On Aug. 25, 2011, Bank of America (NYSE:BAC) announced the sale of $5 billion of 6% Cumulative Perpetual Preferred Stock to Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B). The preferred stock is redeemable by Bank of America at any time at a 5 percent premium.
In conjunction with this agreement, Berkshire also received warrants to purchase 700,000,000 shares of Bank of America common stock at an exercise price of $7.14 per share. The warrants may be exercised in whole or in part at any time, and from time to time, during their 10-year life.
At Bank of America’s closing price of $6.87 per share on Jan. 11, 2012, what are these warrants worth? Although these warrants are currently “out of the money” since the underlying common shares are selling below the strike price of $7.14, they have considerable value which can be estimated using a Black-Scholes calculator.
When applying a strike price of $7.14, stock price of $6.87, time remaining of 3520 days, historical volatility of 59% (source: TD Ameritrade), and a risk-free interest rate of 2% (10-year U.S. Treasury), each warrant is valued at $4.59. Therefore, Berkshire’s 700,000,000 warrants have a total current value of approximately $3.2 billion.
Warren Buffett’s $5 billion investment in Bank of America’s 6% preferred stock is not only earning $300 million per year in dividends, but has also added $3.2 billion in shareholder value from the 700 million warrants that it has acquired.
It is interesting to note, that in The Government Employees Insurance Company’s third quarter 2011 filing with the National Association of Insurance Commissioners, this Berkshire subsidiary showed that it had acquired 229.6 million Bank of America warrants at a cost of $328.0 million, or $1.43 per warrant on Sept. 1, 2011. Using Bank of America’s closing price of $7.89 on September 1, each warrant would have had a value at that time of $5.52. Therefore, it appears that Berkshire had used very conservative accounting and assigned a total value to its Bank of America warrants of $1.0 billion.
Many discussions of Berkshire’s $5 billion investment in Bank of America omit a valuation of the warrants since they are currently out of the money. However, these warrants have added considerable value to Berkshire Hathaway.
About the author:
Tyser Teaching Fellow, Department of Finance
Ph.D., Harvard University
Robert H. Smith School of Business
4412 Van Munching Hall
University of Maryland
College Park, MD 20742-1815
Email: [email protected]
Dr. David Kass has published articles in corporate finance, industrial organization, and health economics. He currently teaches Advanced Financial Management and Business Finance. Prior to joining the faculty of the Smith School in 2004, he held senior positions with the Federal Government (Federal Trade Commission, General Accounting Office, Department of Defense, and the Bureau of Economic Analysis). Dr. Kass has recently appeared on Bloomberg TV, CNBC, Maryland Public Television, Business News Network TV (Canada), and WYPR Radio (Baltimore), and has been quoted on numerous occasions by Bloomberg News, where he has primarily discussed Warren Buffett and Berkshire Hathaway. He has also launched a Smith School “Warren Buffett” blog. Dr. Kass has accompanied MBA students on trips to Omaha for private meetings with Warren Buffett, and Finance Fellows to Berkshire Hathaway’s annual meetings. He is an officer of the Harvard Business School Club of Washington, DC, and is a member of the investment and budget committees of a local nonprofit organization. Dr. Kass received a Smith School “Top 15% Teaching Award” for the 2009-2010 academic year.