CHAPTER - I

INTRODUCTION

1.1 Introduction of Capital Structure and Leverage

A firm’s total assets are financed from equity and debt. Equity capital is owners’ money
and consists of common stock, paid in capital and retained earnings. Debt is borrowed
money and can be classified as short-term debt and long-term debt. The composition of
short-term debt and long-term debt is called financial structure. In other words, the
financial structure is the mix of short-term debt, long-term debt, preferred stock and
common equity. The financial structure includes all source of capital whereas capital
structure includes only the long-term sources of capital.

The particular distribution of debt and equity that makes up the finances of a company or
a firm is known as capital structure. Capital structure is also known as the debt-to-equity
ratio. The term capital structure is used to refer to the mix of long-term sources of capital
(i.e. Long-term debt and equity capital). In other words the capital structure is how a firm
finances its overall operations and growth by using different sources of funds. Debt
comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. It allows a firm to understand what
kind of funding the company uses to finance its overall activities and growth. The
purpose of capital structure is to provide an overview of the level of the company’s risk.
The higher the proportion of debt financing a company has, the higher its exposure to risk
will be.

The capital structure issue is basically associated with the use of debt capital by a
company. A company that uses debt financing along with equity s called levered
company. On the other hand, a company that uses all equity financing is called unlevered
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company. The capital structure is concerned on whether or not and to what extent a firm
should use debt financing.

The mix of debt and equity capital that results to minimum weighted average cost of
capital is called optimal capital structure. The capital structure with lowest cost of capital
is also known as the optimal capital structure. The optimal capital structure is actually a
firm’s target capital structure.

Leverage, as a business term, refers to debt or to the borrowing of funds to finance the
purchase of a company's assets. Business owners can use either debt or equity to finance
or buy the company's assets. Using debt, or leverage, increases the company's risk of
bankruptcy. It also increases the company's returns; specifically its return on equity. This
is true because, if debt financing is used rather than equity financing, then the owner's
equity is not diluted by issuing more shares of stock. There are three types of leverage.
They are Operating Leverage, Financial Leverage and Combined or Total Leverage.

1.2 Literature Review

Capital structure is tightly related to the ability of firms to fulfill the needs of various
stakeholders. Capital structure includes different types of equities and liabilities (Riahi
Belkaoni, 1999). The debt equity mix can take unlevered option (i.e. 100% equity and 0%
debt). Another option is not to have the equity (i.e. 0% equity and 100% debt). This
option is not realistic or possible. The third option is most realistic one. It combines
certain percentage of debt and equity.

Research on the theory of capital structure was pioneered by the seminal work of
Modigliani and Miller (1958). By following this theory a vast theoretical literature
developed, which lead to the formulation of alternative theories such as the static trade
theory pecking order theory and agency cost theory.
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The trade- off theory states that the optimal debt ratio is set by balancing the trade-off
between the benefit and cost of debt. The pecking order theory emphasizes the
information asymmetry between the firm insiders and the outside investors suggesting
that firms use debt only when the internal financing is not available (Myers & Majluf,
1984). Besides, the agency cost theory predicts the capital structure choice based on the
existence of agency cost. This theory investigates the relationship between the manager
of the firm, and the outside equity and debt holders (Jensen & Meckling, 1976).

Frank and Goyal (2003) found out that internal financing is not sufficient to cover
investment spending on average for U.S. firms. External financing was heavily used and
debt financing did not dominate equity financing in magnitude.

Many empirical and theoretical extensions are followed and now firm choose the
appropriate or optimal level of debt. There are many benefits in use of debt in capital
structure. The main benefit is lower cost of capital. It does not mean that the firm should
go on increasing the debt proportion in its capital structure. There are costs which ate
bound with the debt financing. The capital structure should be designed in such a way as
to lead to the objective of maximizing shareholders wealth by making efforts to achieve
the best approximation to the capital structure.

1.3 Statement of Problems

 Banks usually don’t do many researches about the debt and equity after and before
formulation. They ignore the impact of the capital structure on profitability of the
bank. Hence it affects effectiveness and efficiency of its financial activities and
profitability.
 To find out the appropriate mix of the debt and equity for effective and efficient
formulation of bank is very difficult.
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 The financing decision mix of debt and equity represents a fundamental issue faced
by financial managers of firms. The actual impact of capital structure on corporate
performance in bank has been a major problem that has not been resolved.
 The capital structure choice of a bank can lead to bankruptcy and have an adverse
effect on the performance of the bank if not properly utilized.

1.4 Objective of the Study

 To find out the appropriate mix of the debt and equity for smooth running of financial
activities of the bank.
 To find out the impact of capital structure on profitability.
 To determine the leverage risk of the bank.

1.5 Significance of the Study

 An appropriate capital structure is a critical decision for any business organization. It

is important not only because of the need to maximize returns, but also because of the
impact such a decision has on an organizations ability to deal with its competitive
environment.
 This study have significant role to play in filling gap in understanding of the impact
of capital structure decisions on profitability of core business operations of Everest
Bank Limited.
 It will serve as reference for financial managers to apply their knowledge of the
potential problems in financing decisions / capital structure and profitability, as well
as determining their optimal level of capital structure to achieve optimum level of
firm’s profitability so that to meet wealth maximization goal of firms.

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1.6 Limitation of the study
Every study and research have their own limitation because every aspect of related
subject matter can’t be studied and researched in limited period, resources and the
knowledge of the researcher. This study also has some limitations. They are as follows.

 Finance has many topics for the research but this study is mainly concerned with the
study of the capital structure and the leverage.
 The study is completed with short span of time and also lack adequate resources.
 It contain sample of Everest Bank Limited only.
 It also covers inferior working period and limited review of literature. It's difficult to
evaluate firm's managerial and financial activities and provide recommendation of our
own.

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 CHAPTER - II
METHODOLOGY

2 Research Methodology
Research methodology is the systematic, theoretical analysis of the procedures applied to
a field of study. It is a systematic plan for conducting research. It can be also define as it
is a way to find out the result of a given problem on a specific matter or problem that is
also referred as research problem. Research methodology encompasses concepts such as
research designs, target population, sample size and sampling procedure, data collection
instruments and data analysis procedure.

2.1 Research Design

The research design refers to the overall strategy that one may choose to integrate the
different components of the study in a coherent and logical manner. This is done in order
to ensure that one effectively addresses the research problem. Research design constitutes
the blueprint or the roadmap for the collection, measurement, and analysis of data. In this
study descriptive research designs is used.

2.2 Nature and Sources of Data

This study includes both primary and secondary data related to capital structure. It also
includes the quantitative and qualitative data. Data which are developed by the researcher
himself for the purpose present research is known as primary data. In this study
interview, questionnaire and observation methods are used to collect primary data.

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Secondary data are those which are gathered by someone other than the researcher.
Secondary data can also be defined as the data which are already published or printed by
someone which are related to same subject matter. In this study published data (like
annual report), unpublished data (like reports, records) are used for reliability and
suitability.

2.3 Population and Sample

There are more than 30 commercial banks in Nepal among them this study includes the
sample of the Everest Bank Limited. Financial Statement of previous five year
(2069/2070 – 2073/2074 BS) has been taken as the sample data for evaluating capital
structure of Everest Bank Limited.

2.4 Analysis of Data

Analysis of data is a process of inspecting, cleansing, transforming, and modeling
data with the goal of discovering useful information, suggesting conclusions, and
supporting decision-making.
For the effective and efficient results, findings and conclusion of capital structure this
study includes both the financial as well statistical tools.

2.4.1 Financial Tools

Financial tools are one of the most efficient ways that can be used for good decision
making of the any organization. It provides the most effective information related to the
profit and other perspective of the organization. Ratio analysis plays an important role in

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the study of the financial performance of the organizations. The following financial tools
are used in this study.
 Return on Assets (ROA)
 Return on Equity (ROE)
 Earnings per Share (EPS)
 Debt to Capital ratios

2.4.2 Statistical Tools

Statistical tools are those tools which are used collecting, summarizing and analysis of
the data. Statistical tools plays important role in decision making of the organization. In
this study following tools are used.
 Mean
 Standard Deviation
 Correlation
 Regression

2.5 Data Collection Procedure

This study is based on the sample of the Everest Bank Limited. For collection of the data
related to capital structure many questionnaires are formed. The data can be also taken by
the interview as well as the observation. Secondary data like the annual reports are
obtained from the internet, journals, blogs etc. Data can also be collected by the
interaction with the informants also.

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2.6 Organization of Study
This study includes two chapters in order to make it simple, effective and easy for
understanding. It will be carried out into different phases and steps in order to prepare it
in proper structure.

Chapter 1 Introduction
This chapter includes the introductory part of the topic of the study like general
background of the study, statement of the problems, objectives of the study, significance
of the study, limitation of the study and other introductory framework.

Chapter 2 Methodology
This chapter includes the method of the collecting, analyzing and interpretation of the
data. It includes research design, nature and sources of data, population and sample,
analysis of data.

Chapter 3: Presentation and Analysis of Data

This chapter is the important part of the whole study. The collected relevant data are
analyzed and interpreted with the help of different financial & statistical tools. The major
findings of the study are explained.

Chapter 4: Summary, Conclusion and Recommendation

It contains the summary of the study, conclusion recommendation and suggestion on the
basis of the study. At the end of this thesis Bibliography and Appendix were presented.

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 REFERENCES

Bajracharya, B.C., (2012), Business Statistics and Mathematics, M. K. Publisher,

Kathmandu.
Dangol, R.M., (2015), Accounting for Financial Analysis and Planning, Taleju
Prakashan, Kathmandu.
Paudel, Rajan, (2016), Fundamental of Corporate Finance, Asmita Publsher,
Kathmandu,
Concise Oxford Dictionary, Second Edition, New Delhi Publication, P107
Joshi P.R. Research Methodology, Buddha Academic Publishers & Distributors
Pvt. Ltd., Kathmandu, 1st Edition, 2014 A. D.
Adhikari, R, Dev, (2016), Business ResearchMethods, Asmita Publiser,
Kathmandu
http://www.fao.org/docrep/
https://www.slideshare.net/sh_neha252/research-methodology-4821125
http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/capital-
structure-decision-factors.asp

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 Table of Contents
CHAPTER I INTRODUCTION
1.1 Introduction of Capital Structure and Leverage..........................................................1
1.2 Literature Review........................................................................................................2
1.3 Statement of Problems.................................................................................................3
1.4 Objective of the Study.................................................................................................4
1.5 Significance of the Study.............................................................................................4
1.6 Limitation of the study.................................................................................................5
CHAPTER II METHODOLOGY
2 Research Methodology................................................................................................6
2.1 Research Design..........................................................................................................6
2.2 Nature and Sources of Data.........................................................................................6
2.3 Population and Sample................................................................................................7
2.4 Analysis of Data..........................................................................................................7
2.4.1 Financial Tools..................................................................................................7
2.4.2 Statistical Tools.................................................................................................8
2.5 Data Collection Procedure...........................................................................................8
2.6 Organization of Study..................................................................................................9
REFERENCES..................................................................................................................10