Yes, the problem is with DPI scaling.
You can set exceptions to the general DPI scaling by changing the .EXE's property in Windows so that the 125% scaling you set (or any other, for that matters) won't apply to the game. Right-click on swkotor.exe (to find it right click on the game's name found in your Library list of the Steam app and choose Manage -> Browse Local Files) and then choose Properties, then Compatibility, and then Change High DPI settings near the bottom of the window that opened up. In the next window that pops up choose now "Override High DPI scaling behavior".
Said that, I would recommend you use KOTOR Patch Manager to play the game in widescreen and high resolution. Or alternatively, KMRP - KOTOR Modern Restoration Patch.
Good luck!