Investment Analysis: Bank of America Corporation 2014

Running head: INVESTMENT ANALYSIS 1

Investment Analysis Paper on Bank of America Corporation

Robert E. Davis

Walden University

INVESTMENT ANALYSIS 2

Investment Analysis Paper on Bank of America Corporation

Bank of America Corporation (BAC) is a registered publicly traded financial services

institution. Headquartered in Charlotte, North Carolina, BAC is categorically a bank and

financial holding company as presented within their United States Securities and Exchange

Commission (2012) 10K filings. BAC’s banking and nonbanking subsidiaries furnish a diverse

collection of financial products and services through five primary business segments: Global

Banking, Global Markets, Global Wealth & Investment Management, Consumer & Business

Banking, and Consumer Real Estate Services (Bank of America Corporation, 2014a). Since the

organization’s inception, retail banking operations have grown to encompass approximately

5,100 business centers, 16,300 automated teller machines (ATMs), as well as regional call

centers and technologically savvy banking platforms (Bank of America Corporation, 2014a).

Furthermore, BAC sustains over 53 million consumer and small business relationships (Bank of

America Corporation, 2014a).

Board of Directors

There are 15 available BAC seats on the board of directors. According to the 2014 proxy

statement, the BAC selection of directors is held annually and follows a majority balloting rule in

uncontested elections (Bank of America Corporation, 2014b). For transparency, within the BAC

proxy statement is the biographical history of each nominee eligible for selection as a member of

the firm’s highest oversight committee (Bank of America Corporation, 2014b). The BAC proxy

statement also presents the practices pertaining to how individuals are nominated and ratified for

board membership (Bank of America Corporation, 2014b). Currently, a substantial majority of

the BAC directors and chairperson are independent (Bank of America Corporation, 2014b).


Lastly, the new nominees and incumbents up for reelection convey seasoned leadership with

diverse experiences appearing to possess the necessary qualifications, attributes, and skills to

allow effective oversight of the organization (Bank of America Corporation, 2014b; Carver,

2010).

Monitoring Potential of the Firm's Board of Directors

Formation of governance committees are necessary to ensure board members have varied

interests with the capability to integrate organizational values (Carver, 2010), high ethical

standards, and the insight to pose resolute queries to organizational administrators (Maharaj,

2009). And most importantly, governance committees should ensure board members sustain

independence from operational management and interact considering their overall purpose

(Maharaj, 2009). To ensure adherence to these suggested theoretical board membership

requirements, BAC has established a Corporate Governance Committee responsible for

recommending acceptable candidates to the Board of Directors for selection (Bank of America

Corporation, 2014b). In this matter, the Corporate Governance Committee assesses the Board’s

diversity when identifying and evaluating potential directors (Bank of America Corporation,

2014b). Specifically, the Corporate Governance Committee reviews relevant, accessible

information concerning each potential candidate, such as qualifications, experience, skills,

integrity, race, gender, ethnicity, as well as independence (Bank of America Corporation,

2014b).

Strengths and Weaknesses of Board Structure

Though BAC has deployed a Corporate Governance Committee, the board of directors

has strengths and weaknesses. From a governance perspective, the board’s structural strengths


are initial monitoring of diversity, independence, as well as meeting attendance requirements

(Bank of America Corporation, 2014b). Whilst BAC structural fault in the board is the omission

of a formal diversity policy (Bank of America Corporation, 2014b; Carver, 2010).

Ethical Concerns

Given the current state of business affairs, it appears that BAC directors have not

significantly encouraged ethical behavior in business relationship. As a particular, the number

and associated accusations of legal claims raises a concern regarding the promotion of ethical

behavior by the BAC Board of Directors. Specifically, judicial contingent liabilities exist for

representations, warranties, servicing and foreclosure processes (Bank of America Corporation,

2013).

Competitive Financial Ratio Comparison

BAC is a registered publicly traded financial services organization. Wells Fargo &

Company (WFC) is a registered publicly traded financial services institution that competes in

BAC markets (“Bank of America Corporation's,” n.d.; Wells Fargo & Company, 2014). WFC

offers banking, insurance, investments, mortgage as well as consumer and commercial finance

(Wells Fargo & Company, 2014) to individuals, businesses, and institutions. In comparing the

aforementioned competitors, DuPont identity financial ratio enables singular and joint

profitability analysis of return on assets (ROA) and equity multiplier to produce a return on

equity (ROE) (Ross, Westerfield, & Jaffe, 2013). To assist in competitive financial ratio

analysis; the financial information in Table 1 was selectively extracted from the year-end

financial statements of BAC (Bank of America Corporation, 2014a) and WFC (Wells Fargo &

Company, 2014), respectively. Derivatively, the calculations in Table 2 show the ROE, profit


margin, asset turnover, and equity multiplier over three years.

DuPont Identity

The DuPont identity calculation is a ROE ratio that reflects how well the stockholders

benefit from investing in the organizational formation (Ross et al., 2013). Under the DuPont

identity formula, ROE equals profit margin times total asset turnover times equity multiplier

(Ross et al., 2013). Thus, regarding organizational performance, ROE gauges the profit per

monetary unit of recorded worth (Ross et al., 2013).

Table 1

Selected Financial Information of BAC and WFC for 2011, 2012, and 2013 in Millions, Except

for the Share price as of December 31, 2013 and Earnings per share

BAC Year 2013 Year 2012 Year 2011

Net income $11,431 $4,188 $1,446

Revenue $89,801 $84,235 $94,426

Assets $2,102,273 $2,209,974 $2,129,046

Equity $232,685 $236,956 $230,101

Dividends paid $1,677 $1,909 $1,738

Share price as of

December 31, 2013

$15.57 $11.61 $5.56

Earnings per share $0.94 $0.26 $0.01


WFC Year 2013 Year 2012 Year 2011

Net income $21,878 $18,897 $15,869

Revenue $83,780 $86,086 $80,948

Assets $1,527,015 $1,422,968 $1,313,867

Equity $171,008 $158,911 $141,687

Dividends paid $5,953 $4,565 $2,537

Share price as of

December 31, 2013

$45.40 $34.18 $27.56

Earnings per share $3.95 $3.40 $2.85

Table 2

BAC and WFC DuPont Identity for 2011, 2012, and 2013

ROE

NI/ Equity

Profit Margin

NI/ Revenue

Asset Turnover

Revenue/

Assets

Equity Multiplier

Assets/ Equity

BAC Year 2013 4.91% 12.72% .04 9.04

Year 2012 1.78% 4.97% .04 9.33

Year 2011 .62% 1.58% .04 9.25

WFC Year 2013 12.79% 26.11% .06 8.93

Year 2012 11.89% 21.95% .06 8.95

Year 2011 11.20% 19.60% .06 9.27


Differences or Trends

Comparatively, BAC and WFC have divergent ROE ratios (see Table 2). At the end of

2011, BAC had .62%, and WFC had 11.20% ROEs. At the end of 2012, BAC had 1.78%, and

WFC had 11.89% ROEs. At the end of 2013, BAC had 4.91%, and WFC had 12.79% ROEs.

Summarily, BAC’s DuPont identity is trending upward from 2011 to 2013. Moreover, WFC’s

DuPont identity also rose from 2011 to 2013.

ROE increased for both BAC and WFC. BAC’s and WFC’s ROE increases are due to

increases in profit margins from 2011 to 2013 (see Table 1). The increase in profit margin

coincides with an increase net income from 2011 to 2013. Similarly, net income for BAC and

WFC increased during the three years from 2011 to 2013. Thus, BAC and WFC sustained a

growth trend in net income for the last three years. However, BAC revenues recovered from the

10.79% decrease occurring between 2011 and 2012, while WFC revenues decreased by 2.67%

between 2012 and 2013. Furthermore, the profit margin for both organizations is increasing.

Nevertheless, in Table 2, the profit margin demonstrates a significant contrast between the two

enterprises from 2011 to 2013.

BAC’s profit margin is semi-erratic with 1.58% in 2011, 4.97% in 2012, and 12.72% in

2013. WFC’s profit margin reflects relatively slow growth with 19.60% in 2011, 21.95% in

2012, and 26.11% in 2013. Consequently, an increase in WFC’s profit margin in 2013 is notably

less than BAC. As shown in Table 1, net income grew every year at BAC and WFC, but at an

exceptional higher rate between 2012 and 2013 for BAC. Additionally, BAC’s equity multiplier

varied upward from 9.25 in 2011 to 9.33 in 2012 then downward to 9.04 in 2013. In contrast,

WFC’s equity multiplier steadily trended downward from 9.27 in 2011 to 8.95 in 2012 to 8.93 in


2013.

Growth

A dividend growth model is typically utilized for calculating valuation of organizational

formations paying out dividends under three conditions: zero, constant, and differential growth

(Ross et al., 2013). Firms with more effective corporate governance have larger dividend

payouts (Adjaoud & Ben-Amar, 2010). However, this academic research finding can be

mitigated by deployed regulatory controls (Rexrode, 2014). Consequently, BAC has sustained

the same yearly dividend payout since 2009 at $.04 per common stock share (Bank of America

Corporation, n.d.b). For the dividend growth model zero growth sub-model, the dividend

amount would remain constant, which in-turn would make the derived stock price sensitive to

the applied discount rate (Ross et al., 2013).

Dividend Growth Model

Dividend growth comes under the customary caption of dividend policy (Ross et al.,

2013). Thereby, part two of an organization’s United States 10-K filing should convey the

primary market of traded enfranchising securities -- with low and high sales prices -- and

dividends paid during the prior two years (“Guide to SEC filings,” n.d.). Moreover, besides

dividend payment frequency and amount information, statements concerning future dividend

payouts are recorded within the 10-K form (“Guide to SEC filings,” n.d.). Thus, the

aforementioned required 10-K documentation can be construed as the corporation’s adopted

dividend policy.

In correspondence to the topic in this section, the dividend growth model provides the

present value of future dividends as reflected in the stock price (Ross et al., 2013). BAC has


paid quarterly $.01 dividend since 2009 (Bank of America Corporation, n.d.b). A firm’s growth

rate reflects the increasing rates of earnings and dividends. In the case of BAC, the overall

growth rate would only pertain to organizational earnings remiss of rising dividends.

The formula for the constant growth rate of dividends for a firm is:

P =Div

k − g. (1)

P is the present value of the common stock investment. Div is the expected dividend paid per

share at the next year end. As for the denominator, the appropriate discount rate is k, and g is the

firm’s growth rate. Moreover, to determine g, the following formula is brought into service:

g = Retention ratio x Return on retained earnings (ROE). (2)

In the above formula, retention ratio is the percentage relationship between retained

earnings and generated earnings (Ross et al., 2013). Return on retained earnings represents an

estimate of the historical ROE for the enterprise. Comparably, the dividend growth rate equates

to earnings growth rate based on the assumption that the dividends to earnings ratio is constant

(Ross et al., 2013).

The retention ratio is a required calculation for completing the growth in earnings that

employs the formula:

Retentionratio = 1 − Cashdividends

Netincome . (3)

Given the total dividend for 2013 is $.04 and net income $11,431,000,000, the BAC retention

ratio is 99.99%. Consequently, the firm’s ROE is equal to the growth rate in earnings. For 2013,

BAC’s ROE was 4.91% (see Table 3). Therefore, the estimated growth rate in earnings is 4.91%

(see Table 3).


Table 3

BAC Growth Rate in Earnings and Price-to-Earnings Ratio Calculation

Analysis Formula Year 2013

ROE Net income / Equity 4.91%

Retention ratio 1 – (cash dividends / net

income)

99.99%

Growth rate in earnings Retention ratio x ROE 4.91%

Price-to-earnings ratio Market price per share /

Earnings per share

3.94%

Issues with Using the Growth Model

BAC’s current dividend constraints restrict application of the constant growth model.

Specifically, the organization is under United States Federal Reserve supervision and must seek

approval to increase the distribution amount of earnings to stockholders in the form of dividends

(Rexrode, 2014). The financial statements of BAC indicate the firm’s ROE is trending upward

(see Table 2), yet stockholders are not benefiting from the higher rates of returns in the form of

dividends due to the imposed 2009 distribution restriction. Therefore, the appropriate stock price

valuation tool for BAC is a zero-growth model (Ross et al., 2013).

Reasonableness of Constant Growth

As presented by Foerster and Sapp (2005), the dividend discount model is distinct from

the dividend growth model. In this regard, Foerster and Sapp (2005) and Ross, Westerfield, and

Jaffe (2013) corresponding formulas are the dividend discount model and the dividend discount


model differential growth sub-model. Moreover, the Gordon growth model and the dividend

discount model constant growth sub-model have similar formulas (Foerster & Sapp, 2005; Ross

et al., 2013). Therefore, the dividend discount model and dividend growth model formulas

uniquely convert theoretical assumptions (Foerster & Sapp, 2005; Ross et al., 2013).

Annual Report

BAC’s previously planned growth strategy reflects relationship marketing theory to gain

a competitive advantage (Bank of America Corporation, 2014a; Szmigin, Canning, & Reppel,

2005). Thus, the strategic emphasis is focused on linking the company’s outstanding capabilities

with three groups: individuals, organizational formations, and institutional investors (Bank of

America Corporation, 2014a). Operationally, BAC is making more loans, attracting additional

deposits, achieving excellent results in the wealth management business, and sustaining a

leadership position in investment banking (Bank of America Corporation, 2014a). In support of

the adopted growth strategy, BAC is investing in industry-leading online and mobile banking

platforms as well as small business and wealth management (Bank of America Corporation,

2014a). Moreover, BAC is investing in systems that serve large corporate clients and

institutional investors (Bank of America Corporation, 2014a).

Projects such as online and mobile banking platforms, systems that serve large corporate

clients and institutional investors, as well as small business and wealth management services

have real options that impact the firm’s financial health (Ross et al., 2013). These real options

are adjustments that can occur with the undertaking of new projects such as online and mobile

banking (Ross et al., 2013). Nonetheless, BAC competitors are pursuing similar growth

strategies using real options in capital budgeting situations.


Potential Real Options

Information technology (IT) has impacted all business sectors enormously (Acharya,

Kagan, & Lingam, 2008; Kotler & Keller, 2012). As particulars, increasing demand for online

banking products and services, rising competition from large financial institutions, potential

profitability improvements, and reduced marketing costs are the primary drivers behind IT

adoption by the banking industry (Acharya et al., 2008). At BAC, IT contributes directly to the

firm’s capability and availability in terms of furnishing financial products and services. In

considering the influence of the Internet on consumer demand, BAC is pursuing a strategy to

enable and improve the enterprise’s technology-based business systems. However, there are real

options available for utilization within BAC’s growth strategy. Whereby, during a new project,

BAC can consider real options for determining a strategic, tactical, or operational project path

(Ross et al., 2013). These options include project expansion, abandonment and timing

alternatives for IT projects (Ross et al., 2013).

Capital Budgeting Process

Given the size of BAC, the chief financial officer (CFO) does not have sole responsibility

for approving capital budgeting projects supporting the firm’s long-term strategic drives (Bank

of America Corporation, 2014a; Danielson & Scott, 2006). Specifically, the financial portfolio

committee manages the firm’s investments with membership consisting of executive-level

administrators (Bank of America Corporation, 2014a). Resultantly, the enterprise’s management

monitors investment activity to make decisional changes after acceptance through real options

(Bank of America Corporation, 2014a; Ross et al., 2013).


Beta

When measuring systematic risk through the lens of a diversified investor, beta represents

the sensitivity of a security to movements in the collective market (“Beta,” n.d; Ross et al.,

2013). Contextually, the average beta across all securities is one, when weighted by the

proportion of each security’s market value to that of the market portfolio (Ross et al., 2013).

Consequently, in assessing market changes, a beta of one denotes that a security's price moves

concurrently with the market (“Beta,” n.d). Whereas, a beta below one reflects the security's

price is less active than the market, and a beta exceeding one indicates the security's price is

more active than the market (“Beta,” n.d). Regarding BAC, the beta coefficient is 2.00 as of

August 1, 2014 (“Bank of America Corporation (BAC),” 2014); thus indicating a relatively high-

risk factor (Ross et al., 2013) and a stock price more sensitive than the equity securities market.

Expected Return – CAPM

Capital asset pricing model (CAPM) describes the relationship between risk and return

that enables pricing a security (“Capital asset pricing model,” n.d.; Ross et al., 2013).

Mathematically, CAPM permit calculating an expected return for comparison to the required

return (“Capital asset pricing model,” n.d.; Ross et al., 2013). In this matter, the CAPM formula

for an individual stock is:

R� = R� + β × �R� − R��. (4)

RF is the risk-free rate; β is the responsiveness of a security to movements in the market

portfolio, and RM is the expected return on the market portfolio. Whereby, the variable Rs

represents the expected return. As a particular, the risk-free rate reflects the interest rate if an

investment is remiss of uncertainty. A common estimate for risk-free interest rate is United


States Treasury bills (Ross et al., 2013). The current interest rate for three month United States

Treasury bills is .03% as of August 1, 2014 (U. S. Department of the Treasury, 2014).

The expected market return formula is:

R� = R� + Riskpremium. (5)

RF is the risk-free rate, and risk premium is the applied rate of equity uncertainty. Whereby, RM

is the expected return on a market portfolio. Through investigation, the average historically-

based international equity premium is 6.9% or .069, thus 7% or .07 is an appropriate estimate for

the equity risk premium (Ross et al., 2013). Resultantly, the calculation for the expected market

return is .0703 (= .0003 + .07). Whereby, the CAPM is .1403 (= .0003 + 2.00 x (.0703 - .0003)).

Therefore, the expected rate of return for BAC is 14.03%.

Dividend Growth Model versus CAPM

The dividend growth model reflects the increasing rates of earnings and dividends (Ross

et al., 2013). In the case of BAC, the estimated growth rate in earnings is 4.91% (see Table 3).

However, regulatory constraints imposed by the United States Federal Reserve since 2009 have

mitigated BAC dividend growth to zero (Rexrode, 2014). Thus, the dividend growth model only

pertains to BAC earnings remiss of rising dividends. In this matter, the dividend growth model

formula for zero-growth for calculating the discount rate (dividend yield) is:

R� =Div

P . (6)

Div is the expected dividend paid per share at the next year end, and price per share of common

stock is P. Whereby, RS is the discount rate (Ross et al., 2013). Therefore, given a $.04 total

dividend for 2013 and a current price per share of $15.20; the discount rate is .26% (Amjaroen,


2014; “Equity detail,” 2014; StockOptionsChannel.com, 2014).

Contrastingly, CAPM is also applicable to BAC because generating the expected return

does not rely on dividend growth (Ross et al., 2013). Considering CAPM valuation depends on a

calculated equity beta, adopted risk-free rate, and market return rate (Ross et al., 2013); the

expected BAC return rate is 14.03% which is significantly higher than the expected market

return rate of 7.03%. However, because stocks have risk, the actual market return can result in

lower or higher value over a particular time span (Ross et al., 2013).

Debt and Equity

In accord with Ross et al. (2013), leverage reflects the amount of fixed cost of capital in a

firm’s capital structure relative to operating income as well as debt to equity ratio. Thereby,

leverage creates financial risk relating directly to the cost of capital (Ross et al., 2013).

Moreover, whenever the return on assets is greater than the cost of debt, additional leverage is

favorable (Ross et al., 2013). Consequently, Korteweg (2010) find optimal leverage is positively

related to tangible asset proportions and negatively related to profit volatility, depreciation, and

market-to-book ratios.

Organizational worth is evaluated considering debt and equity market value (Ross at el.,

2013). Strategically, achieving a relative high company valuation is beneficial to shareholders

(Ross at el., 2013). Therefore, financial managers typically attempt to maximize the firm’s value

through debt and equity management. When managing the debt and equity of the firm, leverage

can produce higher per share earnings (Ross at el., 2013). However, financial risk is also

elevated (Ross at el., 2013).

Equity


The market value of an equity instrument is constantly changing due to variations in

outstanding shares and stock price. Since BAC’s zero growth dividend is $.04 per annum, an

increase in retained earnings will increase equity. Nevertheless, mathematically, the market

value of equity is the stock price multiplied by the number of outstanding shares. Regarding this

calculation, as of August 8, 2014, BAC’s market value of equity is $159,841,072,000 (=

10,515,860,000 x $15.20) (Bank of America Corporation, n.d.c; “Bank of America Corporation

(BAC),” 2014). In contrast, the cost of equity capital is the same as the expected stock return

(Ross et al., 2013). Whereby, the CAPM formula (see Equation 4) can assist in determining the

cost of equity capital. Resultantly, the cost of equity for BAC is 14.03%.

Debt

BAC has outstanding long-term debt instruments. Thus, the after-tax cost of debt is

determinable. Computationally, the formula is:

Aftertaxcostofdebt = �1 − Taxrate�xBorrowingRate. (7)

Wherefore, the market value of debt and tax rate can represent estimated book valuations. For

BAC, as of June 30, 2014, the book value of long-term debt was $257 billion (Bank of America

Corporation, n.d.a), and the effective tax rate was 26.41% (“Bank of America Corporation

(BAC),” n.d.d). Considering BAC has multiple long-term debt issuances, an average yield

maturity rate for bonds was employed to estimate the borrowing rate of 3.83% (“Bonds,” n.d.).

Consequently, BAC’s after-tax cost of debt is 2.82% (= .7359 x .0383).

Weighted Average Cost of Capital

As conveyed, standard trade-off theory suggests there is an optimal capital structure


(Ross et al., 2013). So, the question is: What is the optimal capital structure for a firm?

According to academic research, the optimal capital structure minimizes the weighted average

cost of capital (WACC) and thereby maximizes organizational value (Fernández, 2001).

Typically, firms are unable to identify this optimum capital structure point precisely (Eckbo,

2008). Resultantly, corporate officers find an optimum range within which to maintain the

firm’s capital structure. Supporting deployment of this debt policy measurement tool, based on a

study by Bancel and Mittoo (2004), the majority of European managers attempt to minimize the

WACC to assist in achieving capital structure optimization.

The combined value of capital for BAC is $416.8 billion (see Table 5). Utilizing the

equity and debt amounts, as well as a derived tax rate, the WACC for BAC is 7.18% (see

Appendix A). Therefore, interpretively, 7.18% BAC WACC reflects the expected financial

return to sustain organizational value (Ross et al., 2013). Moreover, the calculated WACC

permits usage as a discount rate for net present value (NPV) and internal rate of return (IRR)

calculations because the resulting percentage reflects the firm’s risk and capital structure (Ross et

al., 2013).

Capital Budgeting Assumptions

WACC enables assessing the feasibility of projects (Ross at el., 2013). ). If utilized as an

evaluation approach for projects, there is an assumption that a high WACC conveys greater

financial risk when seeking capital financing. There is also the assumption when using the

WACC rate that the firm’s earnings will continue at the current rate. Additionally, though equity

value fluctuates with market pricing, there is an assumption that the WACC rate will remain

constant. Lastly, there is an assumption that the firm’s risk will remain unchanged throughout a


project’s life cycle (Ross et al., 2013).

Competitive Review of Debt and Equity Mix

WFC is a registered publicly traded financial services institution that competes in BAC

markets (“Bank of America Corporation's,” n.d.; Wells Fargo & Company, 2014). WFC and

BAC offer banking, insurance, investments, mortgage as well as consumer and commercial

finance (Wells Fargo & Company, 2014) to individuals, businesses, and institutions. Similarly,

BAC and WFC sustained upward trends in net income for the last three years. However, BAC

equity decreased from the 2012 level in 2013, while WFC equity increased year-over-year

between 2011 and 2013. Comparatively, the debt and equity mix of WFC and BAC enables

leverage analysis (Ross et al., 2013). To assist in competitive leverage analysis considering

current year events; the WFC financial information in Table 5 is a selective extraction from the

2014 second quarter financial statements.

Competitive Review

As of August 8, 2014, WFC’s market value of equity is 5.29 billion outstanding shares

multiplied by per share stock price of $50.00 which equals $264.5 billion (United States

Securities and Exchange Commission, 2014; “Wells Fargo & Company (WFC),” 2014b). The

market value of debt and tax rate can represent estimated book valuations (see Equation 7). For

WFC, as of June 30, 2014, the book value of long-term debt was $168 billion (“Wells Fargo &

Co (NYSE:WFC),” n.d.), and the effective tax rate was 30.63% (“Wells Fargo & Company

(WFC),” n.d.a). Moreover, beta for WFC is 0.89 (“Wells Fargo & Company (WFC),” 2014a).

Based on variable substitution (see Equation 4), WFC’s CAPM is calculated as 0.0626 (= .0003

+ 0.89 x (.0703 - .0003)), whereby the cost of equity for WFC is 6.26%.


Considering WFC has multiple long-term debt issuances, an average yield maturity rate

for bonds was employed to estimate the borrowing rate of 4.72% (“Bonds,” n.d.). Consequently,

WFC’s after-tax cost of debt is 3.27% (= .6937 x .0472). Furthermore, the combined value of

capital for WFC is $432.5 billion (see Table 5). Consequently, the WACC for WFC is 5.05%

(see Appendix B).

Table 5

Debt and Equity Information for BAC and WFC in Billions, Except for the Debt-equity ratio,

CAPM and WACC

BAC Value

Book value of long-term debt as of June, 30, 2014 $257.0

Market value of equity as of August 8, 2014 $159.8

Total combined value of capital $416,8

Debt-equity ratio 160.83%

CAPM 14.03%

WACC 7.18%

WFC Value

Book value of long-term debt as of June, 30, 2014 $168.0

Market value of equity as of August 8, 2014 $264.5

Total combined value of capital $432.5

Debt-equity ratio 63.51%

CAPM 6.26%

WACC 5.05%


BAC has a higher calculated debt-equity ratio than WFC (see Table 5). Furthermore,

BAC has a higher WACC rate than WFC, thus reflecting a higher overall expected return BAC

must earn to maintain the value of assets (Ross et al., 2013). Therefore, the lower calculated

WFC WACC percentage reflects a lower risk and capital structure rate (Ross et al., 2013). If

utilized as an evaluation approach for projects by WFC, the lower WACC communicates lesser

financial risk when seeking capital financing compared to BAC. In other words, WFC projects

require a lower return rate from raised capital than BAC. Nonetheless, WFC has increased

equity over the last three years (see Table 1) indicating WFC is decreasing leverage-based risk.

Capital Structure Theories

Empirically, academic evidence demonstrates industry classification, ownership

concentration, firm size, growth options, asset specificity, and profitability are primary

determinants of capital structure choice reflecting theoretical assumptions (Bhabra, Liu, &

Tirtiroglu, 2008). The fundamental assumption of the trade-off theory is leveraging exhibits

optimization adjustment where deviations from the target face gradual elimination (Eckbo,

2008). The key forecast of pecking-order theory is the strict ordering of financing. These two

concepts can represent broad organizing frameworks conceivably aiding in accounting for

numerous facts related to capital structuring (Eckbo, 2008). Nevertheless, it is also reasonable to

assess both theoretical explanations as elements of a wider factor set determining a firm’s capital

structure (Eckbo, 2008). Regarding this matter, scholars as well as practitioners appear prone to

see both theories in this more restrained approach (Eckbo, 2008; Ross et al., 2013).

Trade-off theory addresses a firm’s capital structure decision between the tax benefits,

distress costs and agency costs (Ross et al., 2013). Tax benefits accrue to a corporate issuer


through debt when the government regulator permits interest payments as a reduction in taxable

income, thereby enabling a tax shield (Ross et al., 2013). Distress denotes the direct legal and

administrative costs of reorganization or liquidation; while indirect costs include the impaired

ability to conduct business and agency costs (Ross et al., 2013). Contentiously, a trade-off exists

because a firm’s value increases through debt acquisition for organizations remitting corporate

taxes. Whereby, tax benefits are offset by the financial distress created with an increased risk of

failure due to the inability to pay creditors or investors (Bhabra et al., 2008; Ross et al., 2013).

Alternatively or correspondingly, pecking-order theory in pure form assumes timing is

the only consideration in issuing equity (Ross et al., 2013). Nevertheless, as prioritized, under

the pecking-order theory organizations should deploy internal financing before external

financing and issue the safest securities first for external financing. Moreover, the pecking-order

implies if there is a requirement for outside funding, issue debt before equity (Ross et al., 2013).

Lastly, only upon reaching the firm’s debt capacity should an organization consider equity

financing (Ross et al., 2013).

Similarly, trade-off and pecking-order theory in practical application require assessable

taxes, distress costs, and agency costs consideration (Ross et al., 2013). However, timing is an

important motivator under the pecking-order theory (Ross et al., 2013). Furthermore, pecking-

order theory primary inferences reflect having no leverage target value, profitable firms

exercising less debt, and retaining relatively large cash balances (Ross et al., 2013). Wherefore,

the attraction of interest tax shields and the threat of financial distress are secondary

consideration assumptions (Shyam-Sunder & Myers, 1999). Contrastingly, the trade-off theory

suggests an optimal amount of leverage exists for firms (Ross et al., 2013). Additionally, more

profitable firms generate greater debt capacity to capture the leverage benefits, and debt has a


lesser impact on public perception of capital overvaluation under the trade-off theory (Ross et al.,

2013).

BAC and WFC are two entities exemplifying utilization of capital structure theory.

Though the leverage ratio of WFC is higher than BAC; both financial services firms have

relatively high individual debt levels compared to equity (see Table 5). In replicating most

industry norms, BAC and WFC appear to have employed trade-off theory as a basis for high debt

financing rather than the pecking-order theory (Ross et al., 2013). Therefore, BAC and WFC are

receiving the tax benefits of debt financing. However, as previously stated, the trade-off theory

suggests that there is an optimal balance of debt financing and costs of distress as well as agency

(Ross et al., 2013).

Summary

BAC is a financial services firm with a previously planned growth strategy that reflects

relationship marketing theory to gain a competitive advantage (Bank of America Corporation,

2014a; Szmigin, Canning, & Reppel, 2005). Thus, BAC’s strategic emphasis is focused on

linking the enterprise’s outstanding capabilities with individuals, organizational formations, and

institutional investors (Bank of America Corporation, 2014a). Regarding this matter, in the last

three years, ROE increased for BAC. Whereby, BAC’s ROE increases are due to increases in

profit margins (see Table 1). BAC’s upward trend in profit margin (see Table 2) coincides with

an increase net income (see Table 1). Moreover, as of December 31, 2013, BAC’s ROE and

growth rate is 4.91%, which indicates a mature firm experiencing moderate expansion (see Table

3). However, regulatory constraints imposed by the United States Federal Reserve since 2009

have mitigated BAC dividend growth to zero (Rexrode, 2014).


For BAC, the 2013 price-to-earnings multiple of 3.94 is lower than the growth rate of

4.91% which can produce stock undervaluation cognitions and appear likely to have future value

increases (see Table 3). Furthermore, BAC’s beta of 2.00 indicates high stock price volatility to

market movement and a relatively high-risk factor (Ross et al., 2013). As a consequence,

utilizing the CAPM formula (see Equation 4), the expected investment return for BAC is

14.03%. This CAPM percentage represents a rate higher than the average historically-based

international equity premium of 7% (Ross et al., 2013). Whereas, the BAC WACC is 7.18%

(see Table 5). Whereby, the BAC WACC rate indicates a low risk of distress associated with

debt given the significantly high CAPM percentage.

Expected inflation apparently operates through the ability to capture aspects of the firm's

anticipated future (Frank & Goyal, 2009). When forecasted inflation is high, firms tend to have

higher leverage enabling higher real valuation of tax deductible debt (Frank & Goyal, 2009).

Thus, the trade-off theory predicts leverage having a positive relationship with expected inflation

(Frank & Goyal, 2009). Moreover, market timing in debt markets "results in a positive relation

between expected inflation and leverage if managers issue debt when expected inflation is high

relative to current interest rates" (Frank & Goyal, 2009, p. 10). Consequently, if needed, firms

should "issue more debt when current interest rates are low relative to historical levels" (Frank &

Goyal, 2009, p. 11).

Currently, Standard & Poor’s foresees international new debt and refinancing demand

rising up to $60 trillion between 2014 and 2018 for organizations, an increase from an estimated

$53 trillion for the 2013-2017 period (Hong, 2014). Rising bond yields were one of the reasons

companies were able to attract investors (Cherney, 2013). Despite the growth in yields, interest

rates have remained at relatively low levels, a state that has encouraged firms to continue


borrowing money (Cherney, 2013). Furthermore, in 2013, retaining investment-grade debt was a

money-losing maneuver for investors (Cherney, 2013). Nevertheless, corporate bonds

outperformed other debt offerings (Cherney, 2013). Therefore, given BAC strengths outweigh a

high debt management risk by most measures included in this analysis and a current price-to-

earnings ratio of 19.77 (= 15.22/.77), BAC stock is a recommended investment (“Bank of

America Corporation (BAC),” 2014).


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Appendix A

Calculations for the weighted average cost of capital for BAC.

Weighted average cost of capital formula:

�� =�

� + � × �� +�

� + � × �� × �1 − ��

S is market value of equity = $159,841,072,000

B is market value of debt (in thousands) = $257,000,000,000

RS is return on stock = 14.03%

RB is the borrowing rate on debt = 3.83%

tc is the average tax rate = tax / income before tax = $717,000,000/$3,008,000,000 = 23.84%

�� =159,841

257,000 + 159,841 × 14.03% +257,000

257,000 + 159,841 × 3.83% × �1 − 23.84%�

�� = .3834 × .1403 + .6166 × .0383 × .7616 = .7616 = 7.18%


Appendix B

Calculations for the weighted average cost of capital for Capella, Inc.

Weighted average cost of capital formula:

�� =�

� + � × �� +�

� + � × �� × �1 − ��

S is market value of equity = $262,495,000,000

B is market value of debt (in thousands) = $167,878,000,000

RS is return on stock = 6.26%

RB is the borrowing rate on debt = 4.72%

tc is the average tax rate = tax / income before tax = $2,869,000,000/$8,655,000,000 = 33.15%

�� =262,495

167,878 + 262,495 × 6.26% +167,878

167,878 + 262,495 × 4.72% × �1 − 33.15%�

�� = .6099 × .0626 + .3901 × .0.0472 × .6685 = .0505 = 5.05%

Investment Analysis: Bank of America Corporation 2014

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