CHAPTER I

1. INTRODUCTION

1.1 Background of the study

In general term capital refers to the total amount that is required for the initiation and
operation of any sort of business and its further expansion. It is taken as the
investment of money to generate the additional money. Capital plays vital role in
every business. The adequacy of capital gives inspiration to entrepreneurs and
businessmen to improve their business and seek more profit whereas the inadequacy
of the capital harasses the skilled and experienced entrepreneurs too. It is one of the
motivating factors for the businessmen. So, in the present business era, the businesses
with huge capital sources are able to expand and in existence their business activities
in long run. But, one should keep in mind that with the availability of capital is not all
but proper management of the available capital is also another side of the business.

When a firm expands, it needs capital, and that capital can come from debt or equity.
Debt has two important advantages. First, the interest paid is a tax deduction, which
lowers debt’s effective cost. Second, debt holders get a fixed return, so stock holders
do not have to share the profits if the business is extremely successful. However, debt
also has disadvantages. First, the higher the debt ratio, the riskier the company, hence
the higher it’s cost of both debt and equity. Second, if a company falls on hard times
and operating income is not sufficient to cover interest charges, its stockholders will
have to make up the shortfall, and if they cannot, bankruptcy will result. Companies
whose earnings and operating cash flows are volatile should therefore limit their use
of debt. On the other hand, companies with less business risk and more stable
operating cash flows can take on more debt.

Mathur views, "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.”

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Managers do not make the capital structure decision once and then forget about it.
Instead, firms regularly raise capital to invest in assets to support growth, and each
time they must choose the mix of equity and debt used to obtain these funds. Many
firms also pay dividends, which reduce retained earnings and thus increases the
amount they must raise externally to support their operating plans. According to
Weston and Brigham "Capital structure of the firm is the permanent financing
represented by long term debt, preferred stock and shareholder's equity. Thus, a
firm's capital structure is only part of its financial structure."

Many factors influence the capital structure decision, and, as you will see,
determining the optimal capital structure is not an exact science. Therefore, even
firms in the same industry often have quite different capital structures. Firms should
first analyze a number of factors, and then establish a target capital structure. This
target may change over time as conditions change, but at any given moment,
management should have a specific capital structure in mind. If the actual debt ratio is
below the target level, expansion capital should generally be raised by issuing debt,
whereas if the debt ratio is above the target, equity should generally be issued. For
more clear information on capital structure one can go through some of the experts
view on the topic. Van Horn expresses that Capital structure is the mix (or
proportion) of a firm's permanent long term financing represented by debt, preferred
stock and common stock equity.

Similarly Weston and Brigham have viewed that Capital structure of the firm is the
permanent financing represented by long term debt, preferred stock and
shareholder's equity. Thus, a firm's capital structure is only part of its financial
structure.

On the other hand Solomon says that the optimal capital is the mix of debt and equity
which will maximize the market value of the company .If such an optimum exists in
two fold. It maximizes the value of the company and wealth of the owners; it
minimizes the company’s cost of capital which in turn increases the ability to find
new wealth creating investment opportunities.

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As mentioned in Wikipedia, the free encyclopedia capital structure refers to the way
a corporation finances its assets through some combination of equity, debt, or hybrid
securities. A firm's capital structure is then the composition or 'structure' of its
liabilities.

In reality, capital structure may be highly complex and include tens of sources.
Gearing Ratio is the proportion of the capital employed of the firm which come from
outside of the business finance, e.g. by taking a long term loan etc. In each and every
country economic development is highly depend on the industrialization for which a
massive infrastructure should be prepared by government and only then
industrialization can be promoted. The industrialists are the persons who mobilize the
idle amount in to the productive field. They use their accumulated amount and some
from outsiders in business purpose. Collecting money from outsiders is not an easy
job whereas managing it, so that it gives the expected return is the more challenging
job than fund collection. Banks are the institutions that give the external funds for
industrialists collecting the small amounts from the citizens.

Commercial banks are the suppliers of finance for trade and industry. This plays vital
role in the economic and financial life of the country. They help in the formation of
capital by investing the saving in productive areas. Commercial banks pool the saving
of community and arrange to lend to the entrepreneur in the forms of individual,
firms, companies and other organized sector as well. In most of the countries, the
commercial banks generally concentrate in urban and semi urban sectors. They
neglect rural sector due to low return.

In Nepal, the institutional source of external capital can be gained from the
commercial banks, development banks, finance companies etc. According to the
report of Nepal Rastra Bank (NRB) till December 2009 altogether 28 commercial
banks, 20 development banks, 150 finance companies, 120 microfinance institutions,
16 NRB licensed co-operatives, 46 NRB licensed Non-Government Organizations to
undertake limited financial transactions, 25 insurance companies. Out of 28 existing
commercial banks 9 are the joint venture banks which are jointly operated with the
foreign banks which are as follows:

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 Table No.1
List of Joint Venture Commercial Banks of Nepal
S.N Name of the Bank Estd. Foreign Joint Venture Head Office
01. Nabil Bank Ltd. 1984 NB (International) Kamaladi, Kathmandu
Limited, Ireland
02. Himalayan Bank Ltd. 1993 Habib Bank Limited, Thamel, Kathmandu
Pakistan

03. Standard Chartered 1987 Standard Chartered Bank Baneshwor, Kathmandu

Bank Ltd. PLC, London

04. Nepal Bangladesh 1994 IFIC Bank Limited, Bijulibazaar,

Bank Ltd. Bangladesh Kathmandu

05. Everest Bank Ltd. 1994 Punjab National Bank, Lazimpat, Kathmandu
India

06. Nepal SBI Bank Ltd. 1993 State Bank of India, Hattisar, Kathmandu
India
07. Nepal Investment 1986 Credit Agricole Durbarg Marg,
Bank Ltd. Indosuez, Kathmandu
France
08. Bank of Kathmandu Ltd. 1993 SIAM Commercial Bank Kamalpokhari,
PCC, Thailand Kathmandu
09. Nepal Credit and 1996 Bank of Ceylon, Sri Siddhartha Nagar,
Commerce Bank Ltd. Lanka Rupandehi

This study covers the all the joint venture commercial banks operating in Nepal. A
brief introduction of the banks’ as follows:

Nabil Bank Limited

Nabil Bank Limited, the first foreign joint venture bank of Nepal, started operations in
July 1984. Nabil was incorporated with the objective of extending international
standard modern banking services to various sectors of the society. Pursuing its
objective, Nabil provides a full range of commercial banking services through its 19
points of representation across the kingdom and over 170 reputed correspondent
banks across the globe.

Nabil, as a pioneer in introducing many innovative products and marketing concepts

in the domestic banking sector, represents a milestone in the banking history of Nepal
as it started an era of modern banking with customer satisfaction measured as a focal
objective while doing business. Bank is fully equipped with modern technology which
includes ATMs, credit cards, state-of-art, world-renowned software from Infosys
Technologies System, India, Internet banking system and telebanking system.

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Himalayan Bank Limited
Himalayan Bank was established in 1993 in joint venture with Habib Bank Limited of
Pakistan. Despite the cut-throat competition in the Nepalese Banking sector,
Himalayan Bank has been able to maintain a lead in the primary banking activities-
Loans and Deposits. Legacy of Himalayan lives on in an institution that's known
throughout Nepal for its innovative approaches to merchandising and customer
service. Looking at the number of Nepalese workers abroad and their need for formal
money transfer channel; HBL has developed exclusive and proprietary online money
transfer software- Himal Remit. By deputing its own staff with technical tie-ups with
local exchange houses and banks, in the Middle East and Gulf region, HBL is the
biggest inward remittance handling Bank in Nepal.

Himalayan Bank Limited holds of a vision to become a Leading Bank of the country
by providing premium products and services to the customers, thus ensuring attractive
and substantial returns to the stakeholders of the Bank. To become the Bank of first
choice is the main objective of the Bank.

Nepal SBI Bank Limited

Nepal SBI Bank Ltd. (NSBL) is the first Indo-Nepal joint venture in the financial
sector sponsored by three institutional promoters, namely State Bank of India (SBI),
Employees Provident Fund (EPF) and Agricultural Development Bank Ltd. NSBL
was incorporated as a public limited company at the Office of the Company Registrar
on April 28, 1993 under Regn. No. 17-049/50 with an Authorized Capital of Rs.12
Crores and was licensed by Nepal Rastra Bank on July 6, 1993 under license No.
NRB/l.Pa./7/2049/50. NSBL commenced operation with effect from July 7, 1993 with
one full-fledged office at Durbar Marg, Kathmandu with 18 staff members.

Standard Chartered Bank Nepal Limited

Standard chartered Bank Ltd was established as a joint venture between ANZ
Grindlays and Nepal Bank Ltd. This bank is known as standard Chartered Bank since
July 2001. Standard Chartered Bank Ltd was renamed from Nepal Grindlays Bank
Ltd which was established in 1987 A.D. as one of the commercial bank of Nepalese
economy. The bank is providing many of the banking services its customers through
the branches national wide. The bank places a great emphasis on being equipped with
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the best human resources so as to continue to be the leader of the industry. To
improve the skills and knowledge of the staff, the bank continues to provide
development programs, including on the job training and job rotation. The bank
provides various services and facilities such as:
• Loan and Advances • Trade finance • Remittances
• Deposits • Bank guarantees • ATM facility

Nepal Bangladesh Bank Limited

Nepal Bangladesh Bank Ltd. was established in June 1994 with an authorized capital
of Rs. 240 million and Paid up capital of Rs. 60 million as a Joint Venture Bank with
IFIC Bank Ltd. of Bangladesh. Its Head Office is situated at Bijuli Bazar, Kathmandu.

The prime objective of this Bank is to render banking services to the different sectors
like industries, traders, businessmen, priority sector, small entrepreneurs and weaker
section of the society and every other people who need Banking Services. Bank has a
network of 17 branches. Bank has developed Agency and Correspondent relationship
with more than 200 prominent Foreign Banks in the world.

Everest Bank Limited

Everest Bank Limited (EBL) started its operations in 1994 with a view and objective
of extending professionalized and efficient banking services to various segments of
the society. The bank is providing customer-friendly services through its Branch
Network. All the branches of the bank are connected through Anywhere Branch
Banking System (ABBS), which enables customers for operational transactions from
any branches. Punjab National Bank (PNB), joint venture partner (holding 20% equity
in the bank) is the largest nationalized bank in India.

The bank has been conferred with “Bank of the Year 2006, Nepal” by the banker, a
publication of financial times, London. The bank was bestowed with the “NICCI
Excellence award” by Nepal India chamber of commerce for its spectacular
performance under finance sector. EBL was one of the first banks to introduce Any
Branch Banking System (ABBS) in Nepal.

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Nepal Investment Bank Limited
Nepal Investment Bank Ltd. (NIBL), previously Nepal Indosuez Bank Ltd. was
established in 1986 as a joint venture between Nepalese and French partners. The
French partner (holding 50%) of the capital was Credit Agricole Indosuez, a
subsidiary of one of the largest banking groups in the world.

The name of the bank was changed to Nepal Investment Bank Ltd. upon approval
of the Bank’s Annual General Meeting, Nepal Rastra Bank and Company
Registrar’s Office. Investment Bank has been awarded by "the banker" under the
publication of British financial group as "a bank of the year-2003, 2005 and 2008
Nepal" is the first bank receiving the award 3 times.

Bank of Kathmandu Ltd.

Incorporated in 1993, in collaboration with SIAM Commercial Bank PCC, Thailand,
Bank of Kathmandu started operation in March 1995. Out of 30% holding diluted
25% holdings to the Nepalese citizens in 1998. It is a culmination of a comprehensive
vision of the promoters to take the Nepalese economy to a newer realm in the global
market. Promoters own 42% of total share of the bank and general public owns the
other 58%. The bank started its operation with the authorized capital of Rs. 100
million, issued capital of Rs. 50 million, and paid up capital of Rs. 46.35 million.

Nepal Credit & Commerce Bank Ltd.

Nepal Credit & Commerce Bank Ltd. (NCC Bank) formally registered as Nepal -
Bank of Ceylon Ltd. (NBOC), commenced its operation on 14th October, 1996 as a
Joint Venture with Bank of Ceylon, Sri Lanka. It was the first private sector Bank
with the largest authorized capital of NRS. 1,000 million. The Head Office of the
Bank is located at Siddhartha Nagar, Rupandehi, the birthplace of LORD BUDDHA,
while its Corporate Office is placed at Bagbazar, Kathmandu.

The name of the Bank was changed to Nepal Credit & Commerce Bank Ltd., (NCC
Bank) on 10th September, 2002, due to transfer of shares and management of the
Bank from Bank of Ceylon, an undertaking of Government of Sri Lanka to Nepalese
Promoters.

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1.2 Statement of Problem
This section deals with the areas of the topic that should be studied rather than the
problems that facing by the selected organizations for the research study. Banking
sector in the present context of Nepal which is trying to overcome form its 10 years
internal war period which declined the whole economy of the country, is the only one
sector which is survived up to now passing through the profit in the days of critical
situation of the country also. The research work has tried to explore the topic capital
structure management of joint venture commercial banks of Nepal and covered the
following areas:
• Whether the Nepalese joint venture commercial banks maintain optimal
capital structure or not.
• Whether the joint venture commercial banks of Nepal are applying any
technique in determining their capital structure mix or not.
• Whether JVCBs follow NRB directives in capital structure decision or not.
• Whether there are any factors that affect the capital structure of the joint
venture commercial banks of Nepal.
• Whether there is increment in profit because of restructure the existing capital
structure or not.

1.3 Objectives of the Study

The thesis is the preparation in course of the fulfillment of requirement for the degree
of master of business studies as approved by the Tribhuvan University which deals
with capital structure management of joint venture commercial banks of Nepal. This
thesis may help the upcoming researchers in the course of preparation of the research
report in topic "Capital Structure Management of Joint Venture Banks of Nepal". The
objectives of the thesis can be listed out as follows:
a) To study the present status of the capital structure management in joint venture
commercial banks of Nepal.
b) To examine relationship between the capital and profit earned by these banks.
c) To Analyze and evaluate the effect of deposit and loan on the EBIT of the
joint venture commercial banks of Nepal.
d) To provide the suggestions and recommendations based on the above study.

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1.4 Rationale of the study

Banking and financial institutions are the vital sectors for the economic growth of any
country. The banking and financial sectors are the backbone of the economic
development of the country as it provides the huge amount of capital for the
infrastructure development and overall upliftment of the economic condition of the
country. Any study in this sector will helpful for several stakeholders of this sector.
Researcher believes that following institution and individual will be benefited from
the study covering the capital structure management of joint venture commercial
banks of Nepal:

• Individual who will carryout further research work in capital structure

management of any banking and financial sectors.

• All the stakeholders of commercial banks especially stakeholders of joint

venture commercial banks of Nepal.

• Individuals who have keen interest in Nepalese banking & financial sector and
institutions related to the topic.

1.5 Limitations of the Study:

Each and every thing in the environment has its own strengths and weakness. None is
free from his/ her weaknesses. On the same way this thesis has its importance and
strengths in one hand which is followed by its weakness or limitations as its shadow.
The study and outcome of the study is an individual effort. As only joint venture
commercial banks of Nepal are under study the findings of the research may not be fit
for the other commercial banks of Nepal and financial institutions. The weakness or
limitations of the study can be pointed out as follows:
a) The study is mainly based on secondary data; therefore, the accuracy of results
and conclusions highly depends upon the reliability of these data.

b) As the title specifies the study covers about capital structure management
subject only other factors beside it is not covered by the study.

c) Due to constraints, the study covers only past five years [F.Y 2004 to 2008] &
selected sample banks.

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1.6 Plan of the work

The thesis proposal is the initial stage of the research work and thesis writing. It gives
the way to the successfully completion of the research project It is the blue print of the
research to be done or a small model of the research report that to be prepared on the
completion of the research on the selected topic. Finally after completion of the
research work, thesis prepared divided into five chapters:

Chapter I – This is the introduction section that covered the background of the study,
the introduction to sample institutions selected for study, objectives &
limitations as well as statement of problem and rationale of the study
which gives the importance, area coverage and strengths & weakness of
the selected topic.

Chapter II – This section literature review, which covered the citation of the
previously conducted research work on the same field as well as review
of the books, articles related to the capital structure.

Chapter III – This section is named as research methodology which gives the brief
introduction of the methods that are applied for research work in order to
get the result of the study.

Chapter IV – In this section of research report contains the data presentation, analysis,
interpretation related to the research problem based on the annual reports
of joint venture commercial banks of Nepal.

Chapter V – Last but not the least, the final section of the research report included
summary, conclusion and recommendation on which the total findings of
the study is summarized point wise as well as the conclusion of the
research work and recommendations if any.

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 CHAPTER II

2. LITRETATURE REVIEW
This chapter is focused on brief discussion about the abstract regarding the theories of
capital structure management. Literature review is basically a 'stock taking' work of
available literature. To make the research more realistic, review of literature is
required. It provides significant knowledge in the field of research. Thus, the review
of books, research studies and articles has been used to make clear about the concept
of capital structure management.
The purpose of literature review is to find what research studies have been conducted
in one’s area of study and what remains to be done. It provides foundation to the
study.

2.1 Conceptual Framework

What Does Capital Mean?
Capital, in the most basic terms, is money. All businesses must have capital in order
to purchase assets and maintain their operations. Business capital comes in two main
forms: debt and equity. Debt refers to loans and other types of credit that must be
repaid in the future, usually with interest. In contrast, equity generally does not
involve a direct obligation to repay the funds. Instead, equity investors receive an
ownership position which usually takes the form of stock in the company.

Capital is a scarce 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. Under a financial concept of capital, such as
invested money or invested purchasing power, capital is synonymous with the net
assets or equity of the entity. It refers to the funds provided by lenders (and investors)
to businesses to purchase real capital equipment for producing goods/services. Real
Capital or Economic Capital comprises physical goods that assist in the production of
other goods and services. According to Weber and Somber, “Capital can be defined
as that amount of wealth which is used in making profits and which enters into the
accounts."

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“Financial capital can refer to money used by entrepreneurs and businesses to buy
what they need to make their products or provide their services or to that sector of the
economy based on its operation, i.e. retail, corporate, investment banking, etc.”
-Wikipedia, the Free Encyclopedia

What Does Capital Structure Mean?

The capital structure concerns the proportion of capital that is obtained through debt
and equity. There are tradeoffs involved: using debt capital increases the risk
associated with the firm's earnings, which tends to decrease the firm's stock prices. At
the same time, however, debt can lead to a higher expected rate of return, which tends
to increase a firm's stock price. The term capital structure is also known as capital
plan or leverage. The financing decision of a firm is one of the firm’s objectives of
shareholder’s wealth maximization. As Brigham explained, "The optimal capital
structure is the one that strikes a balance between risk and return and thereby
maximizes the price of the stock and simultaneously minimizes the cost of capital."

Capital structure or capitalization of the firm is the permanent financing represented

by long term debt, preferred stock and shareholders’ equity. The capital structure is
the firm's various sources of funds used to finance its overall operations and growth,
combination of a company's long-term debt, common equity, and preferred equity.
The proportion of short-term and long-term debt is considered in analyzing a firm's
capital structure. When people refer to capital structure, they most likely are talking
about a firm's debt/equity ratio, which provides insight into how risky a company is.
Usually a company financed heavily by debt poses greater risks because it is highly
leveraged.

A firm can raise its required funds by the issue of various types of financial
instruments. Investors hold different claims on the firm’s assets and cash flows thus
they are exposed to different degree of risk. The nature of capital structure could
differ from one company to the other, which is directly guided, regulated and
controlled by the management of the company. However a reasonable satisfactory
capital structure can be determined by considering relevant factors and analyzing the
impact of alternative financing proposals on the earning per share.

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Capital structure of a company consists of debts and equity securities, which provide
funds for a firm. Capital structure is made up of debt and equity securities which
comprise a firm’s finance of its assets. It is the permanent financing of a firm,
represented by long term debt plus preferred stock plus net worth. (Kulkarni)

Thus capital structure is a rational judicious mix of debt, preferred stock and common
stock. By the capital structure concept, already given, it remarks that a sound capital
structure depends upon the efficiency in the management of the rational estimation of
capital mix. The financial manager should adhere in proper mixing of debt and equity
that can maximize the value and minimize the overall cost of capital of the firm.

How does Capital Structure differ from Financial Structure?

Financial Structure Capital Structure
a) Financial Structure refers to the a) Capital structure refers to the
composition of all sources and combination of long term sources of
amount of funds collected to use or funds.
invest in business

b) It includes both long term and short b) It includes only long term sources of
term sources of financing. financing like Debt, Preference
share, Equity share, Reserves and
Surpluses.

c) It covers wide area than capital c) It is only a part of Financial

structure. Structure.

d) The Financial structures changes d) Once capital structure is determined

more frequently in comparison to by top level, it lasts for long period.
the change in capital structure.

e) Financial structure gives picture of e) Capital structure gives picture on

capital for investment as well as capital for investment.
source of funds for revenue
expenditure too.

Factors Affecting Capital Structure Management (CSM)

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Firms should first analyze a number of factors, and then establish a target capital
structure. This target may change over time as conditions change, but at any given
moment, management should have a specific capital structure in mind. If the actual
debt ratio is below the target level, expansion capital should generally be raised by
issuing debt, whereas if the debt ratio is above the target, equity should generally be
issued.
Capital structure policy involves a trade-off between risk and return:
• Using more debt raises the risk borne by stockholders.
• However, using more debt generally leads to a higher expected rate of return
on equity.
Higher risk tends to lower a stock’s price, but a higher expected rate of return raises it.
Therefore, the optimal capital structure must strike a balance between risk and return
so as to maximize the firm’s stock price. Four primary factors influencing capital
structure decisions are:
1. Business Risk or the riskiness inherent in the firm’s operations if it used no
debt. The greater the firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position, a major reason for using debt is that interest is
deductible, which lowers the effective cost of debt. However, if most of a
firm’s income is already sheltered from taxes by depreciation tax shields, by
interest on currently outstanding debt, or by tax loss carry-forwards, its tax
rate will be low, so additional debt will not be as advantageous as it would be
to a firm with a higher effective tax rate.
3. Financial flexibility or the ability to raise capital on reasonable terms under
adverse conditions. Corporate treasures know that a steady supply of capital is
necessary for stable operations, which is vital for long-run success. They also
know that when money is tight in the economy, or when a firm is experiencing
operation difficulties, suppliers of capital prefer to provide funds to companies
with strong balance sheets. Therefore, both the potential future need for funds
and the consequences of a funds and the consequences of funds shortage
influence the target capital structure – the greater the probable future need for
capital, and the worse the consequences of a capital shortage, the stronger the
balance sheet should be.

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 4. Managerial conservation or aggressiveness, some managers are more
aggressive than others, hence some firms are more inclined to use debt in an
effort to boost profits. This factor does not affect the true optimal, or value-
maximizing, capital structure, but it does influence the manager determined
target capital structure.
These four points largely determine the target capital structure, but operating
conditions can cause the actual capital structure to vary form the target. In addition to
the types of analysis discussed above, firms generally consider the following factors
when making capital structure decisions.
1. Sales Stability: A firm whose sales are relatively stable can safely take on
more debt and incur higher fixed charges than a company with unstable sales.
Utility companies, because of their stable demand have historically been able
to use more financial leverage than industrial firms.
2. Asset Structure: Firms whose assets are suitable as security for loans tend to
use debt rather heavily. General-purpose assets that can be used by many
businesses make good collateral, whereas special-purpose assets do not. Thus,
real estate companies are usually highly leveraged, whereas companies
involved in technological research are not.
3. Operating Leverage: Other things the same, a firm with less operating
leverage is better able to employ financial leverage because it will have less
business risk.
4. Growth Rate: Other things the same, faster-growing firms must rely more
heavily on external capital. Further, the flotation costs involved in selling
common stock exceed those incurred when selling debt, which encourages
rapidly growing firms to rely more heavily on debt. At the same time,
however, these firms often face greater uncertainty, which tends to reduce
their willingness to use debt.
5. Profitability: One often observes that firms with very high rates of return on
investment use relatively little debt. Although there is not theoretical
justification for this fact, one practical explanation is that very profitable firms
such as Intel, Microsoft, and Coca-Cola simply do not need to do much debt
financing. Their high rates of return enable them to do most of their financing
with internally generated funds.

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 6. Control: The effect of debt versus stock on a management’s control position
can influence capital structure. If management currently has voting control
(over 50% of the stock) but is not in a position to buy any more stock, it may
choose debt for new financings. On the other hand, management may decide
to use equity if the firm’s financial situation is so weak that the use of debt
might subject it to serious risk of default, because if the firm goes into default,
the mangers will almost surely lose their jobs.
7. Lender and rating agency attitudes: Regardless of mangers’ own analysis of
the proper leverage factors for their firms, lenders’ and rating agencies’
attitudes frequently influence financial structure decisions. In the majority of
cases, the corporation discusses its capital structure with lenders and rating
agencies and gives much weight to their advice.
8. The firm’s internal condition: A firm’s own internal condition can also have
a bearing on its target capital structure. For e.g; suppose a firm has just
successfully completed an R & D program, and it forecasts higher earnings in
the immediate future. However, the new earnings are not yet anticipated by
investors, hence are not reflected in the stock price. This company would not
want to issue stock – it would prefer to finance with debt until the higher
earnings materialize and are reflected in the stock price. Then it could sell an
issue of common stock, retire the debt, and return to its target capital structure.

What Does Optimal Capital Structure Mean?

The optimal capital structure usually involves some debt, but not 100% debt.
Ordinarily, some firms cannot identify this optimal point precisely, but they should
attempt to find an optimal range for the capital structure. Capital structure with a
minimum weighted-average cost of capital and thereby maximizes the value of the
firm's stock, but it does not maximize earnings per share (EPS). Greater leverage
maximizes EPS but also increases risk. Thus, the highest stock price is not reached by
maximizing EPS.

“The optimal capital structure is the one that maximizes the price of the firm’s stock,
and this generally calls for a debt ratio that is lower than the one that maximizes
expected EPS.” (Brigham and Houston)

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If the capital structure decision affects the total value of the firm, it should select such
a financial mix as well as maximize the shareholders wealth. Such a capital structure
refers to optimal capital structure. (Khan and Jain)

Similarly Khadka says that a capital structure with reasonable proportions of debt
and equity capital, which can maximize the shareholder’s wealth to a limit possible
and simultaneously can minimize the firm’s cost of capital as a whole, is called
optimal capital structure.

On the other hand Pandy expresses that an optimum capital structure would be
obtained at the combination of debt and equity that maximizes the total value of the
firm or minimize the weighted average cost of capital.

2.2 Review of Related Studies

Theories of Capital Structure
One viewpoint is that if there is a change in the nature of capital structure or in
proportion of debt to equity, it will affect earning per share and also the value of the
firm. Another view point is that the financing mix or combination of debt and equity
has no impact on the value of the firm and on shareholders wealth. There is nothing
like optimum capital structure. There is an approach which is a middle course
between the two. All these theories are based on three factors viz. earnings cost of
cost and financial risk.

Many debates over whether an optimal capital structure exists are found in the
financial literature. Argument between those who believe in the absence of such
optimal capital structure began in late 1950’s and there is yet no resolution of 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 capital structure change. So, in order to understand how firms should
make the target capital structure decision, it is important to have some idea of major
elements of capital structure theory.

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The history presents several theories on capital structure management. In order to
analyze the capital structure of any company four theories are to be considered. These
theories are as follows:
(a) Net income approach
(b) Net operating income approach
(c) Traditional approach
(d) Modigliani- Miller’s approach

(A) Net Income Approach

According to net income approach, the change in capital structure takes place a
change in (i) overall cost of capital and also in (ii) total value of firm. To be more
precise if financial leverage is increased by raising the ration of debts to equity there
will be a decrease in weighted average cost of capital and an increase in the market
value of its shares. Conversely if financial leverage is reduced by lowering the ratio of
debts to equity, there will be an increase in weighted average cost of capital and a
decrease in the market value of its shares.

The above calculations suggest that net income approach is based on certain
assumptions. They are as follows.
1. There are no taxes on companies.
2. The cost of debt (Kd) is less than the cost of equities (Ke).
3. A change in the ration of debts to equity does not affect the degree of risk that
the investors bear. In other words whatever may be the ratio of debts to equity
the cost of debts as also the cost of equity capital remain constant.

The implication of these assumptions is that with the increase in debts, a less
expensive source of capital increases in amount Figure No. 1
and consequently, weighed average cost of Net Income Approach to CSM

capital falls, while the overall market value of

the firm moves up. Conversely when debts are
K
reduced a less expensive source of capital e

decreases in amount. Consequently weighted K

O
K
average cost of capital rises, while the overall d

market value of the firm moves down. 0 Leverage (D/A)

18
(B) Net Operating Income Approach
The second approach as propounded by David Durand, the net operating income
approach examines the effects of changes in capital structure in terms of net operating
income. In the net income approach discussed above net income available to
shareholders is obtained by deducting interest on debentures form net operating
income. Then overall value of the firm is calculated through capitalization rate of
equities obtained on the basis of net operating income, it is called net income
approach. In the second approach, on the other hand overall value of the firm is
assessed on the basis of net operating income not on the basis of net income. Hence
this second approach is known as net operating income approach.

The NOI approach implies that (i) whatever may be the change in capital structure the
overall value of the firm is not affected. Thus the overall value of the firm is
independent of the degree of leverage in capital structure. (ii) Similarly the overall
cost of capital is not affected by any change in the degree of leverage in capital
structure. The overall cost of capital is independent of leverage.

If the cost of debt is less than that of equity capital the overall cost of capital must
decrease with the increase in debts whereas it is assumed under this method that
overall cost of capital is unaffected and hence it remains constant irrespective of the
change in the ratio of debts to equity capital. The advocates of this method are of the
opinion that the degree of risk of business increases with the increase in the amount of
debts. Consequently the rate of equity over investment in equity shares thus on the
one hand cost of capital decreases with the increase in the volume of debts; on the
other hand cost of equity capital increases to the same extent. Hence the benefit of
leverage is wiped out and overall cost of capital remains at the same level as before.
Figure No. 2
Net Operating Income Approach to CSM

Ke

V=B+S
KO

Kd

0 Leverage (D/A) 0 Leverage (D/A)

19
(C) Traditional Approach
Traditional approach is an intermediate approach between the net income approach
and net operating income approach. According to this approach;
1. An optimum capital structure does exist.
2. Market value of the firm can be increased and average cost of capital can be
reduced through a prudent manipulation of leverage.
3. The cost of debt capital increases if debts are increases beyond a definite limit.
This is because the greater the risk of business the higher the rate of interest
the creditors would ask for. The rate of equity capitalization will also increase
with it. Thus there remains no benefit of leverage when debts are increased
beyond a certain limit. The cost of capital also goes up.

Thus at a definite level of mixture of debts to equity capital, average cost of capital
also increases. The capital structure is optimum at this level of the mix of debts to
equity capital.

The effect of change in capital structure on the overall cost of capital can be divided
into three stages as follows;

First stage
In the first stage the overall cost of capital falls and the value of the firm increases
with the increase in leverage. This leverage has
Figure No. 3
beneficial effect as debts are less expensive. Traditional Approach of CSM
The cost of equity remains constant or
K
e
increases negligibly. The proportion of risk is
K
less in such a firm. O

K
d

Second stage
A stage is reached when increase in leverage
S ta g e 1 s t S ta g e 2 n d S ta g e 3 rd

has no effect on the value or the cost of capital, o L e v e ra g e (D /A )

of the firm. Neither the cost of capital falls nor the value of the firm rises. This is
because the increase in the cost of equity due to the assed financial risk offsets the
advantage of low cost debt. This is the stage wherein the value of the firm is
maximum and cost of capital minimum.
20
Third stage
Beyond a definite limit of leverage the cost of capital increases with leverage and the
value of the firm decreases with leverage. This is because with the increase in debts
investors begin to realize the degree of financial risk and hence they desire to earn a
higher rate of return on equity shares. The resultant increase in equity capitalization
rate will more than offset the advantage of low-cost debt.

It follows that the cost of capital is a function of the degree of leverage. Hence, an
optimum capital structure can be achieved by establishing an appropriate degree of
leverage in capital structure.

(D) Modigliani-Miller Approach

Modern capital structure theory began in 1958, when Italian born American Professor
of Economics Franco Modigliani (1918 – 2003) and American Economist Merton
Miller (1928 – 200) hereafter MM published what has been called the most influential
finance article ever written. MM proved, under a very restrictive set of assumptions,
that a firm’s value is unaffected by its capital structure, and capital structure is
irrelevant. However, MM’s study was based on some unrealistic assumptions;
• There are no brokerage costs.
• There are no taxes.
• There are no bankruptcy costs.
• Investors can borrow at the same rate as corporations.
• All investors have the same information as management about the firm’s
future investment opportunities.
• EBIT is not affected by the use of debt.

Despite the fact that some of these assumptions are obviously unrealistic, MM’s
irrelevance result is extremely important. By indicating the conditions under which
capital structure is irrelevant. MM also provided with clues about what is required for
capital structure to be relevant and hence to affect a firm’s value. MM’s work marked
the beginning of modern capital structure research, and subsequent research has
focused on relaxing the MM assumptions in order to develop a more realistic theory
of capital structure.

21
MODIGLIANI MILLER THEORY WITHOUT TAXES

M&M Proposition I

Before moving to the MM theory let’s move to one interesting case of Yogi Berra
which helps to understand MM theory: When a waitress asked Yogi Berra (Baseball
Hall of Fame catcher for the New York Yankees) whether he wanted his pizza cut
into four pieces or eight. Yogi replied, “Better make it four; I don’t think I can eat
eight.”

Yogi’s quip helps convey the basic insight of MM. The firm’s choice of leverage
“slices” the distribution of future cash flows in a way that is like slicing a pizza. MM
recognize that if you fix a company’s investment activities, it’s like fixing the size of
the pizza; no information costs means that everyone sees the same pizza; no taxes
means the IRS gets none of the pie; and no “contracting” costs means nothing sticks
to the knife.

So, just as the substance of Yogi’s meal is unaffected by whether the pizza is sliced
into four pieces or eight, the economic substance of the firm is unaffected by whether
the liability side of the balance sheet is sliced to include more or less debt under MM
assumptions.

The MM as described on their proposition I that without taxes states that the overall
value of the firm is not affected by the capital structure maintains by a firm. One way
to illustrate MM proposition I is to imagine two firms that are identical on the left-
hand side of the balance sheet. Their assets and operations are exactly the same. The
right-hand sides are different because the two firms finance their operations
differently. In this case, can view the capital structure question in terms of a “Pie”
model. Why choosen this name is apparent from figure below gives two possible
ways of cutting p the pie between he equity slice, E, and the debt slice, D: 30% - 70%
and 70% - 30%. However, the size of the pie in figure is the same for both firms
because the value of the assets is the same. This is precisely what MM proposition I
states: The size of the pie doesn’t depend on how it is sliced, how the debt and equity
is structured in a corporation is irrelevant. The value of the firm is determined by Real
Assets and not its capital structure

22
 Figure No.4
Modigliani Miller Proposition I without taxes

Source: www.financescholar.com

M&M Proposition II

Although changing the capital structure of the firm does not change the firm’s total
value, it does cause important changes in the firm’s debt and equity. Now examine
what happens to a firm financed with debt and equity when the debt-equity ratio is
changed. M&M Proposition II states that the value of the firm depends on three
things:
1) Required rate of return on the firm's assets (Ra)
2) Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)
If you recall the tutorial on Weighted Average Cost of Capital (WACC), the formula
for WACC is:
E D
WACC = Re × + Rd ×
V V
E D
It can be manipulated and written in another form: Ra = Re × + Rd ×
V V
The above formula can also be rewritten as: Re = Ra + (Ra – Rd) x (D/E)
Where,
Re = Required rate of return on equity
Rd = Required rate of return on debt
Ra = Required rate of return on the firm’s overall assets
E = Equity
D = Debt
V = Total value of the firm

23
This rewritten formula is what M&M Proposition II is all about. It can analyze this
more clearly with the help of following graph:
Figure No.5
Modigliani Miller Proposition II without taxes

Re

WACC
Rd

Debt Equity Ratio (D/E)

Source: www.financescholar.com

In the above figure, x- axis represent Debt equity ratio and y-axis cost of capital. It is
drawn the required rate of return on debt, equity and overall cost of capital on
different levels of Debt equity ratio. It tells us that the Required Rate of Return on the
firm (Re) is a linear straight line with a slope of (Ra - Rd)

Why is Re linear curved and upwards sloping? This is because as a company borrows
more debt (and increases its Debt/Equity ratio), the risk of bankruptcy is even more
higher. Since adding more debt is risky, the shareholders demand a higher rate of
return (Re) from the firm's business operations. This is why Re is upwards sloping: So,
As Debt/Equity Ratio Increases, Re will Increase (upwards sloping).

Notice that the Weighted Average Cost of Capital (WACC) in the graph is a straight
line with no slope. It therefore does not have any relationship with the Debt/Equity
ratio. This is the basic identity of M &M Proposition I and II, that the capital structure
of the firm does not affect its total value. WACC therefore remains the same even if
the company borrows more debt (and increases its Debt/Equity ratio).

24
MODIGLIANI MILLER THEORY WITH TAXES

MM’s original work, published in 1958, assumed zero taxes. In 1963, they published
a second article that incorporated corporate taxes. With corporate income taxes, they
concluded that leverage will increase a firm’s value. This occurs because interest is a
tax-deductible expense; hence more of leverage firm’s operating income flows
through to investors. Here are the MM propositions when corporations are subject to
income taxes.

M&M Proposition I

The value of a levered firm is equal to the value of an unlevered firm in the same risk
class (VU) plus the gain from leverage. The gain from leverage is the value of the tax
savings, found as the product of the corporate tax rate (T) times the amount of debt
the firm uses (D): VL = VU + T ×D

The important point here is that when corporate taxes are introduced, the value of the
levered firm exceeds that of the unlevered firm by the amount T × D. Since the gain
from leverage increases as debt increases, in theory a firm’s value is maximized at
100 percent debt financing because all cash flows are assumed to be perpetuities, the
value of the unlevered firm can be found by using equation below with zero debt, the

EBIT (1 − T )
value of the firm is its equity value: VU =
K eU

M&M Proposition II

The cost of equity to a levered firm is equal to (i) the cost of equity to an unlevered
firm in the same risk class plus (ii) a risk premium whose size depends on the
differential between the costs of equity and debt to an unlevered firm, the amount of
financial leverage used, and the corporate tax rate.
KeL = KeU + (KeU – Kd) (1 – T) (D/S)
Note that the above equation given is identical to the corresponding without tax
equation given in MM proposition II without taxes rewritten formula except for the
term (1 – T). Because (1 – T) is less than 1, corporate taxes cause the cost of equity to
rise less rapidly with leverage than it would in the absence of taxes. Proposition II,

25
coupled with the fact that taxes reduce the effective cost of debt, is what produces the
proposition I result, namely, that the firm’s value increases as its leverage increases.
Illustration of the MM Models
To illustrate the MM models, assume that the following data and conditions hold for a
firm given.
The firm has currently no debt; it is in an all equity company.
Expected EBIT = Rs.24,00,000. EBIT is not expected to increase over time.
Needing no new capital, firm pays out all of its income as dividends.
If the firm begins to use debt, it can borrow at a rate K d = 8%. This borrowing rate is
constant, it does not increase regardless of the amount of debt used, Any money
raised by selling debt would be used to repurchase common stock so the firm’s assets
would remain constant
The business risk inherent in the firm’s assets and thus in its EBIT is such that its
required rate of return, KeU, is 12% if no debt is use.

Without Taxes:
EBIT Rs .24 ,00 ,000
VL = VU = K = = Rs.2,00,00,000
eU 0.12

If the firm uses Rs.1,00,00,000 of debt its stock value must be Rs.1,00,00,000

Next also find the firm’s cost of equity KeL and its WACC at a debt level of 1 crore.
First, use Proposition II equation to find KeL
KeL = KeU + (KeU – Kd) (D/S)
= 12% + (12% - 8%) (1 crore/ 1 crore)
= 12% + 4%
= 16%

Now find the company’s WACC;

WACC = (D/V) (Kd) (1 – T) + (E/V) Ke
1,00 ,00 ,000 1,00 ,00 ,000
= 2,00 ,00 ,000 ×8% ×(1 − 0 ) + 2,00 ,00 ,000 ×16 %

= 12%
The firm’s value and cost of capital based on the MM model without taxes at various
debt levels are show in Panel A on the left side of Figure 6 in page 29 where see that

26
in an MM world without taxes, financial leverage simply does not matter. The value
of the firm, and its overall cost of capital, is independent of the amount of debt.
With corporate Taxes:
To illustrate the MM model with corporate taxes, assume that all of the previous
conditions hold except these two:
Expected EBIT = Rs.40,00,000
The firm has 40 percent federal plus state tax rate, so T = 40%
Other things held constant, the introduction of corporate taxes would lower the firm’s
net income, hence its value, so increased EBIT from Rs.24,00,000 to Rs.40,00,000 to
make the comparison between two models easier

EBIT (1 −T )
When the firm has zero debt but pays taxes, VU =
K eU

Rs .24 ,00 ,000 (1 −0.4)

=
0.12
= Rs.2,00,00,000

Now, if the firm uses Rs.1,00,00,000 debt in a world with taxes, see by proposition I
of MM Model with taxes that its total value rises to Rs.2,40,00,000.
VL = VU + T × D
= Rs.2,00,00,000 + 0.4 × Rs.1,00,00,000
= Rs.2,40,00,000.

Therefore, the value of the firm’s stock must be Rs.1,40,00,000.

S=V–D
= Rs.(2,40,00,000. - 1,00,00,000)
= Rs.1,40,00,000.

It can also find the firm’s cost of equity KeL and its WACC at a debt level of
Rs.1,00,00,000. First use proposition II equation of MM Model with taxes to find K eL,
the leveraged cost of equity is:

KeL = KeU + (KeU – Kd) (1 – T) (D/S)

Rs .1,00 ,00 ,000
= 12% + (12% - 8%) × 0.6 × Rs .1,40 ,00 ,000

27
 =12% + 1.71%
= 13.71%
The company’s weighted average cost of capital is 10%;
WACC = (D/V) (Kd) (1 – T) + (S/V) Ke
Rs .1,00 ,00 ,000 Rs .1,40 ,00 ,000
= Rs .2,40 ,00 ,000 ×8% ×(1 − 0.4 ) + Rs .2,40 ,00 ,000 ×13 .71 %

= 10%

The firm’s value and cost of capital at various debt levels with corporate tax are show
in Panel B on the right side of figure above. In MM world with taxes, financial
leverage does matter. The value of the firm is maximized and its overall cost of
capital is minimized, if it uses debt financing. The increase in value is due solely to
the tax deductibility of interest payments, which lowers both the cost of debt and the
equity risk premium by (1 – T).

Table No. 2
Modigliani Miller Model Without Taxes
Rs. ‘000000’
Debt Equity Value of the Firm Debt Ratio
(D) (E) (V) (D/V) Kd Ke WACC
Rs. 0 Rs. 20 Rs.20 0 8.00% 12.00% 12.00%
5 15 20 0.25 8.00% 13.33% 12.00%
10 10 20 0.5 8.00% 16.00% 12.00%
15 5 20 0.75 8.00% 24.00% 12.00%
20 0 20 1 8.00% 0 12.00%

Table No. 3

Modigliani Miller Model With Taxes

Rs. ‘000000’
Debt Equity Value of the Firm Debt Ratio
(D) (E) (V) (D/V) Kd Ke WACC
Rs. 0 Rs. 20 Rs.20 0% 8.00% 12.00% 12.00%
5 17 22 22.73 8.00% 12.71% 10.91%
10 14 24 41.67 8.00% 13.71% 10.00%
15 11 26 57.69 8.00% 15.27% 9.23%
20 8 28 71.43 8.00% 18.00% 8.57%
25 5 30 83.33 8.00% 24.00% 8.00%
30 2 32 93.75 8.00% 48.00% 7.50%

28
 33.33 0 33.33 100 8.00% 7.20%

Figure No. 6
Modigliani Miller Model with and without taxes
Pannel A: MM Model without taxes Pannel B: MM Model with taxes

Ke
40 Ke 40

30 30

20 20
WACC
10 10
WACC
Kd
K (1 - T)
d
0 20 40 60 80 100 0 20 40 60 80 100
D/ V Ratio (%) D/ V Ratio (%)

40 40
V
L
30 30
TD
V = 20 VL V
U VU= 20 U

10 10

0 5 10 15 20 0 5 10 15 20 25 30
Debt (Rs.) Debt (Rs.)

2.2.1 Review of Books

THE HAMADA EQUATION
An increase in the debt ratio also increases the risk faced by shareholders, and this has
an effect on the cost of equity, Ke. This relationship is harder to quantify, but it can be
done. A stock’s beta is the relevant measure of risk for diversified investors.
Moreover, it has been demonstrated, both theoretically and empirically, that beta
increases with financial leverage. Indeed, Robert Hamada developed the following
equation to specify the effect of financial leverage on beta.
b = bu [1 + (1 – T) (D/E)]
The Hamada equation shows how increase in the debt/ equity ratio increases beta.
Here bu is the firm’s unlevered beta coefficient, that is, the beta it would have if it has
no debt. In that case, beta would depend entirely upon business risk and thus be a

29
measure of the firm’s “basic business risk”. D/E is the measure of financial leverage
used in the Hamada Equation.
Note that beta is the only variable under management’s control in the cost of equity
equation, Ke = Krf + [Km – Krf] bi. Both Krf and Km are determined by market forces
that are beyond firm’s control. However, bi is determined (i) by the firm’s operating
decisions and (ii) by its capital structure decisions as reflected in its D/E ratio.

As a starting point, a firm can take its current beta, tax rate, and debt/ equity ratio and
calculate its unlevered beta, bu by simply transforming equation as follows:
b
bu = 1 +(1 −T )( D / E )

Then, once bu is determined, the Hamada Equation can be used to estimate how
changes in debt/ equity ratio would affect the leveraged beta, bi and thus the cost of
equity Ke.

It can illustrate the procedure with example assuming that

Risk free rate of return (Krf) = 6%
Required rate of return on average stock (Km) = 10%
Unlevered beta (bu) =1.5

Now, with bu, Krf, and Km specified it can use the CAPM to estimate how much
market beta would rise if it began to use financial leverage, hence what its cost of
equity would be at different capital structures. Currently based on above data current
cost of equity is 12% as calculated below:
Risk premium = Km = Krf
= 10% - 6%
= 4%

Ke = Krf + Risk premium

= 6% + 4% × 1.5
= 12%

30
The first 6% is the risk free rate, the second the risk premium. Because firm has
currently uses no debt, it has no financial risk. Therefore, the 6 percent is risk
premium reflects only its business risk.
If the firm changes its capital structure by adding debt, this would increase the risk
stockholders bear. That, in turn, would result in an additional risk premium.
Conceptually, this situation would exist:
Ke = Krf + Premium for business risk + Premium for financial risk
Figure No.7
The Hamada Model
The figure alongside describes the
18 Ke
firm’s required return on equity at 16 Premium
for
Finanical Risk
different debt ratios. As the figure 14

12
shows, Ke consists of 6% risk free
10 Premium
rate, a constant 6% premium for 8
for
Business Risk

business risk, and a premium for Krf = 6

Risk Free Rate:
4 Time Value of
financial risk that starts at zero but Money Plus
2 Expected Inflation
rises at an increasing rate as debt
0 10 20 30 40 50 60
ratio increases. Debt/ Assets (%)

TRADE-OFF THEORY
The trade-off theory of leverage in which firms trade off the benefits of debt financing
(favorable corporate tax treatment) against the higher interest rates and bankruptcy
costs. A summary of the trade-off theory is expressed graphically in figure. Here are
some observations about the figure:

The fact that interest is a deductible expense makes debt less expensive than common
or preferred stock. In effect, the government pays part of the cost of debt capital, or, to
put it another way, debt provides tax shelter benefits. As a result, using debt causes
more of the firm’s operating income (EBIT) to flow through to investors. Therefore,
the more debt a company uses, the higher its value and stock price. Under the
assumptions of the Modigliani-Miller with taxes paper, a firm’s stock price will be
maximized if it uses virtually 100 percent debt, and the line labeled “MM Result
Incorporating the Effects of Corporate Taxation” in figure expresses the relationship
between stock prices and debt under their assumptions.
31
In the real world, firms rarely use 100 percent debt. The primary reason is that firms
limit their use of debt to hold
Figure No.8
Trade off theory of CSM down bankruptcy-related
MM Result incorporating the
effects of corporate taxation:
costs.
Price of the stock if there were

Value Added by Debt

no bankruptcy related costs
There is some threshold level
Tax Shelter Benefits
Value Reduced by
Bankruptcy related costs of debt, labeled D1 in figure,
below which the probability
of bankruptcy is so low as to
Value of Stock with Value of Stock if
thefirm used no
Zero Debt = $20
fianancial leverage be immaterial. Beyond D1,
Actual Price of Stock
however, bankruptcy-related
0 D
1
Threshold Debt Level
D Optimal Capital Structure
2 Marginal Tax Shelter Benefits =
Leverage (D/A)
costs reduce but do not
where bankruptcy costs Marginal Bankruptcy related Costs
become material completely offset the tax
benefits of debt, so the firm’s stock price rises (but at a decreasing rate) as its debt
ratio increases. However, beyond D2 bankruptcy related costs exceed the tax benefits,
so from this point on increasing the debt ratio lowers the value of the stock.
Therefore, D2 is the optimal capital structure. Of course, D1 and D2 vary from firm to
firm, depending on their business risk and bankruptcy costs.

SIGNALING THEORY
MM assumed that investors have the same information about a firm’s prospects as its
managers- this is called symmetric information. However, in fact managers often have
better information than outside investors. This is called asymmetric information, and
it has an important effect on the optimal capital structure. To see why, consider two
situations, one in which the company’s managers know that its prospects are
extremely favorable (Firm F) and one in which the managers know that the future
looks unfavorable (Firm U).

Suppose, for example, that Firm F’s Research & Development labs have just covered
a non-patentable cure for the common cold. They want to keep the new product a
secret along as possible to delay competitor’s entry into the market. New plants must
be built to make the new product, so capital must be raise. How should Firm F’s
management raise the needed capital? If the firm sells stock, then, when profits from
the new product start flowing in, the price of the stock would rise sharply, and the
32
purchasers of the new stock would make a bonanza. The current stockholders
(including managers) would also do well, but not as well as they would have done if
the company had not sold stock before the price increased, because then they would
not have had to share the benefits of the new product with the new stockholders.
Therefore, one would expect a firm with very favorable prospects to try to avoid
selling stock and, rather, to raise any required new capital by other means, including
using debt beyond the normal target capital structure.

Now let’s consider Firm U. Suppose its managers have information that new orders
are off sharply because a competitor has installed new technology that has improved
its products’ quality. Firm U must upgrade its own facilities, at a high cost, just to
maintain its current sales. As a result, its return on investment will fall (but not by as
much as if it took no action, which would lead to a 100% loss through bankruptcy).
How should Firm U raise the needed capital? Here the situation is just the reverse of
that facing Firm F, which did not want to sell stock so as to avoid having to share the
benefits of future developments. A firm with unfavorable prospects would want to sell
stock, which would mean bringing in new investors to share the losses.

The conclusion from all this is that firms with extremely bright prospects prefer not to
finance through new stock offerings, whereas firms with poor prospects do like to
finance with outside equity. How should you, as an investor, react to this conclusion?
You ought to say, “If I see that a company plans to issue new stock, this should worry
me because I know that management would not want to issue stock if future prospects
looked good. However, management would want to issue stock if things looked bad.
Therefore, I should lower my estimate of the firm’s value, other things held constant,
if it plants to issue new stock.”

If you gave the above answer, your views are consistent with those of sophisticated
portfolio managers of institutions such as Morgan Guaranty Trust, Prudential
Insurance, and so forth. In a nutshell, the announcement of a stock offering is
generally taken as a signal that the firm’s prospects as seen by its management are
not bright.

What are the implications of all this for capital structure decisions? Since issuing
stock emits a negative signal and thus tends to depress the stock price, even if the

33
company’s prospects are bright, firms should, in normal times, maintain a reserve
borrowing capacity that can be used in the event that some especially good investment
opportunity comes along. This means firm should, in normal times, use more equity
and less debt than is suggested by the tax benefit/ bankruptcy cost trade off model.
Operating Leverage
Other things held constant, the higher a firm’s fixed costs, the greater its business risk.
Higher fixed costs are generally associated with more highly automated, capital
intensive firms and industries. However, businesses that employ highly skilled
workers who must be retained and paid even during recessions also have relatively
high fixed costs, as do firms with high product development costs, because the
amortization of development costs is an element of fixed costs.

If a high percentage of total costs are fixed, then the firm is said to have a high degree
of operating leverage. In business terminology, a high degree of operating leverage,
other factors held constant, implies that a relatively small change in sales results in a
large change in ROE.

Figure illustrates the concept of operating leverage by comparing the results that firm
could expect if it used different degrees of operating leverage. Plan A calls for a
relatively small amount of fixed costs, $20,000. Here the firm would not have much
automated equipment, so its depreciation, maintenance, property taxed, and so on
Figure No. 9
Degree of Operating Leverage
Plan A: Plan B:

Operating Profit Operating Profit

(EBIT) (EBIT)
240 240

200 200

160 160

BEP
120 Operating Loss 120 Operating Loss

80 Breakeven Point 80
EBIT = 0
Fixed Costs
40 40

Fixed Costs
0 20 40 60 80 100 120 0 20 40 60 80 100 120
Sales (Thousands of Dollars) Sales (Thousands of Dollars)
would be low. However, the total operating costs line has a relatively steep slope,

34
indicating that variable costs per unit are higher than they would be if the firm used
more operating leverage. Plan B calls for a higher level of fixed costs, $60,000. Here
the firm uses automated equipment to a much larger extent. The breakeven point is
higher under Plan B 60,000 units versus only 40,000 units under Plan A.
One can calculate the breakeven quantity by recognizing that operating breakeven
occurs when ROE = 0, hence when earnings before interest and taxes (EBIT) = 0.
EBIT = PQ – VO – F = 0
Here P is average sales price per unit of output, Q is units of output, V is variable cost
per unit, and F is fixed operating costs. If solve for the breakeven quantity, QBE, can
obtain this expression:
F
QBE =
P −V
Thus for Plan A, Plan B
$20 ,000 $60 ,000
QBE = = 40,000 units QBE = =
$2.00 − $1.50 $2.00 −$1.00

60,000 units

How does operating leverage affect business risk? Other things held constant, the
higher a firm’s operating leverage, the higher its business risk. This point is
demonstrated in figure, where probability distributions for ROE under Plans A and B.

Financial Risk
Financial risk is the additional risk placed on the common stockholders as a result of
the decision to finance with debt. Conceptually, stockholders face a certain amount of
risk that is inherent in a firm’s operations – this is its business risk, which is defined
as the uncertainty inherent in projections of future operating income. If a firm uses
debt (financial leverage), this concentrates the business risk on common stockholders.
To illustrate, suppose ten people decide to form a corporation to manufacture disk
drives. There is a certain amount of business risk in the operation. If the firm is
capitalized only with common equity, and if each person buys 10 percent of the stock,
then each investor shares equally in the business risk. However, suppose the firm is
capitalized with 50 percent debt and 50 percent equity, with five of the investors
putting up their capital as debt and the other five putting up their money as equity. In
this case, the five investors who put up the equity will have to bear all of the business
risk, so the common stock will be twice as risky as it would have been had the firm

35
been financed only with equity. Thus, the use of debt, or financial leverage,
concentrates the firm’s business risk on its stockholders. This concentration of
business risk occurs because debt holders, who receive fixed interest payments, bear
none of the business risk.

2.2.2 Review of Journals

Hari Bahadur Khadka published an article “Leverage and the Cost of Capital: Some
Tests using Nepalese Data” where he expressed that the MM’s propositions about the
relationship between leverage and cost of capital in the context of Nepalese capital
markets are tried to analyze. The main objective of the study is to determine whether
the firm’s overall cost of capital and cost of equity decline with the increasing use of
leverage and the overall cost of capital. Therefore the leverage may not be regarded
as contributing variable to the cost of capital function for Nepalese firms. But finding
contradicts with the traditional approach of the capital structure theories. It is further
concluded that the cost of capital declines not only with leverage because of the tax
deductibility feature of interest charge. The relationship between the cost of equity
and leverage is also strongly negative. Besides leverage, the size, and D-P Ratio are
other important variables that affect the cost of capital in Nepalese context. The study
was based on 15 listed Nepalese firms at NEPSE that are using debt capital in their
total capitalization covering different sectors like banks, manufacturing industry,
insurance companies, Airlines companies, Hotels, Public enterprises etc.

Rima Devi Shrestha published an article entitled “Focus on Capital structure of

selected and listed public companies” and written that - most of these companies have
debt capital relatively very higher than equity capital. The study used data from 19
companies, which covered different sectors such as manufacturing, finance, utility
service and other allied areas. Consequently most of them are operating at losses to
the extent that payment of interest on loan has been serious issues. Most of the losses
are after charging interest on loan. It should develop a suitable capital structure
guideline to make public enterprise aware of its responsibility to repay the debt
schedules. Their generated income is sufficient to cover the operating expenses but
the profit is not sufficient the cover the interest to be paid for the debt capital it has
employed in the enterprises. Government has to analyze cost and risk rerun trade off.
36
Thus, capital structure needs to be made more determinate by realistic analysis of
cost. Lastly, she concluded that policy makers have to be careful in developing the
suitable capital structure guidelines in making public enterprises.

2.2.3 Review of Articles

PAUL MARSH (Marsh P, "The choice between Equity and Debt". The Journal of
Finance, vol XXVII No. 1, March 1982)
In the article, "the Choice between Equity and Debt", following issues are expressed
• Whether companies are having the targeted debt ratio.
• If debt ratio or financial instruments are influenced by other factors.
• How accurately can predict whether the company will issue equity or debt?
It has suggested that:
• While planning, company should consider future as well as current debt ratio.
• Any overall change in tax level could cause issuing companies to shift their
performance towards either debt or equity.
• Equity issues seem to be favorable as it provides strong share price and overall
market performance.

SUDHIR POUDYAL (Poudyal S, "Capital Structure: It's impact on value of a Firm,

Seminar on Emerging Issues and Challenges in Corporate Finance in Nepal,
Research Paper Submitted to Faculty of Management, TU, Kathmandu, Nepal, 2002)

"A study on Capital Structure: Its impact on value of a Firm," an article by Sudhir
Poudyal concentrated to examine the interrelationship between the objective of
achieving an optimal capital structure and to provide conceptual framework for the
determination of the optimal capital structure.

For this, a hypothetical firm is constructed and different assumptions are laid down to
analyze the effect of capital structure. Various statistical and financial tools like ratio
analysis are used to extract reasonable figure for the hypothetical firm. It is observed
that the minimum weighted average cost of capital, maximum value of the firm and
price per share are attended at debt ratio of 30%.

37
Furthermore, if there is flexibility to select capital structure in any proportion, optimal
capital structure range from 30% to 40%. An optimal capital structure would fulfill
the interest of equity shareholder and financing requirement of a company as well as
other concerned groups.
2.2.4 Review of Thesis
MISS SUVITA YADAV (Yadav S. “The Capital Structure Management of Buddha
Air Private Limited”, Master’s Thesis, T.U., Kathmandu, 2007)

The main objectives of the study are to analyze and examine the capital structure of
Buddha Air Private Limited, analyze trading on equity, find out the profitability
position, analyze the assets utilization. The study mainly used secondary data for the
analysis. The methodology used includes financial tools such as Ratio Analysis and
Statistical tools such as Correlation Co-efficient and Probable Error. The study has
found that Buddha Air is very highly levered. Debt capital is proportionately higher
than the equity capital. This higher debt capital is a serious implication from the
firm’s point of view. In this condition, the capital structure will lead to inflexibility in
the operation of the firm as creditors would exercise pressure and interfere with
management. Buddha Air has raised debt from different commercial banks and has to
pay heavy portion of profit as interest, so the payment of the interest will be
hazardous when profit is declining. So, it is suggested that Buddha Air Private
Limited should decrease its debt capital as far as possible, and company should
increase the equity proportion in financing its assets to be in a safe mode against
liquidation.

MR. CHANDRA GHIMIRE (Ghimire C. “A study on Capital Structure Management

on Commercial Banks of Nepal (special reference to EBL, NIBL, and HBL)”
Master’s Thesis, T.U., Kathmandu, 2007)
The basic objective of the study made by Mr. Chandra Ghimire was to analyze the
capital structure in terms of debts to shareholders equity, total debts to total assets,
interest coverage, return on capital employed, and return on shareholder’s equity of
selected commercial banks and provide suggestions to overcome various issues and
gaps.

38
The study used primary data as well as secondary data for the analysis. And the study
has used Financial Tools such as Ratio Analysis, EBIT- EPS Analysis, overall
capitalization rate, equity capitalization rate, total value calculation etc. and Statistical
Tools such as Karl Pearson’s correlation coefficient and probable errors.

The study concluded that all the commercial banks are using high percentage of total
debt in raising the assets and all the banks are able to pay interest. The study
suggested that the bank must reduce the level of debt by increasing equity level future
years to compensate the capital of debt. And Nepal Investment Bank Ltd. must reduce
its debt level for procurement of the assets. It is also suggested to bear low risk so that
additional return on capital and equity could be realized. This is essential from
investor attraction point of view. The bank needs to reduce its higher operational
expenses and control fluctuations in the earnings per share (EPS) to improve its
market price per share.

MISS PRAFULLA SHAKYA (Shakya P., “a study on Capital Structure of Nepalese

Commercial Banks (with special reference to Bank Of Kathmandu Ltd., Nepal
Investment Bank Ltd. and HBL)” Master’s Thesis, T.U., Kathmandu, 2006)
The basic objective of the study made by Miss Prafulla Shakya was to analyze the
interrelationship of capital structure with various important variables such as earning
per share, dividend per share and net worth of the commercial banks and to provide
suggestions to overcome various issues and gaps.

The study used primary data as well as secondary data. It used Financial Tool ratio
analysis and Statistical Tools Karl Pearson’s correlation coefficient and probable
errors.

The study concluded that all of the sample banks have fluctuating trend of long term
debt to total debt ratio. All the sample banks do not have appropriate ratio of long
term debt to capital employed and all the samples banks are able to cover the interest
but as higher interest coverage ratio is better. The study suggested that the banks
should follow the theoretical aspects of the capital structure management or give a bit
more attention in this matter and try to manage the activities accordingly. All these
banks should plan their capital structure well analyzing the possible financial
39
alternatives considering high return and least risk. And the banks should minimize the
financial and other expenses so the interest coverage ratio could be increased.
Researcher recommended to use less cost debt, improve strategy of promotion
activities, analyze and evaluate before making investments, and to increase the return
and decrease risk.
MISS AISHA MALIK (Malik A., “Capital Structure Management in Nepal”)
Master’s thesis, T.U, Kathmandu, 2009)

The thesis submitted by Miss Aisha Malik on the topic “Capital structure
Management in Nepal with reference with Nabil, NIBL, NTC, NEA and HGICL was
prepared with the objectives of analyzing the return on equity and assets, value of the
firm, relation between assets and liability etc. It has used secondary data for the study
covering the 5 years period from F.Y 2003 to 2007. It has used financial tool ratio
analysis and statistical tools correlation, trend analysis and regression analysis for
drawing the conclusion of the study.

The profit trend of the NTC is found in increasing trend which is followed by Nabil
and NIBL too. On the other hand, NEA is in heavy loss trend with HGICL declining
profit trend. Correlation between deposit and credit of banks seems to be
approximately +1 whereas of NEA and NTC is approximately -1 and researcher has
not disclosed of HGICL. Similarly, the values of the firms are highest of NTC and
followed by NEA, Nabil, NIBL and HGICL. Return on capital employed is
satisfactory of all selected samples as well as return on shareholders’ equity. On the
same way other ratios calculated are also found satisfactory.

It discovered that the firms are using more debt and recommended to acquire optimal
level of capital structure. NEA has negative degree of financial leverage due to heavy
losses it has occurred and high level of fixed costs in comparison to others and need to
seek for profit for long run survive as well as sound financial plan. Last but not the
least it has disclosed that the firms have not considered the capital structure decisions
which ultimately leads to the increase in the value of the firm.

Even though the study tried a lot to discover the facts related to the capital structure
and its importance using different tools, the study failed to match the study with its
40
objectives mentioned in the thesis. The conclusion of the study is not drawn whereas
findings of the study are not able to relate the objectives. It has well reviewed the
literature but still it failed to formulate the proper research design which helps to
guide the study in shaping the study with objectives of the thesis.

MISS URMILA KANDEL (Kandel U., “A comparative analysis of capital structure

of commercial banks with reference to HBL and BOK”, Master’s thesis, Tribhuvan
University, Kathmandu, 2008)

Kandel with a long history of banking world as well as Nepal formulated the
objectives of the study as to evaluate the role of capital structure on growth of
commercial banks in Nepal , examine present capital structure of commercial banks
of Nepal and to state a relationship of capital structure with EPS, DPS and net worth.
Out of 25 listed commercial banks of Nepal, 2 banks are selected as samples for the
study and study is based on cent percent secondary data of the sample banks. With
well research design it focused on the various tools such as ratio analysis, leverage
analysis, traditional analysis, capital structure analysis and MM analysis on the study.

From the study it was found that the commercial banks of Nepal are not using large
portion of debt in their capital structure which is shown by finding of the study the
long term debt to total assets ratio 0.046 of HBL and 0.060 of BOK in average and its
interest coverage ratio is satisfactory. The return on shareholders’ equity of HBL is
22% and 21% of BOK which is good indication and EPS of Rs.53.26 HBL and
Rs.32.50 also shows the same. It has tried to test the MM proposition that value of
firm is affected by the use of debt in capital structure by using MM model which has
given mixed result that increase in debt causes increase in value of firm in some years
whereas in some years increase in debt caused decrease in value of the firm. On the
correlation analysis it found the relation between long term debt and EPS is
insignificant but the relationship between EBIT and DPS is significant.

Researcher recommends to have knowledge on capital structure and minimize risk of

the shareholders’ even though they are having high return in present policy. The thesis
mentioned lots of tools for analysis on research design but fail to use them on thesis
whereas the conclusion on relevant or irrelevant of capital structure on value of firm is
41
still not able to find. The findings of the thesis will be difficult to indicated for the
whole commercial banks of Nepal as the thesis title suggest because the sample size is
not sufficient which represent only 8% of the total population which is so much far
below the total population.

M/S CHANDANI SHRESTHA (Shrestha C., “A study on Capital Structure

Management of listed manufacturing companies” with special reference to JSML,
BNL, NLOL and NLL, unpublished Master’s Thesis, Tribhuvan University,
Kathmandu, 2010)

Chandani Shrestha of Khwopa College prepares her undergoing thesis subject capital
structure management of listed manufacturing companies. The thesis is prepared with
the main objective to know the existing capital structure of manufacturing companies
optimal or not with other objective to analyze the cost of capital and profitability and
access the debt servicing capacity of the selected Nepalese manufacturing companies.
With the help of secondary data of selected samples using the ratio analysis,
correlation and regression analysis tried to draw the conclusion according to her
research design describes.

She has concluded the thesis with the major findings that the listed manufacturing
industries have in an average positive degree of operating leverage as well as financial
leverages. Some manufacturing industries found to be used 82.82% long term debt
and some haven’t at all. The calculation of profit margin ratio found out that less than
5% only in average profit is making according to the sample study of four
manufacturing companies of Nepal taken for study. Due to high use of leverage the
EPS also not satisfactory and book value per share of these industries is less than their
face value. Only negligible companies are distributing dividend on irregular basis but
most of haven’t given dividend since a long time. In the correlation and regression
analysis also found similar results indicating the need of restructure of capital of the
manufacturing industries and need of proper management system to let survive the
existing manufacturing industries of Nepal except some of can be counted in fingers.

The recommendation given by researcher was to reduce the level of debt because the
heavy loss is incurred after charging interest on debt capital only. The research is very
42
much useful to manufacturing industries. Still the researcher has to go through more
review of literature and increase the sample from 4 as the total no. of listed
manufacturing companies in NEPSE till research period reached more than 35 which
may not represent the whole population.

CHAPTER III

3. RESEARCH METHODOLOGY
The term research methodology refers to the various segmental steps to be adopted by
a researcher in studying a problem with certain objectives in a view. It describes the
methods and process applied in the entire aspect of study. This process of
investigation involves a series of well thought out activities of gathering, recording,
analyzing and interpreting the data with the purpose of finding answers to the
problem. Thus the entire process by which attempt to solve problems is called
research.

It is significant to have appropriate choice of research methodology that helps to make

the research study meaningful and more scientific. Therefore, appropriate
methodology has been followed to meet the objectives of the study. So, the
methodologies of this research include the research design, research question, period
covered, selection of enterprises, types and sources of data, data processing
procedures, presentation of data and method of analysis.

3.1 Research Design

The term “research” refers to the systematic and organized effort to investigate a
specific problem that needs a solution. “Design” means planning to carry out
investigation conceived to obtain an answer to research question. Thus research
design is a plan, structure and strategy of investigation conceived to obtain possible
solution to the research problem in one’s area of study.

Selection of appropriate research design is necessary to meet the study objectives. The
main objective of the study is to analyze capital structure of the selected organizations
in Nepal. It emphasizes on descriptive plus analytical study of collected data of Profit

43
& Loss Account and Balance Sheet over the period of time. Comparatively this study
has been designed as a descriptive cum analytical design. This study is concluded
with the measurable suggestion to strengthen or improve the capital structure
management in the position of the selected firms.

3.2 Sources of Data

The research needs data to draw its conclusion regarding objectives of study. The data
may be qualitative or quantitative. Generally the quantitative data give clear
information for the conclusion drawn from the study rather than qualitative data.
Quantitative data are based on arithmetical figures so that they give clear and true
information. Either qualitative or quantitative data that needed to be collected for any
research study which can be gathered through either primary source or secondary
source.

The primary source is the 1st hand data that is directly collected by researcher using
own skill and different techniques of data collection method. It needs lots of time and
dedication to collect primary data. On the other hand, secondary source is the 2 nd hand
data that are collected by other related to research study.

Mainly, the study is conducted on the basis of secondary data. The required data are
extracted from balance sheets, profit and loss accounts and different financial
schedules of sample banks’ annual reports, websites. Other supplementary data are
collected from a number of institutions and regulation authorities like Nepal Rastra
Bank, Nepal Stock Exchange Ltd., security exchange board, etc. and from related
websites. The research study is based on the past 5 years (F.Y 2004 to 2008) data of
the sample banks provided on their annual reports and websites.

3.3 Population and Sample

Population here means set of data consisting of all conceivable observations of a
certain phenomenon. The total no. of observations that comes under the research
study is called population. Generally population will be large and study of whole
population will be almost all impossible such as checking the blood where to take all
and test that is impossible. So that it is use to take some samples only of the
population that represent the whole population and study will be fast and easy. In this
44
research study the population represents the total no. of joint venture commercial
banks operating in Nepal till date. The total no. of joint venture commercial banks
operating in Nepal till the study period is 9 whose list is given above also in unit I
table no.1. So total population of the study is not so big and neither small for MBS
thesis study.
A Sample contains only part of these observations. In statistics, a sample is a subset of
a population. Typically, the population is very large, making a census or a complete
enumeration of all the values in the population impractical or impossible. The sample
represents a subset of manageable size. Samples are collected and statistics are
calculated from the samples so that one can make inferences or extrapolations from
the sample to the population. This process of collecting information from a sample is
referred to as sampling. For research purpose 3 joint venture banks operating in Nepal
are selected on the basis of their capital structure difference rather than using a
particular method of sampling technique in order to get the exact situation of capital
structure of joint venture commercial banks of Nepal.
Population Sample Banks
1. Nabil Bank Ltd.
2. Standard Chartered Bank Nepal Ltd.
3. Himalayan Bank Ltd.
4. Nepal SBI Bank Ltd. 1. Everest Bank Ltd.
5. Nepal Bangladesh Bank Ltd. 2. Himalayan Bank Ltd.
6. Everest Bank Ltd. 3. Nepal Investment Bank Ltd.
7. Bank of Kathmandu Ltd.
8. Nepal Credit and Commerce Bank Ltd.
9. Nepal Investment Bank Ltd. Sample size : 33.33%

3.4 Tools for Analysis

Method of analysis is an important part in research work. The careful study of
available facts for proper understanding of data and extraction of the conclusion from
them on the basis of established principles and sound logic is Analysis.

The analysis of data requires a number of closely related operations such as

establishment of categories, the application of these categories to raw data through
collecting, tabulation and then drawing statistical interlays. On the basis of research

45
problem and objectives of the study data and information needed is identified and
collected. The collected data are properly processed and arranged in the form of the
table for simplicity. Following Financial and statistical tools have been used for
analysis and interpretation of arranged data.
3.4.1 Financial Tools for Analysis
To evaluate the performance of any organization financial tools are very useful to
determine the strengths and weakness of a firm as well as its historical performance
and current financial condition. Ratio is an important analytical tool to summarize the
large quantities of data and to make quantitative judgments about organization. The
financial tools employed in this study basically represent ratio analysis, leverage
analysis and EBIT-EPS analysis and others.

Long term debt to Total Assets ratio

Long-term debt to total assets ratio reflects the relative claims of creditors against the
assets of the firm. In other words, this ratio indicates the relative proportion of debt in
financing the assets of the firm. This ratio is also known as external equity ratio and is
calculated as follow:
Long term debt
Debt ratio =
Total Assets
Where, long term debt includes debentures and loan not maturing with one year.
Creditors prefer low debt ratios because the lower the ratio, the greater the cushion
against creditor’s loses in the event of liquidation. Stockholders, on the other hand
may want more leverage because it magnifies expected earnings.

Interest coverage ratio (Debt capacity ratio)

This ratio is called “Time Interest Earned Ratio (TIE Ratio).” This ratio indicates the
ability of the company to meet its annual interest costs or it measures the debt
servicing capacity of the firm. In other words, it measures the debt servicing capacity
of a firm in so far as the fixed interest on the total loan is concerned. It is determined
by dividing the operating profit or Earning before Interest and Taxes (EBIT) by the
fixed interest (I) change on loan. Thus, in the calculation of Interest Coverage Ratio,
IC-Ratio in times is expresses as.

46
 EBIT
Interest Coverage Ratio (in Times) = Interest Charge (I)

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

service interest payment on a loan. This ratio is also known to determine whether a
firm has the ability to meet its long-term obligations. From the creditors point of view
the larger the coverage the greater the ability the firm to handle charges.
EBITDA Coverage Ratio
The TIE ratio is useful for assessing a company’s ability to meet interest charges on
its debt, but this ratio has two shortcomings: (i) Interest is not the only fixed financial
charge, companies must also reduce debt on schedule and many firms lease assets and
thus must make lease payments (ii) EBIT does not represent all the cash flow
available to service debt especially if a firm has high depreciation and/ or
amortization charges. To account for these deficiencies, bankers and others have
developed the EBITDA coverage ratio, defined as follows:

EBITDA + Lease Payments

EBITDA Coverage Ratio = Interest + Principal Payment + Lease Payments

The EBITDA Coverage ratio is most useful for relatively short-term lenders such as
banks, which rarely make loans (except real estate backed loans) for longer than about
five years. Over a relatively short period, depreciation-generated funds can be used to
service debt. Over a longer time, those funds must be reinvested to maintain the plant
and equipment or else the company cannot remain in business. Therefore, banks and
other relatively short-term lenders focus on the EBITDA coverage ratio whereas long-
term bondholders focus on the TIE ratio.

Return on Shareholders Equity

Shareholders are the owners of the company. To measure the return of shareholders,
can use return on shareholders' equity. This ratio analyze if the company has been
able to provide higher return on investment to the owners or not. It is calculated as:
Net Profit After Tax
Return on Shareholders’ Equity (ROSE) = Shareholde rs' Equity

A company's owners always prefer higher ratio of return on shareholders' equity. And
higher ratio represents the higher profitability of the firm and vice versa.

Basic Earning Power (BEP) Ratio

47
The basic earning power ratio is calculated by dividing earning before interest and
taxes (EBIT) by total assets as follows:
EBIT
Basic Earning Power Ratio =
Total Assets

This ratio shows the raw earning power of the firm’s assets, before the influence of
taxes and leverage, and it is useful for comparing firms with different tax situations
and different degrees of financial leverage.
3.4.2 Statistical Tools for Analysis
In course of data study and analysis related to the study different statistical tools are
often employed as well as interpretation of data taking consideration to the objectives
of the study. Following statistical tools are used during the data presentation and
analysis section of the thesis.
• Trend Analysis
• Coefficient of correlation
• Regression Analysis

Trend Analysis:

Today, trend analysis often refers to the science of studying changes in social
patterns, including fashion, technology and the consumer behavior. The term "trend
analysis" refers to the concept of collecting information and attempting to spot a
pattern, or trend, in the information. Trend analysis is a mathematical technique that
uses historical results to predict future outcome. In another words, an aspect of
technical analysis that tries to predict the future movement of a stock based on past
data. Trend analysis is based on the idea that what has happened in the past gives
traders an idea of what will happen in the future.

Ratio analysis is not able to show the fluctuation of the financial position of the
companies with time. The financial position is improving or deteriorating over the
years show by the use of trend analysis. The significance of a trend analysis or ratios
lies in the fact that the analysis can know the direction of movement, i.e. whether the
movement is favorable or unfavorable. For example, the ratio may be low as
compared to the norms and standard but the trend may be upward. On the other hand,

48
though the present level may be satisfactory, the trend may be a declining one. Thus,
trend analysis is of great significance to the study.

Trend analysis tries to predict a trend like a bull market run and ride that trend until
data suggests a trend reversal (e.g. bull to bear market). Trend analysis is helpful
because moving with trends, and not against them, will lead to profit for an investor.
In this study efforts will go for trend of EPS and Net Income with the help of past five
years records of EPS and Net Income.
Coefficient of correlation
The correlation is one of the most common and most useful statistics. A correlation is
a single number that describes the degree of relationship between two variables.
Correlation is a statistical technique that can show whether and how strongly pairs of
variables are related. For example, height and weight are related; taller people tend to
be heavier than shorter people. The main result of a correlation is called the
correlation coefficient (or "r"). It ranges from -1.0 to +1.0. The closer r is to +1 or -1,
the more closely the two variables are related. If r is close to 0, it means there is no
relationship between the variables. If r is positive, it means that as one variable gets
larger the other gets larger. If r is negative it means that as one gets larger, the other
gets smaller (often called an "inverse" correlation).

In case of simple correlation, it studies the degree of relationship between two

variables: independent and dependent variables. But in real life so many independent
variables do affect the dependent variable and the study on degree of relationship
between a single dependent variable and a number of independent variables in
combination is called multiple correlation analysis which is denoted by R1.23 where
the subscript left to the dot is the dependent variable and to right is the independent
variables. Let us consider three variables for this thesis that X1, X2 and X3 then
R1.23 = Correlation coefficient between dependent variable X1 and joint effect of the
independent variables X2 and X3 on X1.

The formula for the calculation of multiple correlation coefficients can be expressed
in terms of r12, r23 and r13 as follows:

49
 2 2
r + r13 − 2 × r12 × r23 × r13
R1.23 = 12 2
1 − r23
The square of multiple correlation coefficients is known as the coefficient of multiple
determinations and is used to interpret the value of multiple correlation coefficients. It
is the fraction that represents the proportion of total variation of dependent variable
that is explained by regression plan. Coefficient of multiple determination measures
how well the multiple regression plan fits the data. For e.g: If R 1.23 = 0.9 then
coefficient of multiple determination R21.23 = 0.81. This tells us that 80% of the total
variation in X1 is due to the variables X2 and X3 and remaining is due to the other
factors.
Regression Analysis:
The term ‘regression’ literally means ‘stepping back towards the average’. The
concept of regression was first given by the English biometrician Sir Francis Galton
in reports of his research on heredity. The regression analysis is used to estimate the
likely value of one variable from the known value of other variable. The cause and
effect relationship is clearly indicated through regression analysis than by correlation.
There are two types of variables in regression analysis – dependent variable and
independent variable. The dependent variable is also known as regressed or explained
variable while the independent variable is called as regressor or predictor or
explanatory variable. It studies the statistical relationship between variables. The main
objective of regression analysis is to predict or estimate the value of dependent
variable corresponding to a given value of independent variables.

Multiple Regression equation is the algebraic relationship between one dependent

variable and two or more independent variables. This relationship is used to estimate
the value of dependent variable for the given values of independent variables. In this
thesis discussion to one dependent variable X1 and two independent variables X2 and
X3, So that the multiple regression equation for the observed data is given by,
X1 = a + b1X2 + b2 X3
Where,
a = point of intercept on y-axis
b1 = corresponding change in X1 for each unit change in X2 while X3 is held constant
b2 = corresponding change in X1 for each unit change in X3 while X2 is held constant

50
The values of constants a, b1 and b2 are determined by solving simultaneously
following three normal equations obtained by the method of least squares;
∑X 1 = na + b1 ∑ X 2 + b2 ∑ X 3 - - - (i)

∑X 1 X 2 = a ∑ X 2 + b1 ∑ X 2 + b2 ∑ X 2 X 3
2
- - - (ii)

∑X 1 X 3 = a ∑ X 3 + b1 ∑ X 2 X 3 + b2 ∑ X 3
2
- - - (iii)

CHAPTER IV

4. DATA PRESENTATION AND ANALYSIS

4.1 Introduction to Data Presentation and Analysis
The part data presentation and analysis is the most important section of this thesis
where the collected data after manipulation have been presented in easy and attractive
form related to the thesis in various tables, diagrams etc. To make the research
analytical, the presented data are analyzed, using different appropriate tools, and the
findings are tried to synthesize to the objectives of the study. It is the systematic
disclosure of the data related to the study and analysis of the data in a corrective way
drawing the conclusion of analysis and finally matching it with the statement of
problems of the research study. Here attempt has been made to analyze the data
collected from EBL, HBL and NIBL related to this study systematic presentation so
that descriptive and analytical research design can be applied effectively and
reviewers’ can grasp the gist of the study easily in a convenience way.

4.2 Present Scenario of Joint Venture Commercial Banks (JVCBs) of Nepal

4.2.1 Presentation of Current Capital Structure
Chapter I and II cleared about the capital and capital structure of the banks. So here
an attempt has been made to present the existing capital structure mix followed by
sample banks. It helps to clearify more on the capital sturcutre mix and the current
capital structure mix followed by the JVCBs of Nepal.

51
 FigureThe
No. pie
10 alongside represent the capital structure mix of EBL in F.Y 2008 with total
Current Capital Structure of EBL capital of Rs.1,138,821,000. Out of its
18% 26%
total capital Rs.300,000,000 is financed
by debt which represent 26% of total
capital. The remaining 74% is financed
56% Debt by using share capital. EBL has
Equity
Pref. Share currently raised 24% of share capital
(18% of total capital) by 7% cumulative
convertible preference share amounting
Rs.200,000,000 and Rs.638,821,000 (56% of total capital) by common equity.
Figure
The current capital structure of HBL in the form of pie chartNo.
can11be presented as it
Current Capital Structure of HBL
shown in the figure alongside where
the overall pie is divided into two
71%
parts: Debt and Equity. It shows that
29%
the HBL is currently financed its
required capital some portion by
Debt Equity
using debt and some portion by
common equity. In the figure the
black shaded part of pie represent the Debt whereas the dotted shaded part represent
the equity financing.

The total authorised capital of HBL is Rs.2,000,000,000 out of which

Rs.1,216,215,000 is issued as well as paid up capital. HBL has not used preference
share but used debt as a source of capital. 29% of its total capial employed is finaced
by 8% Himalayan bank bond of face value Rs.1000 which totals Rs.500,000,000. The
remaining 71% totaling Rs.121,621,500 is financed issuing comman share to public.

Figure No. 12
Current Capital Structure of NIBL NIBL’s capital structure includes
mix of debt and common equity
70%
shown in pie to left. In F.Y 2008 it
30% has authorized capital of Rs.4
billion. It has issued
Debt Equity
Rs.2,409,097,700 and paid up
Rs.2,407,068,900 i.e 70% of total
52
capital financing. The bank currently used worth Rs.1,050,000,000 as a debt financing
which is 30% of current capital financing of NIBL comprises 7.5% debt
Rs.300,000,000, 6% debt Rs.250,000,000, 6.25% debt Rs.250,000,000 and 8% debt
of Rs.250,000,000 according to the annual report published by NIBL of F.Y 2008.

From the three presentation of the capital structure mix it can be concluded that
JVCBs of Nepal are using debt and equity mix in capital structure and started using
the preference share also in capital financing. The overall financing of JVCBs capital
is dominated by common equity and the mix of debt and preference share should be
on coming days to maximize value of the firm.
4.2.2 Presentation of operating profit of JVCBs of Nepal

Nowadays mostly banks whenever releases their success report they never forget to
highlight their operating profit earned during the fiscal year. The operating profit
represents the income left after deducting the operating expenses of the fiscal year. In
a true sense, the increase in operating profit does not mean to all time increase the
value of the firm which can get clearly after completion of the thesis. Here effort has
been made to present the last five years operating profit and its trend with help of
table and bar diagram.

The table below shows the operating profit (EBIT) of the sample banks from the F.Y
2004 to 2008 which help to have a comparative study and acquire the operating
income trend of the JVCBs of Nepal as well as commercial banks.

Table No. 4
Comparative NOI of EBL, HBL and NIBL
Banks
EBL HBL NIBL
F.Y
2004 Rs. 277,828,439 Rs. 666,059,177 Rs. 335,566,256
2005 377,200,894 684,092,180 544,310,564
2006 487,972,659 688,886,636 727,510,111
2007 718,133,853 954,953,506 1,121,956,413
2008 972,950,326 1,159,945,198 1,310,854,953

The table above presents the operating profit earned by the sample JVCBs of Nepal
from the F.Y 2004 to 2008. In this table if one looks at EBL, the EBIT of the bank is

53
increased every year against former fiscal year. The same kind of result could observe
in the 3rd column of table represented HBL. The HBL’s EBIT also showed an
increasing over the years than previous year. The 3rd sample bank NIBL’s EBIT on
column 4th crystal clears that the bank is able to generate more and more operating
income every year in comparison to its own previous year.

From the EBIT presentation table what it can be said that in the current situation the
JVCBs of Nepal are performing better and able to increase the EBIT with
management of the banking operations.
The operating profit or operating income (EBIT) after deducting the operating
expenses of the three sample banks EBL, HBL and NIBL are graphically shown
below with the help of bar diagram.
Figure No. 13
Operating Profit on Past Five Years of Sample Banks
EBL

1400000000 HBL
NIBL
Operating Profit in Rs.

1200000000
1000000000
800000000
600000000
400000000
200000000
0
2004 2005 2006 2007 2008
Fiscal Years

In the above diagram, the x-axis represents Fiscal Years and y-axis by operating
profit. The dark bar represent operating profit of the EBL which can be seen taller and
taller as the fiscal year passes which indicates the incremental operating profit of EBL
in each and every years. The middle bar between two bars of every fiscal years shaded
by diagonal line leads the HBL’s EBIT. It increased in snail speed during in 2005 and
2006 whereas it increased remarkably in the year 2007 and 2008. The dotted bar
shows the EBIT trend of NIBL whose height increased as the year passed describes
the noticeable management of operation of bank increasing the operational income of
the bank.

54
4.2.3 Presentation of EPS trend of JVCBs of Nepal
Earning per Share (EPS) is the earning received by a share from the profit of the year.
General concept in mind is that if the bank’s disclosed profit (operating profit) is
increased EPS also increases. But this perception is wrong because, interest on bond,
tax and others expenses are deducted before distribution of profit to shareholders. The
EBIT presented above shows, the operating income of the banks are increased every
year in an increasing trend. In this section the EPS of F.Y 2004 to 2008 are presented
with help of line graph to analyze the EPS trend of selected banks and find out EPS
increases with increase in EBIT or not.
Figure No. 14
Trend Line of EPS of Sample Banks
120
100
80
EPS in Rs.

60
40
20
0
2004 2005 2006 2007 2008
EBL 54.22 62.78 78.42 91.82 99.99
HBL 47.91 59.24 60.66 62.47 61.9
NIBL 39.5 59.35 62.57 57.87 37.42

The line graph above is drawn with the help of EPS of sample JVCBs of Nepal’s EPS
given in its annual reports published each year. It is given data table also along with
graph for convenience understanding. The EPS of EBL is comparatively higher than
others which dominated the trend line lying at above other two banks’ trend line. The
EPS trend of EBL is in increasing trend. In the EBIT study it found EBIT in
increasing trend and here EPS also found in increasing trend.

The thickest trend line represents the EPS trend of HBL in the past five fiscal years
from 2004 to 2008. The highest EPS paid by HBL is in the year 2007 of Rs. 62.47. It
was in increasing trend from 2004 but after 2007 its trend direction sloped down. It
was able to pay only Rs. 61.90 rupee which is 0.57 paisa less than previous year. In
the EBIT presentation it was found that EBIT of HBL is increased in 2008 than 2007.
So it showed the increase in EBIT always does not increase EPS.

55
The thinnest trend line represent NIBL’s EPS trend. It is observed that it increased
from Rs. 39.5 in 2004 to Rs.59.35 and Rs.62.57 in 2005 and 2006 respectively but
decreased to Rs.57.87 in 2007 continuing the trend to Rs. 37.42 in 2008. Whereas it
found NIBL’s EBIT in increasing trend but EPS in fluctuating trend.

Thus it is concluded that though the EBIT is increased the EPS may not increase. It is
because interest on debt, return on preference shares, tax etc expenses are deducted
before income distribution to the common shareholders.
4.3 Financial Analysis
Financial ratio analysis is designed to determine the relative strengths and weakness
of business operations. It also provides a framework for financial planning and
control. Financial managers need the information to analyze as well as to evaluate the
firm’s past performance and to map future plans. Financial analysis concentrates on
financial statement analysis, which highlights the key aspects of firm’s operation.
Here attempt has made to evaluate some debt related ratios and others that help to
identify the strength and capability of the banks to handle the debt on its capital
structure and related to it.

4.3.1 Debt Ratio

The ratio of total debt to total assets measures the percentage of the firm’s assets
financed by creditors. The lower the ratio the greater the protection afforded by
creditors in the event of liquidation. The industry average of debt ratio is 30%.

Table No. 5
Debt Ratio of Everest Bank Limited

Year Total Debt Total Assets Total Debt

Debt Ratio =
Total Assets
2004 775,368,432 11,732,516,418 6.61%
2005 1,079,364,640 15,959,284,687 6.76%
2006 1,961,381,060 21,432,574,300 9.15%
2007 1,020,443,592 27,149,342,884 3.76%
2008 990,574,715 36,916,848,654 2.68%

Average Debt Ratio of EBL 5.79%

56
The above table shows the total debt portion of EBL on its assets financing. It has
used minimum 2.68% in F.Y 2008 and maximum of 9.15% of total assets during F.Y
2006. On an average, EBL uses 5.79% of total assets financing needed by raising debt
from creditors. This indicates that the bank is financing its assets from its own source.
This supports the concept that lower the debt ratio is good for both creditors and
organization. EBL’s debt ratio is found in satisfactory level as well as safe level. EBL
uses less debt financing only may be due to unconfident of management to earn the
consistent income due to fluctuating and unsecured economic condition.
Table No. 6
Debt Ratio of Himalayan Bank Limited
Year Total Debt Total Assets Total Debt
Debt Ratio =
Total Assets
2004 979,028,756 27,418,157,873 3.57%
2005 964,953,390 39,460,389,672 2.45%
2006 1,181,370,476 33,519,141,111 3.52%
2007 1,537,543,324 36,175,531,637 4.25%
2008 1,346,836,284 39,320,322,069 3.43%

Average Debt Ratio of HBL 3.44%

The above table presents HBL’s of debt ratio is for last five years from 2004 to 2008.
Within these study periods, HBL has used a minimum debt for financing its assets.
Less than 5% debt is used by HBL. In the F.Y 2005 bank’s debt ratio was 2.45%
which is the lowest debt ratio over the study period and maximum debt ratio was
4.25% in F.Y 2007. The average debt ratio of HBL is 3.44% which is less than
industry average. So, it could be concluded that the debt ratio maintained by HBL is
in secured level from both organizational and creditors’ point of view.

Table No. 7
Debt Ratio of Nepal Investment Bank Limited
Year Total Debt Total Assets Total Debt
Debt Ratio =
Total Assets
2004 839,317,041 16,274,063,706 5.16%
2005 856,446,334 21,330,137,542 4.02%
2006 1,179,920,126 27,590,844,761 4.28%
2007 1,617,242,931 38,873,306,084 4.16%
2008 1,881,113,110 53,010,803,126 3.55%

57
 Average Debt Ratio of NIBL 4.23%

The average debt ratio, calculated based on past five years data covering F.Y 2004 to
2008 is 4.23% for NIBL is shown in above table. It observed that the NIBL used
minimum 4.02% and maximum of 5.16% debt financing in its total assets financing.
The average debt ratio is found below the industry average. The lower debt ratio
indicates the self sufficiency of organization, which shows the capital structure of
NIBL is in good condition.
4.3.2 Interest Coverage Ratio
The ratio of earnings before interest and taxes (EBIT) to interest charges is called
Interest Coverage Ratio. This ratio measures the ability of the firm whether it could
meet its annual interest payments or not. This ratio is also known as time interest
earned (TIE) ratio which measures the debt servicing capacity of a firm. Higher TIE
ratio shows the financial soundness of the firm. Generally higher the TIE ratio is
preferred because higher the ratio indicates higher capacity to bear the high volume of
interest charge and vice versa.

Table No. 8
Calculation of Times Interest Earned Ratio of EBL
Year EBIT Interest EBIT
TIE Ratio =
Interest
2004 277,828,439 4,604,057 60.34x
2005 377,200,894 18,004,726 20.95x
2006 487,972,659 18,000,000 27.11x
2007 718,833,853 23,634,098 30.42x
2008 972,950,326 25,397,027 38.31x

Average TIE Ratio of EBL 35.43x

The TIE ratio of EBL fallen down to 20.95x in F.Y 2005 from 60.34x of F.Y 2004. It
showed an increasing trend over the year. The average TIE ratio is found 35.43x.
Higher the TIE ratios better the healthiness of the organization to cover its fixed
charge interest on debt employed by the bank. So, the overall position of the EBL on
covering its interest charge related to its loan and debt is good. Table shows that
except in the initial year 2004, the TIE ratio is below the average. From this angle, the
financial position is not satisfactory.

58
The TIE Ratio is the highest among the three selected joint venture commercial banks
for the study. Even though its average TIE ratio is 35.43 times F.Y 2005, 2006 and
2007 is below the average whereas in F.Y 2004 and 2008 only it is more than average.
It may be attributed to the decrease in income due to internal war period in the
country and the increase in use of debt. During study period, Nepal has been through
critical situation due to internal war at which almost of all the sectors of Nepal has
been through the trough period of the business cycle. In such unfavorable condition
also the banks maintained its reputation and profit.

Table No. 9
Calculation of Times Interest Earned Ratio of HBL

Year EBIT Interest EBIT

TIE Ratio =
Interest
2004 666,059,177 36,215,162 18.39x
2005 684,012,180 34,962,414 19.56x
2006 688,886,636 34,791,155 19.80x
2007 954,953,506 50,473,520 18.92x
2008 1,159,945,198 95,225,408 12.18x

Average TIE Ratio of HBL 17.77x

The above table shows the TIE ratio for the HBL from F.Y 2004 to 2008 and their
average. The HBL has high interest coverage of 19.80x and a lowest of 12.18x is
maintained. The overall of 17.77x TIE ratio in average maintained by HBL is
satisfactory in banking industry.

The average TIE ratio of the HBL is below TIE ratio of last four years . The creditors
of HBL have comparatively higher level of risk than creditors of EBL. The TIE ratio
of the HBL seems to be in decreasing trend. It decreased from 18.39 times in F.Y
2004 to 12.18 times in F.Y 2008. A decrease in TIE ratio is questionable. It may be
attributed from management of the bank, which is not investing the capital in
profitable sector or the management’s inability to recover disbursed loan.

Table No. 10
Calculation of Times Interest Earned Ratio of NIBL

59
 Year EBIT Interest EBIT
TIE Ratio =
Interest
2004 333,566,256 26,229,974 12.72x
2005 544,310,564 28,267,818 19.26x
2006 727,510,111 40,495,699 17.97x
2007 1,121,956,413 75,785,662 14.80x
2008 1,310,854,953 90,300,749 14.52x

Average TIE Ratio of NIBL 15.85x

The NIBL, showed its average interest coverage ratio at a lowest of 15.85 times which
shows the NIBL’s ability to cover the fixed charge interest on its debt financing. It has
a maximum of 19.26 times of interest coverage ability for security of interest
payment. Similarly The EBIT of the bank is at a minimum of 12.72 times of its
liability to pay interest. So, the NIBL’s study result gives the conclusion it has
maintained good TIE ratio that coverage all interest on debt very well.

Although the income of NIBL is average of 15.85 times of its fixed cost interest to be
bear on debt capital, it is observed that in 2007 and 2008 its TIE ratio is going below
the average level. It goes down to 14.80 times in F.Y 2007 and further decreased to
14.52 times during the F.Y 2008. It may be attributed to increased in total debt capital
financing by the NIBL and comparatively lower level of increase in the operating
income of the bank which caused the higher interest charge and the increased EBIT is
not able to meet the increased debt capital financing. So, the bank should focus
towards increase its operating income in comparison to increased debt capital
financing by the bank which ensures the debt holders for the security of their
investment and belief towards the management that they are effectively using the debt
financing.

The TIE ratio for EBL, HBL and NIBL gives a clear picture that the EBL has the
highest TIE ratio among the three selected banks with an average of 35.43x and the
NIBL has the lowest TIE ratio of 15.85x. It is also observed that the TIE ratio of more
of the JVCBs of Nepal are decreasing in these years due to high volume of debt
financing and higher level of competition among the private commercial banks and
JVCBs for the liquidity and increased deposit interest rate and decreasing interest rate
on the loan disbursement.

60
From the above analysis of the interest coverage ratio or TIE ratio, it could be
concluded that overall JVCBs of Nepal have good TIE ratio and are able to secure the
annual fixed charges to be paid on debt financing made by JVCBs. The debt holders
are secured to receive interest on their investment. The JVCBs of Nepal are utilizing
the debt capital efficiently and effectively but still their effort is not sufficient due to
decreasing TIE ratio of most of the JVCBs of Nepal.

4.3.3 EBITDA Ratio

EBITDA ratio is similar to TIE ratio but it is more inclusive because it recognizes that
many firms lease assets and have sinking funds payments associated with debt. It is
also known as fixed charge coverage ratio. A ratio whose numerator includes all cash
flows available to meet fixed financial charges and whose denominator includes all
fixed financial charges more than interest. A problem with TIE ratio is that it is based
on EBIT, which is not really a measure of cash available to pay interest. The reason is
that depreciation and amortization, a non cash expense has been deducted out. So for
convenience of fixed charges coverage EBITDA coverage ratio is better.
Table No. 11
Comparative EBITDA Coverage Ratio of Sample Banks
Banks
EBL HBL NIBL
F.Y
2004 2 1 1
1.01 x 9.89 x 1.59 x
2005 1 2 1
3.34 x 1.54 x 7.73 x
2006 2 2 1
1.78 x 2.17 x 9.47 x
2007 1 2 1
7.36 x 0.63 x 5.89 x
2008 1 1 1
9.82 x 3.13 x 5.76 x
Average EBITDA
18.66x 19.49x 16.09x
Coverage Ratio
Source: Annex 1, 2 and 3

A common variation on EBITDA is earning before interest, taxes, depreciation and

amortization (EBITDA). Here amortization refers to a non cash deduction very
similar conceptually to depreciation, except it applies to an intangible asset (such as a
patent) rather than a tangible asset (such as a machine). Since depreciation and

61
amortization refers non cash outflow, the deducted amount also could be used to meet
the fixed charges.

The above table shows the EBITDA coverage ratio of EBL, HBL and NIBL. The
average EBITDA coverage ratio of HBL is 19.49x, the highest whereas NIBL 16.09x
is the lowest. EBL has 18.66x average EBITDA coverage ratio. The EBL and NIBL
reduced its EBITDA coverage ratio than TIE ratio because of its high lease payments.
From the above study it could be conclude that if the firm has not need to pay lease
payments, its EBITDA coverage ratio higher than TIE ratio else generally EBITDA
coverage ratio higher than TIE ratio due to availability of the deducted deprecation
and amortization amount for coverage of fixed charges interest and lease payments. In
summary the EBITDA coverage ratio analysis shows that the JVCBs of Nepal has
high fixed charge of interest and lease payments but still they have a good coverage
capability financially, a good indication of the JVCBs.

4.3.4 Return on Shareholders’ Equity

One of the main sources of capital is equity which is raised from issue of common
shares to public. People use their savings on share with a expectation of return from
their investment in equity. So every time equity holders want to know about return on
shareholders’ equity of the firm. Higher the ROSE is preferred by the equity holders.
The calculated ROSE of selected sample banks are presented below:

Table No. 12
ROSE Calculation for Everest Bank Limited

ROSE =
Net Income Shareholders' Equity Net Income
Year Shareholde rs' Equity
2004 168,214,611 998,000,000 16.86%
2005 237,290,936 1,198,000,000 19.81%
2006 296,409,281 1,514,600,000 19.57%
2007 451,218,613 2,112,600,000 21.36%
2008 638,732,757 2,620,000,000 24.38%

Average ROSE of EBL 20.39%

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The table gives the glimpse of last five years ROSE provided by the EBL to its equity
holders. The equity holders of EBL are paid 16.86% in F.Y 2004, rose to 19.81% in
F.Y 2005. The ROSE of F.Y 2006 is 19.57% which increased in to 21.36% and
24.38% in F.Y 2007 and 2008 respectively. The average ROSE of EBL is 20.39%
over the study period. The ROSE for the last 5 years showed an increasing trend,
which is the symptom of good performance by the bank.

Table No. 13
ROSE Calculation for Himalayan Bank Limited
Net Income Shareholders' Equity Net Income
ROSE = Shareholde rs' Equity
Year
2004 308,275,171 1,541,747,000 20.00%
2005 457,457,696 1,766,176,000 25.90%
2006 491,822,905 2,146,500,000 22.91%
2007 635,868,519 2,512,992,000 25.30%
2008 752,834,735 3,119,881,000 24.13%

Average ROSE of HBL 23.65%

The return on shareholders’ equity of HBL seems to be of fluctuate type as given

from the calculation shown in above table. The ROSE is increased in F.Y 2005 from
2004 whereas declined to 22.91% in F.Y 2006 and again it increased to 25.30% in
F.Y 2007 and again declined in F.Y 2008. In an average, the HBL has given 23.65%
annual returns to its shareholders on their investment made. Average ROSE of HBL is
seems satisfactory as it showed over the average in latest part of the study period.

Table No. 14
ROSE Calculation for Nepal Investment Bank Limited
Net Income Shareholders' Equity Net Income
ROSE = Shareholde rs' Equity
Year
2004 232,147,098 1,180,173,000 19.67%
2005 350,536,413 1,415,440,000 24.77%
2006 501,398,853 1,878,124,000 26.70%
2007 696,731,516 2,686,786,000 25.93%
2008 900,619,072 3,907,840,000 23.05%

Average ROSE of NIBL 24.02%

63
The average shareholders’ equity for NIBL for the last is 24.02%. This 24.02%
represents that annually the NIBL provides 24.02% return to its shareholders’ equity.
Even the average 24.02%, the actual ROSE of NIBL shows the bank has fluctuating
type of ROSE. From F.Y 2004 to 2006 the ROSE equity increased but in recent years
its ROSE decreased slightly below the average. However the return to shareholders is
normal.
Figure No. 15
Trend Line of ROSE of Joint Venture Commercial Banks of Nepal

30.00%
25.00%
ROSE in percentage

20.00%
15.00%
10.00%
5.00%
0.00%
2004 2005 2006 2007 2008
EBL 16.86% 19.81% 19.57% 21.36% 24.38%
HBL 20.00% 25.90% 22.91% 25.30% 24.13%
NIBL 19.67% 24.77% 26.70% 25.93% 23.05%

From the above study of the ROSE, the ratio analysis has given picture that the
JVCBs of Nepal has not stable trend on its return on share. It is fluctuating years by
years. The JVCBs may not be able to attract its investors on common equity more due
to fluctuating nature of return. Generally investors seek increasing trend of ROSE.
Although return on shares has got variation on year by year, the average return on
JVCBs share is attractive. So, the investors on common equity of JVCBs of Nepal
need not be worry regarding their investment on common equity. However, among
these three banks, the position of EBL is better.

In a part of this thesis can see easily that the EBIT is increased every year of all the
selected JVCBs of Nepal however it is observed that the EPS are not increased every
year. It shows that merely increase in operating profit does not ensure increase in
wealth of the shareholders. Increasing debt in capital structure is not only the thing
but also effectively management of the increased debt that increase the return to debt
holders as well as of the shareholders is the main part to be focused in the capital

64
structure management. The management should not focus on the TIE ratio only but
also has to focus on the EPS also otherwise it could raise a question on company
management by the shareholders on decreased EPS. It could affect the reputation of
the bank in the market which entirely declines or gives negative impact to the
investors on debt. Finally it may cause to the dissolution of the bank too. So TIE ratio
and EPS should be focused together but ultimate goal should be to increase EPS.
4.3.5 Basic Earning Power Ratio
The general concept of BEP ratio is the ability of the firms’ assets to generate
operating income. It shows how much income generated by its total assets financed. It
is the ratio of EBIT to Total Assets. The increasing ratio is favorable for a company
which shows that the gross profit is increasing. The calculated BEP ratio for EBL,
HBL and NIBL are given below in table.

Table No. 15
Calculation of Basic Earning Power Ratio of EBL
Year EBIT Total Assets EBIT
BEP Ratio =
Total Assets
2004 168,214,611 11,732,516,418 1.43%
2005 237,290,936 15,959,284,687 1.49%
2006 296,409,281 21,432,574,300 1.38%
2007 451,218,613 27,149,342,884 1.66%
2008 638,732,757 36,916,848,654 1.73%

Average BEP Ratio of EBL 1.54%

The BEP for the EBL is 1.43% in F.Y 2004, increased to 1.49 in F.Y 2005 then
decreased to 1.38% in F.Y 2006 thereafter increased to 1.66% and 1.73% on two
consecutive years. The average BEP ratio for EBL is 1.54% of its total assets. It
means the gross income of the EBL is only 1.54% of total assets which is very much
low. So the BEP of the EBL is not satisfactory because the management team is not
able to maximum utilize the total assets and generate the higher level of income. The
return is the negligible in comparison to its investment in total assets.

Table No. 16
Calculation of Basic Earning Power Ratio of HBL
Year EBIT Total Assets BEP Ratio =

65
 EBIT
Total Assets
2004 666,059,177 27,418,157,873 2.43%
2005 684,012,180 39,460,389,672 1.73%
2006 688,886,636 33,519,141,111 2.06%
2007 954,953,506 36,175,531,637 2.64%
2008 1,159,945,198 39,320,322,069 2.95%

Average BEP Ratio of HBL 2.36%

The above table presents the HBL’s assets ability to generate income. The general
HBL’s assets ability to generate income is 2.36% of its total assets which is very far
low generation. During F.Y 2004 BEP ratio was 2.43% but decreased to 1.73% in
following year. But in the recent last three years the BEP ratio of HBL is increasing.

Table No. 17
Calculation of Basic Earning Power Ratio of NIBL
BEP Ratio =
Year EBIT Total Assets EBIT
Total Assets
2004 333,566,256 16,274,063,706 2.05%
2005 544,310,564 21,330,137,542 2.55%
2006 727,510,111 27,590,844,761 2.64%
2007 1,121,956,413 38,873,306,084 2.89%
2008 1,310,854,953 53,010,803,126 2.47%

Average BEP Ratio of NIBL 2.52%

The Basic Earning Power of the assets of NIBL is calculated and summarized in the
above table. From the F.Y 2004 to 2007, the BEP ratio of NIBL was increasing but at
the recent year in F.Y 2008 it declined from 2.89% to 2.47%. The average BEP ratio
of NIBL is 2.52%. Only 2.52% of its total assets employed generated income which is
not at satisfactory level as it is very much low return to its total investment in asset.

Even though the joint venture commercial banks of Nepal have increasing earning the
level of income is very much low return in comparison to its total assets. It may be
due to increased total financing but the increased financing is not able to generate
additional income. The another reason of unsatisfactory level of BEP ratio is may be

66
management have ignored concept of BEP ratio which is till date not calculated by
any JVCBs of Nepal instead they go for others only.

From the above study it could be concluded that level of BEP is unsatisfactory. The
JVCBs of Nepal are not able to well utilize their assets in more profitable way. They
are not even able to generate operating income of 3% of its total assets employed. So
the bank should seriously think to increase BEP ratio taking corrective measures and
maximum use of its assets for higher level of return.
4.4 Statistical Analysis
Statistical method of analysis is one of the most popular methods on data analysis
specially on thesis writing and research. There are different statistical tools simplex to
complex for data analysis, here is used simple statistical tools such as correlation
analysis and regression analysis taking consideration to time bound to complete the
thesis and data availability. Here goes the use of statistical tools for data analysis:

4.4.1 Multiple Coefficients of Correlation

The multiple correlations show the relationship of a dependent variable with multiple
independent variables that affects the dependent one. In this study related to capital
structure the Net Income (EAT) is taken as depended variable whereas the two
variables Debt and Equity portion of capital structure taken as independent variable.
Attempt has made to establish the relationship between debt, equity and Net Income.
It shows how close relationship they have with each others and change in Net Income
with changes in debt or equity of the firm.
Table No. 18
Multiple Correlation Co-efficient of EBL
Year Net Income Debt Equity Correlation
(X1) (X2) (X3) (r)
2004 168,214,611 300,000,000 518,000,000
2005 237,290,936 300,000,000 518,000,000 r12 = 0.0000
2006 296,409,281 300,000,000 518,000,000 r13 = 0.9097
r 23 = 0.0000
2007 451,218,613 300,000,000 831,400,000
2008 638,732,757 300,000,000 838,821,000 r1.23 = 0.9097

Total 1,791,866,198 1,500,000,000 3,224,221,000

Source: Annex 4

67
The above table presents the data of past five years Net Income, Debt, Equity of EBL
and calculated correlation of Net Income with Debt, Equity and Debt with Equity.
The multiple correlation of Net Income with Debt and Equity also finally calculated
with help of simple correlations which is given in annex part of the thesis.

The Net Income is noted as X1, Debt as X2 and Equity as X3 for making calculation
work easier and convenience. The calculated correlation between Net Income and
Debt (r12) is 0.0000, Net Income and Equity (r13) is 0.9097 and Debt and Equity (r23) is
0.0000. It shows that Net Income and Debt has no relationship at all as well as of
Debt and Equity. It is all because the Debt is constant for whole study period. The
debt financing employed by EBL is neither increased nor decreased since it employed
debt financing. The debt remained constant whereas the equity capital changed. The
change in equity has not affected the debt financing at all as a consequence the
relationship between debt and equity as well as debt and net income became zero.

The multiple correlations (r1.23) of 0.9097 show the positive relationship of debt and
equity with Net Income. It means the change in debt or equity changes the net income
of the EBL. There is high degree of relationship of net income with debt and equity
especially with equity in this case as the debt remained constant over the study period.
The calculated multiple coefficient of determinant (square of r1.23) that makes the
work easier for interpretation of the data and findings is (0.9097)2 i.e 0.8276. The
multiple coefficient of determinant 0.8276 states that the 82.76% of total variation in
Net income of EBL is influenced by the variables debt and equity rest 17.24%
variation in the net income of EBL is influenced by other factors rather than the debt
and equity financed by the bank. The significant of multiple correlations is calculated
by using probable error as follows:
1−r 2
Probable Error (PE) = 0.6745
n

1 − (0.9097 ) 2
= 0.6745 ×
5
= 0.0520
Then,
PE 6 PE r Result
0.0520 0.3120 0.9097

68
 r > 6 PE Significant

It is well known fact that if r < PE the correlation is insignificant, if r > 6 PE only then
the calculated correlation will be significant. And if PE < r < 6 PE nothing can be
calculated. In the above calculation, neither PE < r nor PE < r < 6 PE but r > 6 PE.
So, the calculated correlation coefficient is significant.

69
 Table No. 19
Multiple Correlation Co-efficient of HBL
Year Net Income Debt Equity Correlation
(X1) (X2) (X3) (r)
2004 308,275,171 360,000,000 643,500,000
2005 457,457,696 360,000,000 772,200,000 r12 = 0.5716
2006 491,822,905 360,000,000 810,810,000 r13 = 0.9884
r 23 = 0.5469
2007 635,868,519 860,000,000 1,013,512,500
2008 752,834,735 500,000,000 1,216,215,000 r1.23 = 0.9891

Total 2,646,259,026 2,440,000,000 4,456,237,500

Source: Annex 5

AS per the annex 5 for calculation of correlation the correlation coefficient for Net
Income and debt (r12) is 0.5716, Net Income and Equity (r13) is 0.9884 and Debt and
Equity (r23) is 0.5469 given in above table.

The multiple correlations (r1.23) of 0.9891 for the HBL showed the positive
relationship of debt and equity with Net Income. Here calculated multiple coefficient
of determinant (square of r1.23) is (0.9891)2 i.e 0.9783. It means out of the overall
variation in Net Income of HBL 97.83% is due to the factors Debt and Equity it used
on its capital structure. Remaining 2.17% variation on the net income is caused by due
to other factors besides the debt and equity. The significant of multiple correlations
can be calculated by using probable error based on the above calculated multiple
correlations for the HBL as follows:

1−r 2
Probable Error (PE) = 0.6745
n

1 − (0.9891 ) 2
= 0.6745 ×
5
= 0.0065
Then,
PE 6 PE r Result
0.0065 0.0393 0.9097
r > 6 PE Significant

70
If,
r < PE the correlation is insignificant
r > 6 PE only then the calculated correlation will be significant.
PE < r < 6 PE nothing can be calculated.
So, the calculated correlation coefficient is significant.

Table No. 20
Multiple Correlation Co-efficient of NIBL
Year Net Income Debt Equity Correlation
(X1) (X2) (X3) (r)
2004 232,147,098 300,000,000 587,738,500
2005 350,536,413 550,000,000 590,586,000 r12 = 0.9445
2006 501,398,853 800,000,000 801,352,600 r13 = 0.9224
r 23 = 0.7446
2007 696,731,516 1,050,000,000 1,203,915,400
2008 900,619,072 1,050,000,000 2,407,068,900 r1.23 = 0.9999
2,681,432, 3,750,000, 5,590,661,
Total 952 000 400
Source: Annex 6

The multiple correlation coefficients for net income with reference to debt and equity
(r1.23) is 0.9999 calculated in annex 6. It gives the positive relationship between
income and debt, equity. The increment in debt and equity on capital structure of
NIBL causes positive change in net income of NIBL. For more clear information on
relation of debt and equity with net income here is coefficient of multiple
determination which is the square of correlation denoted by R1.23.

The coefficient of multiple determination of NIBL is R1.23 = (0.9999)2 i.e 0.9998. It

states that the variation on net income of NIBL is 99.98% caused by the factors debt
and equity; only negligible variation is caused by other factors rather than debt and
equity. The significant of multiple correlations can be calculated by using probable
error as follows:
1−r 2
Probable Error (PE) = 0.6745
n

1 − (0.9999 ) 2
= 0.6745 ×
5
= 0.0001

71
Then,
PE 6 PE r Result
0.0001 0.0006 0.9999
r > 6 PE Significant

If,
r < PE = correlation insignificant
r > 6 PE = correlation significant
PE < r < 6 PE = nothing can be calculated.

As per the calculation above the multiple correlation is greater than six times Probable
Error which indicated the calculated multiple correlation for NIBL is significant.

Among the three JVCBs of Nepal selected for the study NIBL has the highest degree
of positive correlation of net income with debt and equity upto 0.9999 whereas the
EBL has lowest of 0.9097. The HBL has 0.9891 positive high degree of relationship
among the net income, debt and equity financing. Finally, Conclusion can be drawn
based on the above study of the multiple correlation of net income with debt and
equity for the JVCBs of Nepal that JVCBs of Nepal have got higher degree of
positive relationship between the debt and equity it used on its capital structure with
the Net Income it earned. More than 80% of the variation on the net income of JVCBs
of Nepal is due to the factors debt and equity financed by JVCBs of Nepal in its total
financing and remaining variation on net income around 20% is caused by other
factors than the debt and equity financing on capital structure of JVCBs of Nepal.

4.4.2 Multiple Regression Analysis

In this part the researcher tried to find out the relationship of the deposit collection
and loan disbursement of the JVCBs of Nepal with the EBIT. It used the multiple
regressions that give the regression line of EBIT on Deposit and Loan which helps in
forecasting the future EBIT of the bank with the projected deposit collection and loan
mobilization for the bank. Here calculated the multiple regression lines for the
selected JVCBs and coefficient of multiple determinations in terms of multiple
regressions.
Table No. 21
72
 EBL’s Multiple Regression Analysis Data Table
Year EBIT (X1) Deposit (X2) Loan (X3) Result
2004 277,828,439 10,097,690,989 7,618,671,476
2005 377,200,894 13,802,444,988 9,801,307,676 a = – 49,802,981
2006 487,972,659 18,186,253,541 13,664,081,664 b1= 18,272,665
2007 718,833,853 23,976,298,535 18,339,085,562
2008 972,950,326 33,322,946,246 23,884,673,616 b2 = 17,190,043

Total 2,834,786,171 99,385,634,299 73,307,819,994

Source: Annex 7

The above table presents the data collected for the EBL of 2004 to 2008 in terms of
EBIT, Deposit and Loan. With the help of above data can get the multiple regression
line for EBL as follows:
X1 = – 49802981 + 18272665 X2 + 17190043 X3
The calculation is given in annex part where if observed a = - 49,802,981 that shows
if the deposit collection and loan remain constant the firm will suffer from loss. The
value of b1 = 18,272,665 shows the times deposit will effect on EBIT in case of loan
remain constant whereas the b2 = 17,190,043 gives times change on loan mobilized on
EBIT if the deposit collection remain constant. For more analysis will go for
calculation of coefficient of multiple determinations with reference to multiple
regressions calculated for EBL as below:

a ∑ X 1 + b1 ∑ X 1 X 2 + b2 ∑ X 1 X 3 − n X 1 ( ) 2

R21.23 =
∑X 1
2
( )
− n X1
2

− 0.0491 × 2.8348 + 0.0183 × 66 .5437 + 0.0172 × 48 .9036 − 5 × (0.5370 ) 2

1.9210 − 5 × (0.5670 ) 2

= 0.9960 or 99.60%

It gives that the EBIT of the EBL is affected by 99.60% due to the factors deposit it
collected and loan it has mobilized. Only negligible affects of other factors are shown
by the coefficient of multiple determinations.

73
 Table No. 22
HBL’s Multiple Regression Analysis Data Table
Year EBIT (X1) Deposit (X2) Loan (X3) Result
2004 666,059,177 24,814,011,984 12,424,520,646
2005 684,012,180 26,490,851,640 14,642,559,555 a = 78,026,506
2006 688,886,636 30,048,417,756 16,997,997,046
b1= – 42,179,467
2007 954,953,506 31,842,789,356 19,497,520,482
2008 1,159,945,198 34,681,345,179 24,793,155,269 b2 = 700,599,441
147,877,415,91 88,355,7
Total 4,153,856,697 5 52,998
Source: Annex 8

The variable a in the multiple regression line represent the point of intercept on y-
axis, b1 slope of X1 with variable X2 holding variable X3 constant and b2 slope of X1
with variable X3 holding variable X2 constant. While calculating for the multiple
regression line of EBIT on deposit and loan for HBL in annex 8 of the section annex
at the end of the thesis the following line obtained:
X1 = 700599441 – 42179467 X2 + 78026506 X3

The multiple regression line shows the estimation basis for the HBL’s EBIT on the
given deposit collection and loan mobilized. It states that even the deposit collection
and loan mobilization are held constant also the bank able to earn Rs.700,599,441
EBIT from other sources of income except deposit collection and loan mobilization.
The calculation for coefficient of multiple determination based on regression line
calculated above in annex part shows that the changes in EBIT of the bank is caused
by deposit and loan upto 99.97% and remaining negligible changes is due to other
factors.
Table No. 23
NIBL’s Multiple Regression Analysis Data Table
Year EBIT (X1) Deposit (X2) Loan (X3) Result
2004 333,566,256 14,254,573,663 10,126,055,623
2005 544,310,564 18,927,305,974 12,776,208,037 a = 563,435,287
2006 727,510,111 24,488,855,696 17,286,427,389
b1= – 11,654,849
2007 1,121,956,413 34,451,726,191 26,996,652,258
2008 1,310,854,953 46,698,100,065 36,241,206,558 b2 = 26, 825, 662

Total 2,834,786,171 99,385,634,299 73,307,819,994

Source: Annex 9

74
In the table EBIT is represented by X1, Deposit collection by X2 and Loan mobilized
by X3 so that the calculation work will be easier. While solved for the regression line
with the above data using least square method, the values of a, b1 and b2 as shown in
table above is observed. The NIBL’s value of a = 563,435,287 means the bank will be
able to earn EBIT of that much when the X2 = X3 = 0. The b1 = - 11,654,849 means
the corresponding change in X1 for each unit change in X2 while X3 is held constant.
On the same way the b2 = 26,825,662 gives the corresponding change in X1 for each
unit change in X3 while X2 is held constant.

The multiple regression line based on the above data calculated for the NIBL in the
annex section of this thesis presented detail in annex 9. The multiple regression line
for NIBL as follows:
X1 = 563435287 – 11654849 X2 + 26825662 X3

This is the estimation line that helps in the forecasting the EBIT of the NIBL with the
values of the deposit collection and the loan mobilization for the year. If substitutes
the values of X2 deposit collection for the year and X3 loan mobilization for the year
in the above multiple regression line for NIBL, It helps for the predicted EBIT for the
same year of NIBL.

The calculation of coefficient of multiple determinations in terms of multiple

regression line for NIBL can be made as follows:

2
a ∑ X 1 + b1 ∑ X 1 X 2 + b2 ∑ X 1 X 3 − n X 1 ( ) 2

R 1.23 =
∑X 1
2
( )
− n X1
2

0.5635 × 4.0383 + ( −0.0117 ) ×93 .4175 + 0.0268 ×100 .7069 − 5 ×(14 .6616 ) 2
3.9142 − 5 ×(14 .6616 ) 2

= 0.9999 or 99.99%

The coefficient of multiple determinations gives that the percentage changes on the
dependent variable due to the independent variables. The 99.99% change on EBIT is

75
due to the changes in deposit and loan and rest negligible caused by other factors
except deposit and loan.
4.5 Determination of Optimal Capital Structure for JVCBs of Nepal
The word optimal means the point that is perfect or that cause the minimum risk and
maximum return. In other words, optimal is used for such where maximum return is
obtained. According to Oxford dictionary, optimal means the best possible or
producing the best possible results. In this study calculates for the optimal capital
structure. It means concentrate focus to determine optimum level of the mix of debt
and equity in formation capital structure that maximizes the value of the firm whereas
reduces the overall cost of capital of the firm.

It is not an easy job to determine the optimal capital structure. Some economic expert
and financial experts say there is no optimal level of capital structure, whereas some
view that 100 percent is the optimal capital structure where it can get the minimum
overall cost of capital. Some regarded existence of optimal capital structure with the
rational mix of debt proportion and equity capital. The Brigham and Ehrhardt on their
book Financial Management: Theory and Practice given a model to calculate the
optimal capital structure. Here also applied same model and try to find optimal level
of capital structure for joint venture commercial banks of Nepal as follows:

Table No. 24
Optimal Capital Structure Test for JVCBs of Nepal
Debt
Assets Kd (1-T) Ks = Krf + (Km - Krf) b WACC Remark
0.00 3.60 17.50 17.50
0.10 3.60 18.00 16.56
0.20 3.90 18.63 15.68
0.26 4.05 19.08 15.17 EBL
0.29 4.14 19.35 14.94 HBL
0.30 4.20 19.43 14.86 NIBL
0.40 4.80 20.50 14.22
0.50 5.70 22.00 13.85 Optimal
0.60 7.20 24.25 14.02

Source: Annex 10

76
The above table is the part of the overall calculation made for the optimal capital
structure determination in annex part. The table shows that the current WACC for
EBL is 15.17%, HBL is 14.94% and 14.86% for NIBL whereas the optimal capital
structure level for JVCBs of Nepal is 13.85% WACC with 50% Debt financing and
50% Equity financing. The JVCBs of Nepal are currently using around 30% only
debt. As the debt is tax deductible, the use of debt reduces the overall cost of capital
but more use of debt causes for increase in bankruptcy risk so the debtholders also
asks for higher return and increases the overall cost of capital. That’s why limit use of
debt capital reduces the overall cost of capital and increases the value of the firm so
optimal capital structure level is determined with the rational used of debt and equity
in capital structure.

As the determining optimal capital structure is not an easy job one should go through
detail study and have a rational decision upon debt and equity mix in capital structure
that helps in minimization of weighted average cost of capital and maximize the
overall value of the firm.

4.6 Findings of the Study

The data presentation and analysis using different financial and statistical tools find
out the followings:
a) The JVCBs of Nepal are found with the debt and equity mix in capital
structure and some are found to be used preference share also in financing its
capital structure. The banks are around 30% of total capital structure is using
debt for its capital financing.
b) The Operating Income or EBIT is increasing for the JVCBs of Nepal. The
banks are well operating its business.
c) The Earning per share is found to be increased but it discovered that only the
increased in EBIT does not mean to increase the EPS. The increase in EBIT
deducts interest in debt capital it has employed so EPS may be zero if large
portion of debt is used and operating income is low.
d) The calculation of debt ratio found that around 5% of total assets it has
financed are employed from debt. The majority of the total assets are financed
by equity source.

77
 e) The interest coverage ratio for the JVCBs of Nepal is found satisfactory. The
banks are able to meet its interest expenses on debt employed on its capital
structure. EBL 35.43 times, HBL 17.77 times and NIBL 15.85 times.
f) The EBITDA ratio is found 18.66 times for EBL, 19.49 times for HBL and
16.09 times for NIBL.
g) The ROSE is found to be in satisfactory level. It is maximum in NIBL with
24.02% and lowest in EBL of 20.39% among three sample banks with 23.65%
in HBL.
h) The Basic Earning Power of the banks are found to be low. The BEP in EBL
is 1.54%, HBL 2.36% and NIBL 2.52% of total assets.
i) The relationship of Net Income with Debt and Equity while calculated for the
sample banks found to be positively correlated. The EBL’s correlation of Net
Income with debt and equity is 0.9097, HBL 0.9891 and NIBL 0.9999.
j) The multiple regression analysis made of EBIT on Deposit and Loan found the
fluctuation of EBIT is more than 90% due to the change in Deposit and Loan.
The other factors effect on EBIT is found to be negligible.
k) The optimal capital structure for the JVCBs of Nepal is with 50% debt and
50% equity financing.

4.7 Major Findings of the Study

The major finding of the study represents the findings from the study related to the
objectives and statement of the study which are as below;
a) The deposit collection and loan mobilization of JVCBs of Nepal is in
increasing trend. The deposit collection is increased every year with new
schemes to attract the deposits whereas the loan mobilization also found
increased every year as the business are expanding with the peace in country.
b) The relationship of the Net Income (EAT) with the debt capital and equity
capital financing is highly positively correlated. The changes in capital
structure causes change in net income also.
c) The EBIT of the JVCBs of Nepal are highly depended on the deposit
collection and loan mobilized as calculated using multiple regression analysis.
d) The current capital structure of the JVCBs of Nepal is financing low level of
debt only in its capital structure. It can minimize its WACC with increase in

78
 level of debt financing. Banks should go for 50/50 percent mix of debt and
equity in its capital structure.

CHAPTER V

5. SUMMARY, CONCLUSION AND RECOMMENDATION

The final chapter of the thesis is summary, conclusion and recommendation. This
chapter is divided into three sections: Summary, Conclusions and Recommendations.
In this chapter, the summary section contains the summarized form of the whole
thesis, the conclusion of the study based on the findings from the study and some
useful recommendations to improve the banking performance and manage capital
structure of the JVCBs of Nepal in a more effective way.

5.1 Summary of the study

Capital, in the most basic terms, is money. All businesses must have capital in order
to purchase assets and maintain their operations. Capital is a scarce 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. Capital structure or capitalization of the firm is the permanent financing
represented by long term debt, preferred stock and shareholders’ equity. The thesis
tried to explore present capital structure, capital structure mix, factors affecting CSM
and relation of dependency of profit on loan and deposit of JVCBs of Nepal with the
following major objectives:
a) To find out the present capital structure management of joint venture
commercial banks of Nepal are optimal or not.

b) To determine the relationship between the capital and profit.

c) To Analyze and evaluate the effect of deposit and loan on the EBIT of the
joint venture commercial banks of Nepal.

Before the study and during the study, the researcher has been through several books,
journals, websites, articles, dissertations related to the thesis problem in order to have

79
detailed knowledge on research topic and the findings of previous researches.
Researcher has been through review of the four capital structure related theories:
(a) Net income approach (c) Net operating income approach
(b) Traditional approach (d) Modigliani- Miller’s approach
Similarly, the review on leverage, signaling theory, trade off theory related to capital
structure is also done in the section literature review part of the study. National and
international journals and articles published are also reviewed in the same section.
Finally the most useful review of past thesis and dissertations completed by the
students of Tribhuvan University in different academic years in partial fulfillment of
MBS degree related to capital structure are studied and reviewed.

The one of the most guideline of the thesis research design is prepared in the 3rd
section of thesis. The thesis used analytical plus descriptive research design using
financial tools ratio analysis, statistical tools: average, multiple correlations, multiple
regressions, trend analysis etc. The research is based on completely secondary data
available in the websites of sample banks. It has been selected three sample JVCBs:
EBL, HBL and NIBL out of 9 JVCBs of Nepal which is 33.33% of the total
population.

The real talent of the researcher is described through the fourth chapter of the thesis
which is called data presentation and analysis. This unit comprised of the systematic
presentation of data related to the study and analysis to draw the conclusion related to
the objectives of the study. Researcher has given his best effort to present the
necessary and related data only as far as attractive and convincing way that helps to
easy grasp the concerned material by the others. Simple tables and attractive diagrams
of various types suitable to the study are used on this section. The analysis is made
using appropriate analysis technique with details in annex is done. The reference of
every analysis is given in descriptive form in annex which definitely help who will go
through this thesis to get step by step knowledge on the analysis made by researcher.
Finally the findings of the study are summarized at the end of this section as well as
the major findings which are related to the thesis objective is presented.

Last but not the least, the final chapter of the study presented the overall summary of
the thesis in a brief. The next of this section are the conclusions drawn by the
80
researcher from the study. The researcher has made little effort to provide some useful
recommendations based on his study so that the JVCBs of Nepal can increase their
efficiency and effectiveness.

5.2 Conclusion of the study

Finally the outcome of the thesis conclusion is presented as below based on the study
made by researcher and results obtained in the data presentation and analysis part of
the thesis. Based on the findings, major findings and the researcher’s analysis the
conclusions of the study are:
a) As the title of the thesis presents capital structure management of joint venture
commercial banks of Nepal, the present scenario of JVCBs of Nepal in terms
of capital structure the study found that 18% preference share, 26% Debt and
56% Equity mixed capital structure of EBL; 71% Equity and 29% Debt in
HBL; 70% Equity and 30% Debt in NIBL. So it can be conclude that the
JVCBs of Nepal are adopting capital mix instead of single capital source and
are diversifying sources of capital but still their capital structure is dominated
by common equity. It is supported by the average of 5.79% Debt ratio for
EBL, 3.44% average Debt ratio of HBL and 4.23% in an average of NIBL.

The JVCBs of Nepal‘s present capital structure is not an optimal capital

structure as they used less amount of debt only. The optimal capital structure
level is at 50% Debt and 50% Equity financing and majority portion of the
total assets is financed by equity capital and the present capital structure of
JVCBs of Nepal focused on common equity.

b) As the name also suggests commercial banks focuses their functions on profit
earning. None commercial banks of Nepal are operated to serve public
occurring loss. Even though NRB has given directions for combined effort on
economic development, banks have not shown keen interest on that matter.
Keeping this situation in mind researcher has tried to find the relationship
between the capital and profit condition of the JVCBs of Nepal. The Net
Operating Income schedule presented in chapter IV concludes that the profit
of EBL, HBL and NIBL are increased every year to its former year and shows
that the profit trend of JVCBs is towards increasing trend. It is supported by
81
 the average ROSE calculated for EBL 20.39%, HBL 23.65% and NIBL with
24.02% average ROSE. Every year they have been paying good return on the
shareholders’ investment so their capital profit ratio is positive.
The 2nd conclusion of the study is that there is positive and significant
relationship between the Debt, Equity and Net Income (EAT). The changes on
the capital structure of the banks fluctuates the net income of the banks in
higher extent. For this one can see the multiple coefficients of correlation
calculated on the chapter IV where it has shown that EBL, HBL and NIBL has
positive correlation between Equity, Debt and Net Income and all the
correlations calculated are significant with multiple correlation of EBL is
0.9097, HBL is 0.9891 and of NIBL is 0.9999.

c) The EBIT of the JVCBs calculated are enough to cover the interest to be paid
on the debt financing. The TIE ratio of EBL is 35.43 times in average, 17.77
times of average for HBL and 15.85 times of average for NIBL. It shows the
high profit of the banks and lower level of debts financing. The Loan and
Deposit plays significant role in the banks. The profit of the bank highly
depends on the deposit collection and loan mobilization. The next conclusion
drawn is that the dependency of EBIT of the JVCBs is on its deposit collection
and loan mobilized.

The EBIT of the JVCBs are highly dependent on the loan and deposit. The
coefficient of multiple determination with reference to multiple regressions
calculated for EBL shows the EBIT is affected by 99.60% by the factors
deposit and loan, similar result occurred for HBL also where 99.97% changes
of EBIT is caused by deposit and loan. The NIBL’s result further supported
the dependency of EBIT on loan and deposit by 99.99% calculated on chapter
IV in multiple regression analysis. So, the conclusion from these results is that
the deposit collection and loan mobilization has significant and prominent role
in the increase or decrease in the EBIT of the banks. The large portion of
EBIT is fluctuated with the fluctuation on loan and deposit.

So in the conclusion, the present capital structure of the JVCBs is dominated by the
equity portion and there is the significant relationship between the Debt, Equity and

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Net Income. On the same way the multiple regression line of EBIT on deposit and
loan has shown EBIT is highly depended on deposit collection and loan mobilization
of the banks.
5.3 Recommendations of the Study
Recommendations are the suggestions for the organizations to solve the problems
existing in the organization. Here based on the analysis made in chapter IV, findings
of the study and conclusion drawn from the study the researcher has little effort made
to provide some recommendations that will be beneficiary for the JVCBs of Nepal on
their cost of capital reduction and increment of profit and overall efficiency of the
joint venture commercial banks of Nepal.

As form the study and conclusion also states that the majority of the capital structure
is equity capital. The first recommendation goes for the increment of the debt capital
financing as the debt has got the tax beneficiary and cost of capital can be reduced
which ultimately increases the profit of the firm and value maximization. The optimal
capital structure is the rational mix of debt and equity capital that reduces the cost
associated with the capital which can be obtained through 50% debt on present capital
structure of the banks. On the same way as the operating profit of the banks is in
increasing trend but the EPS is decreased it is due to high volume of equity on capital
structure.

Relationship between the Debt, Equity and Net Income is significant & positive. The
changes on the capital structure should be done with the detail study and thorough
analysis of its impacts on the overall organization. As the TIE ratio is high it can
employ little more debt in capital structure mix and get the advantage of tax benefit
and increase the EPS rather than only increasing the operating profit.

The high dependency of EBIT on loan and deposit recommends that the banks should
collect as far as more deposit and the loan mobilization should be so good that can be
realized easily rather than going through the legal hassles and bear extra costs for loan
collection. So, more attention should be paid on the loan mobilization.

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Besides these, the banks Basic Earning Power is also too much low. It is merely 3%
of total assets so the JVCBs of Nepal should focus on the increment of the basic
earning power of the banks too.

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