In his 2016 letter to Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) shareholders, Warren Buffett said he would exercise Berkshire's warrants to buy 700 million shares of Bank of America (NYSE:BAC) common stock if the bank raised its annual dividend to $0.44 or more. If this were to happen, Berkshire would become the single largest shareholder in the banking giant, and after the recently released bank stress test results, it's highly likely to happen.

Warren Buffett's Bank of America investment

Buffett insists that Berkshire Hathaway keep a minimum of $20 billion in cash at all times, and it often has a lot more than that. This allows Buffett to capitalize during tough economic times, or to "be greedy when others are fearful," as he's said.

Warren Buffett at Berkshire Hathaway's annual meeting.

Image Source: Getty Images.

That is exactly what Buffett did in 2011 when he invested $5 billion of Berkshire's capital in Bank of America in the wake of the financial crisis. However, Buffett didn't simply buy Bank of America stock. Instead, he worked out a deal that turned out to be extremely lucrative.

Buffett purchased $5 billion worth of preferred stock that paid a 6% annual dividend and, along with it, received warrants to purchase 700 million shares of Bank of America's common stock at any time before September 2021 for a price of just $7.14 per share.

Notice that the exercise price of $7.14 times 700 million equals (roughly) $5 billion, the same as the value of Berkshire's preferred stock. This was very intentional. This essentially gives Buffett the ability to exchange Berkshire's preferred stock in a cashless exchange for 700 million shares of B of A.

Bank of America's newly approved 2017 capital plan

Bank of America shareholders are likely to be pleased with the outcome of the Federal Reserve Board's 2017 stress test and the approval of the bank's capital plan.

Most significant for Buffett's purposes (more on that in a moment), Bank of America announced that it would increase its dividend by 60% to $0.12 per quarter ($0.48 annually), starting in the third quarter of 2017.

Perhaps even more significant from a general shareholder's point of view, Bank of America also announced that its already-generous buyback program would be more than doubled for 2017. The bank's board approved the repurchase of $12 billion in common stock during the period from July 1, 2017, through June 30, 2018, up from $5 billion on the current year's capital plan. This indicates that the bank's management still sees its stock as an attractive value.

Why Buffett may exercise his warrants now

In recent years, Buffett had indicated that Berkshire would probably exercise its Bank of America warrants shortly before they expired in 2021.

This year, however, Buffett modified this statement. Specifically, Buffett said, "If the dividend rate on Bank of America common stock -- now 30 cents annually -- should rise above 44 cents before 2021, we would anticipate making a cashless exchange of our preferred into common."

Why did Buffett care about a $0.44 dividend threshold? Well, the preferred stock pays Berkshire 6% on $5 billion, or $300 million per year. On the other hand, if Berkshire owned the 700 million common shares for which it has warrants, a $0.44 dividend would translate to $308 million in annual dividend income.

Since Bank of America is raising its annual dividend rate to $0.48, Berkshire can increase its income stream from its investment by $36 million per year by making the cashless exchange. Therefore, doing so is a no-brainer from Buffett's perspective.

To be clear, I'm not saying Buffett is necessarily going to make the conversion immediately. However, I'd be surprised if it wasn't done before Bank of America's third-quarter ex-dividend date.

Not a bad deal for the Oracle of Omaha and his shareholders

To sum up what's happening, over a period of roughly six years, Buffett has turned an investment worth $5 billion that pays $300 million per year into one that's worth about $17 billion and pays $336 million. This translates to an annualized return of roughly 23% on the investment thus far, and if Buffett's shareholder letters are any indication, he may hang on to his Bank of America shares for years to come.

Matthew Frankel owns shares of Bank of America and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.