Capitalization Rate Kd
= Cost of Debt
Ke = Cost of
Equity
LTD = Long Term Debt LTDCE
= Long Term Debt to Capital Employed Ratio LTDTD
= Long Term Debt to Total Debt Ratio NBL
= Nabil Bank Ltd
NG = Nepal
Government
NI = Net Income
NIBL = Nepal Investment Bank
Ltd
NOI = Net Operating
Income
 P.E = Probable Error
PC = Permanent
Capital
r = Correlation
Coefficient
RBB =
Rastriya Banijya
ROA = Return on Assets
ROE = Return on Equity
S = Market Value of Stock
TA = Total Assets
TD = Total Debt
V = Value of Firm
WACC =Weighted Average Cost of Capital
TABLE OF
Recommendation CONTENTS
Viva-Voce Sheet
Declaration
Acknowledgemen
t Table of
Contents List of
Tables
List of Figures
Page No.
Abbreviations
CHAPTER – I INTRODUCTION
1.1 Background of the Study 1
1.2 Focus of the Study 3
1.3 Statement of the Problems 3
1.4 Objectives of the Study 5
1.5 Significance of the Study 5
1.6 Limitations of the Study 6
1.7 Organization of the Study 6

CHAPTER – II REVIEW OF LITERATURE

2.1 Conceptual Frame Work 8
2.1.1 Meaning of Capital Structure and Financial Structure 8
2.1.2 Approaches to Capital Structure 12
2.1.2.1 Traditional Approach 14
2.1.2.2 Net Income Approach 17
2.1.2.3 Net Operating Income Approach (NOI) 20
2.1.2.4 Modigliani-Miller Approach (MM approach) 21
2.1.2.5 Financial Leverage 25
2.2 Review of Independent Studies 25
2.3 Review of Thesis 29
CHAPTER – III RESEARCH METHODOLOGY
3.1 Research Design 34
3.2 Period Covered 34
3.3 Nature and Sources of Data 34
3.3.1 Financial Analysis 34
3.3.1.1 Ratio Analysis 35
3.3.1.2 Profitability Ratio 39
3.4 Statistical Tools 39
3.4.1 Correlation Coefficient (r) 40
3.4.2 Probable Error (P.E) 40
3.4.3 Simple Regression Analysis 41

CHAPTER – IV DATA PRESENTATION AND ANALYSIS

4.1 Introduction 43
4.2 Presentation and Analysis of Data 43
4.2.1 Capital Structure Analysis 43
4.2.1.1 Debt Equity Ratio 43
4.2.1.2 Long Term Debt to Capital Employed Ratio 45
4.2.1.3 Debt to Total Assets Ratio 46
4.2.1.4 Long Term Debt to Total Debt Ratio 48
4.2.1.5 Interest Coverage Ratio 49
4.2.1.6 Return on Share Holders’ Equity 51
4.2.1.7 Return on Total Assets 52
4.2.1.8 Earning Per Share (EPS) Analysis 54
4.2.1.9 Dividend Per Share (DPS) Analysis 55
4.2.2 Analysis of Financial Leverage 56
4.2.3 Correlation Analysis 58
4.2.3.1 Correlation of Nabil Bank 59
4.2.3.2 Correlation of Himalayan Bank 60
4.2.3.3 Correlation of Nepal Investment Bank Ltd 60
4.2.3.4 Overall Correlation 61
4.2.4Simple Regression Analysis
62
4.3 Major Findings of the Study
63
CHAPTER – V SUMMARY, CONCLUSION AND RECOMMENDATIONS
5.1 Summary 66
5.2 Conclusion 67
5.3 Recommendations 68

Bibliography
Appendices
 LIST OF TABLES

Table No. Title Page

No.
4.1 Comparative Debt – Equity Ratio 43
4.2 Comparative Long Term Debt to Capital Employed Ratio 45
4.3 Debt to Total Asset Ratio 46
4.4 Comparative Long Term Debt to Total Debt 48
4.5 Interest Coverage Ratio 49
4.6 Return on Shareholder's Equity 51
4.7 Return on Total Assets 52
4.8 Comparative Earning Per Share 54
4.9 Comparative Dividend per Share 55
4.10 Degree of Financial Leverage 57
4.11 Correlation of Nabil Bank 59
4.12 Correlation of Himalayan Bank 60
4.13 Correlation of Nepal Investment Bank Ltd 60
4.14 Overall Correlation 61
4.15 Debt Equity (DE) is Regressed on Return on Equity 62
4.16 Debt Equity (DE) is Regressed on Return on Assets 62
4.17 Debt Equity (DE) is Regressed on Dividend Payout Ratio 63
 LIST OF
FIGURES

Figure No. Title Page No.

2.1 The effect of Leverage on Cost of Capital under Traditional Theory 17
2.2 The effect of Leverage on Cost of Capital 19
2.3 The effect of leverage on Total Market Value of the Firm 19
2.4 The effect of Leverage of Cost of Capital 21
2.5 The effect of Leverage on value of firm 21
2.6 The cost of capital under the MM hypothesis 23
2.7 Behavior of K, Kd and Ks under M-M hypothesis 25
4.1 Comparative Debt Equity Ratio 44
4.2 Comparative Long Term Debt to Capital Employed Ratio 45
4.3 Debt to Total Asset Ratio 47
4.4 Comparative Long Term Debt to Total Debt Ratio 48
4.5 Comparative Interest Coverage Ratio 50
4.6 Comparative Return on Shareholder's Equity Ratio 51
4.7 Comparative Return on Total Assets Ratio 53
4.8 Comparative Earning Per Share 54
4.9 Comparative Dividend Per Share 56
4.10 Comparative Degree of Financial Leverage 57
 CHAPTER - I
INTRODUCTION

1.1 Background of the

Study
The commercial bank has been a vital ingredient for economic development. They
are intermediaries, which mobilize funds through the prudential combination of
investment portfolios in advanced countries. Whereas in Nepal the role of joint
venture banks are still to be realize as an essential machine of mobilizing internal
saving through various banking schemes in the economy. Hence, to uplift the
backward economic condition of the country, the process of capital accumulation
among other pre requisition, should be expedited.

Capital accumulation plays an essential role in acceleration of the economic

growth of nations. But the capacity of saving in the developing country is quite low
with a relatively higher marginal propensity of consumption. As a result developing
countries are badly trapped into the vicious circle of poverty. The basic problem of
these countries is raising the level of saving and investments. In order to collect the
enough saving and put them into productive channels, financial institutions like
banks are necessary. It will be utilize within the economy and will either be
diverted abroad or used for productive consumption or speculative activities.

“Capital structure concept holds a major place in the financial management.

Capital structure refers the proportion of debt and equity capital. A perfect balance
between debt and equity is required to ensure the trade-off between risk and
return. Thus, optimal capital structure means the capital structure having
reasonable proportion of debt and equity. An optimal financial structure makes
better use of society’s fund of capital resources, and thus it increases the total
wealth of society” (Solomon; 1969: 92). Also, by increasing the firm’s opportunity
to engage in future wealth-creating investment, it increases the economy’s rate of
investment and growth.
Commercial banks are the suppliers of finance for trade and industry, which plays
vital role in the economic and financial life of the country. They help in the
formation of capital by investing the savings in productive areas. Rural people of
under developed countries like Nepal need various banking facilities to enhance its
economy. In most of the countries, the banks are generally concentrated in urban and
semi-urban sectors. They neglect rural sector due to heavy risk and low return,
which is in fact, without it, other sectors of economy cannot be flourished.

The concept of banking is developed from the history with the effort of ancient
gold smith who developed the practices of storing people’s gold and valuables. They
received valuables and used to issue a receipt to the depositors. As such receipts
are good for payment equipment to the amount mentioned, it become like the
modern cheque, as a medium of exchange and means of payment.

The history of the systematic development of commercial banks in Nepal as

compared to other developed countries is of recent origin. In Nepal, efforts are
being made to accelerate the pace of economic development after the adaptation of
first five year plan in
1956. Nepal Bank Limited, the first and oldest bank in modern banking history of
Nepal, was established in 1937A.D. (30 th Kartik, 1994 B.S) with 51% government
equity. Nepal Bank Limited also used to function as central bank of the country up
to 2012 B.S. On
2013 B.S, Nepal Rastra Bank was established as central bank of Nepal under the
Nepal Rastra Bank Act 2012. Government initiated some corrective measures to
stabilize the economy with the assistance of IMF standby arrangement in mid
1980s. In F/Y 1985, it subsequently embarked upon structured adjustment program
encompassing measures to increase domestic resource mobilization, strengthen
financial sectors and liberalize industrial and trade policies. Since then several
financial institutions and commercial joint venture banks have been
established in the process of development and liberalization policy for the
economic development of the nation.
The commercial bank collect the scattered saving and place them into
productive channels. They hold the deposit of many persons, government
establishments and business units. They make funds available through their lending
and investing activities
to borrowers, individuals, business firms and government establishments. In doing
so, they assist both the flows of goods and services from the government. They are
media through which monetary policy is affected. These banks are resource for
development. It maintains economic confidence of various segments and extends
credit to people.
At present altogether 26 commercials banks are operating in Nepal. The condition of
two oldest public sector banks is bad at the moment. But the third public sector
development bank, ADB/N (Agriculture Development Bank Limited) which is
also operating as a commercial banking and is still doing well despite political and
bureaucratic interference and internal problems. The remaining private sector banks
are all in a profitable position even when there is cut through neck competition
among them. Some development banks and well managed finance companies are also
competing with these banks.

1.2 Focus of the Study

As it is a well known fact that the commercial banks can affect the economic
condition of the whole country, the effort is made to highlight the capital
structure policy of commercial banks expecting that the study can balance the
proportion of the equity and debt capital used by the commercial banks. Banking in
this era has a new meaning and dimension which is now offering many extra
services rather than just accepting deposits and granting loans. So this thesis has
been initiated to have a bird eye view on the capital structure of the commercial
banks/JVBs, with special reference to NABIL Bank Ltd, Himalayan Bank Ltd
and Nepal Investment Bank Ltd. This Thesis tries to evaluate various aspects of
capital structure as earning per share of bank, cost of capital, share holder’s
equity etc. The thesis focuses on the capital structure of Nabil bank Ltd,
Himalayan Bank Ltd and Nepal Investment Bank Ltd and examines its financial
position in various years by range of capital structure tools and various approaches.
It primarily put spot light on the capital structure of Nabil Bank / Himalayan Bank /
Nepal Investment Bank and merely focuses on other aspects such as management,
profit functions, banks performance etc.

1.3 Statement of the

Problems
Capital structure refers to the proportion of different types of securities issued by the
firm like common shares, long term debt, preference share capital, debentures and
retained earnings. We know that major portion of the capital comprises of
owners fund and creditors fund. The owners expect dividend and appreciation in
the share price whereas creditors expect interest and return of the fund at the
mentioned time. So the capital structure of the firm is important factor in
determining the success of the firms. The firm is successful if it can optimize its
capital structure and the capital is optimal when the overall cost of capital of the
firm is minimized and profitability is maximized. So, analysis of the capital
structure of the selected CBs will help optimal capital structure, which minimizes
cost of capital and maximizes profitability.

Always being controversy in capital structure between financial theorists

and corporate manager. So, there is number of capital structure theories
proposed by different personalities. This is the area in which several
theoretical and empirical works have been done by different personalities.
Capital structure theories developed so far are clung to the question of
existence of the optimal capital structure. Most of the theoretical and empirical
debuts so far are revolved around the maximization of the value of firms
through the judicious composition of its debt and equity fund.
Net income (NI) approach and Traditional theory of capital structure claims
that there is the existence of the optimal capital structure. They contend that
proper mix of debt and equity can maximize the value of the firms.
Whereas, net operating income (NOI) approach and M-M hypothesis contend
that capital structure is irrelevant to the value and cost of capital of the firm.
According to the NOI approach, cost of equity increases linearly as debt
increases in the capital structure.
M-M hypothesis states that there is no level optimal capital structure. They
support the NOI approach by providing logically consistent behavioral
justifications in its favor. Between the two extreme views, we have the middle
position of intermediate version advocated by the traditional writers. Thus,
there exists an optimum capital structure at which the cost of capital is low.
 As different approaches hold different beliefs related to the impact of
capital structure on the value of the firm, this thesis has been commenced,
analyzing different aspect of commercial bank’s capital structure which is
done by taking Nabil Bank Ltd, Himalayan Bank Ltd and Nepal Investment
Bank Ltd as reference.

Thus this thesis has been commenced, analyzing different aspect of commercial
bank’s capital structure which is done by taking Nabil Bank Ltd, Himalayan Bank Ltd
and Nepal Investment Bank Ltd as reference and has been tried to map out the
current capital structure and the solvency as well as the relationship between debt
equity ratio, long term debt to debt ratio, debt ratio, Return on Assets and Return
on Equity of these three commercial banks.

1.4 Objectives of the Study

The main objective of this study is to analyze capital structures of sample banks,
more specifically the objectives are as follow
To examine the capital structure of commercial banks.
To examine the correlation and the significance of their relationship
between different ratios related to capital structure.
To analyze the debt servicing capacity of the sample banks.
To analyze effect of capital structure on ROA, ROE and Dividend payout Ratio.

1.5 Significance of the Study

The study has been done in reference to the periodical performance of Nabil Bank
Ltd, Himalayan Bank Ltd and Nepal Investment Bank Ltd. The study has tried to
focus on capital structure of the bank so the study could be significant in revising the
banks ca pital structure for past five years at a glance. The study could be beneficial
to various groups of people in following ways
a. Investors: This study provides the valuable information about the debt and
equity (leverage) ratio of the selected Nepalese enterprise. Investors will be
benefited by such information to perform securities analysis before taking
investment decision.
 b. Financial manager: Financial managers of Nepalese enterprise will be
benefited because they will get important information regarding optimum
capital structure which will help them to make least cost combination of debt
and equity.
c. Future Researchers: Researcher will get additional information in capital
structure and cost of capital in the literature of finance. They will be
benefited by getting secondary data in this context.

The proposed study will help to enhance the level of understanding in capital
structure for other researchers, management scholars and other stakeholders.
1.6 Limitations of the Study
The study has been prepared by the help of the financial reports and publications of
the bank. The thesis has been initiated with view of tracing out different aspect of
capital structure of the bank and the calculation has been done by the figures given
by the bank. Further, the study has been initiated by the student rather than by
some economic or financial analyst so the study has some of its own limitations as
stated below:-
As mentioned earlier, this thesis is based on secondary data (published
annual reports of commercial banks), journals, newspapers, magazines etc and
unpublished thesis.
The study covers only 8 years data, beginning from 2001/02 to 2008/09.
The study covers only the capital structure of the bank and ignores other
aspects of banks.
Among 26 commercial banks, three of them are studied due to time and
resources constraints. Thus, we cannot have a true picture of the overall
conditions of commercial banks in Nepalese banking sector and the average
performances of this bank is not the average of all the commercial banks in
Nepal. Thus, the findings of the study cannot be generalized.
 To some extent, the data published on the websites may vary sometimes, with
that of the annual reports of commercial banks. So, the data from the
websites are considered as authentic one.

1.7 Organization of the

Study
The entire study is divided into 5 chapters. Brief information of what each
chapter contains is given below.

Chapter I:
Introduction
It is an introductory chapter, which includes general background of bank. It
also discusses about focus and significance of study, statement of problem,
objective and limitation of the study.

Chapter II: Review of

Literature
This chapter deals with the review of literature. It includes reexamination or
appraisal of the existing works in relevant areas and includes the concept of
commercial banks, its roles, and a review of previous thesis too.
Chapter III: Research
Methodology
It is concerned with research methodology. It includes research design, sources of
data, population and sample and method of analysis.

Chapter IV: Data Presentation &

Analysis
This is the heart of the chapter as it is concerned with presentation and analysis
of relevant data and information. In order to find out the true picture of the capital
structure of NABIL Bank, Himalayan Bank Ltd and Nepal Investment Bank ltd,
various financial and statistical tools and techniques are used. Thus, this chapter is
concerned with the findings of the analysis.

Chapter V: Summary, Conclusion and

Recommendations
This chapter summarizes the overall picture of the study, draws conclusions,
offer suggestions and recommendations for improvement in the future.
 CHAPTER - II
REVIEW OF
LITERATURE

This chapter has been classified into the following

subchapters:
Conceptual Frame work
Review of Independent studies
Review of Previous Thesis

2.1 Conceptual Frame Work

2.1.1 Meaning of Capital Structure and Financial
Structure
“Capital structure refers to the mix of long term sources of funds, such as
debentures, long term debt, preference share capital and equity share capital
including reserves and surplus” (Pandey; 1999:18).

“The optimum capital structure may be defined as that capital structure or

combination of
debt and equity that leads to the maximum value of the firm” (Khan and Jain;
1990:487).

“Erza Soloman expresses the optimum capital structure and its implications as:
optimum leverage can be defined as that mix of debt and equity which will
maximize the market value of the claims and ownership interest represented on the
credit side of the balance sheet” (Solomon; 1969:132). Further, the advantages of
having an optimum does exist, is two fold: it maximizes the value of the company
and hence the wealth of its owners, it minimizes the company’s cost of capital
which in turn increases its ability to final new wealth creating investment
opportunities. Also, by increasing the firm’s opportunity to engage in future
wealth –creating investment, it increases the economy’s rate of investment and
growth
Capital Structure refers to the relationship among various long term forms of
financing which includes mainly three types securities i.e. equity shares,
preference shares and debenture (Pandey; 1998:258-259). It is sometimes known as
financial plan, refers to the
composition of long term sources of funds such as debentures, long term debt,
preference share capital and equity share capital including reserves and surplus.

1.1.1 Financial Structure

Financial structure refers to the composition of all sources and amount of funds
collected to use or invest in business. In other words, financial structure refers to the
‘Capital and Liabilities side of Balance Sheet’. Therefore, it includes shareholder’s
funds, long-term loans as well as short-term loans. It is different from capital
structure as capital structure includes only the long-term sources of financing while
financial structure includes both long term and short-term sources of financing.
Thus, a firm's capital structure is only a part of its financial structure.

1.1.2 Features of Optimal Capital Structure

The optimal capital structure is the structure (combination of debt and

equity) that maximizes the price of the firm’s stock. Hence, it maximizes
shareholders wealth and minimizes the firm’s cost of capital. There are
also some other features of optimal capital structure, which are discussed
below.

1.
Return
The capital structure of the company should be most advantageous. Subject to
other considerations, it should generate maximum returns to the shareholders
without additional cost to them.

2. Risk
Optimal capital structure should be less risky. The use of excessive debt threatens
the solvency of the company. Company should use debt to that extent up to which
debt does not add significant risk, otherwise its use should be avoided.
3.
Flexibility
The capital structure should be flexible. Flexibility in capital structure helps to
grab market opportunity as company can raise required funds whenever it is
needed for profitable investment opportunities. It also helps to reduce costs
(Cost of debt and preferred stock) when fund raised from debt and preferred stock
are no more required in the business.

4.
Capacity
The capital structure should be determined within the debt capacity of the company,
and this capacity should not be exceeded. The debt capacity of a company
depends on its ability to generate future cash flows. It should have enough cash to
pay creditors' fixed charges and principal sum.

5.
Control
Control power is the one of the most concerned part for the management.
Management always wants to maintain control over the firm. The capital
structure should involve minimum risk of loss of control of the company. Issue of
excess equity shares to new investors may bring threats to the control by existing
manager.

Determinants for Capital Structure

Decisions
In addition to the types of analysis discussed above, firms generally consider
the following factors when making capital structure decisions:
1. Sales stability: A firm whose sales are relatively stable can safely take on more
debt
and incur higher fixed charges than a company with unstable sales.
Utility companies, because of their stable demand, have historically been able
to use more financial leverage than industrial firms.
2. Asset structure: Firms whose assets are suitable as security for loans tend to
use debt rather heavily. General- purpose assets that can be used by many
businesses make good collateral, whereas special-purpose assets do not.
Thus, real estate
 companies are usually highly leveraged, whereas companies involved
in technological research are not.
3. Operating leverage: Other things the same, a firm with less operating
leverage is better able to employ financial leverage because it will have less
business risk.
4. Growth rate: Other things the same, faster-growing firms must rely more
heavily on external capital. Further, the flotation costs involved in selling
common stock exceed those incurred when selling debt, which encourages
rapidly growing firms to rely more heavily on debt. At the same time,
however, these firms often face greater uncertainty, which tends to reduce their
willingness to use debt.
5. Profitability: One often observes that firms with very high rates of return
on investment use relatively little debt. Although there is no theoretical
justification for this fact, one practical explanation is that very profitable
firms such as Intel, Microsoft, and Coca-Cola simply do not need to do much
debt financing. Their high rates of return enable them to do most of their
financing with internally generated funds.
6. Taxes: Interest is a deductible expense, and deductions are most valuable to
firms with high tax rates. Therefore, the higher a firms tax rate, the greater the
advantage of debt.
7. Control: The effect of debt versus stock on a management’s control position
can influence capital structure. If management currently has voting control
(over 50 percent of the stock) but is not in a position to buy any more stock, it
may choose debt for new financings. On the other hand, management may
decide to use equity if the firm’s financial situation is so weak that the use of
debt might subject it to serious risk of default, because if the firm goes into
default, the managers will almost surely lose their jobs. However, if too little
debt is used, management runs the risk of a takeover. Thus, control
considerations could lead to the use of either debt or equity, because the type
of capital that best protects management will vary from situation to situation.
 In any event, if management is at all insecure, it will consider the control
situation.
8. Management attitudes: Since no one can prove that one capital structure will
lead to higher stock prices than another, management can exercise its own
judgment about
 the proper capital structure. Some management tends to be more conservative
than others, and thus use less debt than the average firm in their industry,
whereas aggressive managements use more debt in the quest for higher profits.
9. Lender and rating agency attitudes: Regardless of managers’ own analyses of
the proper leverage factors for their firms, lenders’ and rating agencies’
attitudes frequently influence financial structure decisions. In the majority
of cases, the corporation discusses its capital structure with lenders and rating
agencies and gives much weight to their advice. For example, one large
utility was recently told by Moody’s and Standard & Poor’s that its bonds
would be downgraded if it issued more bonds. This influenced its decision to
finance its expansion with common equity.
10. Market conditions: Conditions in the stock and bond markets undergo both
long- and short- run changes that can have an important bearing on a firm’s
optimal capital structure. For example, during a recent credit crunch, the junk
bond market dried up, and there was simply no market at a “reasonable” interest
rate for any new long-term bonds rated below triple B. Therefore, low rated
companies in need of capital were forced to go to the stock market or to the
short-term debt market, regardless of their target capital structures. When
conditions eased, however, these companies sold bonds to get their capital
structures back on target.
11. The firm’s internal condition: A firm’s own internal condition can also
have a bearing on its target capital structure. For example, suppose a
firm has just successfully completed an R&D program, and it forecasts
higher earnings in the immediate future. However, the new earnings are not
yet anticipated by investors, hence are not reflected in the stock price. This
company would not want to issue stock- it would prefer to finance with debt
until the higher earnings materialize and are reflected in the stock price. Then it
could sell an issue of common stock, retire the debt, and return to its target
capital structure. This point was discussed earlier in connection with asymmetric
information and signaling.
12. Financial flexibility: An astute corporate treasurer made this statement to
the authors:
 13. Our company can earn a lot more money from good capital budgeting and
operating decisions than from good financing decisions. Indeed, we are not sure
exactly how financing decisions affect our stock price, but we know for sure
that having to turn down a promising venture because funds are not available
will reduce our long –run profitability. For this reason, my primary goal as
treasurer is to always be in a position to raise the capital needed to support
operations.

We also know that when times are good, we can raise capital with either stocks or
bonds, but when times are bad, suppliers of capital are much more willing to
make funds available if we give them a secured position, and this means debt.
Further, when we sell a new issue of stock, this sends a negative “signal” to investors,
so stock sales by a mature company such as ours is not desirable.

2.1.2 Approaches to Capital

Structure
There are number of capital structure theories proposed by different individuals
which also create some controversy due to different concepts of capital structure
theory hold by different personalities. This is the area in which several theoretical
and empirical works have been done by different personalities. Capital structure
theories developed so far revolve around the question of existence of the optimal
capital structure. Most of the theoretical and empirical debuts so far are revolved
around the maximization of the value of firms through the judicious composition of
its debt and equity fund. Net income (NI) approach and Traditional theory of capital
structure claims that there is the existence of the optimal capital structure. They
contend that proper mix of debt and equity can maximize the value of the firms.
Whereas, net operating income (NOI) approach and M- M hypothesis contend that
capital structure is irrelevant to the value and cost of capital of the firm. According
to the NOI approach, cost of equity increases linearly as debt increases in the
capital structure. The use of debt does not affect the value of the firm as the benefit
of debt capital is just offset by the increase in the cost of equity. (Ezra
Solomon, 1969) Likewise, M-M hypothesis states that there is no level optimal
capital structure. They support the NOI approach by providing logically consistent
behavioral
justifications in its favor. Between the two extreme views, we have the middle
position of intermediate version advocated by the traditional writers.

This section is developed to discuss briefly about the theoretical concept regarding
the theories of capital structure and financial leverage. All the approaches are based
on some common assumptions, which are as follows:

Basic Assumptions and

Definitions
1. Two types of capital are employed, long term debt and shareholders equity.
2. There is no tax on corporate income.
3. The firm’s total assets are fixed but its capital structure can be changed
immediately by selling debts to repurchase common stocks or stock to retire
debt.
4. All investors have the same subjective probability distribution of expected
future operating earnings (EBIT) for a given firm, that is, investors have
homogeneous expectations.
5. The operating earnings of the firm are not expected to grow, that is, the
firm’s
expected EBIT is same in all future periods.
6. The firm’s business risk is constant over time and is independent of its
capital
structure and financial risk.
7. The firm is expected to continue indefinitely.

In addition to above assumption, the following symbols are

employed. S= Total market value of the Stocks (Equity)
B= Total market value of the Bonds
(Debt)
V= Total market value of the Firm =
B+S
EBIT = Earnings before Interest and Taxes = Net Operating Income
(NOI) I=Interest Payments

Debt
Cost of debt (kd) = Interest/Debt =
I/B
So, Value of Debt (B) = Interest/ k d = I/ kd
 Equity or common stock
Cost of equity capital (k s)=d1 / Po
+g
Where,
d1=next dividend
Po=Correct price per
share. g=expected growth
rate.

Overall or Weighted Average cost of

capital
K=Kd(B/V) + Ks(S/V)
= Kd(B)/B+S + Ks(S)/B+S

The Total value of the firm is

thus, V = B + S
= I/Kd + EBIT-I/Ks

2.1.2.1 Traditional
Approach
“The value of firm can be increased or the cost of capital can be reduced by a
judicious mix of debt and equity capital, and that an optimum capital structure exists
of every firm. This approach very clearly implies that the cost of capital decreases
within the reasonable limit of debt and then increases with leverage” (Barges;
1983:44). Thus, an optimum capital structure exists, and it occurs when the cost of
capital is minimum or the value of firm is maximum.

According to this view, the traditional view of capital structure which is also known
as an Intermediate approach is a compromise between the Net Income Approach
and the Net Operating Income Approach. It states that when a company starts
to borrow, the advantages and the disadvantages. The cheap cost of debt,
combined with its tax advantage, will cause the WACC to fall as borrowing
increases. However, as gearing increases, the effect of financial leverage causes
shareholders to increase their return (i.e. the cost of equity rises). At high gearing the
cost of debt also rises because the chance of
the company defaulting on the debt is higher (i.e. bankruptcy risk). So at higher
gearing the WACC will increase.

The statement that debt funds are cheaper than equity funds carries the clean
implication that the cost of debt plus the increased cost of equity together on the
weighted basis will be less than the cost of equity which existed on the equity before
debt financing. That is the weighted average cost of capital will decrease with the use
of debt up to a limit.

According to the traditional position, the manner in which the overall cost of
capital reacts to changes in capital structure can be divided into three stages.

First Stage: Increasing

Value
“The first stage starts with the introduction of debt in the firm’s capital structure. In
this stage, the cost of equity (Ke) either remains constant or rises slightly with debt
because of the added financial risk. But it does not increase fast enough to offset
the advantage of low cost debt” (Soloman; 1969:139). In other words, the advantage
arising out of the use of debt is so large that, even after allowing for higher cost of
equity, the benefit of the cheaper sources of funds are still available. As a result the
value of the firm (V) increases as the overall cost of capital fails with increasing
leverage.
During this stage cost of debt (Kd ) remains constant or rises only modestly.
The combined effect of all these will be reflected in increase in market value of the
firm and decline in over all cost of capital (K).

Second Stage: Optimum

Value
In the second stage, further application of debt will raise cost of debt and equity
capital so sharply as to offset the gains in net income. Hence, the total market
value of the firm would remain unchanged. While the firm has reached a certain
degree of leverage, increase in it has a negligible effect on the value of the firm or
overall cost of capital of the firm (Pandey; 1999:358). The increase in the degree of
leverage increases the cost of equity due to the added financial risk that offsets the
advantage of low cost debt. Within
the range of such debt level or at a specific point, the value of the firm will be
maximum or the cost of capital will be minimum.

Third Stage: Declining

Value
Beyond the acceptable limit of leverage, the value of the firm decreases with the
increase of the leverage or the overall cost of capital increases with the additional
leverage. This happens because investors perceive a high degree of financial risk,
which increases the cost of equity by more than enough to offset the advantage of
low cost debt. The overall effect of these three stages is to suggest that the cost of
capital is a function of leverage, i.e. first falling and after reaching minimum point
or range it would start rising. The relation between cost of capital and leverage is
graphically shown in figure below.

Figure: 2.1
The effect of Leverage on Cost of Capital under Traditional
Theory
 Ke

Cost of
Capital Stage-2

Kd
Stage -1 Stage -3

Leverage

In figure 2.1, it is assumed that Ke rise at an increasing rate with leverage, whereas
Kd is assumed to rise only after significant leverage has occurred. At first, the
weighted cost of capital, K, declines with leverage because the rise in Ke does not
entirely offset the use of cheaper debt funds. As a result, K declines with moderate
use of leverage (Srivastav;
1984:881). After a point, however, the increase in Ke more than offset the use of
cheaper debt funds in the capital structure, and K begins to rise. The rise in k is
supported further once Kd begins to rise. The optimal capital structure is point
X. thus the traditional position implies that the cost of capital is not independent of
capital structure of the firm and that there is an optimal capital structure.

2.1.2.2 Net Income

Approach
David Durand proposed the Net Income Approach. This approach states that firm
can increase its value or lower the cost of capital by using the debt capital.
According to NI approach, there exists positive relationship between capital
structure and valuation of firm and change in the pattern of capitalization bring
about corresponding change in the overall cost of capital and total value of the firm.
Thus, with an increase in the ratio of debt to equity, overall cost of capital will
decline and market price of equity stock as well as value of firm will rise. The
converse will hold true if ratio of debt to equity tends to
decline. The approach assumes no change in the behavior of both stockholders and
debt holders as to the required rate of return in response to a change in the debt-equity
ratio of the firm. They want to invest since debt holder are exposed lesser degree of
risk, assumed of a fixed rate of interest and are given preferential claim over the
profit and assets, the debt holders’ required rate of return is relatively lower than that
of equity holders. So, the debt financing is relatively cheaper than equity. For this
reason, at constant cost of equity (Ke) and cost of debt (Kd), the overall cost of
capital (K) declines whit the increased proportion of the debt in the capital
structure. This suggests that higher the level of debt, lower the overall cost of capital
and higher the value if firm. It means that a firm attends an optimal capital structure
when it uses 100% debt financing. Running a business with
100% debt financing, however, is quite uncommon in the real
world.

This approach is base on the following

assumptions:
1. The cost of equity and debt remain constant the acceptable range of leverage.
2. The corporate income taxes do not exist.
3. The cost of debt rate is less than the cost of equity.
4. The increasing leverage brings about no deterioration in the equity of net
earnings so long as borrowing is consigned to the amount below the acceptable
limits.

The firm can achieve optimal structure by making judicious use of debt and equity
and attempt to maximize the market price of its stock (Durand; 1959:91-116).

In sum, as per NI approach, increase in ratio of debt to total capitalization brings

about corresponding increase in total value of firm and decline in cost of capital
(Pandey;
1999:26). On the contrary, decrease in ratio of debt to total capitalization causes
decline in total value of firm and increase cost of capital. Thus, this approach is
appeared as relevancy theory.

Graphically, the effect of leverage on the firm’s cost of capital and the total market
value of the firm is shown below.
33
 Figure: 2.2 Figure: 2.3
The effect of Leverage on Cost of Capital The effect of leverage on
Total
Market Value of the Firm

V=B+S
Ke
Cost of
Capital
Total
K Market
Value
Kd

Degree of Degree of Leverage

Leverage

Figure 2.2 shows a continuous decrease in K with the increase in debt-equity ratio,
since any decrease in K directly contributes to the value of the firm. It increases
with the increase in the debt-equity ratio (figure 2.3). Thus the financial leverage,
according to the NI approach is an important variable in the capital structure decision
of a firm. Under the NI approach, a firm can determine an optimal capital structure.
If the firm is unleveled the overall cost of capital will be just equal to the equity
capitalization rate.

In brief, the essence of the net income approach is that the firm can lower its cost
of capital by using debt. The approach is base on the crucial assumption that the use
of debt does not change the risk perception of the investor (Pandey; 1999:26).
Consequently, the interest rate of debt (Kd) and the equity capitalization rate (Ke)
remain constant to debt. Therefore, the increased use of debt results in higher
market value of shares and as a result, lower overall cost of capital (K).

34
2.1.2.3 Net Operating Income Approach
(NOI)
NOI approach is another behavioral approach suggested by Durand David. This
approach is diametrically opposite from the NI approach with respect to the
assumption of the behavior of equity holders and debt holders. The essence of
this approach is that the leverage/capital structure decision of the firm is irrelevant
(Khan & Jain; 1997:481). The overall cost of capital is independent of the degree
of leverage; any change in leverage will lead to change in the value of the firm
and the market price of the shares. Net operating approach is slightly different
from NI approach, unlike the NI approach in NOI approach, the overall cost of capital
and value of firm are independent of capital structure decision and change in degree
of financing. Leverage does not bring about any change in the value of firm and cost
of capital.

Under NOI approach, the Net operating income, i.e. the earning before interest and
tax (EBIT), instead of net income is taken as the base. Like the NI approach,
the NOI approach also assumes a constant rate Kd, which means that the debt
holders do not demand higher rate of interest for higher level of leverage risk.
However, unlike the assumption of NI approach, NOI approach assumes that the
equity holders do react to higher leverage risk and demand higher rate of return
for higher debt-equity ratio (Pandey; 1999:31). This approach says that the cost
of equity increases with the debt level and the higher cost of equity offset the
benefit of cheaper debt financing, resulting no effect at all on Overall Cost of Capital
(K).

The NOI approach is based on the following

assumptions:
1. The market capitalizes the value of the firm as a whole. Thus, the split between
debt and equity is not important.
2. The market uses an overall capitalization rate, K to capitalize the net
operating
 income. K depends on the business risk. If the business risk is assumed to
remain unchanged, K is constant.
3. The use of less costly debt funds increases the risk of shareholders. This causes
the equity-capitalization rate to increase. Thus, the advantages of debt are offset
exactly by the increase in the equity capitalization rate, Ke.
 4. The debt-capitalization rate Kd is constant.
5. The corporate income taxes do not exist.
The function of Ks under NOI approach can be expressed in equation as
follows: Ks=K+(K-Kd)B/S

The relationship between financial leverage and K, Ke, and Kd has been
graphically depicted in following figures.

Figure: 2.4 Figure: 2.5

The effect of Leverage of Cost of Capital The effect of Leverage on value of
firm

Ke

K Total
Cost of V=B+S
Capital Market
Kd Value

Leverage Leverage

In the figure 2.4, it is shown that the curve K and Kd are parallel to the horizontal x-
axis and Ks is increasing continuously. This is because K and Kd remains constant
under all the circumstances but the Ke increases with the degree of increase in
the leverage (Gitman; 1998:791). Thus, there is no single point or range where the
capital structure is optimum. It is known obviously from figure 2.4 that under the NOI
approach, as low cost of debt is used, its advantage is exactly offset by increase in
cost of equity in such a way that the cost of capital remains constant. By this, value
of the firm also remains constant. At the extreme degree of financial leverage,
hidden cost becomes very high hence the firm’s cost of capital and its market
value are not influenced by the use of additional cheap debt fund.

36
2.1.2.4 Modigliani-Miller Approach (MM
approach)

37
The Modigliani-Miller thesis relating to the relation is akin to net operating
income approach. MM approach, supporting the net operating income approach,
argues that, in the absence of taxes, total market value and cost of capital of the firm
remain invariant to the capital structure changes. They make a formidable attach on
the transitional position by offering behavioral justification for having the cost of
capital, K, remain constant through all degree of leverage MM contend that
cost of capital is equal to the capitalization rate of pure equity stream of income
and the market value is ascertained by capitalizing its expected income at the
appropriate discount rate of its risk class. MM position is based on the idea that no
matter how you divide up the capital structure of a firm among debt, equity and
other claims, there is a conversion of investment value. The MM cost of capital
hypotheses can be best expressed in terms of their proposition I and II (Modigliani &
Miller; 1958:261 297). However, the following assumptions regarding the behavior
of the investors and the capital market, the actions of the firms and the tax
environment are crucial for the validity of the MM hypothesis.
1. Perfect capital markets: The implication of perfect capital market is that
securities are infinitely divisible, investors are free to buy and sell securities,
investors can borrow without restrictions on the same terms and conditions as
firms can, there are no transaction costs and investors are rational and behave
accordingly.
2. Firms can be grouped in to homogenous risk classes. Firms would be
considered to belong to a homogenous risk class as their expected earnings,
adjust for scale differences have identical risk characteristics. The share of
the homogeneous firm would be perfect substitute for one another.
3. Firms distribute all net earning to the shareholders, i.e. divided payout ratio is
100 percent.
4. There are no taxes. This assumption is removed later.
5. The assumption of perfect information and rationality, all investors has the
same exception of firm’s net operating income with which to evaluate the
value of any firm.
Proposition
I
MM argues that, for the same risk class, the total market value is independent of the
debt- equity mix and is given by capitalizing the expected net operating income
by the rate appropriate to the risk class. This is their proposition I (Pandey;
1999:34). In equation this can be expressed as follows:

Value of the Firm = Market value of debt + Market value of

Equity
= Expected net operating income/Expected overall capitalization
rate
EBIT
=
EBT

For an unleveled Firm,

EBIT
Vu=
Ks

Where,
K=Ks in case of unleveled firm.
Proposition I can be expressed in terms of the firm’s overall capitalization rate, K,
which is the ratio of Net operating income (EBIT) to the market value of all its
securities, i.e.; K=NOI/S+B
=NOI/V
K can also be expressed as
K=Ke(S)/S+B + Ke (B)/S+B

It means K is the weighted average of the expected rate of return on equity and
debt capital of the firm since the cost of capital is defined as the expected net
operating income divided by the total market value of the firm and since MM
conclude that the total market value of the firm is unaffected by the financing mix,
it follows that the cost of capital is independent of the capital structure and is equal to
the capitalization rate of a pure equity stream of its class.

The overall cost of capital function as hypotheses by MM is shown in figure below:

Figure: 2.6
 The cost of capital under the MM hypothesis
Y

K K

Thus two firms identical in all respects except for their capital structure cannot
command
alues
O n
different market v or have different cost of D/V 1999:37). But if there
(Pandey
capital ;
is discrepancy in the market values or the cost of capital, arbitrary will take place,
which will enable investors to engage in personal leverage to restore equilibrium in
the market.

Proposition
II
MM proposition II, which defines the cost of equity, follows from their proposition I
and shows the implications of the net operating approach. The proposition II states
that the cost of equity rise proportionately with the increase in the financial
leverage in order to compensate in the form of premium for bearing additional
risk arising form the increasing leverage. The equation for the cost of equity can be
derived from the definition of the average cost of capital.

𝐾𝑒 ( 𝑆 )
K= +
Kd( B)
S+B S+B
��( 𝐵 +𝑆 ) Ke( B) ( B+S)
Ke= S
–
(S+B)S
K(1+D) Kd(D)
Ke= S
– S

K +( K
Ke= −Ke)B
S
NO I
Ke (Cost of Equity)= = N
−I
S
I S

The above equation states that for any firm in a given risk class the cost of equity,
Ke, is equal to the constant average cost of capital, K, plus a premium for the
financial risk, which is equal to debt-equity ratio times the spread between the
constant average cost of
capital and the interest rate. As the proportion of debt increases, the Cost of
Equity increases continuously even though K and Kd are constant. The crucial past
of the MM hypothesis is that K will not rise even if very excessive use of leverage
is made. This conclusion could be valid if Kd remains constant for any degree of
leverage. But in practice, Ks increases with leverage beyond a certain
acceptable level of leverage. However, MM maintains that even if Ke is a function
of leverage, K will remain constant as Ke will increase at a decreasing rate to
compensate. This can be shown as:
 Figure: 2.7
Behavior of K, Kd and Ks under M-M
hypothesis
Ke, Kd

Ke

Kdm

K
Kd

O D/S

It is clear from the figure that Ke will increase till the marginal rate of interest
(Kdm) is below the cost of capital. As soon as, the marginal rate of interest cuts
the Cost of Capital, Ke will start falling (Pandey; 1999:37).

2.1.2.5 Financial
Leverage
Financial leverage involves the use of funds obtained at fixed costs in the hope
of increasing the return to stockholders. Weston and Brigham (Weston and
Brigham;
1981:556) defined financial leverage as the ratio of total debt to total assets or total
value
of the firm. The use of the fixed charges sources of funds , such as debt and
preference share capital along with the owner’s equity in the capital structure, is
described as financial leverage or ‘trading on equity’ ( Pandey ; 1999:23).
Trading on equity is derived from the fact that it is the owner’s equity that is used
as a basis to raise debt, i.e. the equity that is traded upon. The supplier of debt
has limited participation in the company’s profit, therefore, debt holder will insist
on protection in earnings and value represented by ownership capital.

2.2 Review of Independent Studies

In the Modigliani and Miller’s first study they used the previous works of “Allen
And Smith” in support of their independence hypotheses in the first part of their
work M – M tested their proposition I, the cost of capital is irrelevant to the firms
capital structure by correlation after tax cost of capital with leverage B/V they found
that the correlation co- efficient are statically in significant and positive in sign.
The regression line doesn’t consist of curvilinear “U” Shaped cost of capital key of
traditional view, when the data are shown in setter diagram.

In the second part of their study, they tested their proposition II the expected yield
on common share is a linear function of debt to equity ratio. The second part of their
study is consistent with their views i.e. if the cost of borrowed funds increases, the
cost of equity will decline to offset this increases Modigliani and Miller second study.

M – M, were conducting the second study in 1963 with correcting their

original hypotheses for corporate income taxes and expected cost of capital to be
affected by leverage for its tax advantages, therefore they wanted to test whether
leverage had tax advantages or not, for this they conducted the mathematical
analysis regarding the effect of leverage and other variable on the cost of capital,
they found that the leverage is significant only because of the tax advantage
involved (Modigliani & Miller; 1958:261).

Vanhorn, has also presented controversial decision about capital structure.

According to him financial signaling occurs when capital structure change
conveys information to security holders (Van Horne; 1985:277). It assuming as
symbolic information between management and stock holders management behavior
result in debt issue being regarded on gold news by investors and stock issue as bad
news empirical evidence seems to be consistent with the nations.
Weston (1963), in “A Test of Cost of Capital Proposition” made some
important- improvement in the cost of capital modes. He included firm size and
growth as additional explanatory in his model.
He found the regression co-efficient of leverage to be positive and significant, when
he used M – M model. However when the multiple regression was shown he found
that the correlation coefficient is significant and the regression co-efficient of
leverage in negative and significant when the influence of growth is isolated
leverage is found to be negative correlation with the cost of capital. He concluded
that the apparent lack of influence of leverage on the overall cost of capital
observed by M – M was due to the negative correlation of leverage with earning
growth Weston also listed M – M proposition II.

Wiper (1960), in “Financial Structure and Value of the Firm” has made a test
to empirical relationship between financial structure and value of the firm he
tried to eliminate the principle problem of empirical study on the leverage and
attempted to offer what were hoped to be more, alternative’s in determining the
relationship between leverage and cost of capital. He found the share holder’s
wealth can be enhanced by judicious by judicious use of debt financing.

Sharma and Rao, (1969), in “Leverage and the Value of the Firm” concluded the
list of M-M hypothesis on the influence of debt on the value of a firm to a
non-regulated industry. They argued that estimate of cost of capital arrived at through
the model will be accurate only when their hypothesis on debt and dividends are
correct this is an essential condition for the employment of the model.

Calculation of variables was done in exactly the same ways done by M.M. with
two exceptions. They experimented with total assets and sale for deflecting the
variables and the result are meaningful when fixed of total assets of fixed assets was
used as the growth variable the result were some what inconsistent with economic
reasoning they therefore took the earning froth rate as the growth variable because
this would and account growth of earning due both to the utilization of existing
capacity and to the additional of new capacity they include that debt has non tax
advantage also thus this paper-support-that the investors refer corporate to personal
leverage and therefore the value of a firm sizes up to leverage rate considered
prudent.
Rao and Litzaberge, (1970) in, “Leverage and the Cost of Capital in Less
Developed Capital Market Comment” conduct the study of the effect of capital
structure on the cost of capital in loss developed and less efficient capital market
(India) and in highly developed and efficient capital market(US) They used 28
India utilize and 77 American utilized. They conducted the study for five cross
section years 1962-1966. They found that the result for the American utilities are
constant to the M-M proposition except for the advantage of debt financing the cost
of capital independent of capital structure and result also supported that the M-M
hypothesis that investors are different for the firm’s dividend policy in case of India
utilities, the result are in consistent to the M-M approach and support the traditional
belief the judicious use of financial leverage will lower the firms cost of capital
and investors have a reference for current dividends. In conclusion, they contended
that the M-M approach after allowing for the tax advantage of debt the firms cost
of capital is independent of capital structure does not appear to be applicable in the
case of a developing economy.

Shrestha, (1985), conducted a thesis research on, “Analysis of Capital

Structure in Selected Public Enterprises”. The study found that the public
enterprises have a very confusing capital structure. In many instances adhoeism
became the basis of capital structure and in that also most of them want to
eliminate debt if possible to relieve financial obligations. Further more, the
determination of capital structure is greatly influenced by the inflow of
International Donor Agency long term credit through the medium of His
Majesty’s Government of Nepal (HMG). In a way, neither the public enterprises
nor HMG developed criteria in determine capital structure nor this is the reason
as to why debt equity ratio became a ticklish problem. Also true that the
calculation of equity capitalization rate and overall capitalization rate according to
given data provide very fantastic results in many cases, although they carry
valid and meaningful results in some instances. As such, the use of Net
Operation Income Approach and Net Income Approach on the whole is more an
academic exercise rather than proving much valid. While determined and there is
growing tendency among most of public enterprises to have least combination of
debt with equity to escape financial
obligations as far as possible. Again, it is an implied fact that the contribution of
debt to procurement of assets shows significant deviations. The earning of the public
enterprises in most cases does not prove satisfactory except in limited few.
There are many unfavorable side effects such as growing accumulated losses
climbing greater heights and little maintenance of tax provisions.

He suggested that debt equity ratio neither should neither be highly levered to create
too much financial obligations that lie beyond capacity to meet nor should it be
much low levered to infuse operational strategy to bypass responsibilities without
performance (The Nepalese Journal of Public Administration, March 1985).
Shrestha, (1999), conducted a thesis research on, “Focus on Capital Structure
(Selected and listed Public companies)”. She found that in Nepalese public
enterprises the definition of capital structure is not a problem but what matters is the
problem of putting the definition of capital structure into practice. As for instance,
public enterprises as well as listed public limited companies have higher debt equity
mix. As a result their liabilities have increased together with higher fix charges due to
failure to utilize borrowed capital properly. Thus in market circle investors often
express dissatisfaction for not getting expected return as per commitment made by
the listed companies in the prospectus to the investing public. This is even very
serious in government owned companies.

The researcher clearly suggested that the capital structure of both selected
public enterprises and listed companies have high proportion of debt mixed with
equity. Most of them have to face high interest burden on one side and increasing
accumulated losses on the other hand. She further suggests to the government that it
is important to monitor the use of debt and its impact on the overall earnings of
enterprises. This factor has been neglected by HMG. The bitter experience reveals
that government in these enterprises has not been able to specify the capital
structure mix (Pravaha Journal of Management, Vol 10: 1, 1999)
2.3 Review of Thesis
Pathak, (1995), conducted research on, “Study on Capital Structure
Management of Gorakhkali Rubber Udyog Ltd” The basic objective was to analyze
the debt equity ratio, interest coverage ratio with some of the measures to improve the
policy. He had analyzed all the variables in the form of ratio analysis.
In his findings especially to the capital structure and profitability
position, following issues has drawn.
As compared to the shareholder’s equity and the trend of debt –equity the ratio
was increasing everyday.
Company’s debt serving capacity was very poor due to the negative
interest
coverage ratio.
The operational performance was not satisfactory due to negative earnings and
low volume of sales revenue.
The company was not able to utilize its capacity more than 50% which result
the huge losses.
At last, he suggested lowering down the amount of debt and obtaining
additional funds through issue of equity share, improving its working capital
and reducing over staff, making strategic plans and developing the motivations
management.

Shrestha, (1999) , conducted his research on, “Comparative Evaluation of

Capital Structure Between Selected Manufacturing and Trading Companies of
Nepal” has access on debt serving capacity of the companies and as well as return
on equity, debt ratio, following the calculation earning before interest and tax ,
earning per share.

He also observed that manufacturing companies had a higher risk with higher
return on the interest and debt and low dividend. The study further indicated that
the amount of profit earned could only meet the interest and because of that had to
suffer losses.
It has concluded that there was not enough return to pay interest, debt and dividend
for both types of companies although maintaining a high risk of debt.
And he finally recommended for a regular check up the level of debt, earning
before interest and tax (EBIT), earning before tax (EBT) and earning per share
(EPS) by monitoring authority, so that the companies would not fall into a weaker
position.

Prashai, (1999), has made a study on, “The Capital Structure of Nepal Bank Ltd”.
The basic objective of the study made by him was to analyze the interrelationship
and trends among some of the component parts of capital and assets structure
and to provide suggestions for the development of an appropriate capital structure.
It has used financial tools such as ratio analysis and statistical tools such as
Karl Pearson’s co- efficient ratio percentage, Index and average to analyze the
relation between various variables.

It is known that the bank is composition of loan and advances, cash investment and
other assets. Between all these components, loan and advance are the major
portions. During the study, total assets and capitals are in increasing trend. But
increasing rate of component is different. So the interrelationship of the
component is fluctuating. The average growth rate of total deposits and other
liabilities is higher than the average growth rate of net profit, and higher than the
growth rate of total expenses. The total income and total expenses aren’t under
control of the bank, and the net profit is only
40.64% of the total income. The study suggested that the bank must control total
deposit and the bank must also control investment. The bank needs to reduce its
expenses and control fluctuations in the earnings per share to improve its market price
per share.

Kafle, (2001), has conducted research on “A Comparative Analysis of Capital

Structure Between Lumbini Sugar Factory Limited and Birjung Sugar Factory
Limited”. The purpose of this study was to analyze the various ratio of capital
structure decision, net worth, earning before interest and tax and to suggest
measures to improve the policy of the companies.
According to him both the companies were facing serious deterioration in
earnings according to the net operating income approach. He noted down both the
companies had defective capital structure as debt equity ratio were not so much
satisfactory. Birgunj
Sugar Factory had high debt equity ratio indicating more financial risk while
Lumbini Sugar Mills had low debt equity ratio which indicates access power of
equity holders. And both the companies were unable to pay interest because they
were operating at loss. As Birgunj sugar Factory was highly levered Lumbini Sugar
Factory was unlevered both the companies had defective capital structure.

Kafle suggested that it should change the debt equity ratio for sound capital
structure management to maintain it in 1:1 ratio.

Neupane, (2002), conducted research on, “A Study on Capital & Assets

Structure of Nepal Bank Limited”. The basic objective of this study was to
analysis interrelation between different ratio, analysis of component parts of capital
structure; debt equity ratio, net worth, deposit/investment ratio etc. According to
him the research analyzed the different financial aspects of Nepal Bank Limited.

He remarked that the total deposit and total investment were not significantly related.
He concluded that the net worth was used in unproductive assets of the bank and
further commended that the bank needs to have productive use of its net worth.
Shah, (2006), made the study on, “A Study of the Capital Structure of
Selected Manufacturing Companies” with a purpose to access the debt serving
capacity of the mentioned manufacturing companies, examine the relation between
return on equity and total debt, return on equity and debt ratio. Earning after tax and
total debt and interest and earning before interest and tax.

The methodology used in the study included both financial as well as statistical tools.
The financial tools used were ratio analysis and statistical tools used were
correlation coefficient and regression analysis.

The study revealed that Nepal lever Ltd has not been using long term debt and it
was fully equity based. The bottlers Nepal Ltd is free of long term debt because of
improved cash flows and effective management. The Sriram spinning mills has

48
66.33% of assets financed with debt and hence there is less flexibility to the
owners. The degree of

49
financial leverage analysis of Jyoti spinning mills shows the failure of the
company to gain expected profits. And the Arun Vanaspati Udhyog has a
fluctuation Debt Equity ratio. Its long term debt is decreasing and only creditors
make a small share of equity.

Research
Gap
There are various studies accepted on capital structure management of various
state owned banks and public limited companies of Nepal. Most of the study
indicates that a sound principle of capital structure and its management haven’t
been followed by the enterprises in Nepal. The basic objective in all of the
studies shows analysis of components parts of capital structure ratios, its
interrelationship, debt serving capacity, relation between return on equity-debt,
earning before tax and interest. However, their study reveals that they have not
been using long term debt effectively. The net worth of the bank was used in
unproductive assets, shows low debt equity ratio. Even then, different studies
have been carried out regarding the subject matter of gap structure previously by
different researchers. But, the research gap among the previous studies and this
current study lies firstly in fiscal years under which the current study has undertaken.
Secondly, the sample companies are new from the previous studies. Previously
made studies included manufacturing companies, bank etc. The current study
however is a comparative study of capital structure of three commercial banks.
The researcher may feel comfort if the gap created by the previous studies can
be filled up. Besides the analysis of capital structure ratios this study has made an
attempt to analyze the effect of capital structure on the value of the companies.
Further, this study will help research student to carry further studies as well as, it
will helpful to the interested groups in the selected companies to analyze their
position at present and search for the prospective investors.
 CHAPTER - III
RESEARCH
METHODOLOGY

The present researcher has followed analytical as well as descriptive methodology

and the chapter is composed of six sections.

3.1 Research Design

To fulfill the objectives of the study certain research design is essential so the
analysis of this study is based on the nature of data and tools for analysis. To fulfill
the objectives of the study it emphasizes on analytical as well as descriptive research
design.

3.2 Nature and Sources of Data

The study is based on historical or “Secondary Data”. This secondary data is
extensively used in this. The raw secondary data is not modified to some extent for the
study purpose. Mostly data is collected from the “Balance Sheet”. Income statement
and profit and loss account of commercial banks. Some other necessary data in
this study have also been supplemented from Nepal Stock Exchange Ltd. and
various related journal in management and other publication to some extent
necessary primary data are also collected by interviewing related commercial
Banks Manager and other Personal.

3.3 Required Tools for the Analysis

Different tools have been selected according to the nature of data as well as
subject matter. The major tools employed for the analysis of the data is the ratio
analysis which established the quantities or numerical relationship between two
variable of the financial statement. Besides there the statistical tools and in software
SPSS version 2007 are also used.
3.3.1 Financial
Tools
The Financial Tools are: ratio analysis, leverage analysis, EBIT-EPS analysis and
others.
3.3.1.1 Ratio
Analysis
Ratio Analysis is the powerful tool of financial analysis. Financial ratio presents
the relationship between two accounting figure expressed mathematically. Ratio
analysis is defined as the systematic use of ratio to interpret the financial
statements so that the strengths and weakness of a firm as well as its historical
performance and current financial condition can be determined.

The required financial ratios for this study are enabling in detail as
follows:
a. Debt Equity Ratio (Leverage
Ratio)
Leverage Ratio measures the contribution of financing by owners compared
with financial provided by the outsiders. They also provide some measure of
the debt financing by the calculation of the coverage of fixed charge. It is one of the
most popular tools of the long term financial solvency of the firm. It can be
calculated by the long term debt divided by shareholders’ equity. In the calculation ,
shareholders’ equity preference share capital accumulated losses, discount on issue
of share etc, so the shareholders’ equity is defined as net worth and D/E ratio
also called debt to net worth ratio related with the total debt. This debt equity
measures the claim of the creditors an owner against
the company’s assets. In this study following leverage ratios have been
calculated.

Long Term Debt

Debt Equity Ratio
Shareholder′ s equity
=

A high Debt equity ratio indicates that the claim of creditors is greater than that of
the owners and vice-versa.

b. Debt to Total Capital

Ratio
The relationship between creditor’s funds and owner’s capital can also express in
term of debt to total capital ratio one approach is to relate the long term debt to the
permanent capital of the firm. This ratio highlights the need of long term debt
in the capital employed by the firm. Long term debt includes the debt, which
matures in more than one
accounting period whereas capital employed includes long term debt and share
holder’s equity of the firm. This ratio is called the long term debt to capital debt
ratio. Larger the ratio, larger the proportion of long term debt in the capital employed
and vice versa. It is calculated by dividing long term debt with capital employed by
the firm. This ratio is also known as debt to permanent capital ratio whereas
permanent capital means total assets
minus current
liabilities.
Long Term Debt
Debt to Capital Ratio
Permanent Capital
=

Permanent Capital consists of shareholders equity as well as long term

debt.

c. Total Debt to Total Asset

Ratio
The total debt of the firm comprises long term debt plus current liabilities while
total assets consist of permanent capital plus current liabilities. Assets may be
described as valuable resources owned by a business which have been acquired
at a measurable money cost. Assets as an economic resource satisfy three
requirements. They are firstly, the resources must be valuable or it may provide
future benefits to the operations of the firms; secondly, the resources must be owned,
and thirdly the resources must be acquired at a measurable money cost. When
intangible assets are the significant, they are frequently deducted from net
worth to obtain the tangible net worth of the firm. A comparison of debt ratio
for a given company with those of similar firms gives us a general indication, of
the credit worthiness and financial risk of the firm. The reason, that is a general
indication, is that the assets and cash flows of the firm provide the
wherewithal for payment of debt.

This can be calculated

as:
Total Debt
 TD/ TA Ratio
= Total Assets

The ratio however gives some what similar in dictation as debt equity ratio.

d. Long Term Debt to Total Debt Ratio (LTD / TD)

The relationship between long term debt and total debt has a decisive impact on
the financial structure of all two companies under study. Debt is considered as the
total debt, which includes all secured and unsecured loan. Within these two types
of loan there comes long term, short term debt, debenture, overdraft etc. It is
externally borrowed from financial institute. Debt capital is the capital to which a
fixed rate of interest should be paid. Interest paid for debt is deductible expenses. It
can save the tax. Debt capital is a cheap means of financing. But there is a risk in
holding debt capital. Risk in the sense of timely payment of interest and the
redeemable value at the end of maturity period. Debt capital should be limited up to a
level, which the earning capacity of the firm can support. Otherwise, the company
has to sell its assets and be forced to go into liquidation. The ratio of long term
debt to total debt indicates what percentage of company’s total debts is
included in the form of long term debt. It is calculated
as;

Long Term Debt

LTD/ TD =
Total Debt

e. The Degree of Financial Leverage

(DFL)
The degree of financial leverage at a particular EBIT level is measured by the
percentage change in earning per share relative to the percentage change in EBIT.
The company needs a lot of funds to operate activities these funds are collected from
different sources having different rates. On the way to profitability, the company can
use equity capital. In the process of profit planning, it tries to increase the amount of
profit, but different kinds of leverage considered. Degree of financial leverage is
one kind of leverage. Degree of financial leverage (DFL) measures proportionate
change in EPS as a result of given change in EBIT. The financial leverage
measures the financial risk arises due to the interest. Higher the financial leverage
higher the financial risk. The financial leverage exists when the company as debt
capital in the composition of capital structure. The extra amount of investment by
debt capital can be measured only with the help of financial

53
leverage this may be calculated
as:.

% Change in EPS
Degree of Financial Leverage
% change in EBIT
=
EBIT
Degree of Financial Leverage
EBT
=

Where, R represents fixed financial costs which are interest and preference
dividend.

f. Interest Coverage
Ratio
It is also known as time interest earned ratio. This ratio measures the debt
servicing capacity of a firm in so far as fixed interest on long term loan is earned. It
is determined by dividing the operating profits or earning before interest and taxes
(EBIT) by the fixed interest charges on loans. The interest coverage ratio shows
many firms the interest charges are covered by funds that are ordinarily available
to pay the interest. This is
calculated
as,
EBIT
Interest Coverage Ratio
Interest
=

This ratio is very useful in determining whether a borrower is going to be able to

service interest payments on a loan. In other words, the ratio is designed to relate
the financial charges of a firm to its ability to service them. This ratio also
known to determine whether a firm has the ability to meet its long term obligations
A high interest coverage ratio indicates the company’s strong debt servicing capacity.

g. Earning Per Share (EPS)

Earning per share refers the rupee amount earned per share of common stock
outstanding. It measures the return of each equity shareholders. The higher

54
earning indicates the better achievements of the profitability of the banks by
mobilizing their funds and vice versa. This ratio can be computed by dividing the
earning available to common shareholders by the total number of common stock
outstanding of banks. Thus,

Ea r n in g Ava ila ble to Common St ock

EPS = Hol d e rs Number of Common Stock
Outstanding

55
h. Dividend Per Share (DPS)
Dividend per share indicates the rupee earnings actually distributed to common
stockholders per share held by them. It measures the dividend distribution to each
equity shareholders. Generally, the higher DPS creates positive attitude of the
shareholders toward the bank, which consequently helps to increase the market
value of the shares.

Thus,

Tot a l Amou n t of Divid e n d P aid to Or din a r y

DPS = Sha r e hol d e rs Number of Ordinary Shares
Outstanding

3.3.1.2. Profitability
Ratio
Profitability Ratio gives final answers about how effectively the firm is being
managed. In the study following profitability ratio are calculated.

a. Return on Total
Assets
It is also known as Return to Investment or R o 1 before tax basis. Return on total
assets ratio measures the profitability of bank that explains a firm to earn satisfactory
return on all financial resources invested in the bank assets. The ratio explains net
income for each unit of assets. Higher ratio indicates efficiency in utilizing its
overall resources and vice
versa.
EBIT
Return on Total Assets
Total Assets
=

While on after tax basis, because of the tax shelter benefit of interest, we add the after
tax
interest expenses to net income for the numerator of the ratio.
Net Profit after tax
Return on Total Assets
Total Assets
=
b. Return on Net worth (Ordinary Shareholders Equity)
The ratio of net profit taxes to net worth measure the state of return on the stock
holder’s investment is computed by dividing EAT with net worth. This ratio tells
us the earning power on shareholders equity and is frequently used in comparing
two or more firms in an industry. It also indicates that the funds supplied by owners.
The higher ratio indicates that the funds using have effective in the company. It
reflects the extent to which the objective of profit maximization has been
achieved. Here net worth represents only equity capital.

Net profi t after

Return on Share Holder’s Equity =
tax
Share Holder’s Equity

3.4 Statistical Tools

Mandy statistical tools are often employed in the analysis and interpretation of data
as an aid to management and managerial decision. Following statistical are
used more systematically in this chapter.
3.4.1 Correlation Coefficient
(r)
Correlation coefficient measures the relationship between two variables, when they
are so related that the change in value of one variable is accompanied by the change
in the value of the other. It contributes to the understanding of economic behavior,
aids in locating the critical important variables on which others depend, may reveal
to the economist the connection by which disturbances spread stabilizing forces
may become effective. Although there are three types of correlation i.e simple,
partial and multiple but here the focus is on simple correlation based on “Pearson’s
coefficient of correlation”.

The correlation co-efficient denoted by r and shows the direction of relationship

between coefficients.

NXY − XY
r=
√NX2 −(∑ X)2 √NY2−(∑ Y)2
Where,
r = Pearson's correlation coefficient
N = No. of Observation
X, Y =
Variables.

If one variable increases or decreases then r will fall between O and I i.e. the
inverses relationship exists on the other sided, it one variable increases the other
also increases and the value of r will be ranged between O and I i.e. the relationship
exists.

Decision
criteria
When the value of r = + 1, the variables are perfectively correlated
When the value of r = -1, the variables have perfect negative
correlation When the value of r = 0, there is no correlation between
the variables.
If -1 < r < 0 then two variables either increase or decrease but it is the opposite
direction.

3.4.2 Probable Error

(P.E)
The probable error of the coefficient of correlation helps in interpreting its value with
the help of probable error it is possible to determine the reliability of the value
of the coefficient is done for as it depends on the condition of random sampling. The
P.E of the coefficient of correlation is obtained as follows.
(1−r2)
P.E. (r) = 6 0.6745
√N

Where,
r=correlation coefficient
N=no. of parts of observation

Note:
If the value of r is less than the P.E. there is no evidence of correlation i.e.
the value of r is not significant.

57
 If the value of r is more than 6 times of P.E. the coefficient of
correlation is practically certain i.e. the value of r is significant.

3.4.3 Simple Regression Analysis

58
It is a statistical tool which helps to estimate or predict the one variable when the
value of other variable is known. The unknown variable which we have to
predict is called dependent variable and the variable whose value is known is called
independent variable. The analysis used to describe the average relationship between
two variables is known as simple linear regression analysis.

Regression equation of y on
x:
y = a + bx

Regression Constant
(a)
Regression constant synonymous with the numerical constant determines
the distance of the fitted line directly above or below the origin. The value
of the constant which is the intercept of the model indicates the average level of
dependent variable when independent variable (s) is zero. In other words, a
constant indicates the mean or average effect on dependent variable if all
variables omitted from the model.
Regression Coefficient
(b)
The regression coefficient of each dependent variable indicates the
marginal relationship between that variable and value of dependent variable,
holding constant the effect of all other independent variable in the regression
model. In other words, the coefficient describes how much change in independent
variables; affect t he value of dependent variables estimate. It is also known that
the numerical constant which determines the changes in dependent variable
per unit changes in independent variables (i.e. slope of the line).
 CHAPTER - IV
DATA PRESENTATION AND
ANALYSIS

4.1 Introduction
This is the most important chapter of the study. In this chapter the data collected
will be analyzed and presented mathematically. All the above-mentioned financial
and statistical tools will be used to present the data.

To analyze the financial performance in respect to capital structure, various

presentation and analysis have been presented in this chapter according to analytical
research design mentioned in the third chapter using various financial and statistical
tools.

4.2 Presentation and Analysis of Data

It is already stated that Capital structure refers to the combination of preference
share, equity share capital including reserve and surplus as well as long-term
debt. Optimal capital structure refers to that combination of funds, which maximizes
the EPS, value of the firm and overall cost of capital. The analyses in this
chapter are divided into
following sections, which is directly and indirectly related to the capital
structure.

4.2.1 Capital Structure

Analysis
4.2.1.1 Debt Equity Ratio
Table: 4.1
Comparative Debt – Equity Ratio
Fiscal Year Debt Equity Ratio (times)
NABIL HBL NIBL
2001/02 0.36 0.36 0.19
2002/03 0.73 0.29 0.01
2003/04 0.16 0.29 0.50
2004/05 0.01 0.20 0.30
2005/06 0.10 0.13 0.39
2006/07 0.44 0.20 0.38
2007/08 0.58 0.38 0.39
2008/09 0.55 0.16 0.27
 Average 0.35 0.25 0.30
Source: Annual Reports (Refer Appendix 1)
Figure: 4.1
Comparative Debt Equity Ratio
0.8
0.7
0.6
0.5
Ratio

0.4
NABIL
0.3
HBL
0.2
NIBL
0.1
0

Year

The debt equity ratio and average ratio has been calculated in the above table. Eight
years data have been presented here:

The table shows that D/E ratio of NABIL is 0.36, 0.73, 0.16, 0.01, 0.09, 0.44, 0.58
&
0.55 in fiscal years 2001/02 to 2008/09 respectively. The average D/E ratio of
NABIL is
36.66%. It shows that creditors have 36.66% claims on assets where the last three
years ratio are lower than average ratio, it indicates that claim of owners is higher
than the creditors. It also indicates that the company has lesser amount to be paid
as interest on debt.

Calculated value of HBL shows D/E ratio have decreasing trend upto year
2008/09 except in year 2007/08. D/E ratio is 0.29 in the year 2002/03 which remains
constant 0.29 in F/Y 2003/04 too. The ratio decreases to 0.20 in following year then
again decreases to
0.17 in the year 2005/06. The average D/E ratio is 25.4% which implies that the
claim of creditors is 25.00% in compare to owner of the company.
In case of NIBL, above calculation shows that D/E ratio have fluctuating trend over
the study period. The table shows that D/E ratio of NIBL is 0.19 in the year 2001/02
and then it decreases to 0.01 in the year 2002/03. Then it increases to 0.50 in the year
2003/04. In the year 2004/05 it decreases to 0.30 after which its D/E ratio increases to
0.39 in the year
2005/06 and same in fluctuating regularly till 2008/09. This shows that NIBL have
very fluctuating trend of D/E ratio. The average D/E ratio is 30.00% which implies
that the claim of creditors is 30.00% in compare to owner of the company.

Between NABIL, HBL and NIBL, HBL has lowest D/E

ratio.

4.2.1.2 Long Term Debt to Capital Employed

Ratio
Table: 4.2
Comparative Long Term Debt to Capital Employed
Ratio
Fiscal Year Long Term Debt to Capital Employed Ratio (times)
NABIL HBL NIBL
2001/02 0.27 0.26 0.16
2002/03 0.42 0.25 0.01
2003/04 0.13 0.22 0.33
2004/05 0.01 0.16 0.23
2005/06 0.08 0.15 0.28
2006/07 0.31 0.17 0.30
2007/08 0.37 0.27 0.28
2008/09 0.36 0.14 0.21
Average 1.95 0.20 0.23
Source: Annual Reports (Refer Appendix 2)
Figure: 4.2
Comparative Long Term Debt to Capital Employed
Ratio
0.45
Ratio

0.25
0.4 0.2
0.35 0.15
0.3
 0.1
0.05
0

NABIL
HBL
NIBL

Year

NABIL has fluctuating trend of long term debt to capital employed ratio. In F/Y
2001/02 the ratio is 0.27 that means long term debt to capital employed is 27%
and owner of companies contributed remaining 73%. In the following year 2002/03
the ratio increases to 0.42 and in F/Y 03/04, 04/05, 05/06, 06/07, 07/08 & 08/09 ratio
are 0.13, 0.01, 0.08,
0.31, 0.37 & 0.36 respectively. The average ratio shows a ratio of
19.5%.

The Table 4.2 shows that HBL have a decreasing trend in term of LTD to
capital employed ratio till year 2006/07 and in 2007/08 increment upto 0.27
then also in declining phase of 0.14 in 2008/09. In F/Y 2001/02 the ratio is 0.26 that
means 26% of capital is employed by long-term debt and remaining is contributed
by shareholder’s equity. And the ratio is decreasing year by year gradually. The
average ratio is 20.00%.

In case of NIBL also ratio of LTD to capital employed is in fluctuating trend as that
of
NABIL. In F/Y 2001/02 the ratio is 0.16 that means long term debt to capital
employed is
16% and owner of the company contributed remaining 84%. In the following
year
2002/03 the ratio decreases to 0.01 and in F/Y 03/04, 04/05, 05/06, 06/07, 07/08 &
08/09 ratio are 0.33, 0.23, 0.28, 0.30, 0.28 and 0.21 respectively. The average ratio
shows the ratio of 23.00%. Between NABIL, HBL and NIBL, HBL shows highest
ratio which means NIBL has higher amount of capital financed by long term debt.

4.2.1.3 Debt to Total Assets

Ratio
 Table: 4.3
Debt to Total Asset
Ratio
Fiscal Year Debt To Total Asset Ratio (percentage)
NABIL HBL NIBL
2001/02 0.02 0.03 0.02
2002/03 0.06 0.03 0.00
2003/04 0.01 0.03 0.03
2004/05 0.00 0.02 0.02
2005/06 0.01 0.02 0.03
2006/07 0.03 0.02 0.03
2007/08 0.04 0.03 0.03
2008/09 0.04 0.01 0.02
Average 0.03 0.04 0.02
Source: Annual Reports (refer appendix 3)
Figure: 4.3
Debt to Total Asset
Ratio
0.07
0.06
0.05
Ratio

0.04
0.03 NABIL
0.02 HBL
0.01 NIBL
0

Year

The Table 4.3 shows Debt to Total Assets ratio of NABIL is in fluctuating trend. In
F/Y
2001/02 its ratio is 0.02 where as it increases to 0.06 in next year. The ratios are
0.01,
0.06, 0.01, 0.03, 0.04 & 0.04 in following respective years 03/04, 04/05, 05/06,
06/07,
07/08 & 08/09. The average ratio is 0.03 i.e. 3%.
Debt to Asset ratio of HBL is quite steady in last five years still the ratio is very
low. In F/Y 2001/02 its ratio is 0.03 and it remains constant for three years which
then decreases to 0.02 in following year. The ratio again increases in year 2006/07
then follows same in year 2007/08 & 2008/09 in decreasing phase for last two years.
The average ratio of HBL is 0.04 i.e. 4%.

By the above calculation we can say that Debt to Total Assets ratio of NIBL is
in fluctuating trend as that of NABIL but not as fluctuating as that of NABIL.
In F/Y
2001/02 Debt to Total asset ratio of NIBL is 0.02 which means only 2% of total
fund is provided by the creditors. In the following year it decreases to 0% and
then again increases to 0.03 in the F/Y 2003/04. The LTD to TA ratio is 0.02 and
0.03 in the year
2004/05 and 2005/06 respectively and stand constant upto year 2007/08. The LTD to
TA
ratio decreases in year 2008/09. The average ratio for the period is
2%.

The debt to asset ratio of NABIL, HBL and NIBL is insignificant because long term
debt is negligible compared to total asset.

However, average Debt asset ratio of HBL is higher than NABIL and
NIBL..

4.2.1.4 Long Term Debt to Total Debt

Ratio
Table: 4.4
Comparative Long Term Debt to Total
Debt
Fiscal Year Long Term Debt to Total Debt (percentage)
NABIL HBL NIBL
2001/02 0.03 0.03 0.02
2002/03 0.06 0.03 0.00
2003/04 0.02 0.03 0.03
 2004/05 0.00 0.02 0.02
2005/06 0.01 0.02 0.03
2006/07 0.04 0.02 0.03
2007/08 0.04 0.03 0.03
2008/09 0.04 0.01 0.02
Average 0.03 0.02 0.02
Source: Annual Reports (refer appendix 4)
Figure: 4.4
Comparative Long Term Debt to Total Debt
0.07 Ratio
0.06

0.05
Ratio

0.04

0.03 NABIL

0.02 HBL
NIBL
0.01

Year

The trend analysis of the company reveals that NABIL has quite fluctuating trend
of LTD/TD ratio. The above calculation shows that the ratio of LTD/TD of NABIL is
0.03 in F/Y 2001/02. This means contribution of long term debt is 0.03 and
remaining is contributed by current liabilities. The ratio is 0.06 in year 02/03 which
decreases to 0.02 in F/Y 03/04. Then after it decreases to 0% in the following year and
then again increases to 0.01 in the year 2005/06 and stable to 0.04 till the year
2008/09. The average ratio is
3%.

Similarly, HBL has constant trend of LTD/TD ratio .In the fiscal year 2001/02 the
ratio is
0.03 that indicated contribution of long term debt in total debt and remaining portion
is contributed by current liabilities. It remains constant for three years and then
decreases to
0.02 for the last two F/Y and again 0.03 and 0.01 in year 2007/08 &
2008/09 respectively. The average ratio is 2.4%.

Similarly, NIBL also have the fluctuating trend of LTD to TD ratio for the five
sample years. It is 0.02 for the F/Y 2001/02 which indicates contribution of long
term debt in total debt is only 2% and remaining part is current liabilities. The ratio
then is 0.0, 0.03,
0.02, 0.03, 0.03, 0.03 and 0.02 for the F/Y 2002/03, 2003/04, 2004/05, 2005/06,
2006/07,
2007/08 & 2008/09 respectively. The average ratio is 2%.

From the above calculation we can say that NIBL is low levered firm with
comparison to rest two firms since it has used less long term debt than that of NABIL
and HBL.

4.2.1.5 Interest Coverage

Ratio
Table: 4.5
Interest Coverage
Ratio
Fiscal Year Interest Coverage ratio (times)
NABIL HBL NIBL
2001/02 1.89 1.61 1.60
2002/03 2.94 1.65 1.90
2003/04 3.33 1.86 1.71
2004/05 4.12 1.93 1.94
2005/06 3.52 2.04 2.03
2006/07 2.97 2.04 2.16
2007/08 2.58 2.04 2.13
2008/09 2.41 2.04 1.85
Average 2.97 1.90 1.92
Source: Profit and Loss Statement (refer appendix 6)
Figure: 4.5
Comparative Interest Coverage
Ratio
4.5
4
3.5
3
Ratio

2.5
2 NABIL
1.5 HBL
1 NIBL
0.5
0
Year
In the table 4.5 the average ratio of NABIL is 2.97 which imply no. of times of
interest covered by its EBIT. The interest coverage ratio of NABIL shows increasing
trend beside last F/Y. The ICR of NABIL in year 2001/02 is 1.89 times which
increases to 2.94 times in F/Y 02/03 and 3.33 times in 03/04. Then it increases to
4.12 times in 04/05 and 3.52 times in the year 05/06 then in the decreasing trend of
2.97, 2.58 and 2.41 in F/Y 06/07,
07/08 and 08/09 respectively. It shows that NABIL is capable and it is good
indication because higher ratio is preferable.

In case of HBL the ICR is 1.61, 1.65, 1.86, 1.93, 2.04 times in the year 2001/02,
02/03,
03/04, 04/05, 05/06 respectively and constant of 0.24 times till year 2008/09. Here
the ratio shows increasing trend. The average calculated ratio is 1.90 times. This
implies company’s available profit can meet the debt amount.

In case of NIBL the ICR is 1.60, 1.90, 1.71, 1.94, 2.03, 2.16, 2.13 and 1.85 times in
the year 2001/02, 02/03, 03/04, 04/05, 05/06, 06/07, 07/08 and 08/09 respectively.
Here the ratio shows slightly fluctuating trend. But it is in increasing trend in year
2009/07 and slowly in decreasing phase in year 2007/08 and 2008/09 and also the
available profit can meet the debt amount.

The ratio between three banks shows that there is enough profit to meet the claim of
the creditors. Between three firms the ICR of NABIL is greater.

4.2.1.6 Return on Share Holders’

Equity
Table: 4.6
Return on Shareholder's
Equity
Fiscal Year Return on Shareholder's Equity (times)
NABIL HBL NIBL
2001/02 0.24 0.16 0.11
2002/03 0.32 0.12 0.18
2003/04 0.31 0.12 0.21
2004/05 0.32 0.12 0.20
 2005/06 0.34 0.16 0.25
2006/07 0.34 0.17 0.27
2008/09 0.32 0.25 0.26
2008/09 0.34 0.24 0.23
Average 0.32 0.17 0.21
Source: Balance Sheet and Profit and Loss Statement (refer appendix 7)

Figure: 4.6
Comparative Return on Shareholder's Equity
0.4 Ratio
0.35
0.3
0.25
Ratio

0.2
NABIL
0.15
HBL
0.1
NIBL
0.05
0

Year

The Table 4.6 exhibits return’s on shareholder’s equity of sample companies. In

the context of NABIL, it has a fluctuating trend. In the fiscal year 2001/02, the ratio
is 24% that imply that one hundred investment by shareholder’s equity earned
124. In F/Y
2002/03 it increased to 32% then decreased to 31% in next year. Again it
increased to
32% in F/Y 04/05 and further increased to 34% in 06/07. But decreases in year
07/08 to
32% and again increases to 34% in year 08/09. And al The average ratio is
32.00%.

Similarly, HBL shows decreased ratio at the beginning then it remain constant at 12%
till
04/05 that means shareholders earn Rs112 investing one hundred. After that
ROE
increased up to 16% in F/Y 05/06. Then in increasing trend of 17% & 25% in
year
06/07& 07/08 respectively. And in the year 2008/09 ROE is 24%. Its average
ratio is
17.00%
.
In case of NIBL, ROE is in increasing trend for first two years and then it reaches to
0.21 in the F/Y 2003/04. Then it decreases to 0.20 in the following year. ROE of
NIBL then again increases to 0.25 and 0.27 in year 05/06 and 06/07
respectively. And again decreases to 0.26 & 0.23 in the last two year of sample
period 07/08 & 08/09. The average ROE is 21%. By analyzing the above
calculation, it is found that the return
earned by shareholders of NABIL is highly
greater.

4.2.1.7 Return on Total

Assets
Table: 4.7
Return on Total
Assets
Fiscal Year Return on Total Assets (times)
NABIL HBL NIBL
2001/02 0.02 0.01 0.01
2002/03 0.03 0.01 0.01
2003/04 0.03 0.01 0.01
2004/05 0.03 0.01 0.01
2005/06 0.03 0.02 0.02
2006/07 0.02 0.02 0.02
2007/08 0.02 0.02 0.02
2008/09 0.02 0.02 0.02
Average 0.03 0.03 0.02
Source: Balance Sheet and Profit and Loss Statement (refer appendix 8)
 Figure: 4.7
Comparative Return on Total Assets
Ratio
0.035
0.03
0.025
Ratio

0.02
0.015 NABIL
HBL
0.01
NIBL
0.005
0

Year

The Table 4.7 shows the comparative position of return on Total Assets of NABIL,
HBL
and NIBL. From the table ROA of NABIL in the F/Y 2001/02, 02/03, 03/04, 04/05
and
05/06 are 0.02, 0.03, 0.03, 0.03 and 0.03 respectively. And decrease in constant ratio
0.02 in year 06/07, 07/08 and 08/09. Its average ratio is 0.03. The overall trend
is first increasing then remains constant.

Similarly, ROA of HBL in the year 2001/02, 02/03, 03/04, 04/05, 05/06, 06/07 is
0.01 and 0.02 in last two years respectively and the average return is 0.03. The overall
trend is first decreasing then constant and increased in last two F/Y.

In case of NIBL, ROA in the F/Y 2001/02, 02/03, 03/04, 04/05 are 0.01, 0.01, 0.01,
0.01 and in year 05/06 to 08/09 remains constant to 0.02. The average ratio is
0.02. The overall trend is constant for first four financial years and then increased
by 0.02 in last 4 yrs F/Y.

The averages return of NABIL & HBL is equal and higher compared to
NIBL.
4.2.1.8 Earning Per Share (EPS) Analysis
Table: 4.8
Comparative Earning Per
Share
Fiscal Year Earning Per Share (In Rupees)
NABIL HBL NIBL
2001/02 55.25 60.26 33.59
2002/03 84.66 49.45 39.56
2003/04 92.61 49.05 51.70
2004/05 105.49 47.91 39.50
2005/06 129.21 59.24 59.35
2006/07 137.08 60.66 62.57
2007/08 108.31 62.74 57.87
2008/09 106.79 61.90 37.42
Average 102.43 56.40 47.70
Source: Annual
Reports
Figure: 4.8
Comparative Earning Per Share

160
140
120
100
EPS

80
NABIL
60
HBL
40
NIBL
20
0

Fiscal Year

The Earning per share of NABIL are Rs 55.25, Rs84.66, Rs 92.61, Rs 105.49, Rs
129.21, Rs 137.08, Rs 108.31, Rs 106.79 in the F/Y 2001/02, 02/03, 03/04, 04/05,
05/06, 06/07,
07/08 and 08/09 respectively. The average EPS is Rs 102.43. The overall trend
is
increasing. The highest EPS is Rs 137.08 in F/Y 06/07.
Similarly, the earning per share of HBL in the years 2001/02, 02/03, 03/04, 04/05,
05/06,
06/07, 07/08 and 08/09 are Rs 60.26, Rs 49.45, Rs 49.05, Rs47.91, Rs 59.24, Rs
60.66, Rs 62.74 and Rs 61.90 respectively. The average EPS is Rs 56.40. Here the
overall trend is fluctuating. EPS decreases from Rs 60.26 in the F/Y 2001/02 to Rs
47.91 in the year
04/05.

The Earning per share of NIBL are Rs 33.59, Rs 39.56, Rs 51.70, Rs 39.50, 59.35,
62.57,
57.87 and 37.42 in the F/Y 2001/02, 02/03, 03/04, 04/05, 05/06, 06/07, 07/08 and
08/09 respectively. The average EPS is Rs 44.70. Here the overall trend is fluctuating.
EPS first increases and reaches to Rs 62.57 in 2006/07 and then it decrease in the
following year.

Between all three banks EPS of NABIL has the highest Rs 102.43 average which
shows
NABIL is most
profitable.

4.2.1.9 Dividend Per Share (DPS)

Analysis
Table 4.9
Comparative Dividend per
Share
Fiscal Year Dividend Per Share (In Rupees)
NABIL HBL NIBL
2001/02 30 25 30
2002/03 50 1.32 20
2003/04 65 0 15
2004/05 70 11.58 12.50
2005/06 85 30 55.46
2006/07 140 40 30
2007/08 100 45 40.83
2008/09 85 50 20
 Average 78.13 25.36 27.97
Source: Annual Reports
Figure 4.9
Comparative Dividend Per
160 Share
140
120
100
DPS

80
NABIL
60
HBL
40
NIBL
20
0

Year

The dividend per share of NABIL are Rs 30, Rs 50, RS 65, Rs 70, Rs 85, Rs 140, Rs
100
& Rs 85 in the years 2001/02, 02/03, 03/04, 04/05, 05/06, 06/07, 07/08 and
08/09 respectively. The average DPS is Rs 78.13 The highest DPS paid is in the last
financial year 06/07.

Similarly, HBL shows a DPS of Rs 25, Rs 1.32, Rs 0.00, Rs 11.58, Rs 30, Rs 40, Rs
45, and Rs 50 in the F/Y 2001/02, 02/03, 03/04, 04/05, 05/06, 06/07, 07/08 and
08/09. The average DPS is Rs 25.36. HBL has paid a highest dividend of Rs 50 in
the year 08/09 whereas it has paid no dividend at all in the year 03/04.

The dividends per share of NIBL are Rs 20, Rs 30, Rs 15, Rs 12.50, Rs 55.46, Rs 30,
Rs
40.83 and Rs 20 in the F/Y 2001/02, 02/03, 03/04, 04/05, 05/06, 06/07, 07/08 and
08/09 respectively. The average DPS is Rs 27.97. The highest DPS paid is in the last
financial year 05/06.
The table shows that NABIL has paid the highest average dividend of Rs
60.
It shows that the more investors are likely to be attracted in investing at
NABIL.

4.2.2 Analysis of Financial

Leverage
When the company employs debt or other fund carrying fixed charges i.e. interest in
the capital structure, financial leverage exits. If the financial charge is high the
company can have advantage of tax shield but it will affect the owner’s return i.e.
net profit as well. Financial leverage explains the relationship between earning before
interest and taxes and net profit of the company.

Two
Methods
Either dividing percentage change in EPS by percentage change into EBIT or
dividing percentage change into EBT by EBIT can calculate degree of financial
leverage. In this analysis of financial leverage second method is chosen. High the
financial leverage, high will be the financial risk and also high will be the
shareholders’ return. The degree of financial leverage of Sample Company is
presented below:

Table: 4.10
Degree of Financial
Leverage
Fiscal Year Degree of Financial Leverage (times)
NABIL HBL NIBL
2001/02 2.13 2.66 2.67
2002/03 1.52 2.54 2.11
2003/04 1.43 2.17 2.41
2004/05 1.33 2.08 2.06
2005/06 1.40 1.97 1.97
2006/07 1.47 1.86 1.86
2007/08 1.54 1.75 1.88
2008/09 1.61 1.64 2.18
Average 1.55 2.08 2.14
Source: Annual Reports (Refer Appendix 5)
Figure: 4.10
Comparative Degree of Financial
Leverage
 3

2.5

2
DFL 1.5
NABIL
1
HBL
0.5 NIBL
0

Year

Above calculated DFL of NABIL has decreasing trend in first four years of
sample period and is increased in last F/Y. In the fiscal year 2001/02 the DFL is
2.13 times. In second year the DFL is 1.52 times in the fiscal year 2003/04, 04/05,
05/06 the DFL is
1.43, 1.33 and 1.40 times respectively. And DFL is 1.47, 1.54 & 1.61 in year
06/07,
07/08 & 08/09 respectively. The average DFL is 1.55
times.

The trend of HBL is quite constant .The DFL of HBL in the fiscal year 2001/02,
02/03,
03/04, 04/05, 05/06, 06/07, 07/08 and 08/09 are 2.66, 2.54, 2.17, 2.08, 1.97, 1.86,
1.75 and 1.64 times respectively. The average DFL of HBL is 2.08 times.

The trend of NIBL is also quite constant. In case of NIBL, DFL in the fiscal
year
2001/02, 02/03, 03/04, 04/05, 05/06, 06/07, 07/08 and 08/09 are 2.67, 2.11, 2.41,
2.06,
1.97, 1.86, 1.88 and 2.18 respectively. The average DFL of NIBL is 2.14
times.
Analyzing the above data, it is found that the DFL of NIBL is greater than NABIL
and
HBL. It shows that NIBL has greater burden of financial
charges.
4.2.3 Correlation
Analysis
Correlation analysis enables us to have an idea about the degree and direction of
the relationship between two or more variables. The correlation is a statistical tool
which studies the relationship between two or more variables and correlation
analysis involves various methods and techniques used for studying and
measuring the extent of the
relationship between two or more variables. It is denoted by ‘r’. However it
fails to reflect upon the cause and effect relationship between the variables.
Although there are three types of correlation i.e. simple, partial and multiple but
here the focus is on simple correlation based on ‘Pearson’s Coefficient of
Correlation’. In the following section correlation between different variables are
calculated and presented of the sample companies.

4.2.3.1 Correlation of Nabil

Bank
Table: 4.11
Correlation of Nabil
Bank
LTDCE DE DA LTDTD ICR ROE ROA
LTDCE 1 .989(**) .948(**) .971(**) -.742(*) .050 -.592
DE .989(**) 1 .981(**) .977(**) -.657 .096 -.488
DA .948(**) .981(**) 1 .966(**) -.535 .206 -.335
LTDTD .971(**) .977(**) .966(**) 1 -.631 .090 -.416
ICR -.742(*) -.657 -.535 -.631 1 .445 .779(*)
ROE .050 .096 .206 .090 .445 1 .162
ROA -.592 -.488 -.335 -.416 .779(*) .162 1
** Correlation is significant at the 0.01 level (2-
tailed).
* Correlation is significant at the 0.05 level (2-
tailed).
Source: SPSS
Programs

Table 4.11 represents that debt equity ratio of Nabil bank is positively
correlated with long term debt to capital employed ratio, Debt assets ratio and
long term debt to total debt ratio whereas it is negatively correlated with interest
coverage ratio, return on equity and return on assets. Similarly long term debt
to capital employed ratio is positively correlated to Debt assets and Long term
debt to total assets ratio but negatively correlated with return on assets and return
on equity. Debt assets is positively correlated with long tem debt to total debt
ratio and negatively correlated with Interest coverage ratio, ROE and ROA.
Long term debt to total debt ratio is negatively correlated with Interest
coverage ratio, ROE and ROA. Interest coverage ratio is positively correlated
with ROE and ROA. Finally ROE is also positively correlated with ROA.
4.2.3.2 Correlation of Himalayan Bank
Table: 4.12
Correlation of Himalayan
Bank
LTDCE DE DA LTDTD ICR ROE ROA
LTDCE 1 .977(**) .908(**) .908(**) -.619 -.039 .029
DE .977(**) 1 .877(**) .877(**) -.533 .053 .099
DA .908(**) .877(**) 1 1.000(**) -.622 -.368 -.311
LTDTD .908(**) .877(**) 1.000(**) 1 -.622 -.368 -.311
ICR -.619 -.533 -.622 -.622 1 .556 .475
ROE -.039 .053 -.368 -.368 .556 1 .901(**)
ROA .029 .099 -.311 -.311 .475 .901(**) 1
** Correlation is significant at the 0.01 level (2-
tailed).
* Correlation is significant at the 0.05 level (2-
tailed).
Source: SPSS
Programs

From the table 4.12 it can be concluded that the debt equity ratio of Himalayan bank
is positively correlated with long term debt to capital employed ratio, debt assets
ratio and long term debt to total debt ratio whereas it is negatively correlated with
interest coverage ratio, ROE and ROA. Long term debt to capital employed ratio is
positively correlated with debt ratio and debt to total debt ratio but is negatively
correlated with interest coverage ratio, ROE and ROA. Debt ratio is perfectly
positively correlated with long term debt to total assets and negatively correlated
with interest coverage ratio, ROE and ROA. Long term debt to total debt ratio is
negatively correlated with interest coverage, ROE and ROA. Interest coverage
ratio is positively correlated with ROE and ROA. Finally ROE is perfectly
positively correlated with ROA.

4.2.3.3 Correlation of Nepal Investment Bank

Ltd
Table: 4.13
Correlation of Nepal Investment Bank
Ltd
LTDCE DE DA LTDTD ICR ROE ROA
LTDCE 1 .992(**) .970(**) .970(**) .285 .591 .444
DE .992(**) 1 .949(**) .949(**) .290 .612 .412
DA .970(**) .949(**) 1 1.000(**) .283 .537 .516
LTDTD .970(**) .949(**) 1.000(**) 1 .283 .537 .516
ICR .285 .290 .283 .283 1 .851(**) .699
ROE .591 .612 .537 .537 .851(**) 1 .795(*)
ROA .444 .412 .516 .516 .699 .795(*) 1
 ** Correlation is significant at the 0.01 level (2-
tailed).
* Correlation is significant at the 0.05 level (2-
tailed).
Source: SPPS
Programs
Looking at the table 4.13 of Nepal Investment Bank Ltd. the correlation of Debt
equity ratio is positive with long term debt to capital employed, Debt assets and long
term debt to total debt ratio, interest coverage, ROE and ROA. Similarly the long
term debt to capital employed ratio is positively correlated with Debt assets, long
term debt to total debt, ROE, ROA and interest coverage ratio. Debt assets ratio
is perfectly positively correlated with long term debt to total debt positively
correlated with ROE, ROA and interest coverage ratio. Long term debt to total
debt ratio is positively correlated with interest coverage and positively correlated
with ROE and ROA. Interest coverage ratio is positively correlated with both ROE
and ROA. Finally ROE is also positively correlated
with
ROA.

4.2.3.4 Overall
Correlation
Table: 4.14
Overall
Correlation
LTDCE DE DA LTDTD ICR ROE ROA
LTDCE 1 .984(**) .936(**) .946(**) -.234 .248 .024
DE .984(**) 1 .944(**) .948(**) -.130 .334 .113
DA .936(**) .944(**) 1 .967(**) -.182 .159 .022
LTDTD .946(**) .948(**) .967(**) 1 -.111 .241 .101
ICR -.234 -.130 -.182 -.111 1 .749(**) .828(**)
ROE .248 .334 .159 .241 .749(**) 1 .856(**)
ROA .024 .113 .022 .101 .828(**) .856(**) 1
Source: SPSS
Programs

Looking at the overall correlation of the bank, we can conclude that Debt Equity
Ratio is positively correlated with Long term debt to capital employed, Debt asset
ratio, Long term debt to total debt ratio, ROE and ROA where as it is negatively
correlated with Interest coverage ratio. Long term debt to capital employed ratio is
positively correlated with Debt asset ratio and Long term debt to total debt ratio,
and negatively correlated with Interest coverage ratio, ROE and ROA. Debt asset
ratio is positively correlated with
long term debt to total debt ratio and negatively correlated with Interest coverage
ratio, ROE and ROA. Long term debt to total debt ratio is negatively with Interest
coverage ratio and ROA and positively with ROA. Interest coverage ratio is
positively correlated with ROE and ROA. ROE is positively correlated with ROA.
4.2.4 Simple Regression
Analysis
Table gives the result of simple regression analysis, in which ROE, ROA and
Dividend payout Ratio are dependent variable and debt equity ratio is independent
variable for all the banks.

Results of Simple Regression Analysis of the Selected

Variables
Table: 4.15
Debt Equity (DE) is Regressed on Return on Equity (ROE Regression
Equation: dependent variable = a + b1 (independent variable)
Variables Constant (a) Coefficient (b) Bank
ROE=a+b1 DE .311 .012 NABIL
ROE=a+b1 DE .156 .034 HBL
ROE=a+b1 DE .150 .205 NIBL
Source: SPSS Programs

Table 4.15 shows that there is positive effect of debt equity ratio in ROE in NABIL,
HBL and NIBL. The constant value represents that if debt equity is zero the value of
ROE will be .311, .156 and .150 for NABIL, HBL and NIBL respectively.
Table: 4.16
Debt Equity (DE) is Regressed on Return on Assets
(ROA)
Variables Constant (a) Coefficient (b) Bank
ROA=a+b1 DE .029 -.010 NABIL
ROA=a+b1 DE .011 .005 HBL
ROA=a+b1 DE .011 .014 NIBL
Source: SPSS Programs
Looking at table 4.16 coefficient beta means that ROA will decline by -.010 with
every unit increase in debt equity ratio for NABIL and HBL respectively whereas
the value
.014 of NIBL represent that ROA will increase by .014 with increase in one unit of
debt
equity ratio. Similarly, the constant value .029, .011and .011 represents the value of
ROA
for NABIL, HBL and NIBL in the absence of debt equity ratio.
 Table: 4.17
Debt Equity (DE) is Regressed on Dividend Payout Ratio
(DPR)
Variables Constant (a) Coefficient (b) Bank
DPR=a+b1 DE .678 1.62 NABIL
DPR=a+b1 DE .618 -.767 HBL
DPR=a+b1 DE .655 -.233 NIBL
Source: SPSS Programs

In the table 4.17 the relationship between DPR and DE ratio is analyzed. Debt
equity ratio of all the banks has negative effect in dividend payout ratio. It means that
as the debt ratio increases by one unit dividend payout ratio will decline by -.162,
-.767 and -.233 for NABIL, HBL and NIBL respectively. Similarly, the value of
constant .678, .618 and .655 are the value of dividend payout ratio when debt equity
ratio is zero.

4.3 Major Findings of the Study

The average Debt equity ratio of NABIL is 27.2%. It shows that the creditors
of NABIL have 27.2% claims on the assets of NABIL , where the last three
years ratio are lower than average ratio , it indicates that claim of owners is
higher than the creditors. The average D/E ratio of HBL is 25% which
implies that the claim of creditors is 25% in compare to owner of the
company. The average D/E ratio of NIBL is 30% which implies that the claim
of creditors is 30% in compare to owner of the company.

Long term Debt to capital employed ratio highlights the portion of fund
financed by long term Debt in the capital employed by the firm. The data
shows NABIL has fluctuation trend. Its average ratio is 19.5%. Similarly, trend
of Long term Debt to capital employed ratio of HBL shows a decreasing trend.
Its average ratio is 20%. And in case of NIBL the ratio is in fluctuating trend. Its
average ratio is 23% which implies portion of fund financed by long term debt
in the capital employed is 23% in average for the sample period.
 The Debt to Asset ratio of NABIL, HBL and NIBL is insignificant because
long term Debt is negligible compared to Total assets. Overall debt asset ratio of
NABIL is low. Its average ratio is 3%. Similarly, Debt asset ratio of HBL is
quite steady even their ratios are low. The average ratio of HBL is 4%. On the
other hand the average Debt to Asset ratio of NIBL is similar to NABIL which
is 2%.

Long term Debt to Total Debt ratio indicates what percentage of Total
Debt is covered by long term debt of the firm. The trend analysis of
NABIL shows fluctuating LTD/TD ratio. LTD/TD in 2001/02 is 0.03 that
means contribution of LTD is 0.03 and the remaining portion contributed by
current liabilities. NABIL has
3% of average ratio. HBL shows constant ratio. Its average ratio is 2.4%. NIBL
also shows the fluctuating trend of LTD/TD ratio. Its average ratio is 2%. In
these cases the total debt is contributed by current liabilities to large extent.

The average interest coverage ratio of NABIL is 2.97 which imply no. of
times of interest covered by its EBIT. The interest coverage ratio of
NABIL shows an decreasing trend besides last F/Y. It shows the capabilities
of NABIL. In case of HBL, the average ratio is 1.90; this implies company’s
available profit can meet the debt amount. The interest coverage ratio of NIBL
shows slightly fluctuating trend and its average ratio is 1.92. ICR of NABIL is
found to be greater than HBL and NIBL.

Return on shareholder’s equity of NABIL has fluctuating trend. The average ratio
is
32%. Similarly, HBL shows decreased ratio in first two years then it
increases in last two fiscal year. Its average ratio is 17%. ROE of NIBL shows
fluctuating trend. Its average ratio is 21%. Analyzing between three
companies return earned by shareholders of NABIL is highly greater.
 Comparative position of return on Total Asset of NABIL shows average of
0.03.
The overall trend is first decreasing then constant. Similarly, ROA of HBL is
first decreasing then constant and increased in last F/Y .Its average return is
0.02. In case
 of NIBL its average return is 0.012. Its overall trend is first constant and
then increased to 0.02 in the last F/Y. The average return of NABIL & HBL
is higher compared to NIBL.

Earning per share of an organization shows how much earning belongs to

the ordinary share holders. The average earning per share of Nabil is Rs
102.43. Similarly, the average earning per share of HBL is Rs 56.40. And that
of NIBL is Rs 47.70. Between them NABIL has the higher EPS.

The average dividend per share of NABIL is Rs 78.13 .Similarly, HBL shows
an average DPS is Rs 25.36. And that of NIBL is Rs 27.97. Between three of
them, NABIL has paid higher dividend.

Individual value of the firm trend of NABIL shows increasing trend. The
average value of NABIL is Rs 6441.498 million. Similarly, value of HBL has
decreased in first financial year and increased gradually. Its average value is Rs
5850.97 million. The average value of NIBL is Rs 3985.064 and it shows an
increasing trend of value of firm. NABIL has optimum capital structure
compared to HBL and NIBL.

When the company employs debt or other fund carrying fixed charges in the
capital structure, financial leverage exists. From the degree of financial
leverage, it can be concluded that HBL is bearing high financial risk because
it has used more long term debt. NABIL and NIBL have employed lesser long
term debt than that of HBL so they have lesser financial risk.

The correlation between debt equity ratio with ROE and ROA is negative
for
NABIL and HBL whereas it is positive for
NIBL.
The regression analysis shows debt equity ratio has negative effect on ROE
and ROA in NABIL and HBL whereas it is positive for NIBL but all the
banks' dividend pay out ratio has negative effect from debt equity ratio.
 CHAPTER - V
SUMMARY, CONCLUSION AND RECOMMENDATIONS

This is the concluding chapter of this study. This chapter is divided into three
sections; Summary, Conclusion and Recommendations. In this chapter, the
study has been summarized in brief and some recommendations have been given
which could be useful to stakeholders and to concern companies as well.

5.1 Summary
The capital structure of a firm involves the choice of an appropriate mix of
different sources of funds i.e. owner funds and outsider funds. The selection of the
capital structure will obviously depends on the bearing that it has on the firm's
objectives of maximizing of shareholder's wealth. A financial mix which leads to
maximization of shareholders wealth as reflected in the market price of share is
termed as an optimal capital structure. An ideal capital structure should be
determination of proper balance between borrower's fund, i.e. debt capital and
owner's fund i.e. equity, which maximize the shareholders wealth and minimizes
the composite cost of capital.

This study, to analyze about capital structure, three commercials banks; Nabil Bank
Ltd, Himalayan Bank Ltd and Nepal Investment Bank Ltd have been taken. To
make the study more reliable, the whole study has been divided into five
chapters. This study endeavors to evaluate capital structure of commercials banks
with reference to the sample companies. The main objectives of the study are to
evaluate and analyze capital structure ratios of commercials banks under study. For
the realistic study, review of various books, research studies and articles have
been used. Various sequential steps to adopt a systematic analysis have been
explained in the third chapter. Most of the data used in this study are secondary in
nature. Eight years data are taken as sampled years, which are analyzed by using
financial and statistical tools such as Ratio analysis, Leverage analysis, Correlation
analysis and Regression Analysis etc. It employed simple regression model to evaluate
the relationship between debt equity ratio with Return on Equity, Return on
Assets and Dividend Payout Ratio. Calculation was done by using Excel and
SPSS
software which are presented in the appendix. Finally, Summary, Conclusion
and Recommendations of the study are presented separately to understand instantly
about the whole study.

5.2 Conclusion
It’s a renowned fact, whether we like it or not, the globalization of JVBs /CB is a
reality. The growth and increasing integration of the world’s economy has been
parallel by expansion of global banking activities. Nepal, though a developing
country couldn’t deny the fact that JVBs/CB has running potentially, which is
responded by extending loans and developing new, highly innovative financial
techniques that laid the foundation for totally new approaches to the provision of
banking services. On the basis of entire research study, some conclusion has been
deduced.

This study is particularly deals with conclusion about “A Study of capital

structure management of commercials banks – Himalayan Bank Ltd, Nabil Bank
Ltd and Nepal Investment Bank Ltd”. The Capital Structure decision is crucial
because of the need to maximize returns to various organizational constituencies,
and also because of the impact such a decision has on an organization’s ability to
deal with its competitive environment. This present study evaluated the capital
structure ratios and the relationship between capital structure and profitability of
firms. The study reveals that the companies are financially leveraged with a large
percentage of total debt being short term. Commercial bank has been using debt.
The higher D/E ratio constitutes that the outsider’s claim in total assets of the banks
in owner’s claim.

On an average NABIL constitutes 0.35 times of D/E ratio compare to 0.25 times of
D/E ratio of HBL and 0.30 times of D/E ratio of NIBL. The ICR shows that all the
three banks are able in paying interest but in comparison NABIL is operating
efficiently. The average ROE of the NABIL, HBL and NIBL are 0.32, 0.17 and 0.21
times respectively. The debt ratio of NABIL and HBL is found to be negatively
correlated with ROE and ROA whereas it is positively correlated with NIBL.
Simple regression analysis between debt
equity ratio with ROE and ROA also showed the similar results and the Dividend
Payout
Ratio was found to be negatively affected by debt equity ratio for all the
banks.

5.3 Recommendations
In this section of the study, it endeavors to recommend few points that can be
helpful to stakeholders as well as to the company. These recommendations are
based upon above calculations and drawn conclusions. These recommendations are
guidelines which would be helpful in taking prompt and appropriate decision about
capital structure.

These recommendations are given

below:
The Debt ratio of about 33% is considered appropriate (source; J. Fred Weston
and T.E. Copeland “Managerial Finance” Second U.K. edition). So this 33%
ratio can be assumed as standard ratio while analyzing. With comparison to
above standard three of the firm have low ratio. This shows that the share of
total assets financed by outsider’s fund is very low. It indicates that the owner’s
claim on total assets of the company is higher than creditors claim. If the
company is unsuccessful to yield a substantial percentage of return, the
owners should bear heavy losses but the creditors incur only the moderate
loss. Therefore, it is recommended that all the three firms mainly Nabil bank
should raise their debt ratio.
Banks should be aware that the debt financing results in tax saving on
interest charges that would help to maximize profit.
The capital structure of the banks are found to be unstable over the study
period so company should try to use stable capital structure as far as possible.
It is recommended that capital structure decision of commercial banks should
be based on different factors like the agency cost, cost of capital and value of
the firm. Optimal capital structure minimizes agency cost, cost of capital
and maximizes value of the firm.
Share holder’s wealth can be enhanced by judicious by judicious use of
debt financing.
The cost of capital should be considered while taking financing decision by
the commercial banks.
Lowering down the amount of debt and obtaining the additional funds through
issue of equity share, improving its working capital and making strategic
plans and developing the motivations management.
 BIBLIOGRAPHY

Durand, D. (1952). “Cost of Debt and Equity Funds for Business: Trends and
Problems of Measurement”, paper presented in Conference on Research in
Business Finance. New York: National Bureau of Economic Research.
Durand, D. (1959). “Cost of Equity Funds for Business in the Management
of
Corporate”. New York: The Free Press.
Gitman, L.J. (1998). Principle of Managerial Finance. New York: Harper and
Row
Publisher.
Himalayan Bank Ltd, (2001/02 to 2008/09) Annual Reports, Ktm; HBL.
Kafle, P.M. (2001). “A Comparative Analysis of Capital Structure between
Lumbini Sugar Factory Limited and Birgunj Sugar Factory Limited”. An
Unpublished Master’s Degree Thesis, Kathmandu: Faculty of
Management, Tribhuvan University.
Khan, M.Y. & Jain, P.K. (1999). Financial Management. New Delhi: Tata McGraw-
Hill. Lawrence, D.S. and Haley, J. (1983). Introduction of Financial Management.
New York:
McGraw –Hill.
Marsh, P. (1982). “The Choice between Equity and Debt: An Empirical Study”.
Journal of Finance, Aldan Pennsylvania USA: American Finance
Association, Vol. 37:
121–144.
Modigliani, F. and M. Miller. (1958). “The Cost of Capital, Corporation Finance and
the
Theory of Investment”. American Economic Review, Vol. 48: 261-
297. Nabil Bank Ltd. (2001/02 to 2008/09), Annual Reports, Ktm; Nabil.
Nepal Investment Bank Limited (2001/02 to 2008/09,) Annual Reports.
Kathmandu: NIBL.
Neupane, G.P. (2002). “A Study on Capital and Asset Structure of Nepal Bank
Limited (NABIL)". An Unpublished Master’s Degree Thesis, Kathmandu:
Faculty of Management, Tribhuvan University.
Pandey, I. M. (1999). “Financial Management”. New Delhi: Vikas Publishing
House
Pvt. Ltd.
Pathak, K. (1995). “Study on capital structure Management of Gorkhali Rubber
Udyog Ltd”. An Unpublished Master’s Degree Thesis, Kathmandu:
Faculty of Management, Tribhuvan University.
Pradhan, S. (1992). Basic of Financial Management. Kathmandu:
Educational
Enterprises Pvt Ltd.
Prashai, S.R. (1999). “The Capital Structure of Nepal Bank Ltd”. An
Unpublished Master’s Degree Thesis, Kathmandu: Faculty of
Management, Tribhuvan University.
Roa, C.V. & Litzaberges, R.H. (1970). “Leverage and the Cost of Capital in
Less Developed Capital Market Comment”. The Journal of Finance , Aldan
Pennsylvania USA: American Finance Association, 22(19): 15-17.
Shah, Anjana. (2004). “A study on the capital Structure of Selected
Manufacturing Companies –Nepal lever Ltd, Bottlers Nepal Ltd, Sriram
Sugar Mills, Jyoti Spinning Mills, Arun Vanaspati Udhyog”. An Unpublished
Master’s Degree Thesis, Kathmandu: Faculty of Management, Tribhuvan
University.
Sharma, V.L.N & Hanumanta, K. Roa, S. (1969). “Leverage and the Value of the
Firm”.
The Journal of Finance, Aldan Pennsylvania USA: American Finance
Association, Vol. XXIV (March).
Shekhar and Shekhar. (1999). “Banking Theory and Practice”. New Delhi:
Vikas
Publishing House.
Shrestha, M.K. (Dr.) (1985). “Analysis of Capital Structure in Selected
Public Enterprises". The Nepalese Journal of Public Administration . Lalitpur:
Publication Prakashan.
Shrestha, R.D. (1999). “Focus on Capital Structure of Selected and Listed
Public Companies”. Journal of Management, Southern Management
Association, Florida USA, 10(8):1.
Shrestha, U.L. (1999). “Comparative Evaluation of Capital Structure Between
Selected Manufacturing and Trading Companies of Nepal". An
Unpublished Master’s Degree Thesis, Kathmandu: Faculty of Management,
Tribhuvan University.
Shrivastav, R.M. (2002). Financial Management. Meerut: Pragati Prakashan.
Soloman, Erza. (1969). The Theory of Financial Management. New York: McGraw
Hill
Publishing Company Limited.
Van Horne, J.C. (2002). “Financial Management and Policy”. New Delhi:
Pearson
Education.
Weston, J.F., S. Besley and E.F. Brigham. (1996). “Essential of Managerial
Finance”.
San Diego: The Dryden Press.
Wipper, R. (1990). “Financial Structure and Value of the Firm”. Journal of
Finance.
Aldan Pennsylvania USA: American Finance Association.
Wolf, H.K & Pant, P.R. (1999). “A Hand Book for Social Science Research and
Thesis
Writing”. Kathmandu: Buddha Academic Enterprises Pvt. Ltd.
 Appendix 8

Return on Total Assets

(ROA)
Nabil Bank (NBL) (Rs. In Million)
F/Y NetProfitAfterTax Total Assets ROA
2001/02 271.64 17629.26 0.02
2002/03 416.24 16562.62 0.03
2003/04 455.32 16745.49 0.03
2004/05 518.64 17186.33 0.03
2005/06 635.30 21330.00 0.03
2006/07 674.00 27621.00 0.02
2007/08 746.47 37133.00 0.02
2008/09 1031.69 43867.00 0.02

Himalayan Bank(HBL) (Rs. In Million)

F/Y NetProfitAfterTax Total Assets ROA
2001/02 235.02 21315.84 0.01
2002/03 212.13 24198.00 0.01
2003/04 263.05 25729.80 0.01
2004/05 308.27 28871.34 0.01
2005/06 457.45 30579.80 0.01
2006/07 491.82 33519.14 0.01
2007/08 635.86 36175.53 0.02
2008/09 752.83 40046.68 0.02

Nepal Investment Bank(NIBL) (Rs. In Million)

F/Y NetProfitAfterTax Total Assets ROA
2001/02 57.11 4973.89 0.01
2002/03 116.82 9014.24 0.01
2003/04 152.67 13255.49 0.01
2004/05 232.15 16063.54 0.01
2005/06 350.54 21330.14 0.02
2006/07 501.39 27591.00 0.02
2007/08 696.73 38874.00 0.02
2008/09 900.62 53011.00 0.02

94