CHAPTER I

INTRODUCTION

1.1Background of the study

Financial decision must be very sensitive in misappropriate composition of debt
equity in capital structure may lead to bankruptcy of the firm. The optimal capital
structure is attaining at the level where the risk perception of shareholder is
minimized and returns are maximized. As the return to shareholder is maximized
automatically the market value of the firm is maximized. The capital structure
affects the cost of the firm. The financial manager must be sensible while selecting
the optimal capital structure for the firm.

The term capital structure refers to, the relationship between the various long
terms forms of financing such as debentures, preference shares, capital and equity
share capital. Financing the firm assets is a very crucial problem in every business
and as a rule there should be a proper mix of a debt and equity capital financing
the firm’s assets. Though the capital structure cannot affect the total earning of a
firm, it greatly affects the earnings of available equity holders. Managing the
capital structure of a firm is an important aspect of corporate financing. The main
issue with respect to source of financing is concerned with the nature of
relationship between the debt-equity ratio and the market value of the firm.

Capital structure is concerned with qualitative aspects. To meet their requirements,

companies generally issue three types of securities, such as: debenture, equity
shares and preference shares. A decision about the proportion among these types
of securities refers to the capital structure of an enterprise. Different authors have
defined the capital structure in their own way, but for the common man point of

1
view we can say that, for the company to run funds are needed, if funds are
inadequate and are not managed properly the entire organization will suffer badly.

"Capital structure is very crucial part of financial management as the various

composition of debt and equity capital may impact differently on risk and rate of
return to equity shareholders. The funds required to business enterprises are raised
either through the ownership securities (i.e. equity share and preference shares)
and creditor ship securities (i.e. debenture and bond). A business enterprise has to
maintain a proper mix of both the securities in a manner that the cost and risk
perception to the shareholders are minimized. The mix of different securities is
portrayed by the firm’s capital structure". (Koirala; 1990:105)

Capital structure plays a vital role in accelerating the economic growth of nation,
which in turns is basically determined, among others by saving and investment
propensities. But the capacity of saving in the country is quite low with relatively
higher marginal propensity of consumption. As a result developing countries are
badly trapped into the vicious circle of poverty. The basic problem for the
developing countries is raising the level of saving and investment. It will either be
diverted abroad or used for unproductive consumption or speculative activities. In
order to collect the enough saving and put them into productive channels, financial
institution like banks is necessary.

One of the most important tasks in the management of any bank lies in managing
appropriate capital structure. Capital structure reflects the manner of financing a
company. The tax deductibility of interest in some tax environments make the use
of the appropriate amount of debt beneficial to shareholders and share price. The
use of the right amount of debt lowers the companies weighted cost of capital.
Lowering the cost of financial resources improves net economic returns and
increase share value consequently, an optimal capital structure exists.

2
Capital structure plays a vital role in the real life of an enterprise. Enterprises
whether they are government owned or privately owned, have to make pertinent
capital structure decision in identifying exactly how much capital is needed to run
their operations smoothly. Generally, fund is acquired by the firm in two ways;
equity and debt. Equity provides the ownership of the shareholders. On the other
hand, the debt or borrowed fund has a fixed charge irrespective to the earnings of
the firm and firm has to pay the fixed charge periodically to the debt provider.

1.2 Profile of Sample Bank

a) Machhapuchhare Bank Limited
Machhapuchhare Bank Limited was registered in 1998 as the first regional
commercial bank to start banking business from the western region of Nepal with
its head office in Pokhara. Today, with a paid up capital of above 1,314 million
rupees, it is one of the full fledged commercial bank operating in Nepal; and it
ranks in the topmost among the private commercial banks.

Machhapuchhare Bank Limited is striving to facilitate its customer needs by

delivering the best of services in combination with the state of the art technologies
and best international practices.

Machhapuchhare Bank Limited is the pioneer in introducing the latest technology

in the banking industry in the country. It is the first bank in Nepal to introduce
centralized banking software named Globus Banking System developed by
Temenos NV, Switzerland. Currently it is using the latest version of Globus,
referred as T-24 Banking System. The bank provides modern banking facilities
such as Any Branch Banking, Internet Banking and Mobile Banking to its valued
customers.

3
The bank in the last few years have really opened up with branches spread all
around the country. The bank aims to serve the people of both the urban and rural
areas.

b) Bank of Kathmandu Limited (BOKL)

Bank of Kathmandu limited (BOKL) established on 1993. The bank came into
operation on March 1995. At the time of establishment BOK was established by a
group of distinguished civil servants and renowned businessmen in collaboration
with the SIAM Commercial Public co. limited (SCB) a leading bank of Thailand.
The collaboration with SCB supported BOK to bring in the technical and
managerial expertise in the Nepalese banking sector with the well acclaimed
capabilities of the Nepalese management team. BOK has successfully enhanced its
capital structure, profitability, reach to the customers and image in the market. It
has created a positive in the industry in a shortest possible span of time. Nepalese
managing team is handling the bank efficiently to increase the profit year by year.

Share Holding Patterns of BOK:

General Public 58%
Nepalese Promoter 42%

Provided Services are

 Deposit A/C Services
 Credit Facilities
 Inwards\outwards remittance C
 International trade centers
 Business advices
 Safe deposit locker
 Foreign exchange center

4
  ATM service

1.3 Focus of the Study

The research is focused on the capital structure of Nepalese commercial banks
specially two sample banks MBL and BOKL. The success of business
organization depends upon proper composition of debt and equity in the capital
structure. The proper composition helps to generate high return to the business
organization and help in long-term solvency.

Capital structure decision directly affects the shareholders risk and market value of
the share. As capital structure decision includes choice of debt and equity mix,
which has implications for the shareholder's earning and risk, which in turn, will
affect the cost of capital and market value of the firm.
The banks are such business organization, which deals with others about money
and the capital structure in case of the bank are very crucial. This study mainly
focuses on the capital structure management and its impact on profitability of
MBL and BOKL.

1.4 Statement of the Problem

Capital structure has attracted intense debate and academic attention in corporate
finance. However, in the context of Nepal it has received a scant attention. Today
the function of commercial banks is not only confined to do its usual functions but
also to do something for the development of the country. The development of the
country depends upon the financial position of the country. The growth in
financial sector is the base for country's development. In this regard, the
commercial banks collect the scattered resources from different sectors and
mobilize them in productive sectors.

5
“The effect of capital structure on the capital is not very clear. Conflicting
opinions have been expressed on this issue. In fact, this issue is one of the most
continuous areas in the theory of finance and perhaps more theoretical and
empirical work has been done on this subject than on any other”, (Pandey, 1992:
47).

The study of the capital structure in banking business is very important as it deals
with other money. The capital structure decision also impact upon long run
profitability and solvency of the firm. Generally high debt–equity ratio is
considered to be disadvantageous from owner's point of view, especially when the
firm is earning higher rate of return to the capital employed. The financial
manager must be able to maintain appropriate proportion of debt-equity to avoid
financial risk. The proportion of debt in the banking business is obviously larger
than in any other business. The banks accumulate deposit from various unit groups
paying certain percent interest and mobilize in productive sector and earn high
return. The banks are considered as mechanism to canalize the funds from the
small saver to the productive sectors. The study of capital structure, in case of
banking business very important of liquidation of one bank creates contagion
effect over the economy of the country.

The banks are being highly sensitive business. NRB reforms their policy from
time in favors of depositors and owners of the companies.
The problem area for the study is reflected in the following research questions:
 Does the capital structure affect the cost of capital?
 Are the sample bank capable to enhance the earning by its capital
structure?
 What is the relation between capital structure, profitability and EPS of
the banks?

6
1.5 Objectives of the Study
The major objective of the study is to evaluate the capital structure of
Machhapuchhare Bank Ltd. (MBL) and Bank of Kathmandu Limited (BOKL). It
is the study about the capital structure & profitability of MBL and BOKL by
taking the financial data. It tries to analyze the overall capital structure &
profitability. The specific objectives are as follows.
 To examine the capital structure of selected Commercial Banks.
 To evaluate whether the capital structure affects the cost of equity of MBL
and BOKL.
 To analyze the relationship between capital structure, solvency and
profitability, MBL and BOKL.

1.6Significance of the Study

The capital structure affects on the profitability and long-term financial position of
the organization. The earning nature of the organization helps to adopt appropriate
mix of debt and equity in the capital structure. On account of this significance, the
capital structure and profitability of the organization is justified as a specific
matter for the study. In this situation, this study will be helpful to the companies to
overview their capital structure management and formulate future strategies to do
much better in their horizon. Further, the concerned scholars, academicians,
investors, financial manager, researchers may also be benefited from this study.
This study will also help to inform the decision makers about the importance of
capital structure management for their further success.

1.7 Limitations of the Study

The study has been conducted with certain limitations. The time is the one factor
of limitation. Besides it, the scope of the study is limited within the bank. Some
more limitations are follows.

7
  The study analyzes capital structure and profitability of a two banks MBL
and BOKL.
 Only secondary data is used for the present study. No attempt is done to
examine the reliability of the secondary data.
 Variation of data in itself is found when comparing with different sources.
 The study covers only five years ranging from fiscal year 2006/07 to
2010/11.

1.8 Organization of the Study

The study has been organized into five chapters. The title of each of these chapters
is as follows:

Chapter I: Introduction
Introduction chapter comprises background of the study, focus of the study,
statement of problem, objectives of the study, significance of the study and
limitation of the study.

Chapter II: Review Literature

This chapter deals with the review of available literature in the field of the study
being conducted. This includes review of the theories of concerned topic, review
of previous thesis, review of supportive text, review or different articles, books,
bulletins and annual reports published by concerned organization

Chapter III: Research Methodology

Research methodology deals with the method of investigation and includes
research design, nature of the data, data collection procedure and tools used.

8
Chapter IV: Presentation and Analysis of Data
Presentation and analysis of data deal with different statistical and the financial
tools that used in the analysis of the data and findings.

Chapter V: Summary, Conclusion and Recommendation

Last chapter includes the summary, conclusion and recommendation of the study.
After the fifth chapter, bibliography and appendices follow.

9
 CHAPTER - II
REVIEW OF LITERATURE

This chapter is about review of the literature; also this chapter deals with the
review of the capital structure. The more details descriptive manner, for this
study of various books journal and the articles as well as past thesis also
reviews. This chapter tries to detail the conceptual theoretical concept
regarding the definition of capital structure, theories of capital structure and
factors of the capital structure. In the context of Nepalese organization, some
of the literature reviews relating to these studies are presented below:

2.1 Conceptual framework

2.1.1 Concept of Capital Structure
Capital Structure of a company refers to the composition or make-up of its
capitalization and it includes all long-term resources, like loans, reserves,
shares and bonds. The term ‘Capital Structure’ means the proportion of
different types of securities issued by firm. The optimal capital structure is the
set of proportion that maximize the total value of the firm.

The capital structure has many relevant dimensions. The financing mix is one
of them. Other dimensions involve the investment decisions of the firm and
the optimal use of leverage, within the constraints imposed by the internal and
external environmental conditions. These conditions, in turn, affect the
decision of the firm with respect to the timing of investment and financing
transactions as well as the acceptable levels of risk and liquidity. Capital
structure can be dealt with the three different levels of complexity.

10
Capital Structure is considered as the mix of debt and equity and to operate in long
run prospect. A firm must concentrate in its proportion. A firm can raise required
fund by issuing various types of financial instruments. Investors and creditors
being the key supply of capital, they hold greater degree of risk and hence have
claims over firm’s assets and cash flow is uncertain and there is probability that it
may default in its obligations to pay off its interest and principal. In the other
hand, if the firm issues preference share, those shareholders have the priority in
payment of dividend before common shareholders but after debt holders. Since the
percentage of preference dividend is fixed as the percentage of interest to debt, it
is preferably paid off only after interest payment. Common shareholders as are the
owner of the firm; they are paid from cash remaining after all payment is being
made. Since, the common share i.e. equity fluctuate in the market more than the
preference share and debt, there is more risk.

“Capital Structure’ should not be confused with ‘Capitalization’.

Capitalization is a quantitative aspect of financial planning as it refers to the
total amount of securities issued by a company, while capital structure is
concerned with qualitative aspect as it refers to the kinds of securities and the
proportionate amounts that make up capitalization. Capitalization = total of all
types of long term capital: capital structure = proportions of all types of long
term capital, financial structure = proportions of all types of long term and
short term capital” (Upadhaya: 1985, 799).

2.1.2 Basis of Capital Structure

Capital Structure concept has important place in financial management theory. It is
basically known as financial structure, financial plan or leverage. Financial
decision of a firm, as the other financial decision is concerned with the
shareholders wealth maximization. As capital structure refers to the proportion of
debt and equity, a choice in proportion actually financial decision in case to fulfill

11
investment requirement. Therefore, it is a wise decision to select a financing mix,
which maximizes shareholders wealth.

“The term capital denotes the long-term funds of the firm. The long-term funds of
the firm are financed by two major components, i.e. debt capital and equity
capital. Debt capital includes long-term borrowings incurred by the firm. Equity
capital consist long-term funds provided by the firm’s owners. The mix of long-
term debt and equity maintained by the firm is called capital structure. Capital
structure shows, what percentage of the firm’s capital is in equity and what
percentage of firm’s capital is in debt. Capital structure is one of the most complex
areas of financial decision making due to its inter-relationship with other financial
decision variables. A financial manager must understand the firm’s capital
structure and its relationship to risk-return and value for attainment of its primary
objective of wealth maximization.” (Saxena & Vashist, 2002: B.5.1)

“A financial manager must strive to obtain the best financial mix or optimum
capital structure for his/her firm. The firm’s capital structure is optimum when the
market value of share is maximized. The use of debt affects the return and risks of
shareholders; this will increase the return on equity but also risk at the same time.
When the shareholders’ return is maximized with the minimum risk, the market
value per share will be maximized and firm’s capital structure would be
optimum.” (Van Horne, 1983:10).

“Capital structure is permanent financing of the firm represented primarily by

long-term debt, preferred stock and common stock, but excluding all short term
credit” (Weston & Brigham, 1982: 555).

“The term of capital structure is used to represent the proportionate relationship

between debt and equity. The debt and equity mix of a firm is called capital

12
structure. The capital structure decision is a significant financial decision since it
affects the shareholders’ return, risk and market value of shares” (Pandey, 1992:
663).

“The importance of an appropriate capital structure is the obvious. There is a

viewpoint that strongly supports the close relationship between leverage and value
of firm. There is an equally strong body of opinion, which believes that financing
mix or the combination of debt and equity has no impact on the shareholders’
wealth and the decision on financial structure is irrelevant. In other words, there is
nothing such as optimum capital structure” (Khan & Jain, 1999, 111)

“Under the assumption that a firm will attempt to maximize the run market value
of ownership shares; there exists an optimum capital structure for each individual
firm. It varies in different industries because the typical assets structure and
stability of earning, which determine inherent risks vary for different type of
production” (Kulkarni, 1983:368).

“The concern of the financial decision is with the financing mix or capital or
leverage. The financing decision of a firm relates to the choice of the proportion of
these sources to finance the investment requirement. There are two aspects of the
financing decisions. First, the theory of capital structure which shows the
theoretical relationship between the employment of debt and the return to the
shareholders. The use of debt implies a higher return to the shareholders and also
the financial risk. A proper balance between debt and equity to ensure a tradeoff
between risk and return the shareholders are necessary. A capital structure with
reasonable proportion of debt and equity capital is called optimum capital
structure” (Khan & Jain, 1984: 10).

13
2.1.3 Assumptions of Capital Structure
Capital structure theory has some assumptions which are as follows:
 There are mainly two sources of funds used by a firm: Debt and Ordinary
Shares.
 There are no corporate taxes (this assumption is removed later).
 The dividend payout ratio is 100% i.e. the total earnings are paid out as cash
dividend to the shareholders and there is no retained.
 The firm’s total assets are given and do not change. The investment decisions
are in the other words, assumed constant.
 The firm’s total financing remains constant. The firm can change its degree
of leverage either by selling shares and use the proceeds to retire debentures
or by raising more debt and reduce the equity capital.
 The operating profits (EBIT) are not effect to grow.
 All investors are assumed to have the same subjective probability of the
future expected EBIT for a given firm.
 The firm’s business risk is constant over the time and it assumed to the
independent of its capital structure and financial risk.
Perpetual life of the firm. (Khan & Jain, 1999)

2.1.4 Classification of Capital Structure

There are different classifications of capital structure.
Saxena & Vashist, (2002) have classified the capital structure are mentioned
below:

14
2.1.4.1 Simple Capital Structure
(i) Balance Sheet as at …………….
Equity Rs. Fixed Rs.
Share 2,00,000 Assets 1,20,000
Capital Current 80,000
2,00,000 Assets 2,00,000
(ii)Balance Sheet as at …………….
Equity Rs. Fixed Rs.
Share 1,60,000 Assets 1,20,000
Capital 40,000 Current 80,000
Retained 2,00,000 Assets 2,00,000
Earnings

2.1.4.2 Complex Capital Structure

(i) Balance Sheet as at …………….
Equity Rs. Fixed Rs.
Share 1,80,000 Assets 1,20,000
Capital 20,000 Current 80,000
Current 2,00,000 Assets 2,00,000
Liabilities

(ii)Balance Sheet as at …………….

Equity Share Rs. Fixed Rs.
Capital 1,40,000 Assets 1,20,000
Preference 40,000 Current 80,000
Share Capital 20,000 Assets
Retained 2,00,000 2,00,000
Earnings

15
(iii) Balance Sheet as at …………….
Equity Share Rs. Fixed Rs.
Capital 80,000 Assets 1,20,000
Preference Share 40,000 Current 80,000
Capital 20,000 Assets
Retained Earnings 60,000
Debentures and 2,00,000 2,00,000
long-term loan

(iv) Mostly short-term liabilities are omitted in considering capital structure, but
some authors have held the view that considering the importance of bank credit,
etc. it is better to include all liabilities (long-term and short-term) in consideration
of capital structure. The view is not common view. If this view is also considered,
the capital structure will be shown as follows: (J.R. Lindsay and A.W. Samtez)

Balance Sheet as at …………….

Equity Share Rs. Fixed Rs.
Capital 80,000 Assets 1,20,000
Preference Share 40,000 Current 80,000
Capital 20,000 Assets
Retained Earnings 40,000
Debentures and 20,000
long-term loan 2,00,000 2,00,000
Current Liabilities
Normally, current liabilities are considered only in working capital analysis and
not in the analysis of sources of long-term funds.

16
2.1.4.3 Classification based on Sources
Under this category long-term funds can be financed from (i) Internal capital, and
(ii) External capital. Internal capital includes bonus issue, capital reserve and
reserves and surplus. External capital refers to share capital, share premium,
forfeited share, debentures and long-term liabilities.

2.1.4.4 Classification based on Ownership

(i) Ownership capital comprises of equity share capital and retained earnings.
(ii) Debt capital includes debentures and long-term loans.
Preference share capital is treated both as part of ownership capital or as part of
debt capital. It should be grouped based on the view taken by the management.

2.1.4.5 Classification based on Cost Behavior

Classification is also attempted based on cost behaviors of various sources of
capital, i.e., fixed cost capital and variable cost capital.
Fixed cost capital includes preference share capital, debentures, long-term debt.
Variable cost capital includes equity share capital.

2.1.5 Theories of Capital Structure

The theory of capital structure is closely related to the firm's cost of capital.
Many debates over whether an optimal capital structure exists are found in the
financial literature. Argument between those who believe there is an optimal
capital structure for each firm and among those who believe in the absence of
such optimal capital structure began in late 1950's and there is yet no
resolution of the conflict. Modigliani and Miller logically admitted that the
value of the firm or the cost of capital is independent of capital structure
decision of the firm. On the other hand, according to the traditionalist's view,
the value of the firm or the cost of capital is affected by the capital structure
change. So, in order to understand how firms should adhere the target capital

17
structure decision, it is important to have some idea of major elements of
capital structure theory.

The history presents several theories on capital structure management. In order

to analyze the capital structure of any company four theories are considered.
These theories are:
 Net income (NI) approach.
 Net operating income (NOI) approach.
 Traditional approach; and
 Modigliani-Miller (M-M) theory
- Without taxes.
- With taxes.

2.1.5.1 Net Income (NI) Approach

Two capital structure theories, i.e., the net income approach and the net operating
income approach, were propounded by David Durand. According to NI approach,
the firm can increase its total valuation (V), and lower its cost of capital (K0) when
it increases the degree of leverage (D/L). The optimum capital structure can be
attained when the cost of capital of a firm is the lowest and the value of the firm is
the greatest. The main feature of the NI approach is that a firm can lower its cost
of capital continuously by use of debt capital and thus increase its total valuation.
Reduction in the cost of capital (i.e., more and more use of debt and increase in the
value of the firm) is possible when:
i) Cost of debt (Kd) is less than cost of equity (Ke) and it remains constant;
ii) The firm does not become more risky in the minds of investors and
creditors consequent upon increase in the degree of leverage (Saxena &
Vashist, 2002: 45).

18
“The financial leverage according to the NI approach is an important variable in
the capital structure decision of the firm. With the judicious mixture of debt and
equity, a firm can evolve an optimum capital structure which will be the on, at
which value of the firm is the highest and overall cost of capital the lowest. At the
structure the market price per share would be maximum. If the firm uses no debt
be equal to the equity-capitalization rate. The weighted average cost of capital will
decline and will approach the cost of debt as the degree of leverage reaches.”
(Pandey, 1984: 412).

According to this approach, there is optimal capital structure when the market
price per share of stock is maximum. The significances of this approach are that a
firm can lower its cost of capital continually and increase its total valuation by the
use of debt funds. This will increase use of leverage overall cost of capital declines
and total value of the firm rises
Figure: 2.1
Net Income (NI) Approach
Ke
Cost of Capital

Ko Kd

Financial Leverage

B/V
Source: (Khan & Jain, 1984: 411).

Graphically, the effect on the firm’s cost of capital and its total market value is
shown in Figure 2.1. If cost of debt and cost of equity are constant as is assumed
in the NI approach, then the proportion of cheaper debt fund in capital structure
increases, the cost of capital decreases. Thus, under the NI approach the firm can

19
lower its cost of capital and raises its total market value through the addition of
debt capital (Gitman and Pinches, 1985: 710).

Assumption of Net Income (NI) Approach

NI approach is based on the following three assumptions:
a) The cost of debt is less the cost of equity.
b) The debt content does not change the risk perception of the investors, as a
result the capitalization rate Ke and the debt capitalization rate Kd remain
constant with change in leverage.
c) There are no corporate taxes. Therefore, as firm increases its leverage by
increasing its level of debt relatives to equity, the overall cost of capital
declines (Saxena & Vashist, 2002: 56).

"As the portions of the cheaper debt funds in the capital structure, increases,
the weighted average cost of capital decreases and approaches the cost of debt
(Kd)". "Therefore as the firm increases its leverage by increasing its level of
debt relative to equity, the overall cost of capital is that it increases the value
of the firm" (Van Horne, 1999: 380).
Overall cost of capital can be expressed by following formula.
Net Operating Income
Overall cost of capital (Ko)=
Total value of the firm

As per assumptions of NI approach, Ke and Kd are constant and Kd is less

than Ke. Therefore, Ko will decrease as B/V increases. Also, 'Ke'=Ko when
B/V=0.

2.1.5.2 Net Operating Income (NOI) Approach

NOI approach was also advocated by David Durand. This approach is
diametrically opposite to the net income approach. The essence of this approach is

20
that the capital structure decision to the firm is irrelevant. Any change in leverage
will not lead any change in the total value of the firm and the market price of
shares, as the overall cost of capital is independent of the degree of leverage
(Saxena & Vashist, 2002: 88)

Assumption of Net Operating Approach (NOI) Approach

NOI approach is based on the following assumptions:
 The market capitalizes the value of the firm as a whole. Thus, the split
between debt and equity is not important.
 The market uses an overall capitalization rate Ko, to capitalize the net
operating income. Ko, depends upon the business risk. If the business risk
is assumed to remain unchanged, Ke is constant.
 The use of less costly debt fund increases the risk to the shareholders; this
causes the equity capitalization rate to increases. Thus, the advantage of
debt is offset exactly by the increase in the equity capitalization rare, Ke.
 The debt capitalization rate, Kd, is a constant.
 The corporate income taxes do not exist.

Features of Net Operating Approach (NOI) Approach

 Total market value of the firm (V) is obtained by capitalizing net operating
income (EBIT) at the overall cost of capital (K e), which is constant.
 Total value of the stock (S) is found by subtracting the value if debt from
total market value of the firm.
 The cost of equity (EBIT – I)/S tends to rise in correspondent in the degree
of leverage.
 The overall cost of capital is an average of the cost of debt and equity.

21
 Figure: 2.2
(NOI) Approach

Total Market Value V= B+S

B/V
Financial Leverage
Source: Saxena & Vashist, 2002

Under the NOI approach, the capital structure selected is a “more detail” since the
value of the firm is independent of the firm’s capital structure. If the firm increases
its uses of financial leverage more debt directly offset by an increase in the cost of
equity capital.

2.1.5.3 Modigliani-Miller’s (M-M) Hypothesis

Till 1950s, it was believed that judicious mix of debt and equity capital i.e.
financial leverage in the capital structure decreases the overall cost of capital,
increases the value of the firm and helps in determining an optimal capital
structure.

But in 1958, Franco Modigliani and Metron H. Miller published a research

paper, 'The cost of capital, corporation Finance and the Theory of Investment"
and added another milestone on the theory of capital structure.

“This theory propounded by those two researchers is later known as M-M

theory. The M-M theory is based on some assumptions, which are mentioned
below" (Pandey, 1999: 687).

22
Assumptions of Modigliani-Miller’s (M-M) Hypothesis
The M-M hypothesis is based on following assumptions relating to the capital
market, behavior of investors, actions of the firm and tax environment.
a. The securities are traded in perfect market. This means that investors are
free to buy and sell securities. The investors can borrow from the market at
the rate of interest at which firms can borrow.
b. The investors have homogeneous expectations.
c. It is possible to classify the firms into homogeneous risk classes. The firms
in a given risk class are equally risky and their expected future earnings are
capitalized at the same rate, i.e., in a given class, the firms have same
expected and required rate of returns.
d. The dividend payout ratio is 100% i.e. firms distribute all net earnings to
shareholders.
e. There is no corporate tax. This assumption was later on removed ( Saxena
and Vashist, 2002: 98).

Based on the above assumptions, the M-M hypothesis gave two propositions-
proposition I and proposition II. These propositions are discussed below:

Proposition I : This proposition is identical to the NOI hypothesis. The M-M

hypothesis argues that the market value of the firm (V), and its overall cost of
capital (Ko) are independent of its capital structure. For a firm’s risk class, the
market value of the firm is established by capitalizing net operating income (NIO-
EBIT) at an appropriate rate is follows:
EBIT X EBIT
V =S+D=  or K 0 
K0 K0 V

or, Ko = Kd (D/V)+Ke (S/V)

V = The market value of the firm.
S = The market value of equity share.

23
 D = The market value of debt.
X = Net operating income or earnings before interest.
K = The capitalization rate appropriate to risk class of the firm.
In the above formula, EBIT is calculated before interest and for this reason it is
independent of capital structure of leverage. Cost of capital K o is equal to the
capitalization rate appropriate to the risk class of the firm, and therefore, it is
independent of capital structure, market structure, market value (V) must also be
independent of capital structure or leverage. This is explained in the diagram given
below:

Figure No. 2.3

M-M Hypothesis
Cost of capital (%)

KO

0
Leverage

Source: Saxena and Vashist, 2002

Effect of leverage on cost of capital (M-M Hypothesis- Proposition I)

The cost of capital function as hypothesis by M-M through proposition I is shown
above in figure No.3. It is evident from this that average cost of capital is a
constant and is not affected by leverage ( Saxena and Vashist, 2002: 112).

Arbitrage process: M-M hypothesis does not accept the NOI approach as valid. It
is held in this hypothesis that two identical in all respects except for their capital

24
structure cannot command different values nor have different cost of capital. M-M
argues that if two firms differ only:
a. In the way they are financed, i.e. capital structure are different, and
b. In their total market values, investors will sell the share of over- valued
firm and buy the shares of under- valued firm.

“This process will continue till the two firms have the same market value. This is
called arbitrage or switching process. When the equilibrium is reached, the NOI
condition will be fulfilled and the value of the firm and their average cost of
capital will be the same. Thus, it is held that V and Ko are independent of capital
structure” ( Saxena and Vashist, 2002: 118).

Proposition II: The M-M hypothesis argues that cost of capital Ke is equal to
constant average cost of capital Ko plus a premium for the financial risk. This can
be written as follows:
Ke = Ko+ risk premium

The premium for financial risk equals to the difference between equity
capitalization rate Ke and cost of debt multiplied by the ratio of D/S, that is :
Ke = Ko+( Ko - Ke ) ×D/S
In brief, the proposition II implies that firm’s cost of equity increases to offset the
use by cheaper debt capital. Alternatively, the firm’s use of debt increases its cost
of equity as well. Proposition II of M-M Hypothesis presumes a linear relationship
between Ke and debt equity ratio (D/S) (Saxena and Vashist, 2002: 167).

2.1.5.4 Traditional Approach

The traditional approach to valuation and leverage is moderate approach of NI
and NOI approach. This theory assumes that there is an optimal capital
structure and that the firm can increase the total value of the firm through the

25
judicious use of leverage. This approach encompasses all the ground between
the NI approach and NOI approach. This theory is also known as intermediate
approach. The traditional view on the relationship between capital structure
and the cost of capital is that the firm's cost of capital can be reducing by
judicious mix of debt and equity capital and then an optimal capital structure
exists for every firm.

“The approach justifies the view that debt capital is relatively cheaper than
ordinary shares. So changing leverage i.e., using debt instead of equity capital
obviously causes a decline in the overall cost of capital is minimum or raised
further the firm would become financially more risky to the investors who whole
penalize the firm by demanding a higher equity capitalization rate” ( Khan and
Jain, 1992: 495).

“Traditional approach is a compromise between two extremes, i.e. net income

approach and net operating income approach. The advocates of this approach hold
the view that the value of the firm, i.e. V, can be increased or the cost of capital
can be reduced up to certain point by a judicious mix of debt and equity capital.
Beyond that, the increase of equity more than offset the use of cheaper debt capital
in the capital structure and average cost of capital begins to rise. The average cost
of capital structure further rises, when cost of debt also begins to rise. The
optimum capital structure is the point at which overall cost of capital is the
minimum or value of the firm is maximum. The essence of the traditional
approach is that a firm may, through judicious mix of debt and equity, reduce the
cost of capital and increase its total value. Graphically, traditional approach can be
depicted as follows.” (Saxena and Vashist, 2002: 210)

26
The main propositions of the traditional theory are:

STAGE-1
In this first stage, the cost of debt (Kd) remains more or less constant up to a
certain degrees of leverage but rises thereafter at an increasing rate.
It means that cost of equity (Ke) remains constant or rises slightly with debt.
But it does not increase fast enough offsets the advantage of low cost of debt.
During this stage, the cost of debt (Kd) remains constant or rises negligibly.
Since the market views the use of debt as a reasonable policy.
Thus, so long as debt is within acceptable limit and 'Ke' and 'Ki' remains
constant, the value of the firm increases at a constant rate.

STAGE-2
In this stage, once the firm has reached a certain degree of leverage, increases
in it have a negligible effect on the value of the firm. This is so because the
increase in the cost of equity offsets the advantages of low cost of debt within
that range or specific points, the value of the firm will be maximized or the
cost of capital will be minimized.

STAGE-3
The overall cost of capital Ko as a consequence of the above behavior of Ke
and Kd.
 Decrease up to a certain point.
 Remain more or less unchanged for moderate increase in leverage there
after, and
 Rises beyond a certain point.
After the certain level of leverage, the value of the firm increases with
leverage or the overall cost of capital increases with leverage.

27
The cost of debt and equity will tends to rise as a result of increasing the
degree of financial risks that will make to increase in the overall cost of
capital.

Figure: 2.4
The Cost of Capital Behavior (Traditional approach)

Ke

Ko
Cost of capital

Kd
(%)

State I State II State III

Leverage A1

Source: Saxena and Vashist, 2002: 223).

“The traditional theory implies that the cost of capital is not independent of the
capital structure of the firm. The traditional theory holds that this is an optimum
level of capital structure. For degree of leverage before this point marginal cost of
debt is less than the marginal cost of equity. Beyond this point, the marginal cost
of debt exceeds that of equity” (Saxena and Vashist, 2002: 223).

2.1.6 Related Concept of Capital Structure

a) Cost of Capital
“Cost of capital is the rate of return on the investment to be earned in order to
satisfy the investor. Cost of capital may be defined as cost to the firm of
obtaining funds or equivalently as the average rate of return that an investor or
a firm would except for supply capital. This would be the minimum rate of
return that a project must yield to keep the value of the firm intact. Defined

28
cost of capital as the minimum acceptable rate or the required rate of return is
a compensation for time and risk in the use of capital by the project.” (Pandey
1995: 136)

“The cost of each component of the capital structure is also said cost of
capital. Capital components, which are shown in the left hand side of the
balance sheet, include various types of debt, preferred stock, retained earnings
and common stock. Every firm has to reply its borrowed funds with interest
after certain period of time. Interest which it has to pay is called cost of
capital. Cost of preference share is calculated as cost of debt because it is debt
of capital. The cost of equity capital is define as the minimum return of reties
that a firm must earn on the equity financed portion of its investment in order
to leave unchanged the market price of its stock” (Van Horne,1999: 335).

Cost of retained earning is the opportunity cost to the shareholders because

when the firm decides to retained the current earnings in the firm than
shareholders give up their cash dividends. Thus, in the absence of flotation
cost of retained earning and the cost of common stock k is same. The cost of
new common equity is the rate of return which is required by the stockholder.
Due to flotation cost, the cost of common stock is greater than the cost of
retained earning. The weighted average or composition of cost of capital is the
weighted average of the cost of several of capital weight in the proportion of
the sources in the capital structure.

b) Common Stock
“Common stock is a security representing the residual ownership of a corporation.
It guarantees only the right to participate in sharing the earning of the firm if the
firm is profitable. Common shareholders usually have the additional right to vote
at stockholders meeting on issues affecting fundamental policies of the

29
corporation. Also, the shareholders have the right to select the members of their
board of directors, the right to inspect the firm’s books (only for the legitimate
purpose of evaluating the performance of management), and the right to obtain a
list of the names and address of other shareholders” (Hampton, 1986: 38).

“Common equity in a corporation or partnership interests in an unincorporated

firm constitute the first source of funds to a new business and the base of support
for borrowing by existing firms. The nature of equity ownership depends on the
form of the business or organization. The central problems of such ownership
revolve around an apportionment of certain rights and responsibilities among those
who have provided the funds necessary for the operation of the business. The
rights and responsibilities attached to equity consist of positive considerations
(income potential control of the firm) and negative considerations (loss potential,
legal responsibility, and personal liability)” (Weston and Copeland: 1998, 931).

c) Preferred Stock
“Shares whose holders are the first to receive dividends from available profit are
preference shares. Preference shares are redeemed before ordinary shares when a
company is liquidated” (Microsoft Encarta: 2006, 304).

“Preference stock is a source of capital that is part of shareholders equity. It has

lower claim priority than the firm’s debt but a higher priority than its common
stock” (Steven E. Bolten, Robert L. Com, 1981: 612).

Accountants classify preferred stock as equity and generally list it in the equity
portion of the balance sheet under the title “Preferred stock” or “preferred equity”.
However in financial analysis preferred is sometimes treated as debt and
sometimes as equity, depending on the type of analysis being made. If the analysis
is being made by a common stockholder’s then key consideration is the fact that
the preferred dividend is affixed charge, which must be paid ahead of common
30
stock dividends, so the common stock holder will view preferred stockholder’s to
the available income and if the firm fails, debt holder have prior claims to assets
when the firm is liquidated. Thus, to the bondholder preferred stock is similar
stock is similar to common equity. From management’s perspective preferred lies
between debt and common equity. Since the dividends on preferred stock are not a
fixed charge in the sense that failure to pay them represents default on an
obligation, preferred stock is safer to use than debt. On the other hand, if the firm
is highly successful, then the common stockholders will not have to share that
success with the preferred stockholders, because preferred dividends are fixed. We
see then, that preferred broke has some characteristics of debt and some the
characteristics of common stock and it is entirely appropriate (Brigham, 1998:
510).

d. Long Term Debt

If an existing obligation is not to be paid within one year or current operating
cycle (whichever is longer) or placed by another current liability, It is properly
classified as long term liability. The most frequently encouraged long term
liabilities are holds payable; long term notes payable, lease obligations, pension
obligations, differed taxes, other long term deferrals and occasionally contingent
liabilities.

The use of borrowed funds is known as the trading on equity. The customary
reason for using borrowed fund is the expectation of investing them in a capital
project that will provide a return in excess of the cost of the acquired funds.
When additional funds are needed to expand the business or for current operations,
a corporation has the choice of issuing debt or equity securities. There are four
basic reasons why a company may wish to issue debt rather than equity securities.
 Bonds may be the only available source of funds.
 Debt financing has a lower cost.

31
  Debt financing offers a tax advantage.
 The voting privilege is not shared.

e) Retained earning
Retained earnings is also called reinvested earnings. It is increased in stockholders
equity due to profitable operation. It may be capital reserve, revenue reserve etc.

f) Dividend
Dividend, in corporation finance, a fund appropriated out of the profits of a
corporation and distributed among its stockholders; also the share of the fund
received by a stockholder. Dividends are usually declared periodically (quarterly,
semi-annually, or annually) by the directors of a corporation. The action of a board
of directors with respect to the declaration or non-declaration of dividends is
usually final and conclusive upon the stockholders and is subject to review by the
courts only in the event that the action is arbitrary or capricious.

Dividends are distributed on a proportional basis; the fractional share of: the total
dividend received by stockholders is equal to the proportional share of the stocks
owned by them. Holders of the preferred stock of a company generally have a
prior right to the payment of dividends over holders of common stock, and if their
stock so provides, are paid at a fixed periodic rate. Preferred dividends may be
cumulative or non-cumulative. Cumulative dividends are those that, if not paid for
one or more periods, constitute charges on the profits of succeeding periods and
must be paid at a future date before dividends may be distributed on common
stock. Non-cumulative dividends, if omitted. Do not constitute charges on future
profits. 'Dividends may take the form of additional shares of stock or of the right
to purchases stock for a fixed sum per share; such dividends are called stock
dividends and rights.

32
“The term dividend is applied also to the assets of a bankrupt or insolvent business
that are distributed among its creditors during the course of its liquidation. The
term is used in insurance to signify the sum appropriated out of profits for
distribution among policyholders whose policies so provide; such dividends may
be used to reduce the next premium” (Microsoft Encarta 2006).

“Dividend in the normal use of the word refers to that portion of retained earnings
that is paid to stockholders. Dividend policy refers to the policy or guidelines that
management uses in establishing the portion of retained earnings that is to be paid
in dividend” (Bhalla 1983: 167).

2.1.7 Determination of Capital Structure

There are some elements of capital structure for decision. Without the study of
these elements, the company cannot make appropriate capital structure and
analysis of leverage may be incomplete. So it is necessary to study about the
determinants of capital structure.

a) EBIT / EPS Analysis

In the study of leverage the EBIT-EPS, analysis is a must because it is a method of
financing under various assumptions of EBIT that should raise its capital position
in different situations. In that situation, they have to choose better capital source as
per the profitability of the company in the near future. To make balanced and
appropriate capital structure for better future, the company needs to select different
alternatives from different source in different proportion. The EBIT-EPS analysis
is one of the best ways by which, we can understand the exclusive use of equity
capital, debt capital, Preference capital a combination of different proportion and
so on. These are analytical instrument. which will be useful in planning the capital
structure and increasing earnings before interest and taxes with greater value of
EPS.

33
The main objective of any company is to maximize the market value of the firm as
well as shareholder's wealth position. Keeping this in view, the EBIT-EPS analysis
should be considered logically at the stage of designing capital structure. The
EBIT-EPS analyses short the impact of various financial alternatives on EPS at
various levels of EBIT. This method involves the comparison of alternative
method of financing under various assumptions as to EBIT. With these methods,
the financial manager can make an appropriate financial decision.

b) Cost of Capital
Cost of capital is generally used in the sense of overall cost of capital. This overall
cost of capital is comprised of the costs of various components of financing, i.e.,
the sources from which the capital has been raised. Each source has got own cost.
All these costs are combined to compute overall cost of capital of a firm.

Cost of capital is a very widely used term in the literature of finance. It is defined
as the minimum rate of return (or required rate of return), that a firm must earn on
its assets in order to 'maintain its market value and attract needed funds. It is the
rate of return at which the market value of a firm remains, unchanged. In capital
investment proposals, cost of capital is used as discounting rate or hurdle rate, or
cut-off rate that is applied to projects' cash flow stream to determine whether the
project is worthwhile or not. One of the financial objectives of a firm is to earn
more than cost of capital. It is the rate of return required by those who invest in the
firm (Saxena & Vashist, 2002: 267).

c) Flexibility
Flexibility means the firm's ability to adopt its capital structure to the needs of
changing condition. The firm should keep flexible financial plan in order to
economize use of funds by substituting one from financing other.

34
The restrictive covenants are commonly included in long-term loan agreement and
debenture. The covenants in loan agreement may include restriction to distribute
cash dividend, to purchase assets or to raise additional external financial. The firm
also is required to maintain a certain ratio, as debt equity ratio or current ratio at
certain ratio.

The firm having the discretion of refunding its debt and preference shares capital
can enjoy' considerable degree of flexible. The financial plan of the firm should be
flexible enough to change 'the composition of the capital structure as warranted by
the firm's operating strategy and needs.

2.1.8 General Concept of Profitability

The term 'Profit' is being used in several senses. According to Prof.. Knight,"
Perhaps no term or concept in economic discussion is used with a more
bewildering variety of well- established meaning that profit". “Some writers have
defined it as the percentage returns on investment of capital while others haves
called it the reward of ownership. some have referred to it as reward for risk-
taking, while others have called it as a reward for entrepreneurship' There are still
others who have defined profit as the residual income which results after all tire
three factors of production have been paid off. To get an accurate meaning of
profit it appears necessary to, distinguish gross profit from net profit” (Scth M.L.,
1998: 438).

Profitability is a deviation of the term profit which explains ability to make a profit
is a primarily a measuring rod of success of business enterprise. It is the basic, test
performance of any business simply stating. Profit is money excess of sale over
the money spent but the term "Profit" is very controversial and there are several
interpretations about it.

35
“An economist will say that profit is the reward of entrepreneurship for risk
taking. A labour leader might say that it is a measure of how efficiently labour has
produced and that it provides a base for negotiating a wage increase. And investor
will view it is a gauge of the return on his/her money. An internal revenue agent
might regard it as a base for determining income taxes. The accountant will define
it simply as the excess of firm's revenue over expenditure of producing revenue in
given fiscal period” (Lynch & Williamson. I989: 99).

The profit and simply the money gained from a sale, which is more than the
money spent. According to the dictionary of commerce, profit is termed as to
describe the surplus resulting after a defined trading period but must be regarded
as the first essential charge upon business' being a reward for engaging resources
in conditions of speculative risk for the satisfaction of consumer resources of
speculative risk for the satisfaction of consumer demand' It furnishes resources to
invest in future operations and consequently its absence must result in a decline in
effective capital resources and ultimately competitive extinction of the business.

The term 'profit' can be used in two senses. As a owner oriented concept it refer to
amount and share of national income which is paid to the owners of business, that
is those who supply equity capital as variant is described as profitability. In other
word, profitability refers to situation where output exceeds input that is the value
created by the use of resources is more than the total of input resource.

In this regard, American institute of Banking say's, "Under the free enterprise
system like USA, the interest of the nation as well as those of the individual
stockholders is supposed to be best served by vigorously seeking profit. But the
profit cannot be a sole objective of an enterprise and an enterprise should not be
evaluated just on the ground of the profit it earned. Neither bank nor the
community will be the best served it the banker unreasonably sacrifices safety

36
funds of the liquidity of bank in an effort to increase income" (American Institute
of Banking, 1972: .i5).

Every business firm has different types of goal. Profit maximization is the goal of
business. Profit is very important for business firm. It is equally important as for is
water. To cover cost of staying in business such as replacement of machines,
furniture, obsolescence of machines, market or technical risks etc. Profit is
essential in the sense to the self-financing principal. It provides structure and helps
to minimize cost of capital. Profit of business is attraction for investors. So
investors would invest their money where there is adequate profit. Hence profit is
required to ensure and satisfy the entire expectation of management, shareholders,
investors, employees and nation as whole

2.1.8.1 Traditional Approach towards Profit

"Profit is the measurement of the business firm's overall performance. A business
firm can claim it to be successful if it can maintain maximum profit to justify the
worth of return on investment. This helps business firm to save from shortage of
funds and provide best opportunities to undertake the expansion of assets to
enlarge business" (Shrestha. I 980: 33-24).

Profit maximization is the traditional approach of business environment and

economic theory on the ground of profit for firm. In the economic theory, one of
the assumptions is profit maximization. It always assumes that a firm sets a target
to maximize the profit and is discretionary behavior of the firm, so in the
managerial economics, to maximize profit is the central belief.

The promise of profit provides a strong incentive to owners and manager to act
efficiently. Therefore, it is common in economic theory to hypothesis that the
criteria for evaluating the action of the firm are profit maximization. The basic

37
incentives for business are to produce goods and services. The profit in this sense
is revenue that remains after deducting both explicit and implicit costs, including
nominal profit considered of the entrepreneur's services. "Profit is essential for
every enterprise to survive in the long run as well as to maintain capital adequacy
through retained earnings. It is also necessary to accept market for both and equity
to provide funds for increased assistance to the productive sector" (Robinson.
1951: 21-22).

2.1.8.2 Modern Approach towards Profit

Business environment is totally different from past to today. In past time one of
main objectives of firm was profit maximization. But today sales maximization is
the main objective of the firm. So that firm's objective may be to maximize its
growth rate or satisfaction shareholders' wealth maximization.

Today every business firms finance by equity owners, creditors. Professional

management is related to customer, employee, government and society concerned
with firm. Besides other objectives of business firm, wealth maximization of
shareholders' is normal objective of firm or otherwise a firm should set a standard
for reasonable profit.

There are threats given to profit maximization and the economists to the
profitability concept of firm give so many alternatives. Though there are denials
towards profitability Maximization model of a firm. Economists still do not have
unified views to cover the alternative model when markets are perfect competitive,
Monopolistic or oligopolistic form. Therefore, the profitability model is still in the
existence. A business firm still prefers to maximize profit as far as possible.
"Business has multiple goals and the needs of survival, goodwill, security and both
commonly call for some sacrifice of short term profits. Most business does,
However, rate profitability consistently high among their term objectives and it

38
could be argued short term goal such as security and growth rate subordinate to
long term profitability."

2.2 Review of Journals and Articles

Pathak (2007) has carried out a study on “capital structure and profitability: a
comparative case study between the Nepal Indosuez bank ltd (now Nepal
Investment Bank Ltd) and then Nepal Grindlay Bank Ltd (now Standard Chartered
Bank Ltd)”. The capital structures of both banks are highly levered, so it is difficult
for them to pay interest and principal that may ultimately lead them to liquidity or
for them to pay interest and principal that may ultimately dead them to liquidity or
bankruptcy. There is no significant relationship between debt and equity ratio in
terms of fixed deposits to net worth and overall capitalization rates of the banks.
The ROE fluctuation is found to be influenced by the dividend payout ratio and
interest margin in NIB Ltd. Both banks vary in the case of total assets, number of
bank branches and volume of transactions. Both the banks are efficient and well
established and doing well. He has suggested that NIB Ltd should expand assets
and branches, which may ultimately affect the banks performance and increase the
profitability more than ever.

Raheman, Zulfiqar and Mustafa (2007), in their article, “Capital Structure and
Profitability: Case of Islamabad Stock Exchange”, have stated that firstly there is
negative relationship between the long term debt and profitability verifying first
hypothesis, which means that firms with having more long term debt are less
profitable. This can be attributed to the interest cost bear by the company for a
long term debt financing, which increase the fixed costs of the product and
resultantly decrease the profitability. Secondly numeric verifications and statistical
analysis shows negative relationship between net operating profitability and debt
ratio.

39
Thirdly the relationship of profitability with percentage of equity in the total
financing has direct relationship meaning thereby more equity leads to more
profits. Fourthly size with profitability numerical calculations have accepted that
with the increase in size of the firm the profitability increases. The study has taken
the N-log of sales as proxy for growth in size and the increase in sales result in
more profits.

Hutchison and Cox (2010), in their article, “The Causal Relationship Between
Bank Capital and Profitability”, have demonstrated that for banks in the U.S.
there is a positive relationship between financial leverage and the return on equity
for both the 1996-2002 and the 2003-2009 periods. Furthermore, the
proportionality of financial leverage to return on equity appears to have been more
or less maintained between the later more regulated time period as opposed to the
earlier freer period.

Moreover, when viewing the return on assets relationship a similar pattern as the
return on equity to capital relationship is observed. That is, ROA is inversely
related to financial leverage. Again, there seems to be a dearth of evidence to
sustain the notion that the 1996-2002 period is different than the 2003-2009
period. Bank performance has been robust to the regulatory environment that they
have faced.

2.3 Review of Thesis

Giri (2006) had conducted a thesis on “Capital Structure Management of Listed
Joint Venture Commercial Banks” He studied on two joint venture commercial
banks: they are Standard chartered Bank Nepal Limited (SCBNL) and Nepal
Bangladesh Bank Limited (NBBL). He found that JVBs have lack of theoretical
and practical knowledge with regarding to capital structure theories. Nepalese
40
investors are not attracted by the theories' JVBs in Nepal have concentrated their
business with big businessman and industrialists.

The objectives of the study are as follows:

 To find out the capital structure of Joint Venture Commercial Banks.
 To measure the relationship between debt equity capital.
 To examine the relationship of leverage with different financial ratios.

The major findings of the study are as follows:

 Their clients are mostly big manufacture; carpet and garment exporters,
multinational companies, Large scale of industries, NGOs as well as
INGOs, travel agencies. Cargo agencies, Housing companies etc.
Therefore, the JVBs are suggested to open their doors to the small
depositors and entrepreneurs also.
 The capital structure of selected banks is highly levered. The proportion of
debt and equity capital should be decided keeping in mind the efforts of tax
advantage and financial distress. The banks, when they are in difficult to
pay interest and principal, ultimately lead to liquidation or bankruptcy. For
such, the banks should reduce the high use of debt capital. Return ratios
like; return on total assets and return on shareholder's equity are not
satisfactory in NBBL. SCBNL seems very good performing than NBBL in
case of ROE.
 The savings from rural communities are neglected by JVBs, without which
they can't contribute much to the economic development of the country. So,
JVBs recommended being cooperative and should expand the branches by
covering all the five development regions of the country including rural
areas to achieve geographically balanced approach. 'JVBs are basically not
concentrated to mobilize their deposit funds in productive areas.

41
  Nepalese shareholders are very much concerned about the payment of cash
dividend by the joint venture banks rather than their financial statement. He
has suggested paying cash dividend consistently.

Kansakar (2007), in his study, “Capital Structure of Joint Venture Banks of

Nepal”, has the main objective to analyze, examine and interpret the capital
structure of selected three Joint Venture Banks.

The objectives of the study are as follows:

 To examine the solvency position of joint venture banks under study
 To evaluate the effect of capital structure on profitability of Joint venture
banks under study
 To analyze the capital structure of sample banks
 To analyze the comparative capital structure of selected JVBs

The major findings of the study are as follows:

 All JVBs has used high percentage of total debt in raising the assets and
finance its activities. There is the highest ratio of the outsiders‟ claim in total
assets than that of the owners claim. The implication of higher outsiders‟
fund is computed as debt ratio analysis. In an average the highest debt ratio
belongs to Standard Chartered Bank of 93.29% which means that it is
exposed to the greatest financial risk.
 All the JVBs under study show the highest portion of debt in their capital
structure. So they constantly face the burden of huge interest payments. The
analysis shows that Standard Chartered Bank has the highest interest
coverage ratio of 3.04 times on an average which indicates that it has been
successful in generating sufficient income though the utilization of leverage.
The lowest belongs to Himalayan bank of 1.71 times.

42
  The ROA computed for the selected banks depicts the exact utilization of
assets made by them. In comparison to all the other banks, Standard
Chartered bank has the highest ROA which means that it is successful in the
utilization of assets to generate more efficiency.
 The results obtained through ROE calculation of all the selected JVBs shows
the positive reflection of their efficiency of providing satisfactory returns to
their shareholders. Standard Chartered bank has the highest ROE of 36.76%
which means its capacity to utilize the shareholder's equity in an efficient
way. All other remaining bank also shows the satisfactory result though the
lowest ROE belongs to Himalayan Bank.

Bista (2010) In his MBS thesis “Capital Structure Management of Selected

Manufacturing Companies listed in NEPSE" the specific objective were to
examine the capital structure of selected companies, to assess the debt servicing
capacity of the selected companies, to analyze cost of capital and return on capital
in relation to the capital employed and to analyze the relationship between capital
structure and cost of capital in selected Nepalese manufacturing companies.
Researcher has used financial as well as statistical tools like: ratio analysis,
leverage ratio, interest coverage ratio, Profitability ratio, Mean regression,
correlation analysis. Almost all the ratio has been applied to cover analytical part
and fulfill the objectives of this study. It involves more recent date of listed
companies for five year (2004-2009).

The objectives of the study are as follows:

 To analysis the capital structure of the sample companies.
 To find out the relationship between debt and equity capital.
 To examine the relationship of different financial ratios.

43
The major findings of the study are as follows:
 Among all 38 listed manufacturing companies in NEPSE as total
population, sample drawn from target population is two manufacturing
companies -Nepal lube oil Limited (NLOL) and Bottlers Nepal Limited
(BNL).
 The study is based on secondary data. The raw secondary raw data are
modified to some extent for the study purpose mostly; data are collected
from the balance sheet, income statement and profit and Loss account,
auditor general reports and various related journals in a management and
other publications.
 The major findings of the study with respect to capital structure of the
manufacturing companies were the manufacturing companies has low debt
equity ratio, it implies greater claims of owner than creditors. A high
portion of equity provides a large margin of safety for them.
 The researcher had concluded that the mix of capital structure, which leads
to the maximum value and minimum cost of capital optimal capital
structure. A high portion of equity provides a large margin of safety for
them. The company should make such policy to earn high amount of profit
from the sales revenue by increasing operation efficiency.

Shrestha (2010) has done a research on “A study on capital Structure

management of Nepal lube oil limited.”

Main Objectives are as follows:

 To examine the capital structure position of NLOL.
 To examine the structure of working capital of NLOL
 To assess the financial liquidity position of the NLOL.

44
Major Findings are as follows:
 The company had lesser participation of fixed assets in total assets. cash
holds of the company was relatively a small proportion total assets and
inventory held largest portion indicating un sounded inventory
management.
 The company has insufficient in collecting receivable

Adhikari (2011) in his study entitled, “capital structure management of Nepal

Bank Limited” has calculated and analyzed the different ratios by observing
figures of balance sheets of Nepal Bank Limited for the period FY 2004/05 to
2009/10. He remarked that the bank is not found to have been able to utilize its
fund effectively and efficiently for the development of the economy.

Main Objectives are as follows:

 The collection of deposit and loan investment done by the commercial
banks also to sustain themselves in the environment of competitions.
 The deposit funds in productive sectors and to grants more priority to the
local manpower.

Major findings are as follows:

 Economic development of a country cannot be imagined without the
development of commerce and industry
 He has focused on utilization and mobilization of funds and resources of
Nepal Bank Ltd.

45
Karki, (2012) has conducted a study on Working capital Management of
Himalayan Bank Ltd. “A Case Study of Himalayan Bank Ltd.
The main objectives of the study are as follows:
 To analyze the level of different types of working capital faced by
Himalayan Bank Ltd.
 To assess the financial performance of HBL through the help of financial
ratios and standards.

The major findings of the study are as follows:

 Proper policies, procedures, guidelines and tools have been developed with
appropriate triggers.
 That forms the guiding pillars for its operations.
 The banks believe in corporate culture that emanates from the think
Customers" philosophy at all levels of the banks.
 Teamwork, camaraderie, sincerity, dedication, trust, respect, equality,
dignity and valuing each contribution are key pillars on which the corporate
culture of the banks thrives on.

Research Gap
This study is different from the above studies. The study revolves around the
banking industry and the names of the selected banks are Machhapuchhare Bank
Ltd and Bank of Kathmandu Limited. So far, above studies were concerned only
with the capital structure and profitability analysis of various banks in a
comparative way. But there was no detailed analytical study on Machhapuchchhre
Bank Limited (MBL) and Bank of Kathmandu Limited (BOKL). This study is
only concerned with to fill the gap of above and provide the real condition of
capital structure, profitability, cost of equity and cost of debt etc. of this bank with
the help of various financial and statistical tools. This study has been conducted

46
considering the data of five year from 2006/07 to 2010/11. This study attempts to
analyze and evaluate the relationship of capital structure and various variables e.g.
Profitability cost of equity and so on that will provide useful information for
policy makers and the implementation of suggested findings.

The most of the studies has been considered many more objectives which made
their study more complicated but in this research report only four objectives are
taken into study. The researcher has tried best to fill up the gap created by
previous studies. Even there are not enough study conducted on the topic of
relationship between capital structure and cost of capital. Therefore, this study is
also devoted to test the relationship and affect between structure and cost of
capital in BOK and MBL. Most of the researcher did not use SPPS program and
Microsoft excel formula so, I used that program and calculate the statistical tools
which is used in Standard deviation and Covariance.

47
 CHAPTER - III
RESEARCH METHODOLOGY

In this section, the methodology used for conducting the research has been
explained. This section consists of research design, nature and sources of data,
population and sample, data collection, statistical tools, financial tools, capital
structure ratio, profitability analysis and expenses analysis.

3.1 Research Design

Research design is the plan, structure and strategy of investigation conceived so as
to obtain and control variance. The study is evaluative and analytical type of study
regarding the capital structure and profitability' the research design used in the
study is descriptive and evaluative. The data relative to topics are collected though
financial statement of the bank and other available sources.' The data for five years
had been collected and various financial and statistical tools had been used to
resolve the objectives.

3.2 Nature and Sources of Data

This study is based on secondary data. They are collected from Annual report of
the concerned bank; supporting data and information are collected from the office
of the concerned bank. The required date is extracted from the balance sheets,
profit and loss Account, published annual reports. These crude data collected from
will then be properly synthesized, arranged, tabulated and calculated to meet the
objectives of this research.

3.3 Population and Sample

Nowadays a number of commercial banks have been emerging rapidly. Some have
already been established and others are in the process of establishment. Currently,

48
there are 31 commercial banks in Nepal. In this study, all the commercial banks
are population of the study. Among them Machhapuchhare Bank Limited and
Bank of Kathmandu has been selected as samples for the present study on the
basis of good financial performance. The population of the present study is listed
as under, the commercial banks operating in the banking industry of Nepal.

3.4 Tools and Techniques of Analysis

As mentioned earlier' this study is confined to the single analysis of capital
structure profitability of the private commercial bank. To reach the objectives, the
collected data are computed and analyzed using statistical and financial tools.

3.4.1 Statistical Tools

For supporting the study, statistical tool such as Mean, Standard deviation,
Coefficient of Variation, Correlation, Trend Analysis have been used under it.

a. Arithmetic Mean (Average)

Average is statistical constants which enables us to comprehend in a single effort
the significance of the whole. It represents the entire data by a single value. It
provides the gist and gives the bird’s eye view of the huge mass of unwieldy
numerical data. It is calculated as:
Mean (X) =

Where,
= Arithmetic Mean
N = Number of Observations
= Sum of Observations

49
b. Standard Deviation (S.D.)
The standard deviation is the square root of man squared deviations form the
Arithmetic mean and denoted by S.D. or σ. It is used as absolute measure of
Dispersion or variability. It is calculated:

S.D. (σ)=

Where,
σ = Standard Deviation

= Sum of Squares of Observation

= Sum of Square of Mean

c. Coefficient of Variation (CV)

Co-efficient of variance is the relative measure of dispersion comparable across
distribution, which is defined as the ratio of the standard deviation to the mean
express in percent (Levin and Rubin; 1994: 144).

Co-efficient of variance denotes by C.V. is given by:

C.V. = =

d. Correlation Coefficient (r)

Correlation analysis in the statistical tools generally used to describe the degree
which our variable is related to another. This tools is used for measuring the
intensity or the magnitude of linear relationship between two variable X and Y is
usually denoted by ‘r’ can be obtained as:

50
Where,
N = no of observation in series X and Y
= Sum of observation in series X
= Sum of observation in series Y
= Sum of square observation in series X
= Sum of square observation in series Y
= Sum of the product of observation in series X and Y

e. Coefficient of Determination (r2)

It explains the variation percent derived in dependent variable due to the any one
specified variable; it denotes the fact that the independent variable is good
predictor of the behaviour of the dependent variable. It is square of correlation
coefficient.

f. Probable Error of Correlation

The probable error of the co-coefficient of correlation helps in interpreting its
value; it is obtained the following formula.

It is used in interpretation whether calculated value of ‘r’ is significant or not.

1. If r < P.E., it is insignificant. So, perhaps there is no evidence of correlation.
2. If r > P.E., it is significant.
3. In other cases nothing can be concluded.

51
g. Trend Analysis
Trend analysis is very useful and commonly applied tool to forecast future event
in quantitative term on the basis of tendencies in the dependent variable in the past
period. The linear trend values from a series in arithmetic progression.

Mathematically,
Y = a + bX
Where,
Y = Value of dependent variable
a = Y- intercept
b = slope of trend line
X = value of the dependent variable i. e. time

Normal equation of the above are

3.4.2 Financial Tools

1. Capital Structure Analysis
 Fixed deposit analysis
 Fixed deposit composition and index statement
 Fixed deposit to total assets
 Fixed deposit to total debt

2. Shareholders' Equity Analysis

 Shareholders' composition' and index statement
 Net worth as percentage of total liabilities

52
3. Analysis of Financial Mix
The financial analysis mix is performing by using ratio analysis. It is a powerful
tool of financial analysis. Ratio analysis is assess enterprise efficiency and to help
to find reason for inefficiency and also to see management ration.
Ratios reflect symptoms not causes. It is used to interpret the financial statement
so that the strengths and weakness of a firm as well as its historical performance
and current condition can be determined.

4. Capital Structure Ratio

'The ratio indicates the proposition of debt and equity in financing the firm's
assets. It is concerned with long term debt solvency of a firm. Capital structure
ratios are calculated to measure the financial risk and firm's ability of using the
debt for the benefit of the shareholders. The capital structure ratios are as follows:
 Fixed deposit to net worth
 Debt to net worth
 Fixed deposit to capital employed
 Debt to total assets adequacy
 Debt competence ratio
 Capital structure & capitalization rate

5. Profitability Analysis
This is performed by analyzing earning capacity of the assets, expenses analysis,
return ratio, market related profitability ratios to arrive at the conclusion.
Profitability analysis would be incomplete if these above aspects are not taken into
considerations.
 Earning capacity of assets analysis
 Proportion of investment in assets
 Income of assets as % of total income

53
6. Profitability ratio to investment or Return Ratio
 Return on total deposit
 Return on total assets
 Return on capital employed
 Return of shareholders' equity
 Earning per share
 Dividend per share
 Earning and dividend yield
 Price earning ratio
 Market value per share
 Book value per share

54
 CHAPTER-IV
DATA PRESENTATION AND ANALYSIS

In this chapter effort has been made to analyze the capital structure of the MBL
and BOKL. For this, presentation of data of the organization and classification of
the data for analysis has been done. The data collected is to be presented for the
detail analysis by examining it in tables and graphs. This chapter proceeds with
financial analysis and tabulation and then with statistical analysis. The financial
analysis is done through presentation of data and calculating various financial
ratios that reflect the relationship of variables affecting capital structure. The
major variable and the variable affecting capital structure used for analysis are
long term debt, total debt, equity capital, EBIT, interest, total assets, net worth,
current liabilities and current assets. Other related variable are also used when they
are felt necessary.

4.1 Financial Analysis

4.1.1 Analysis of Shareholders' Equity
Paid up capital, reserve and funds are included in the shareholders' equity of the
bank. The reserve and funds include accumulated profit/ loss, general reserve,
capital reserve, share premium, exchange gain loss, proposed bonus share and
other reserve. The researcher had taken shareholders' equity composition and net
worth per share.

55
 Table 4.1
Composition of Shareholders' Equity of MBL
(Rs. In Thousands)
Year 2006/07 2007/08 2008/09 2009/10 2010/11
Paid up 715000000 821651300 901339300 1479269600 1627169560
Capital
Reserve 216091357 185640616 262007958 220829496 146314335
and Funds
Total SHS 931091357 1007291916 1163347258 1700099096 1773483895
Equity
No. of 7150000 8216513 8216513 14792696 16271965
Shares
Net worth 130.22 121.74 141.59 114.93 10.9
per share

Source: Annual Reports of MBL (2006/07 to 2010/11)

Table 4.1 shows that composition of shareholder equity of MBL. The paid up
capital of MBL increased every year from 715000000 in 2006/07 to 1627169560
in 2010/11. So on the reserve and finds was in fluctuating trends. The total
shareholders’ equity is in increasing trend. But the net worth per share is in
fluctuating trend.
Table 4.2
Composition of Shareholders' Equity of BOKL
Year 2006/07 2007/08 2008/09 2009/10 2010/11
Paid up 463580900 603141300 603141300 844397900 1359480700
Capital
Reserve 376152981 390133544 738932488 897192263 714049039
and Funds
Total SHS
Equity 839733881 993274844 1342073788 1741590163 2073529739
No. of 4635809 6031413 6031413 8443979 11821571
Shares
Net Worth
per Share 181.14 164.68 222.51 206.25 175.40
Source: Annual Reports of BOKL (2006/07 to 2010/11)

56
Similarly the paid up capital of the BOKL is in increasing trends but reserve and
funds is in fluctuating trends. So on total shareholders’ equity is in increasing
trends. But, the trend of the net worth per share is in fluctuating trends.

4.1.2 Leverage Ratio or Capital Structure ratio

Leverage ratio is also known as capital structure ratio. The capital structure ratio
judges the long term financial position of the firm. This ratio indicates funds
provided by owner and lenders. As the general rule there should be an appropriate
mix of debt and owner’s equity while financing the firm’s assets. Leverage ratios
have a number of implications. First, is between the debt and shareholders’ equity.
The company has legal obligation to pay the interest to debtors. Second,
shareholders have advantages in employment of debt in two ways.

4.1.2.1 Debt to Equity Ratio

The relationship between lender’s contributions is shown by equity ratio and it
reflects the relative claims of creditors and shareholders against the assets of the
company. This ratio is calculated by dividing total debt by net worth.

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion
of shareholders' equity and long term debt used to finance a company's assets. The
two components are often taken from the firm's balance sheet or statement of
financial position.

57
 Table 4.3
Debt to Equity Ratio
(Rs. In Thousand)
Bank MBL BOKL
Total Net Ratio Total Net Ratio
Year
Debt Worth (times) Debt Worth (times)
2006/07 8138739 931091 8.74 11438596 839733 13.62
2007/08 9810066 1007291 9.74 13588142 993253 13.68
2008/09 11635202 1163347 10.00 16379876 1342049 12.21
2009/10 15790584 1700099 9.29 18754435 1741570 10.77
2010/11 18905280 1773483 10.66 21322688 2073503 10.28
Mean 9.69 12.11
S.D. 0.55 1.57
C.V. 5.71 12.99
Source: Appendix I

Table 4.3 shows the total debt to shareholders equity ratio of MBL and BOKL of
the study period. The table enlightens that the usage of debt amount in MBL is in
increasing trend during the study period, which means that the bank is depending
more on outside fund in each fiscal year in financing the total assets. The long
term debt of the bank has increased from Rs. 8138739 thousands in the fiscal year
2006/07 to Rs. 18905280 thousands in the fiscal year 2010/11. Similarly, the
shareholders’ equity of MBL has ranged from Rs. 931091 in the fiscal year
2006/07 to Rs. 1773483 thousands in the fiscal year 2010/11. With regard to the
trend of both these variables, the debt equity ratio of the bank has increased during
the study fiscal years and thus has ranged from 8.74 times in the fiscal year
2006/07 to 10.66 times in the fiscal year 2010/11. The debt equity ratio clarifies
that in each fiscal year the usage of total debt is greater than the usage of

58
equity capital. Nonetheless, in average the debt equity ratio of the bank is 9.69
times and the variation in the ratio is 5.71%, indicating quite consistency.

So on in BOKL, it has been observed that the bank has increasing its total debt
during the study period; it is ranged form 11438596 thousands to 21322688
thousands in the fiscal year 2006/07 to 2010/11 respectively. However, it is
obtrusive in the increase in equity capital of the bank. The adoption of aggressive
policy in financing the total assets has resulted the debt equity ratio of the bank
above 10 times. In highest, the debt equity ratio is 13.68 times in the fiscal year
2007/08 and in lowest, the debt equity ratio of BOKL is 10.28 times in the fiscal
year 2010/11. In average, the debt equity ratio of the bank is 12.11 times, and the
coefficient of variation is 12.99%.

Comparing the banks on the basis of the debt equity ratio, it can be assumed that
BOKL is more risk taker than MBL. Since, the debt equity ratio of BOKL is
greater than that of MBL, and as a result the capital structure of BOKL is more
dominated by the debt capital percentage than in MBL.

4.1.2.2 Long Term Debt to Total Debt

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.

59
 Table 4.4
Long Term Debt to Total Debt Ratio
(Rs. In Thousand)
Bank MBL BOKL
Long Term Total Ratio Long Term Total Ratio
Year
Debt Debt (%) Debt Debt (%)
2006/07 131,675 8138739 1.62 753,180 11438596 6.58
2007/08 228,504 9810066 2.33 930,000 13588142 6.84
2008/09 88,508 11635202 0.76 300,000 16379876 1.83
2009/10 - 15790584 0.00 300,000 18754435 1.60
2010/11 150,000 18905280 0.79 500,000 21322688 2.34
Mean 1.10 3.84
S.D. 1.01 2.64
C.V. 92.10 68.69
Source: Appendix I

The table 4.4 shows the long term debt to total debt ratio of the selected banks
over the study period. The ratio in the table emblazons that both bank has the
practice of borrowing long term debt extremely very lower than the short term
debt to meet the fund requirement. The ratio of long term debt to total debt of
MBL is in fluctuating trend during the study period. In average, long term debt has
only met 1.10% of the total debt finance of the bank, and other 98.90% of the debt
has been covered by short term debt.

Similarly, the ratio of long term debt to total debt of BOKL has also is in
fluctuating trend, it is ranged from 1.60% in the fiscal year to 2009/10 to 6.84 in
the fiscal year 2007/08. In average, BOKL has met 3.84% of the total debt fund
financing through long term debt, and 96.16% of the total debt through short term
debt.

60
On the basis of the long term debt to total debt, it has been ascertained that MBL is
more risk taking than BOKL, since the usage of short term debt in total debt is
higher in MBL, and thus ultimately the short term debt carries higher risk than
long term debt.

4.1.2.3 Debt Ratio

Debt Ratio is a financial ratio that indicates the percentage of a company's assets
that are provided via debt. It is the ratio of total debt (the sum of current liabilities
and long-term liabilities) and total assets (the sum of current assets, fixed assets,
and other assets such as ‘goodwill’).
Table 4.5
Total Debt to Total Assets Ratio
(Rs. In Thousand)
Bank MBL BOKL
Year Total Debt Total Assets Ratio (%) Total Debt Total Assets Ratio (%)
2006/07 8138739 9069830 89.73 11438596 12278329 93.16
2007/08 9810066 10810330 90.75 13588142 14581395 93.19
2008/09 11635202 12798548 90.91 16379876 17721925 92.43
2009/10 15790584 17490782 90.28 18754435 20496005 91.50
2010/11 18905280 20678790 91.42 21322688 23396191 91.14
Mean 90.62 92.28
S.D. 0.64 0.94
C.V. 0.71 1.02
Source: Appendix I

The table 4.5 shows the practice of debt financing of MBL and BOKL during the
study period. The practice of financing the total assets through debt capital has
increased in the first two fiscal year and then decrease for one year and then again
increases in final year in MBL. In average, 90.62% of the total assets of the bank

61
have been financed through total debt, indicating greater risk taking attitude of the
bank, and the variation in the ratio is just 0.71%, indicating high stability.

Similarly, in BOKL, the debt capital to total assets ratio is in fluctuating trends
through out the study period. It has ranged 91.14 in the fiscal year 2010/11 to
93.19% in the fiscal year 2007/08. In average, 92.28% of the total assets of BOKL
have been financed through debt capital with the variation of 1.02% in the ratio.

Eventually, it has been derived from the analysis that the total assets of each bank
bears greater risk. More specifically, the total assets of BOKL is slightly risky than
that of MBL, since the debt coverage is slightly greater in BOKL than in MBL.

4.1.3 Analysis of Financial mix of the Bank

Using ratio analysis as financial tools for analyzing financial mix of bank, data
available from bank was "Annual Report."

4.1.3.1 Debt to Equity Ratio in Term of Fixed Deposit to Net Worth

It shows the relationship between borrowed funds and owner's capital. This ratio
reflects the relative claims of creditors and shareholders against the assets of the
firm. This ratio measures the long-term financial viability of a firm and it is also
an important tool to appraise the financial structure. It can be calculated in
different ways:
Debt to Equity Ratio in Term of Fixed Deposit to Net Worth
Fixed Deposit
DER 
Net worth

A higher ratio shows a large share of financing by the creditors relatively to

owners. So that, there is a large claims against the assets of the company. It would
be riskier to the creditors. Smaller ratio shows smaller claims of creditors which

62
imply sufficient safety margin and protection against shrink in assets. A high
proportion of debt in the financial structure would land to inflexibility in the
operation of the company because company must pay the interest still to the
company.

Table 4.6
DER in Term of Fixed Deposit to Net Worth of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Year Fixed Net Worth Ratio (%) Fixed Net Ratio
Deposit Deposit Worth (%)
2006/07 2604898 931091 279.77 2709753 839733 322.69
2007/08 2733359 1007291 271.36 3037170 993253 305.78
2008/09 2961140 1163347 254.54 3703175 1342049 275.93
2009/10 3681829 1700099 216.57 4474617 1741570 256.93
2010/11 6572089 1773483 370.58 6383581 2073503 307.86
Mean 278.56 293.84
S.D. 28.03 26.71
C.V. 10.06 9.09
Source: Appendix I

The table 4.6 shows DER in term of fixed deposit to net worth of the selected
banks. This ratio is used to determine whether fixed deposit financing is sufficient
to build up the profitability of the bank or not. The bank has more DER, so that the
worth is less than creditors.

DER of MBL in fiscal year 2010/11 was 370.58 % which was greater proportion
of fixed deposit over the study period. In fiscal year 2009/10 it was 216.57%,
which was the least proportion of fixed deposit to net worth. In on average the

63
fixed deposit to net worth ratio was 278.56% and the standard deviation and C.V.
was 28.03 and 10.06 respectively. Similarly, in BOKL the ratio is in fluctuating
trends. It is ranged from 256.93 in the fiscal year 2009/10 to 322.69% in the fiscal
year 2006/07. In an average the fixed deposit to net worth ratio was 293.84% and
the C.V. of the ratio is 9.09. Every year both of the bank has 100% over claims of
creditors than that of owners. The banks are highly leveraged because their
business depended on the deposit rather net worth.

4.1.3.2 Debt to Total Capital Ratio (DCR)

This ratio indicates the relationship between creditors funds and owners capital. It
states that the outsider’s liabilities are related to the capitalization to the bank and
not only to the shareholders’ equity. These are calculated in this ways:
Fixed deposit
Fixed deposit to total capital ratio =
Total capital employed

Where,
Total capital employed = Shareholders’ Equity +Fixed Deposit
Table 4.7
Fixed Deposit to Total Capital Employed of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Year Fixed Capital Ratio Fixed Capital Ratio
Deposit Employed (%) Deposit Employed (%)
2006/07 2604898 3535989 73.67 2709753 3549486 76.34
2007/08 2733359 3740650 73.07 3037170 4030423 75.36
2008/09 2961140 4124487 71.79 3703175 5045224 73.40
2009/10 3681829 5381928 68.41 4474617 6216187 71.98
2010/11 6572089 8345572 78.75 6383581 8457084 75.48
Mean 73.14 74.51
S.D. 2.35 1.78
C.V. 3.21 2.39
Source: Appendix I

64
Table 4.7 shows DCR in term of fixed deposit to total capital employed of MBL
and BOKL. This ratio constituted 73.67% in fiscal year 2006/07. This means
about 74% of permanent capital has contributed by fixed deposit, which indicates
more than the satisfactory level of long-term debt. This ratio was decreased up to
68.41 in the fiscal year 2009/10 and increased up to 78.75 in the fiscal year
2010/11. On an average, fixed deposit to capital employed was 73.14%. Similarly,
the ratio is in fluctuating over the study period in BOKL. The ratio has decreased
for the first four year and then increased in the final year of the study period.

4.1.4 Analysis of Capital Sufficiency of the Bank

It is used in case of bank to assess the strengths of the capital, the sufficiency of
the capital. Appropriate capital sufficiency ratio always been a controversial issue
for the commercial banks, however very higher or lower capital sufficiency ratio is
considered to be unfavorable in term of lowered return or lowered solvency
respectively. Capital sufficiency is calculated as below:
Capital Fund
Capital sufficiency Ratio (CSR) =
Total Deposit
Where, Capital fund = Paid up capital, general reserve and undistributed profit
Table 4.8
Capital Sufficiency Ratio of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Year Capital Total Deposit Ratio Capital Total Ratio
Fund (%) Fund Deposit (%)
2006/07 931091 7893297 11.80 839733 10,485,359 8.01
2007/08 1007291 9475451 10.63 993253 12,388,928 8.02
2008/09 1163347 11102242 10.48 1342049 15,833,738 8.48
2009/10 1700099 15596790 10.90 1741570 18,083,980 9.63
2010/11 1773483 18535917 9.57 2073503 20,315,834 10.21
Mean 10.67 8.87
S.D. 0.59 1.00
C.V. 5.52 11.26
Source: Appendix I
65
The table 4.8 shows capital sufficiency ratio of MBL and BOKL. There is positive
capital sufficiency ratio in all study period of both banks. The capital sufficiency
ratio was ranged between 9.57% in 2010/11 to 11.80% in 2006/07 of MBL
whereas the ratio of BOKL is ranged from 8.01% in the fiscal year 2006/07 to
10.21% in the fiscal year 2010/11. Capital sufficiency ratio is fluctuating over the
study period of MBL and is in increasing trend in BOKL. The average ratio and
C.V. of the ratio of MBL is 10.67% and 5.52 respectively. Similarly, the average
ratio and C. V. of BOKL is 8.87% and 11.26% respectively.

4.1.5 Analysis Solvency Position of Banks

For the analysis of solvency position of the bank, it has been calculated interest
coverage ratio. It is one of the most conventional ratios, which measures the
relationship between what is normally available from operation of the bank and
claims of the outsiders. It is used to test bank’s debt servicing capacity. It is
calculated as below:
EBIT
Interest Coverage Ratio (ICR) =
Interest

The ratio is too high or too low as well as unfavorable to company. High ratio
implies that the bank is very conservative in using debt and low ratio implies that
the bank is using excessive debt and does not have the ability to offer assured
payment of interest to the creditors.

From the point of creditors the larger the coverage ratio the greater the ability of
the bank to handle fixed charges and guarantee of the payment of interest to the
creditors.

66
 Table 4.9
Interest Coverage Ratio of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Year EBIT Interest Ratio (Times) EBIT Interest Ratio (Times)
2006/07 133996 288661 0.46 202439 308156 0.66
2007/08 76799 397721 0.19 262387 339181 0.77
2008/09 85016 407919 0.21 361496 417543 0.87
2009/10 123251 580036 0.21 461735 563113 0.82
2010/11 73312 1144808 0.06 509263 902927 0.56
Mean 0.23 0.74
S.D. 0.13 0.12
C.V. 56.92 16.80
Source: Appendix I

The table 4.9 shows the interest coverage ratio of MBL and BOKL. The interest
coverage ratios of MBL are 0.46, 0.19, 0.21, 0.21 and 0.06 times in the fiscal year
2006/07, 2007/08, 2008/09, 2009/10 and 2010/11 respectively. The ratio was not
so consistent because it was fluctuated 0.46 times to 0.06 times. On average the
bank had 0.23 times interest coverage ratio, which could be considered as tight
debt service capacity.

Similarly, the interest coverage ratio of BOKL also in fluctuating trend, ranging
from 0.56 times in lowest in the fiscal year 2010/11 to 0.87 times in highest in the
fiscal year 2008/09. In average, the interest coverage ratio of the bank is 0.74
times with 16.80% variation.

67
 Comparing the banks, it can be conclude that of the BOKL has greater capacity to
meet the interest expenses on long term debt then MBL to meet the interest
expenses.

4.1.6 Overall Capitalization Rate (K0)

The overall capitalization rate is calculated under net income approach, which
measures the financial degree of leverage of the bank. This approach assumes that
the cost of debt is less than cost of equity, if financial degree of leverage is
increased the weighted average cost of capital will decline as a result value of
bank will increase. The higher use of debt lowers the cost of increase in value. It is
calculated as follow:
EBIT
Overall capitalization rate (K0)
Value of Firm

Table 4.10
Overall Capitalization Rate of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Year EBIT Total Value Ko EBIT Total Value Ko
of Bank of Bank
2006/07 133996 2629763 5.10 202439 3173334 6.38
2007/08 76799 3426549 2.24 262387 3640311 7.21
2008/09 85016 3634698 2.34 361496 4306316 8.39
2009/10 123251 4440410 2.78 461735 5319015 8.68
2010/11 73312 5309025 1.38 509263 7743061 6.58
Mean 2.77 7.45
S.D. 1.40 1.05
C.V. 50.48 14.04
Source: Appendix I

68
The table 4.10 shows overall capitalization rate of MBL and BOKL which
measures the financial degree of leverage of the bank. Overall capitalization rate
of the MBL is in decreasing trend over the study period. The highest capitalization
rate was 5.10% in 2006/07 and the lowest was 1.38 in 2010/11. On an average
2.77% was recorded over the study period. So on, the capitalization rate in the
BOKL is in fluctuating trends. The ratios are increasing in the first four years and
then decreases in final year of the study period. The average ratio of the BOKL is
7.45% which is higher then that of MBL.

4.1.7 Equity Capitalization Rate (Ke)

The net operating income approach is considered to find out and analyze the
equity capitalization rate of MBL. This approach implies that the total valuation of
the bank is unaffected by its capital structure. In this approach the equity
capitalization rate has to be analyzed. It is calculated as follow.
EPS
Equity capitalization rate (Ke) =
MVPS

Table 4.11
Equity Capitalization Rate of MBL and BOKL
Bank MBL BOKL
Year EPS MVPS Ke EPS MVPS Ke
2006/07 18.74 320 5.86 43.67 850.00 5.14
2007/08 9.02 620 1.45 43.50 1375.00 3.16
2008/09 10.35 1285 0.81 59.94 2350.00 2.55
2009/10 8.33 420 1.98 54.68 1825.00 3.00
2010/11 4.96 282 1.76 43.08 840.00 5.13
Mean 2.37 3.80
S.D. 2.27 1.24
C.V. 95.82 32.71
Source: Appendix I

69
The table 4.11 shows the equity capitalization rate of MBL and BOKL over the
study period. In MBL the ratio is in fluctuating trend over the study period. There
was highest cost of equity of 5.86% in fiscal year 2006/07 and the lowest cost of
equity of 0.81% in fiscal year 2008/09. It was because earning per share was lower
than market value per share. In an average the equity capitalization of the bank
was 2.37 percentages only.

So on the equity capitalization rate of the BOKL is also in fluctuating trend during
the study period. The equity capitalization rate of the BOKL is 5.14%, 3.16%,
2.55%, 3.00% and 5.13% in the fiscal year 2006/07, 2007/08, 2008/09, 2009/10
and 2010/11 respectively. In an average the capitalization ratio of the BOKL is
3.80%.

4.1.8 Profitability of Banks

Profit is the ultimate goal of every business organization. Without it the
organization cannot sustain in the long run. The bank should also need to
accumulate profit to secure its position in the market and to meet the expectations
of the investors. Thus, the profitability position of the banks has been measured
using different financial tools.

4.1.8.1 Return on Total Deposit Ratio

Deposit collection and deposits are mobilized for loans and advances and other
investments are major financial sources of the ban to earn profit This ratio helps
the band either the ban is well efficient or not in mobilizing its total deposit so that
corrective action could be forward to the concerned bank. This ratio is calculated
as below:

70
 Higher the ratio signifies better mobilization and utilization of deposits and vice
versa. The ratio is decreasing trend of ROD represents the weak aspect of a bank
because the major fluctuation of a bank is to utilize the deposit.

Table 4.12
Return on Total Deposit of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Net Total Total
Year Ratio (%) Net Income Ratio (%)
Income Deposit Deposit
2006/07 133994 7893297 1.70 202439 10485359 1.93
2007/08 76799 9475451 0.81 262387 12388928 2.12
2008/09 85016 11102242 0.77 361496 15833738 2.28
2009/10 123251 15596790 0.79 461735 18083980 2.55
2010/11 73312 18535917 0.40 509263 20315834 2.51
Mean 0.89 2.28
S.D. 0.45 0.26
C.V. 50.98 11.50
Source: Appendix I
The table 4.12 shows analysis of return on total deposit of the MBL and BOKL
over the selected period. The ratios of the MBL are 1.70, 0.81, 0.77, 0.79 and 0.40
in the fiscal year 2006/07, 2007/08, 2008/09, 2009/10 and 2010/11 respectively.
Return on total deposit of MBL is in decreasing trend over the study period. The
average return on total deposit ratio was recorded 0.89% over the study period.
The standard deviation and CV of the bank are 0.45 and 50.99 respectively.

Similarly, the table reveals that the net profit in comparison to total deposit of
BOKL has increased for the first four fiscal years and then it has decreased in the
last fiscal year. Thus, the return on deposit has ranged from 1.93% in the fiscal
year 2006/07 to 2.55% in the fiscal year 2009/10, while in the fiscal year 2010/11,
it is 2.51. In average, BOKL has earned 2.28% of the total deposit and the

71
variation in such earning percentage is 11.50%, indicating more consistency then
that of MBL.

Comparing the banks on the basis of return on deposit, it can be said undoubtedly
that BOKL possess greater efficiency than MBL in mobilizing the total deposit to
achieve high net profit. Further, there is high security in return on total deposit of
BOKL than in that of MBL. Thus, the profitability position of MBL is just not
enough in comparison to that of BOKL.

4.1.8.2 Return on Total Assets (ROA)

Return on total assets explains the contribution of assets to generating net profit.
This ratio indicates efficiency towards of assets mobilization. In other words
return on total assets ratio is an overall profitability rate, which measures earning
power and overall operation efficiency of a firm. This ratio helps the management
in identifying the factors that have a bearing on overall performance of the firm.
The ratio explains net income for each unit of asset. Higher the ratio means
efficiency in utilizing its overall resources and vice versa. It is computed as
follow:
Net income
ROA 
Total assets

72
 Table 4.13
Return on Total Assets of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Year Net Total Ratio Net Total Ratio
Income Assets (%) Income Assets (%)
2006/07 133994 9069830 1.48 202439 12278329 1.65
2007/08 76799 10810330 0.71 262387 14581395 1.80
2008/09 85016 12798548 0.66 361496 17721925 2.04
2009/10 123251 17490782 0.70 461735 20496005 2.25
2010/11 73312 20678790 0.35 509263 23396191 2.18
Mean 0.78 1.98
S.D. 0.39 0.25
C.V. 50.20 12.83
Source: Appendix I

The table 4.13 shows analysis of return on total deposit of the MBL and BOKL
over the selected study period. The ratios of the MBL are 1.48, 0.71, 0.66, 0.70
and 0.35 respectively. The highest return on total assets was 1.48% in 2006/07 and
the lowest return on total assets was 0.35% in 2010/11 because at that time net
income was lower than the assets. The average ratio and CV of the bank are 0.78
and 50.20 respectively.

So on, the return on total asset of BOKL is in increasing trend up to the fiscal year
2009/10 and decreased in final year. The ROA of BOKL is just 1.65% in the fiscal
year 2006/07; however, it has been increased to 2.25% by the end of the fiscal
year 2009/10 and then decreased to 2.18 in the fiscal year 2010/11. In average, the
ROA of the bank is 1.98%, indicating generating of Rs. 1.98 net profit from Rs.
100 investment of total assets, and the coefficient of variation in the ratio is
12.83%, indicating quite consistency then MBL.

73
 Comparing the banks on the ground of ROA, it can be concluded that BOKL is
more efficient than MBL in effectively mobilizing the total assets, since the net
profit generation from mobilizing equal amount of total assets is higher in BOKL
than in MBL. Thus, it can be inferred that the profitability management of BOKL
is much robust than that of MBL.

4.1.8.3 Return on Capital Employed

This is another type of return on investment, which is similar to ROI. The term
“Capital employed” refers to the fund supply by creditor and owner of the firm.
The higher the ratio the more efficient is the use of capital employed. It is
computed as follow:
EBIT
ROCE 
Capital emplyed

Table 4.14
Return on Capital Employed of MBL and BOKL
(Rs. In Thousand)
Bank MBL BOKL
Year Net Total Ratio Net Total Ratio
Income Capital (%) Income Capital (%)
Employed Employed

2006/07 133994 3535989 3.79 202439 3549486 5.70

2007/08 76799 3740650 2.05 262387 4030423 6.51
2008/09 85016 4124487 2.06 361496 5045224 7.17
2009/10 123251 5381928 2.29 461735 6216187 7.43
2010/11 73312 8345572 0.88 509263 8457084 6.02
Mean 2.21 6.57
S.D. 0.83 0.73
C.V. 37.69 11.15
Source: Appendix I

74
The table 4.14 shows the return on capital employed of MBL and BOKL. Return
on capital employed of MBL and BOKL is in fluctuating trend over the study
period. There was highest return on capital employed 3.79% in 2006/07 and the
lowest return on capital employed was 0.88% in 2010/11 of MBL. In 2010/11, the
return on capital employed was lowest because of the lowest income among the
years. On an average the bank recorded 2.21% of ROCE. So on, the return on
capital employed of BOKL are 5.70%, 6.51%, 7.17%, 7.43% and 6.02% in the
fiscal year 2006/07, 2007/08, 2008/09, 2009/10 and 2010/11 respectively. In an
average the return on capital employed of BOKL is 6.57. The return of the BOKL
is higher then that of MBL so BOKL is more efficient to use its capital.

4.1.8.4 Return on Shareholders’ Equity (ROSE)

ROSE measures an available return for investor from their investment. According
to this ratio of profitability can be measured by net profit after taxes before interest
dividend by shareholders’ equity. This ratio is calculated by dividing net profit by
common shareholders equity. This ratio measures the return on shareholders
investment in the bank. The higher ratio of return on equity is better for
shareholders. It builds trustworthiness to the customers as well as reputation of the
bank.
Net profit after tax
ROSE 
Shareholde rs' equity

75
 Table 4.15
Return on Shareholders’ Equity of MBL and BOKL
(Rs. In Thousands)
Bank MBL BOKL
Year Net Income Total SHS Ratio Net Income Total SHS Ratio
(%) (%)
2006/07 133994 931091 14.39 202439 839733 24.11
2007/08 76799 1007291 7.62 262387 993253 26.42
2008/09 85016 1163347 7.31 361496 1342049 26.94
2009/10 123251 1700099 7.25 461735 1741570 26.51
2010/11 73312 1773483 4.13 509263 2073503 24.56
Mean 8.14 25.71
S.D. 3.50 1.28
C.V. 43.02 4.97
Source: Appendix I

The table 4.15 shows the return on shareholder equity of MBL. ROE of MBL was
found highly decreasing trend over the study period. The ratios of MBL in the
study period are 14.39%, 7.62%, 7.31%, 7.25% and 4.13% in the fiscal year
2006/07, 2007/08, 2008/09, 2009/10 and 2010/11 respectively. In average, the
bank has maintained 8.14% ROE in the last five consecutive fiscal years, which
means that the bank has generated Rs. 8.14 net profit from Rs. 100 mobilization of
shareholders’ equity.

So on, in BOKL, the return on equity of the bank has followed fluctuating trend
during the study period. The ROE of BOKL has thus ranged from 24.11% in the
fiscal year 2006/07 to 26.94% in the fiscal year 2010/11. In average, the ROE of

76
the bank is 25.71%, indicating Rs. 25.71 net profit generated from Rs. 100
investment of equity capital.

Comparing the banks on the basis of ROE, it can be concluded that BOKL is more
efficient in mobilizing the equity capital, as a result BOKL has earned more profit
from same rupees of investment of equity.

4.1.8.5 Earnings Per Share (EPS)

Earnings per share (EPS) are the earnings returned on the initial investment
amount. Earning per share refers the rupee amount earned per share of common
stock outstanding. It measures the return of each equity shareholders. The higher
earning indicates the better achievements of the profitability of the banks by
mobilizing their funds and vice versa. It is computed as follow:

Table 4.16
Earnings per Share
Bank MBL BOKL
Year EAC No of Ratio EAC No of Ratio
Shares (Rs) Shares (Rs)
2006/07 133991000 7150000 18.74 202445779 4635809 43.67
2007/08 74112947 8216513 9.02 262366466 6031413 43.5
2008/09 85040910 8216513 10.35 361522895 6031413 59.94
2009/10 123223158 14792696 8.33 461716772 8443979 54.68
2010/11 80708946 16271965 4.96 509273279 11821571 43.08
Mean 10.28 48.97
S.D. 4.83 7.84
C.V. 46.95 16.00
Source: Appendix I

77
The table 4.16 shows the trend of EPS of the selected banks. The EPS of MBL is
in decreasing trend during the study period. The ratios are Rs. 18.74, Rs. 9.02, Rs.
10.35, Rs. 8.33 and Rs. 4.96 in the fiscal year 2006/07, 2007/08, 2008/09, 2009/10
and 2010/11 respectively. In average, MBL has earned Rs. 10.28 per share. Also,
the C.V. on EPS is 46.95.

However, the EPS in BOKL is found in fluctuating trend during the study period,
i.e. Rs. 43.67, Rs. 43.5, Rs.59.94, Rs. 54.68 and Rs. 43.08 in the fiscal year
2006/07, 2007/08, 2008/09, 2009/10 and 2010/11 respectively. In average, BOKL
has earned Rs. 48.97 per share and the coefficient of variation on such EPS is
16.00%.

Higher average ratio indicates that BOKL is able to earn more profit per share to
the common shareholders than that of MBL, EPS has been criticizes as the
measure of profitability, because it does not considered the amount of asset of
capital required to generate that level of earning.

4.1.8.6 Dividend Per Share (DPS)

Dividend implies that portion of Net Profit, which is allocated to the shareholders
as return on their investments on cash. The net profit after taxes belongs to
shareholders. But the income, which they really receive, is the amount of earning
distributed as cash dividends. The earning per share implies what the owner are
theoretically entitled to get form the company while dividend per share is that
portion of earning which is allocated to shareholders divided by total number of
share outstanding. Thus, DPS is computed by dividing the total amount of
dividend paid by the number of share outstanding.

78
 Table 4.17
Dividend Per Share
Bank MBL BOKL
Year Earning No of Ratio Earning No of Ratio
Paid to SH Shares (%) Paid to SH Shares (%)
2006/07 114185500 7150000 15.97 83444562 4635809 18
2007/08 0 8216513 0 120628260 6031413 20
2008/09 8627338.7 8216513 1.05 12726281 6031413 2.11
2009/10 0 14792696 0 62232125 8443979 7.37
2010/11 0 16271965 0 177323565 11821571 15
Mean 3.40 12.50
S.D. 7.83 7.53
C.V. 229.90 60.29
Source: Appendix 1

The table 4.17 shows the dividend paid by the MBL and BOKL over the period.
Over the study period MBL has paid dividend only in fiscal year 2006/07 and
2008/09. The ratio is in fluctuating trend it indicates that MBL is not able to pay
dividend year by year.

But BOKL has paid Rs. 18, Rs. 20, Rs. 2.11, Rs. 7.37 and Rs. 15 as dividend in
the fiscal year 2006/07, 2007/08, 2008/09, 2009/10 and 2010/11 respectively. The
average DPS of BOKL is Rs. 12.50 per share. On the basis of DPS, it can be
concluded that BOKL remained more success to retain its existing shareholders
and to attraction the potential shareholders toward it, by distributing dividend.

79
4.1.8.7 Price Earning Ratio (P/E Ratio)
P/E ratio refers to the price currently being paid by market for each rupee of
currently reported EPS. In other words, it measures investors' expectation and the
market appraisal of the performance of the firm. It is an indication of the way that
the investors think the firm would perform better future. Lower the ratio indicates
investors feel that earning is not likely to rise. It is computed as follow:

Table 4.18
P/E Ratio of MBL and BOKL
Bank MBL BOKL
Year EPS MVPS Ratio (Times) EPS MVPS Ratio (Times)
2006/07 18.74 320 17.08 43.67 850 19.46
2007/08 9.02 620 68.74 43.5 1375 31.61
2008/09 10.35 1285 124.15 59.94 2350 39.21
2009/10 8.33 420 50.42 54.68 1825 33.38
2010/11 4.96 282 56.85 43.08 840 19.50
Mean 63.45 28.63
S.D. 44.81 8.81
C.V. 70.62 30.78
Source: Appendix 1

The table 4.18 shows price earning ratio of MBL and BOKL over the selected
period. The P/E ratio of the MBL is increasing trend for first three years and
decreases in 2009/10 and finally increases in 2010/11. It was ranged between
17.08 times in 2006/07 to 124.15 times in 2008/09. Similarly, the price earning
ratio of BOKL is in fluctuating during the study period. The ratios are 19.46%,
31.61%, 39.21%, 33.38% and 19.50% in the fiscal year 2006/07, 2007/08,
2008/09, 2009/10 and 2010/11 respectively. In on average the price earning ratio

80
of the BOKL is 28.63 which is lower than that of MBL. So it can be conclude that
MBL will perform better in future.

4.2 Major Findings

On the basis of above study of this study following findings are made.
 The paid up capital of the MBL and BOKL is in increasing trends but
reserve and funds and the net worth per share is in fluctuating trends.
 The total shareholders’ equity is in increasing trend. But the net worth per
share is in fluctuating trend in the every year.
 Comparing the banks on the basis of the debt equity ratio, it can be
assumed that BOKL is more risk taker than MBL. Since, the debt equity
ratio of BOKL is greater than that of MBL, and as a result the capital
structure of BOKL is more dominated by the debt capital percentage than in
MBL.
 On the basis of the long term debt to total debt, it has been ascertained that
MBL is more risk taking than BOKL, since the usage of short term debt in
total debt is higher in MBL, and thus ultimately the short term debt carries
higher risk than long term debt.
 It has been derived from the analysis that the total assets of each bank bears
greater risk. More specifically, the total assets of BOKL is slightly risky
than that of MBL, since the debt coverage is slightly greater in BOKL than
in MBL.
 DER in term of fixed deposit to net worth of the both bank is more than
100%. Every year both of the bank has 100% over claims of creditors than
that of owners. The banks are highly leveraged because their business
depended on the deposit rather net worth.
 Fixed deposit to total capital employed of MBL and BOKL. This ratio
constituted 73.67% in fiscal year 2006/07. This means about 74% of

81
 permanent capital has contributed by fixed deposit, which indicates more
than the satisfactory level of long-term debt.
 The capital sufficiency ratio was ranged between 9.57% in 2010/11 to
11.80% in 2006/07 of MBL whereas the ratio of BOKL is ranged from
8.01% in the fiscal year 2006/07 to 10.21% in the fiscal year 2010/11.
 On the basis of interest coverage ratio, it can be conclude that of the BOKL
has greater capacity to meet the interest expenses on long term debt then
MBL to meet the interest expenses.
 The overall capitalization rate of the BOKL is higher than that of MBL. So
on the equity capitalization rate of the BOKL is also higher than that of
MBL.
 On the basis of return on deposit, it can be said undoubtedly that BOKL
possess greater efficiency than MBL in mobilizing the total deposit to
achieve high net profit.
 There is high security in return on total deposit of BOKL than in that of
MBL. Thus, the profitability position of MBL is just not enough in
comparison to that of BOKL.
 Comparing the banks on the ground of ROA, it can be concluded that
BOKL is more efficient than MBL in effectively mobilizing the total assets,
since the net profit generation from mobilizing equal amount of total assets
is higher in BOKL than in MBL. Thus, it can be inferred that the
profitability management of BOKL is much robust than that of MBL.
 Highest return on capital employed 3.79% in 2006/07 and the lowest return
on capital employed was 0.88% in 2010/11 of MBL. In 2010/11, the return
on capital employed was lowest because of the lowest income among the
years.
 The ROE of BOKL has thus ranged from 24.11% in the fiscal year 2006/07
to 26.94% in the fiscal year 2010/11. In average, the ROE of the bank is

82
 25.71%, indicating Rs. 25.71 net profit generated from Rs. 100 investment
of equity capital.
 On the basis of ROE, it can be concluded that BOKL is more efficient in
mobilizing the equity capital, as a result BOKL has earned more profit from
same rupees of investment of equity.
 Higher average EPS indicates that BOKL is able to earn more profit per
share to the common shareholders than that of MBL, EPS has been
criticizes as the measure of profitability, because it does not considered the
amount of asset of capital required to generate that level of earning.

83
 CHAPTER-V
SUMMARY, CONCLUSION, AND RECOMMENDATIONS

This chapter is important for the research because this chapter is the extract of all
the previously discussed chapters. This chapter consists of three parts: summary,
conclusion and recommendation. In summary part, revision or summary of all the
four chapters had been made. In conclusion part, the result from the research is
summed up and in recommendation part, suggestion and recommendation has
been made based on the analysis. Recommendation is made for improving the
present situation to the concerned parties as well as for further research.

5.1 Summary
Capital structure plays a vital role in the real life of an enterprise. Capital structure
is the structure of financial management and cost of capital is touchstone of
financing, investment decision and evaluation of financial performance of
enterprises. The capital structure is the combination of long term debt and equity,
it is a part of financial structure i.e., comprised to the total combination of
preferred stock, common stock, long term debt and current liabilities: if current
liabilities are removed from it, we get capital structure, similarly, the capital
structure is the permanent financing of the firm, represent primary by long term
debt, preferred stock and common equity but excluding all short- term credit.
Basically the entire research work focuses on the study on capital structure and
profitability management of MBL and BOKL.

The study is based on secondary data. All the data have been taken from the
concerned banks' annual report, literature publication, balance sheet, profit and
loss account previous thesis report, different website, related books and booklets,

84
journals, articles and primary data are collected through interviews observation
and direct meeting with concerned persons.

Financial institution includes banks, finance companies, co-operative

organizations and insurance companies. All of them do contribute something to
the economy of the country. Financial institutions play a vital role in the proper
functioning of an economy. Among them, banking sector plays an important role
in the economic development of the country. Commercial banks are one of the
vital aspects of this sector, which deals in the process of channeling the available
resources in the needed sectors. It is the intermediary between the deficit and
surpluses of financial resource.

Capital is a scare sources and much more essential to maintain smooth operation
of any firm. The available capital and financial sources should be utilized so
efficiently that could generate maximum return. The term of capital structure is
used to represent the proportionate relationship between debt and equity. The debt
and equity mix of a firm is called capital structure. The capital structure design is a
significant financial decision since it affects the shareholders return, risk and
market value of shares. Both debt and equity are used in most large corporation.
The choice of the amount of debt and equity is made after a comparison of certain
characteristics of each kind of securities of interest factor related to the firm's and
of external factors can affect the firm.

The main theories of capital structure are net income approach, net operating
income approach, traditional approach and Modigliani- miller approach, EBIT/
EPS analysis cost of capital, flexible etc. are the determinant of capital structure.
Without study of these elements the company can not make appropriate capital
structure and analysis of leverage may be incomplete.

85
Profitability is basically an arc around which the ventures every business revolves.
Profit is the main financial indicator of business firm, which is indeed a need to
survive and grow the business environment. Profit is essential to raise the market
price of shares and to attract additional capital investment. Profit is the outcome of
good management, cost control, credit risk management, efficiency of operation
etc. Profit is described in two ways, one is traditional approach (profit
maximization) and another is modern approach (sales maximization).

5.2 Conclusions
On the basis of analysis and findings of this study following conclusion are made.
The paid up capital of the MBL and BOKL is in increasing trends but reserve and
funds and the net worth per share is in fluctuating trends. Comparing the banks on
the basis of the debt equity ratio, it can be assumed that BOKL is more risk taker
than MBL. Since, the debt equity ratio of BOKL is greater than that of MBL, and
as a result the capital structure of BOKL is more dominated by the debt capital
percentage than in MBL. Higher average EPS indicates that BOKL is able to earn
more profit per share to the common shareholders than that of MBL, EPS has been
criticizes as the measure of profitability, because it does not consider the amount
of asset of capital required to generate that level of earning.

On the basis of the long term debt to total debt, it has been ascertained that MBL is
more risk taking than BOKL, since the usage of short term debt in total debt is
higher in MBL, and thus ultimately the short term debt carries higher risk than
long term debt. It has been derived from the analysis that the total assets of each
bank bears greater risk. More specifically, the total assets of BOKL is slightly
risky than that of MBL, since the debt coverage is slightly greater in BOKL than
in MBL. DER in term of fixed deposit to net worth of the both bank is more than
100%. Every year both of the bank has 100% over claims of creditors than that of
owners. The banks are highly leveraged because their business depended on the
86
deposit rather net worth. On the basis of interest coverage ratio, it can be conclude
that of the BOKL has greater capacity to meet the interest expenses on long term
debt then MBL to meet the interest expenses.

The overall capitalization rate of the BOKL is higher than that of MBL. So on the
equity capitalization rate of the BOKL is also higher than that of MBL. On the
basis of return on deposit, it can be said undoubtedly that BOKL possess greater
efficiency than MBL in mobilizing the total deposit to achieve high net profit.
Further, there is high security in return on total deposit of BOKL than in that of
MBL. Thus, the profitability position of MBL is just not enough in comparison to
that of BOKL. Comparing the banks on the ground of ROA, it can be concluded
that BOKL is more efficient than MBL in effectively mobilizing the total assets,
since the net profit generation from mobilizing equal amount of total assets is
higher in BOKL than in MBL. Thus, it can be inferred that the profitability
management of BOKL is much robust than that of MBL. On the basis of ROE, it
can be concluded that BOKL is more efficient in mobilizing the equity capital, as
a result BOKL has earned more profit from same rupees of investment of equity.

5.3 Recommendations
In this section of the study few points that can be helpful to stakeholders as well
as to the banks are recommended based upon above calculations and drawn
conclusions. These recommendations are guidelines which could be helpful in
taking prompt and appropriate decision about capital structure. On the basis of
analysis and findings of this study following recommendations are made.

87
  MBL and BOKL is bearing high interest expenses since it used long- term
debt on its capital structure. As a result, the return of the firm is not
satisfactory. So both of the banks is recommended to minimize interest
expenses by using short term debt as well as decrease other operating
expenses to increase the return of the firm.
 Return on shareholder equity and EPS are not satisfactory. So banks need
to seek more profitable sectors in order to increase profit of the banks. And
also need to maintain optimal capital structure considering cost of capital so
that it helps to enhances the ROSE and profitability of the banks.
 The capital structure of bank is highly leveraged. The proportion of debt
and equity capital should be decided keeping in mind the effects if tax
advantage. It is difficult to pay interest and principal, ultimately lead to
liquidation or bankruptcy.
 The capital structure position is not better. The bank requires maintaining
improved capital structure by increasing equity i.e. issuing more capital,
expanding general reserve and retaining more earning.
 Capital investment should be increased to increase the return to equity
shareholders by employing the equity capital so that the return would be
greater than the overall cost of capital.
 Due to the lack of theoretical knowledge regarding the capital structure,
banks have not given significant attention to the capital structure that
affects EPS, value of the firm, cost of capital etc.

So, it is recommended that it should try to adopt more cooperative approach and
should expand its branches by covering all the inner parts of the country. So that all
the Nepalese living in any nooks and corner of the country can enjoy the banking
facility and can benefit from it.

88