Occasional Paper Page 1 of 15

Financing diversification on local market between wish and necessity

1. Does optimal debt to equity matter?

- Briefing on financing decision

related theories
Carmen Lipar carmen.lipara@brd.ro +4 021 301 4370

Financing mix is an important decision for managers, and many academic papers discuss the determinants of capital structure, the implications of firms capital structure on firms value and on cost of capital (i.e.: Modigliani&Miller, 1963), as well as capital structure features across the world. It might appear quite weird to talk about alternative financing methods given that banks provide approx. 92% of the necessary resources of local corporations, whilst there is marginal concern for the accomplishment of traditional objective of managers, namely firm value maximization, especially in case of large state-owned companies. The effects of capital structure on firms value become even more complicated to analyze, when costs of asymmetric information, agency costs and costs of financial distress are taken into consideration. The expansion of local banking system during the economic boom almost annulled any

Laura Simion, CFA laura.simion@brd.ro +4 021 301 4461

Capital structure has an impact on firms value and on its cost of capital

discussion of financing decision aiming to reach optimal capital structure in relation with business performance outlook. To this we add, lack of capital market depth, and poor capital market reaction to releases of stocks value estimation, which created modest incentives for special attention to value creation process of a firm. The economic recession, orderly deleverage at banking system level seen in the past three years reveal the negative effects of credit risk concentration at banks, through rising NPLs (17.34% as of end-Sep12 vs. 14.18% as of end-Sep11) and the necessity of cautious approach in financing companies and households already significant leveraged. Without taking banks out of the financing game, well known alternative financing resources should be tapped. Conventionally, a corporation can raise funds through internal and external sources. Internal resources refer primarily to retained profit and depreciation, whilst external sources are debt (loans or corporate bonds) and equity (issuance of new preferred & common equity). In our paper, we will discuss these financing means, leaving out for the moment the hybrid financial instruments (i.e.: convertible bonds) through which corporations may gather financial resources. There are country-specific factors (please see table below) identified by academic literature which should be considered when you analyze financing mix of a corporation.

Occasional Paper Page 2 of 15

Country-Specific Factors and Their Assumed Impacts on the Companies Capital Structures
Country-Specific Factor If a Country Then D/E Ratio is Potentially and Debt Maturity is Potentially and our comments for Romania

Institutional framework
Legal system efficiency Is more efficient Lower Longer There is a great level of information asymmetry, especially for stateowned enterprises (SOEs) whose results are not made public on regularly basis, keeping transparency on SOEs operations at low levels. Romania has civil law system, thus it doesn't recognize legal precedent as stare decisis. It is known that civil-law countries (where shareholders rights aren't that stronger in comparison with those in common-law countries) tend to be more bank-oriented. Active presence of local analysts is rather pale given the undersized capital market as compared with auditors business. International empirical research confirmed that large number of auditors and analysts is associated with lower leverage of companies. Currently, the dividend tax rate equals income tax rate at 16%. To our knowledge there is no empirical study on this topic for local companies.

Legal system origin

Has common law as opposed to civil law

Lower

Longer

Information intermediaries

Has auditors and analysts

Lower

Longer

Taxation

Has taxes that favor equity

Lower

not specified

Banking system, financial markets

The average daily turnover on shares segment declined by 25.8% ytd up to EUR 6.84m (as of 22 Nov'12), whilst corporate bonds market includes three issuers (out of which one has been listed on BSE on 20 Nov'12) with infrequent and rare tardes. So, we can assess that local capital market plays a minor role in financial intermediation. As we have already mentioned, local financial system is concentrated on banks, which are the main financial resources providers. Net assets of local pension funds, investment funds increased significantly in the past years, but are still low at approx. 6.57% of GDP in 2011 (vs. 4.4% GDP in 2008).

Equity and bonds markets

Has active bond and stock markets

not specified

Longer

Bank-based or market-based country Investors

Has a bank-based financial system Has large institutional investors

Higher Lower

not specified
Longer

Macroeconomic environment
Romania HICP was 5% as of end-Oct'12, the second highest HICP in EU. Given the largest weight of volatile and administrated prices in consumption basket as compared with EU peers, we expect upside pressures to persist, unless changes in consumption basket might be made. Some academic research found that companies in developing countries with high GDP growth rely more on equity financing. Local corporations preferred loans in the boom years given the easiness in contracting a loan (corporate loans (nominal terms) CAGR 200407 of 40.6% vs. CAGR 2004-07 GDP of 37.7% ; CAGR 2008-11 corporate loans of 6.08% vs. GDP CAGR 2008-11 of 3.98%). Also, on local market only 14 successful IPOs have been run between 2004 and 2010.

Inflation

Has high inflation

Lower

Shorter

Growth

Has high GDP growth

Lower

Longer

Source: Corporate Finance, CFA Program Curriculum, Volume III, Level II 2012, pg. 122, Pearson Publishing House, BRD-GSG Research

Moreover, Damodaran1 identified as macroeconomic factor influencing optimal debt ratio the level of default spread. Thus, if default spread is higher the optimal debt ratio should be lower and vice-versa. Besides, country-specific factors, we can add firm-specific factors with impact on optimal debt ratio as following2: corporate tax rate, pre-tax return on firm, and variance of earnings as listed in the table below.

1 2

Damodaran A., Debt and value Beyond Miller-Modigliani, Stern School of Business, pages.stern.nyu.edu/~adamodar/pdfiles/country/levvalue.pdf Ibid 1.

Occasional Paper Page 3 of 15

Firm-Specific Determinants of Optimal Debt Ratios

1. Tax Rate Higher tax rate Lower tax rate 2. Pre-tax Returns on Firm Higher pre-tax returns Lower pre-tax returns 3. Variance in Earnings Higher Variance Lower Variance Higher Optimal Debt Ratio Lower Optimal Debt Ratio =(Operating Income)/Market Value of Firm Higher Optimal Debt Ratio Lower Optimal Debt Ratio

Lower Optimal Debt Ratio Higher Optimal Debt Ratio

Source: Damodaran A., Debt and value Beyond Miller-Modigliani, Stern School of Business, pages.stern.nyu.edu/~adamodar/pdfiles/country/levvalue.pdf

Firms prefer internal financing, then debt, and finally equity

In relation with how corporations make financial decisions, the academic literature has formulated two theories: pecking order theory and trade-off theory. According to pecking order

theory, firms prefer to use internal financing, then they prefer debt (loans and bonds), and
finally they prefer equity. This can be explained by the fact that managers prefer financing methods with the least potential information content (internally generating funds) and have lowest preference for means with greatest potential information content (public equity offering). Costs of asymmetric information are caused by the uneven allocation of information between managers and investors (creditors and/or shareholders), because always companys managers have more information about future investments and companys performance compared with its investors. For instance, companies with low transparency on their financial standing or companies with lower levels of institutional ownership have higher level of asymmetry in information. Furthermore, Myers&Majluf (1984) find that managers decide to issue new shares when they believe the firm is overvalued by the market, because the stock price declines following an equity offering. Agency costs are related to the fact that managers of the company are not the owners of the company, and stockholders are different from creditors. Thus, managers might not make their best efforts to run the company to maximize its value, but to maximize their own wealth. The costs related to the minimization of this type of conflict of interests were named agency costs.

The static trade-off theory of capital structure refers to the necessity of balancing the
expected costs of financial distress (i.e.: bankruptcy costs) with the positive benefits related to the tax deductibility of interest expenses reflected in tax shields. Thus, there is an optimal debt/equity ratio (leverage ratio) where any additional debt will create higher costs of financial distress as compared with the positive effects of additional tax shields obtained. Optimal debt/equity ratio is difficult to be specified exactly for any company. Consequently, we have mentioned above some country-specific and firms specific factors influencing it.

Occasional Paper Page 4 of 15

The left chart shows the trade-off between positive effects on firms value of tax shields
Market Value of the Firm

once leverage is increasing and negative effects

Maximum Value of Firm

on firms value determined by costs of financial

PV of Costs of Financial Distress

distress or bankruptcy, agency costs of debt, and asymmetric information. VL=VU+tD-PV(Costs of financial distress), where VL is value of levered firm; VU is value of unlevered firm (all-equity financed); t is tax rate; D is total debt; PV is present value of costs of financial distress.

PV of Interest Tax Shields

Value of the firm if allequity financed (unlevered firm)

Optimal Debt/Equity Ratio

Debt/Equity

Source: Corporate Finance, CFA Program Curriculum, Volume III, Level II 2012, pg. 122, Pearson Publishing House

There is a great level of information asymmetry on domestic market, especially for state-owned enterprises (SOEs) whose results are not made public on regularly basis, making a decent level of the transparency difficult to be achieved. 2. Debt financing Loans vs. Bonds Debt can be raised from banks or from capital markets. Typically, banks enjoy information and contract negotiation advantages compared with capital market participants, and this allows them to better monitor and enforce the financial obligations of their clients. Thus, bond market investor protection measures (including enhanced disclosure requirements and consistent crosscountry bankruptcy protection laws) need to be commensurate as debt capital market financing is growing. Bonds financing Pros
Flexibility of the issuer in terms of redemptions, interest rates Usually, bonds are used to finance medium-long terms investments

Loans financing
Easy access to banks financial resources

Cons

Higher transparency costs with the disclosure requirements Need for credit rating assessment and continuous monitoring

Generally, loans finance short-term projects The bank has high negotiating power regarding costs, payment schedule, loan size, setting negative or positive debt covenants

Financial intermediation provided by credit institutions in Romania remains below neighboring peers and EU average. However, Romanian banks hold the largest amount of net assets compared with other financial institutions, whilst capital market is significantly undersized, as showed further.

Occasional Paper Page 5 of 15

Credit institutions - Financial intermediation in 2011

Local net assets (% GDP) evolution (2009-11)

400.0 350.0 300.0 250.0 200.0 150.0 100.0 50.0 0.0 Romania

Assets/GDP Loans/GDP Deposits/GDP

100.0 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0
Investment funds Private Pension funds Insurance companies Non credit financial institutions Credit institutions

Poland

Czech Republic

Hungary

EU27 (avg.)

2009 2010 2011

Source: 2012 NBR Financial Stability report, BRD-GSG Research

Source: 2012 NBR Financial Stability report, BRD-GSG Research

The preference for banking system isnt the feature of our country only, as shown below:
Financial intermediation indicators in 2011
2011 Debt securities issued by corporations (% GDP) 24.2 27.2 0.2 13.3 103 MFI credit to non-government residents (% GDP) 54.5 63.6 38.6 54.5 134.7 Stock market capitalisation (% GDP) 20 16.2 8.6 29 41.5

Czech Hungary Romania Poland EMU

Source: Eurostat, BRD-GSG Research

The ultimate macroeconomic scope of corporate bond market is to mitigate credit risk in an economy

The authors of an IMF study3 (2005) stated that there is no definitive evidence that either a market-based or bank-dominated financial system is better. Moreover, it has been argued that a more diversified financial system would mitigate its vulnerability to systemic risk. For instance, the effects of the Asian crisis and the recession in Japan during the 1990s may well have been far more benign if the countries involved had had well-functioning capital markets and correspondingly less heavy reliance on their troubled banking sectors during this period (see, for example, Greenspan, 1999).

An active corporate bond market cant be developed without improvements in secondary Gov bonds market, more active local institutional investor, larger foreign investor base and favorable general regulation, low fees, commissions, and taxation

The paper also mentioned the factors weighing on demand and the supply of corporate bonds: a) b) c) d) the local institutional investor base; the foreign investor base; issuance costs and taxation; public versus private sector bonds.

a) The local institutional investor base is still undersized, as we have shown in the top-left chart, in spite of positive evolution of investment funds and private pension funds between 2009 and 2011. According to 2012 NBR Financial Stability Report, these sectors increased their joint share in financial system only by 1.27 percentage points between 2009 and 2011, compared with credit institutions increase of 0.87 percentage
3

Luengnaruemitchai P., Lian Ong L., (2005), An Anatomy of Corporate Bond Markets:Growing Pains and Knowledge Gains, IMF Working Paper

Occasional Paper Page 6 of 15

points, and decline of insurance companies of 0.04 percentage points for the same period, respectively. b) The foreign investor base declined, mainly as a consequence of international financial crisis and poor local economic growth prospects. The NSC foreign investments data show that 2011 total foreigners inflows on local capital market amounted to EUR 399.21m, and were 23.1% below 2008. c)

Issuance costs and taxation

In this respect, we may mention the local market regulatory (NSC) decision on 21 Aug12 stating that NSC fee for local corporate bonds, T-bonds, municipal bonds to be zero. Still, local capital market is more expensive compared with neighboring markets, dragging on its development (please refer to our Appendix for a list with fees and commissions for BSE and Warsaw Stock Exchange as of 28 Nov12).

d) Public versus private (corporate) sector bonds

Indeed, moderate development of local secondary T-bonds market (please see more details in our report Developing the government securities market 4), and significant issuance of T-bonds given the financial needs of Ministry of Finance (estimated by us at approx. RON 90bn for 2013) which gather local savings might be significant obstacles in promoting private sector bonds. Since 2009, only one company issued corporate bonds and listed the issue on BSE, namely GDF Suez Energy Romania. The other two issuers are two international financial institutions, European Bank for Reconstruction and Development (EBRD) and European Investment Bank (EIB) - Luxembourg, but trades with these bonds are few (i.e.: in the past 52 weeks no trade has been recorded with EBRD bonds and only 3 trades with EIB bonds). In comparison analysis regarding corporate bonds trades, Czech Republic stands out from the selected peer countries, supported mainly by a large number of listed corporate bonds.
Shares and corporate bonds turnover
2011 Poland Czech Republic Hungary Romania Shares turnover (EUR bn) 65.09 15.09 13.79 2.35 Bonds turnover(EUR bn) 0.20 25.55 1.04 0.13

Source: Source: Warsaw, Prague, Bucharest, Budapest Stock Exchanges websites, BRD-GSG Research

Local market issuers, listed in

corporate bond has only three out of which one Nov12

Thus, GDF Suez Energy Romania raised RON 250m through 5-year corporate bond issuance, with coupon rate of 7.4% p.a. We believe that a major influence in companys decision to issue bonds might be related to the fact that GDF Suez SA, the majority shareholder of the GDF Suez Energy Romania, has a tradition in issuing corporate bonds and notes. Please see below the list of notes/bonds issued be GDF Suez and/or its affiliates, totaling EUR 30.88bn (46.9% of total companys debt worth EUR 65.81bn) as of end-Jun12:

4 For more details on local government securities market, please refer to our Occasional Paper Developing the government securities market published on 28 Nov12.

Occasional Paper Page 7 of 15

Notes/bonds issued by GDF Suez and/or its affiliates

Amount Outstanding Reported Coupon Rate (EURm)*
6,387.6 74.4 300.0 811.7 910.3 177.8 283.1 641.9 1,400.0 600.0 750.0 750.0 1,000.0 1,500.0 39.7 249.8 1,000.0 750.0 1,000.0 34.7 49.6 1,200.0 1,000.0 315.2 500.0 865.1 1,000.0 750.0 1,000.0 1,000.0 1,000.0 148.1 618.0 1,359.5 300.0 230.0 700.0 180.4 -3.140% 5.500% 3.500% 4.750% 1.396% 3.250% 1.170% 6.250% 4.750% 5.000% 5.125% 1.500% 5.625% 4.560% 1.500% 2.750% 5.125% 2.250% 4.770% 4.720% 6.875% 3.125% 5.625% 4.078% 6.125% 6.375% 4.125% 3.500% 3.000% 5.750% 3.180% 7.000% 5.000% 5.950% 3.250% 4.750% 3.750%

Class/Description
GDF SUEZ SA Glow Energy Public Co Ltd - 3b THB Belgelec Finance SA - MTN GDF SUEZ SA - 975m CHF - EMTN GDF SUEZ SA - MTN GDF SUEZ SA - 18b JPY - FRN Belgelec Finance SA - 340m CHF GDF SUEZ SA - 65b JPY GDF SUEZ SA - EMTN Electrabel SA - EMTN GDF SUEZ SA - MTN Belgelec Finance SA - Series B GDF SUEZ SA GDF SUEZ SA - MTN Glow Energy Public Co Ltd - 1600m THB GDF SUEZ SA - 300m CHF GDF SUEZ SA - MTN GDF SUEZ SA - MTN GDF SUEZ SA Glow Energy Public Co Ltd - 1400m THB Glow Energy Public Co Ltd - 2b THB GDF SUEZ SA - EMTN GDF SUEZ SA - MTN E-CL SA - 400m USD GDF SUEZ SA GDF SUEZ SA - 700m GBP - EMTN GDF SUEZ SA - MTN SUEZ Environnement Co SA - MTN GDF SUEZ SA - MTN GDF SUEZ SA Belgelec Finance SA - Series C GDF SUEZ SA - 15b JPY GDF SUEZ SA - 500m GBP - EMTN GDF SUEZ SA - 1.1b GBP - EMTN GDF SUEZ SA - MTN International Power Finance II Ltd International Power Finance Jersey II Ltd International Power Plc - 252.5m USD

Coupon Type
-Fixed Fixed Fixed Fixed 3-month LIBOR+120 Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Floating Fixed Fixed Fixed Fixed Fixed Fixed Floating Fixed -Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed

Maturity Seniority
-2012 2012 2012 2013 2014 2014 2014 2014 2015 2015 2015 2016 2016 2017 2017 2017 2018 2018 2019 2019 2019 2020 2021 2021 2021 2021 2022 2022 2023 2023 2028 2028 2060 2111 2013 2015 2023 Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Conv. Senior Conv. Senior Conv.

Latest Price
-100.01 -100.17 100.95 -105.70 100.00 106.50 109.17 109.37 --114.95 103.20 103.65 107.28 118.58 -101.61 102.05 130.53 108.14 111.38 -123.31 131.73 113.92 109.72 -127.50 -139.70 108.11 106.10 38.55 108.50 38.55

Latest YTW#
-2.80 -1.11 0.76 -0.49 1.17 0.65 1.13 0.78 --0.80 3.84 0.74 1.21 1.41 -4.50 4.37 1.62 1.89 3.98 -2.87 2.09 2.46 2.37 -2.70 -3.63 4.58 5.53 ----

Latest OAS to LIBOR#

---110.97 58.10 -29.64 56.09 13.03 57.44 34.88 --23.36 -37.71 32.70 48.27 ---53.54 59.25 259.10 -129.90 68.17 83.20 69.17 -99.69 -125.37 166.53 331.29 ----

*As of 26 Nov12, # YTW is yield to worst; OAS is option-adjusted spread Source: FactSet, BRD-GSG Research

As we have already mentioned, another important criterion in deciding between loans and bonds is the term for which financial resources are needed. Usually, corporations prefer bank loans for short-term financing, whilst corporate bonds are issued to finance mediumterm investment projects. The maturity breakdown of corporate loans showed that locally there is a preference for loans with the maturity between 1 and 5 years. Some researchers and analysts questioned the evolution of lending criteria which seem to be tightening, especially when NPLs experience a significant rise. Under current domestic circumstances, we may see a propensity for corporate bonds issue, although regulatory bodies should play their role in providing favorable legal framework.

Occasional Paper Page 8 of 15

Corporate loans maturity breakdown

Expectations for corporations lending criteria evolution

100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%
Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12

100.0 Romania (%) 80.0 60.0 40.0 20.0 0.0 Q4'07 Q2'08 Q4'08 Q2'09 Q4'09 Q2'10 Q4'10 Q2'11 Q4'11 Q2'12 -20.0 -40.0 Eurozone (%)

Maturity > 5 year

Maturity > 1 year and < 5 year

Maturity < 1 year

Source: NBR, BRD-GSG Research

Source: 2012 NBR Financial Stability Report, BRD-GSG Research

A major role in promoting corporate bonds on local market should be played by regulatory authority. Locally, Private Pension System Supervisory Commission (CSSPP) published on 10 Oct12 a proposal to amend current regulation regarding the investments of private pension funds. One of the amendments proposed refer to corporate bonds investments criteria, as pension funds will acquire corporate bonds issued by investment grade issuers and/or
Favorable fiscal and specific investment regulations should be supportive for developing local corporate bonds market

investment grade parent companies of the issuer. Few local corporations have credit rating assigned, so in case local corporations would like to issue corporate bonds they should apply for a credit rating with specialized rating agencies. This will translate in additional costs related to rating assignment and monitoring. Although, the proposed amendment to regulation aims to minimize the investment risk of private pension funds, this is expected to have a negative impact on the enlargement of local corporate bonds market. Probably, if incentives (e.g.: fiscal incentives) for those corporations looking for a rating assignment are given, a pale support for private bonds is granted. Moreover, lower commission and fees related to the issuance of bonds and/or equity, maintenance and listing of the issuance that should be paid to different capital market authorities might be another motivation for corporations to use capital market as financing method. 3. Equity financing Beside own financing resources and debt, a company could use fresh equity as a third source for financing growth. If the company decides to raise equity and goes listed also (IPO), the firm will gain access to further resources. Moreover, once listed, companys majority shareholders might decide to exit, an operation easy to be performed by launching an SPO (secondary public offering).

Generally, equity offerings are the least preferred method by corporations to raise financial resources

As we mentioned above, Myers&Majluf (1984) suggested when formulated pecking order theory that managers prefer financing methods with the least potential information content (internal funds) and have the lowest preference for the form with the greatest potential information content (public equity offerings). Also, once a company becomes public, it is expected to

Occasional Paper Page 9 of 15

improve corporate governance and transparency as they have to keep investors informed about its projects and operations. The advantages and disadvantages of equity and debt used as financing method for a firm are summarized below: Debt Pros
Avoiding dilution of shareholders stake Predictable costs Lower issuing costs Interest expense is tax deductible resulting in lower tax income base, namely tax shields Lowering weighted average cost of capital (WACC) Periodical payments of interest and principal affecting the free firm cash flow Higher firm leverage Higher business risk Lower financial flexibility

Equity
No periodical cash outflow affecting companys cash flow Improving firms leverage

Cons

Higher issuing costs Capital dilution No tax shields Increasing WACC

Source: BRD-GSG Research

The first and easiest way to use equity as a financing source is to reinvest current profits, if the shareholders accede to renounce at their annual dividend payment or to receive a smaller amount. The second method is to raise new capital from old and/or new shareholders by issuing new shares. In the first case the costs and time consuming are limited, but also the amount that could be raised. However, the method was frequently used by companies in early growth stage. A relevant example from our local market is the case of Banca Transilvania (TLV) which successfully used this method in the last 15 years and developed from a small bank up to the top five league of Romanian banking system. Listed to Bucharest Stock Exchange back in 1997, the bank used to capitalize its profits by distributing bonus shares, or issuing new shares at preferred prices for its old shareholders and also attracting new ones. We have inserted Banca Transilvania (TLV) stock price evolution chart and the history of share capital increase information.

Occasional Paper Page 10 of 15

Banca Transilvania (share price evolution), where s

stands for the split operation
Splits - Cumulative Split Factor: 0.259 17-May-2012 (1.0729 For 1) Bonus Issue: 0.07294 new shares for 1 existing share 18-May-2011 (6 For 5) Bonus Issue: 0.200102 new shares for 1 existing share 12-May-2010 (1.2875 For 1) Rights Issue: 0.110463 new shares @ 1 RON for 1 existing share; Bonus Issue: 0.25 new shares for 1 existing share 17-Sep-2008 (1 For 10) 14-May-2008 (1.6915 For 1) Bonus Issue: 0.6841 new shares for 1 existing share 09-May-2007 (1.5038 For 1) Rights Issue: 100 new shares @ 0.35 RON for 1000 existing shares 10-May-2006 (1.6010 For 1) Rights Issue: 0.15 new shares @ 0.35 RON for 1 existing share; Bonus Issue: 0.509 new shares for 1 existing share 27-Apr-2005 (1.7220 For 1) Rights Issue: 100 new shares @ 4000 ROL for 1000 existing shares; Bonus Issue: 673 new shares for
Source: FactSet

1000 existing shares 19-Apr-2004 (51 For 40) 27.5% Stock Dividend 22-Mar-2004 (1.0476 For 1) Rights Issue: 1 new share @ 3500 ROL for 10 existing shares 16-Apr-2003 (1.3615 For 1) 36.150002% Stock Dividend 16-Aug-2002 (1.0133 For 1) Bonus Issue: 0.013 new shares for 1 existing share 13-Mar-2002 (9 For 5) 80% Stock Dividend
Source: FactSet

Banks share capital increased by RON 962.61m between 6 Apr04 and 22 Apr08 (shareholders meeting dates, 20 Sep04 and 16 Sep08 modification dates) followed by face value consolidation operation (from RON 0.1 to RON 1). Between 28 Dec09 and 13 Jul12 (modification dates) banks raised its share capital by RON 843.35m.

Note:

We notice that the downward adjustment of TLV stock price following share capital increase operations was short-lived, and positive performance of the stock has been posted if general market conditions allowed it. Moreover, cumulative return (please see table below) between 6 Apr04 and 22 Apr08 calculated for BET (+131.8%) and TLV (+439.7%) show that banks stock performed better compared with BET for the period, in spite of several adjustments following share capital increases. For the period 28 Dec09 and 13 Jul12 the banks stock earned less than BET, but we believe risk aversion towards financial assets played a major role in obtaining this result.
Cumulative return (%) for BET and TLV
Ticker Cumulative return (%) Cumulative return (%)
Source: FactSet, BRD-GSG Research

BET 131.8% -1.2%

TLV 439.70% -25.05%

Calculation period 6 Apr'04 - 22 Apr'08 28 Dec'09 - 13 Jul'12

For projects implying a significant capital injection the most appropriate method is to raise new equity from current and/or new shareholders. Although, companies could use this financing alternative by negotiating with specialized investors like private equity funds, usually the method is associated with a company planning to go public or already listed companies. A company could initially tap the equity market by launching an IPO and then floating its shares to a stock exchange.

Occasional Paper Page 11 of 15

Out of the countries in CEE region, Polish capital market is by far the most successful story as financing channel in the region. The Polish Government has chosen to privatize major stateowned companies by selling minority stakes using the means of the stock exchange. Besides successfully using raising equity method as a viable alternative for state-owned companies financing, the decision had also several collateral benefits: constructed a solid local investors base, encouraged also private companies to come to the stock exchange to seek financing and contributed significantly to the development of the local stock exchange which now competes with traditional European exchanges like London and Vienna to attract both issuers and investors. In 2009, other three CEE markets i.e. Prague, Budapest and Ljubljana grouped around Vienna Stock Exchange and formed an alliance, CEE Stock Exchange Group (CEECEG) aiming to coordinate efforts for strengthening their international positioning among regional capital markets. The results were already visible in 2010 when the amounts raised using capital markets means (IPOs, SPOs, and share capital increases) experienced a significant growth on all the three markets, as is depicted in the charts below.
IPO value in Poland 2005-2011, EUR m:
EUR m
4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 2005 2006 2007 2008 2009 2010 2011
0 2009 2010 2011 H1'12

Total raised capital* in Czech Republic, Hungary and Slovenia, EUR m:

EUR m 300

3,770
250 Czech Republic Hungary Slovenia

2,502 1,740 1,045 2,021 1,594 2,067

200 150 100 50

Source: IPO Watch Europe reports - PwC, BRD-GSG Research

*Includes IPOs, SPOs, share capital increases Source: CEE Stock Exchanges Group, BRD-GSG Research

Romanian market didnt benefit either of a strong Government support in developing the equity market as Poland, or of the alliance with a strong, developed neighbored market. The Government program aimed to sustain the privatization of state owned companies through capital market means had a modest start in 2006-2007 with two IPOs gathering EUR 100m, representing the selling of 10% of the national monopoles for gas and power transport, then the projects pipeline has been postponed one year after another. Additionally, the beginning of the financial crisis in 2008 together with the unsuccessful closing of some IPO-s discouraged potential private issuers. Currently, Romanian equity market stands a few steps behind its peers from CEE region in terms of market capitalization related to GDP and transactions volume as well.

Occasional Paper Page 12 of 15

Mk capitalization as % of GDP:
2008 Bulgaria Czech Republic Hungary Poland Romania Slovenia Slovakia Average 17.94 26.57 12.72 30.70 8.32 22.74 6.02 17.86 2009 17.27 34.64 23.08 56.09 16.12 23.79 5.65 25.23 2010 15.25 36.85 21.49 56.72 19.26 19.74 4.72 24.86 2011 16.04 26.54 14.65 39.31 12.01 13.47 5.28 18.19 2012e* 9.32 28.51 17.39 43.88 14.27 13.00 4.89 18.75

IPO value in Romania, EUR m

EUR m 70 60 50 40 30 20 10 0 2005 2006 2007 2008 2009 2010 2011

*2012e GDP, Mk capitalization as of Oct12 Source: Stock Exchanges websites, Eurostat, BRD-GSG Research

Source: www.kmarket.ro, BRD-GSG Research

After a scarce capital raising in 2009 (EUR 3.3m) and 2010 (EUR 1.4m) and no offers in 2011, this year started modestly with a SPO of Transelectrica placing shares of EUR 37m. However, in 2012 the state selected the managers for some major IPO/SPO projects (Romgaz, Hidroelectrica, Nuclearelectrica, Transgaz) which will be probably launched in 2013. This might be the impulse that local capital market needs to break the vicious circle from past few years when investors base narrowed in the absence of a solid issuers pool leading to declining liquidity which also discouraged potential private issuers. Times are changing, as well as habits and needs, and many corporations dont have the ability to make the necessary transformations to adapt their business to new market and regulatory environment. In Europe, the deleveraging process of banks, more restrictive lending criteria as a result of capital requirements regulations had determined companies to issue bonds for financing their projects. What today might seems to be only a wish, tomorrow might turn into a necessity. In some years we might be forced to pay more attention to medium-long term financing decision.

Occasional Paper Page 13 of 15

References 1. 2. 3. 4. 5. 6. 7. 8. CFA Program Curriculum (2012), Corporate Finance, Level II, Volume III, pg. 122, Pearson Publishing House. Damodaran A. Debt and value Beyond Miller-Modigliani, Stern School of Business,

pages.stern.nyu.edu/~adamodar/pdfiles/country/levvalue.pdf.
Dragota V., Ciobanu A., Obreja L., Dragota M., (2003) Management financiar vol. 2 , Ed. Economica. Dragota M., (2006), Decizia de investire pe piata de capital Ed. ASE Fabozzi F., CFA, Peterson P., (2003) Financial Management and Analysis, John Wiley & Sons. Luengnaruemitchai P., Lian Ong L., (2005), An Anatomy of Corporate Bond Markets: Growing Pains and Knowledge Gains, IMF Working Paper. Modigliani F., Miller M., (1963), Corporate Income Taxes and the Cost of the Capital: a Correction, American Economic Review, Vol 3:433-443. Myers S., Majluf N., (1984) Corporate Financing and Investment Decisions when Firms Have Information that Investors Do Not Have, Journal of Financial Economics no. 13:187-221.

Occasional Paper

Appendix
Polish market fees
Warsaw Stock Exchange

Page 14 of 15

Romanian market fees

Bucharest Stock Exchange

One off fees for admision to trading

Shares IPO - fixed fee PLN 6000

One off fees for admision to trading

Fixed fee for processing admision request, all instrument types RON 1200, exempted until 31.12.2012

Admission to trading fixed fee

min RON 3000 max RON 21000, depending on shares category and share capital size, exempted until 31.12.2012 min RON 1500 max RON 10500, depending on bonds category and issue size, exempted until 31.12.2012 0.135% of issue value

- variable fee

0.03% of issue value, min PLN 8000 - max PLN 96000 Shares

Shares SPO - fixed fee - variable fee

PLN 1500 0.0075% of issue value, min PLN 5000 - max PLN 96000

Bonds Shares IPO and SPO - variable fee Bonds IPO - variable fee Bonds SPO - variable fee

0.007% of issue value

Debt instruments, other than TB 0.0075% of issue value, min PLN 5000 - max PLN - variable fee* 30000 * reduced by 20% if the issuer has other instruments listed (shares or rights) Rights to shares - fixed fee Pre-emptive rights - fixed fee

0.0216% of issue value

PLN 10000 PLN 3000

Annual fees
Shares - First year after listing 0.015% of issue value, min PLN 4000 - max PLN 48000

Annual fees
Shares min RON 3000 max RON 21000, depending on shares category and share capital size, exempted until 31.12.2012 min RON 1500 max RON 10500, depending on bonds category and issue size, exempted until 31.12.2012

- variable fee Shares- next years

Bonds

0.02% of market value, min PLN 9000 - max PLN - variable fee 70000 Debt instruments, other than TB - variable fee 0.002% of issue value, min PLN 500 - max PLN 7500

Polish National Securities Depository

One off fees for securities registration
Shares 0.01% of market value, min PLN 3000 - max PLN - variable fee 100000 Convertible bonds or rights to shares 0.001% of market value, min PLN 300 - max PLN - variable fee 10000 Bonds 0.01% of market value, min PLN 2500 - max PLN - variable fee 50000 Other securities 0.012% of market value, min PLN 3000 - max PLN - variable fee 100000

Central Depository
One off fees for securities registration
Shares IPO - variable fee Shares of state owned companies SPOs - variable fee Fixed income instruments - IPO - variable fee Annual fee - fixed fee 0.004% of offer value

0.008% of offer value

0.001% of offer value min RON 700 - max RON 120000, depending of shareholders number

Polish Financial Supervisory Commission

One off fees for public offers
Shares and othe equity instruments - variable fee 0.06% of offer value, max EUR 25000 Non equity securities - variable fee 0.03% of offer value, max EUR 25000

NSC
One off fees for public sale offers
-fixed fee for prospectus analysis Shares - variable fee Bonds - variable fee - fixed fee for securities registration with NSC RON 1000 0.5% of offer value no fee RON 1000

Source: BSE, Warsaw Stock Exchange, NSC, Central Depository, Polish National Securities Depository, Polish National Securities Depository websites as of 28 Nov12

Occasional Paper Page 15 of 15

BRD-GSG - Research
Florian LIBOCOR Carmen LIPAR Laura SIMION, CFA Roxana HULEA Chief Economist Head of Research Head of Financial Markets Research Equity Analyst Economist

+40 21 301 6850 +40 21 301 6869 +40 21 301 4370 +40 21 301 4461 +40 21 301 4472

research@brd.ro florian.libocor@brd.ro carmen.lipara@brd.ro laura.simion@brd.ro roxana.hulea@brd.ro

Disclaimer. This publication is issued in Romania by or through BRD Groupe Socit Gnrale (BRD - GSG), which is regulated by the Romanian Securities and Exchange Commission and National Bank of Romania. The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell any securities. Investments in emerging markets can involve significant risks, such as uncertainty of dividends, of benefits or of profits, market, foreign exchange, legal, credit, tax and other risks and are not suitable for all investors. The information contained herein, including any expression of opinion, has been obtained from or is based upon sources believed to be reliable, but is not guaranteed as to accuracy or completeness although BRD - GSG believes it to be accurate, clear, fair and not misleading at the time of publication. BRD - GSG, and its affiliated companies, may from time to time to deal in, profit from the trading of, hold or act as market-makers or act as advisers, brokers or in relation to the securities, or derivatives thereof, of persons, firms or entities mentioned in this document or be represented on the board of such persons, firms or entities. Employees of BRD - GSG, and its affiliated companies, or individuals connected to them, may from time to time have a positioning or be to holding any of the investments or related investments mentioned in this document. BRD - GSG, and its affiliated companies, are under no obligation to disclose or take account of this document when advising or dealing with or for their customers and may have acted upon or made use of the information in this document prior to its publication. The views of BRD -GSG reflected in this document may change without notice. To the maximum extent possible at law, BRD - GSG does not accept any liability whatsoever arising from the use of the material or information contained herein. This research document is not intended for use by/or targeted to private customers. In case customers obtain a copy of this report, they should not base their investment decisions solely on this document, but must search for independent financial advice. Important notice: The circumstances in which materials provided by BRD - GSG have been produced are in such manner (for example because of reporting or remuneration structures or the physical location of the author of the material) that it is not appropriate to characterise it the materials as independent investment research as referred to in European MIFID directive and that it should be treated as a marketing material even if it contains a research recommendation. However, it must be made clear that all publications issued by BRD GSG will be accurate, clear, fair, and not misleading. This publication is also not subject to any prohibition or dealing ahead of the dissemination of investment research. Analyst Certification: Each author of this research report hereby certifies that (i) the views expressed in the research report accurately reflect his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed in this report. Copyright BRD - Groupe Socit Gnrale 2012. All rights reserved. Nobody can reproduce, redistribute or pass on to any other person or publish in whole or in part for any purpose this publication.