Fargo NYSE: Wfc , Following The Term Paper

Length: 15 pages Sources: 1+ Subject: Economics Type: Term Paper Paper: #23855909 Related Topics: Debt, Net Present Value, Bank Of America, Stock Portfolio
Excerpt from Term Paper :

The liabilities are subject to reserve requirements, however. This means that the bank cannot have more financial assets than it has liabilities. So debt utilization is an entirely different animal in the banking industry than it is in conventional industries.

Therefore, typical debt utilization ratios are of little relevance. Interest coverage is tied to liquidity, and is therefore not measured for banks. The debt-to-equity ratio is measured, however. For Wells Fargo, this is 3.01. For Bank of America it is 3.97. The industry average is 3.28. The significance of this metric in the banking business is that the higher the ratio, the riskier the business. Another measure is the leverage ratio. This is at Wells Fargo 12.0, versus 9.7 at Bank of America and 14.7 overall. Thus, both of these companies are less highly leveraged than the industry as a whole. Wells Fargo has a lower debt-to-equity ratio indicating lower risk than Bank of America.

8) The DuPont number is used to provide a more in-depth analysis of the return on equity figure. The ROE is broken down into the operating leverage, asset use efficiency and the equity multiplier. The idea as that ROE changes can be understood as being a function of these three items and that it is important to know the relative contribution levels of each of these three. Because of the lack of asset turnover figures, however, the traditional DuPont analysis cannot be used in the banking industry. There is, however, a version of the DuPont that is used for banks. This formula is:

ROA = Asset Utilization -- Expense Ratio -- (taxes/average total assets)

Where asset utilization is the revenues divided by average total assets and the expense ratio is the total operating expense divided by the average total assets.

Using figures obtained from MSN Moneycentral, this figure for Wells Fargo is 0.3. For Bank of America it is 0.4. The Bank DuPont distills returns into cost management and revenue management. We can see that Wells Fargo has a lower figure than its ROA while Bank of America has a higher figure than its ROA. For Wells Fargo, their tax management is weaker, as they paid more tax and less income. This offset the benefits of their asset utilization. Both firms had similar expense ratios. Thus, Wells Fargo uses its assets less efficiently and has weaker tax management than does Bank of America.

9) The degree of operating leverage is the degree to which income changes as a result of a change in sales. Based on figures from MSN Moneycentral, the operating leverage at Wells Fargo is 18.2 and the operating leverage at Bank of America is 14.1. This indicates that Wells Fargo exhibits a steeper reaction to income loss than does Bank of America.

The degree of financial leverage at Wells Fargo is 97.94%, indicating a strong correlation between the decline in EBIT and the decline in EPS. A financial leverage of less than 100% indicates that the firm's earnings are somewhat insulated from declines in EBIT, such that EPS does not decline or increase as quickly as EBIT. The degree of financial leverage at Bank of America is 105%, indicating that its EPS declines or increases more quickly than its EBIT. For Bank of America shareholders, their earnings declined more sharply than the company's earnings last year.

The degree of combined leverage for Wells Fargo is 18.2, whereas the degree of combined leverage for Bank of America is 14.1. These figures are unusual for the year 2008, given how sharply earnings decreased. Both the figures in financial leverage are based on figures net of expenses. Both banks suffered relatively minor declines in top line earnings but posted steep net profit declines as a result of writedowns on their toxic assets. This has skewed the figures for last year, such that the combined leverage score is almost entirely dictated by the operating leverage score.

Part II. 10) Both banks are highly leveraged. Therefore, the cost of capital is heavily weighted to the cost of debt. Within this, it is unreasonable to take debt at banks as being entirely bonds. Banks are, of course, financed by deposits, which are debt. At Wells Fargo, 64.5% of debt is deposits, thus 59.6% of the firm's


Given that, they must be included in the cost of capital. The cost of debt at banks is dictated in part by the prevailing interest rates that must be paid to depositors and the cost of debt that the bank pays to other banks. The latter is determined primarily by liquidity. To determine the cost of debt at a bank we must consider both of these debt forms. The interest expense is isolated on the balance sheet in terms of both interest on deposits and interest on borrowings. This can be evaluated against total deposits and total short-term and long-term borrowings. Thus, at Wells Fargo the cost of debt is 0.84%. This seems unusually low for any business until you isolate the deposit interest, which is 0.57%. Debt is weighted at Wells Fargo of 92.4%; equity at 7.6%.

The cost of equity at Wells Fargo can be calculated by using the capital asset pricing model. The risk free rate is considered to be the 3-month Treasury bond rate. According to Bloomberg, the yield on this is currently 0.15%. The beta for Wells Fargo is 1.3. The market return is taken to be 8.9%, based on the compounded annual gain in the S&P 500 from 1965-2008 (Buffett, 2008). This gives us a CAPM of Ra = 0.15 + (1.3)(8.9-.15) = 11.525%

Thus, the WACC for Wells Fargo is as follows:

(11.525)(.076)+(0.84)(.924) = 0.87 + 0.77 = 1.66%

For Bank of America, the cost of debt is higher, at 2.5%. This is because Bank of America's capital structure is less heavily weighted to deposits than Wells Fargo's structure. At Bank of America, deposits account for just 48.5% of the capital structure. Thus, the cost of debt is more heavily slanted towards bond issues at Bank of America, dramatically increasing this cost. Debt accounts for 90.2% of the capital structure.

The cost of equity is related to the measures above, but reflecting the beta of Bank of America. This beta is 2.39, which indicates severe volatility. Because volatility equates to risk, Bank of America's equity commands a high cost. The cost of equity is 21.06%. This volatility can help explain the high cost of debt relative to Wells Fargo as well.

The weighted-average cost of capital for Bank of America, given these figures, is 4.32%. The high degree of volatility at Bank of America is indicative of a bank where deposits play a lower role in the capital structure. It has resulted in Bank of America having a much higher cost of capital that Wells Fargo.

Indeed, when the corporate bond yields on these two firms are analyzed, this difference in risk is born out. An August 2010 maturity for Wells Fargo has a YTM of .559%; for Bank of America this is 1.945%. Wells Fargo debt is rated AA by Fitch; Bank of America debt is rated A by Fitch.

11) Based on the betas of Wells Fargo and Bank of America, one would expect that the latter would be the far more volatile of the two. Bank of America's 2.39 beta is indicative of a highly volatile firm, while Wells Fargo is much more stable at 1.39. As two of the nation's largest banks, they would be expected to move in much the same direction at the same time. The volatility means that Bank of America's movements should be much more intense in nature, but that they should show the same basic pattern as the movements at Wells Fargo.

What we see is that for the first eight months of the two-year study period (5/07 through 12/07) that the two banks did trade almost in lockstep. Through the end of September, both stocks were rangebound, ending up pretty much where they began. Over the course of the autumn that year, a steep decline begins and both banks finish the year between 15-20% off of their positions on May 1st. Bank of America stock was down further, but there is little indication of the strong volatility suggested by the beta.

In 2008 both banks drop further then begin a swift recovery. Contrary to what might be expected, Wells Fargo has the more intense recovery and more volatile stock price. Bank of America stock pulls slightly higher for a couple of days but this success is short-lived. After April 1st, 2008 the volatility difference between the two stocks becomes more evident. Both banks gradually begin to decline, heading for seasonal lows in mid-July. The difference is that the declines for Bank of America were far more intense during this period. By mid-July, Wells Fargo was down over 40% for the past 15 months, while Bank of America was down over 60%, highlighting the volatility. For the remainder of the summer,…

Sources Used in Documents:

Works Cited:

Company overview and some financials from MSN Moneycentral. Retrieved May 15, 2009 from http://moneycentral.msn.com/companyreport?Symbol=WFC

2008 Wells Fargo Annual Report. Retrieved May 15, 2009 from http://moneycentral.msn.com/companyreport?Symbol=WFC

No author. (2009). Wells Fargo Completes Wachovia Purchase. Reuters. Retrieved May 15, 2009 from http://uk.reuters.com/article/marketsNewsUS/idUKN0133136720090101

Wells Fargo History website. Retrieved May 15, 2009 from http://www.wellsfargohistory.com/

Cite this Document:

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