Convertible Securities

Case: Mogen Inc.

 Convertible Structure
• On January 10, 2006, the managing director of
Merrill Lynch’s Equity-Linked Capital Markets
Group, Dar Maanavi, was reviewing the final
drafts of a proposal for a convertible debt
offering by MoGen, Inc.
• As a leading biotechnology company in the
United States, MoGen had become an important
client for Merrill Lynch over the years
• In fact, if this deal were to be approved by
MoGen at $5 billion, it would represent Merrill
Lynch’s third financing for MoGen in four years
with proceeds raised totaling $10 billion
• Moreover, this “convert” would be the largest
such single offering in history
• The proceeds were earmarked to fund a variety
of capital expenditures, research and
development (R&D) expenses, working capital
needs, as well as a share repurchase program
• The Merrill Lynch team had been working with
MoGen’s senior management to find the right
tradeoff between the conversion feature and the
coupon rate for the bond
• Maanavi knew from experience that there was no
“free lunch,” when structuring the pricing of a
convertible
• Issuing companies wanted the conversion price
to be as high as possible and the coupon rate to
be as low as possible; whereas investors wanted
the opposite: a low conversion price and a high
coupon rate
• Thus, the challenge was to structure the convert
to make it attractive to the issuing company in
terms of its cost of capital, while at the same
time selling for full price in the market
• Maanavi was confident that the right balance in
the terms of the convert could be found, and he
was also confident that the convert would serve
MoGen’s financing needs better than a straight
bond or equity issuance
• But, he needed to make a decision about the final
terms of the issue in the next few hours, as the
meeting with MoGen was scheduled for early the
next morning.
MoGen
Merrill Lynch
 Company History
• Founded in 1985 as MoGen (Molecular Genetics) the • The success of that portfolio had been strong enough
company was among the first in the biotechnology to offset other R&D write-offs so that MoGen was
industry to deliver on the commercial promises of able to report $3.7 billion in profits in 2005 on $12.4
emerging sciences, such as recombinant DNA and billion in sales
molecular biology • Sales had grown at an annual rate of 29% over the
• After years of research, MoGen emerged with two of previous five years, and earnings per share had
the first biologically derived human therapeutic improved to $2.93 for 2005, compared with $1.81
drugs, RENGEN and MENGEN, both of which helped and $1.69 for 2004 and 2003, respectively (Exhibits 1
to offset the damaging effects from chemotherapy and 2)
for cancer patients undergoing treatment • The FDA served as the regulating authority to
• Those two MoGen products were among the first safeguard the public from dangerous drugs and
“blockbuster” drugs to emerge from the nascent required extensive testing before it would allow a
biotechnology industry drug to enter the U.S. marketplace
• By 2006, MoGen was one of the leading biotech
companies in an industry that included firms such as
Genentech, Amgen, Gilead Sciences, Celgene, and
Genzyme
• The keys to success for all biotech companies were
finding new drugs through research and then getting
the drugs approved by the U.S. Food and Drug
Administration (FDA)
• MoGen’s strategy for drug development was to
determine the best mode for attacking a patient’s
issue and then focusing on creating solutions via that
mode
• Under that approach, MoGen had been able to
produce drugs with the highest likelihood of both
successfully treating the patient as well as making
the company a competitive leader in drug quality
FDA
Genentech
Amgen
Gilead Sciences
Celgene
Genzyme
Rengen
Mengen
Mogen
Biosimilars
 Company History
• The multiple hurdles and long lead-times
required by the FDA created a constant tension
with the biotech firms who wanted quick
approval to maximize the return on their large
investments in R&D
• Moreover, there was always the risk that a drug
would not be approved or that after it was
approved, it would be pulled from the market
due to unexpected adverse reactions by patients
• Over the years, the industry had made progress
in shortening the approval time and improving
the predictability of the approval process
• At the same time, industry R&D expenditures had
increased 12.6% over 2003 in the continuing race
to find the next big breakthrough product
• Like all biotech companies, MoGen faced
uncertainty regarding new product creation as
well as challenges involved with sustaining a
pipeline of future products
• Now a competitive threat of follow-on biologics
or “biosimilars” began emerging
• As drugs neared the end of their patent
protection, competitors would produce similar
drugs as substitutes
• Competitors could not produce the drug exactly,
because they did not have access to the original
manufacturer’s molecular clone or purification
process
• Thus, biosimilars required their own approval to
ensure they performed as safely as the original
drugs
• For MoGen, this threat was particularly
significant in Europe, where several patents were
approaching expiration
 Funding Needs
• MoGen needed to ensure a consistent supply of • With 11 late-stage “mega-site” trials expected to
cash to fund R&D and to maintain financial commence in 2006, management knew that
flexibility in the face of uncertain challenges and successful outcomes were critical for MoGen’s
opportunities ability to maintain momentum behind its new
• MoGen had cited several key areas that would drug development pipeline
require approximately $10 billion in funding for • The trials would likely cost $500 million
2006: • MoGen had also decided to diversify its product
• Expanding manufacturing and formulation, and line by significantly increasing R&D to
fill and finish capacity approximately $3 billion for 2006, which was an
• Recently, the company had not been able to scale increase of 30% over 2005
up production to match increases in demand for • Acquisition and licensing
certain core products • MoGen had completed several acquisition and
• The reason for the problem was that MoGen licensing deals that had helped it achieve the
outsourced most of its formulation and fill and strong growth in revenues and earnings per share
finish manufacturing processes, and these (EPS)
offshore companies had not been able to expand •
their operations quickly enough
• Therefore, MoGen wanted to remove such supply
risks by increasing both its internal
manufacturing capacity in its two existing
facilities in Puerto Rico as well as new
construction in Ireland
• These projects represented a majority of
MoGen’s total capital expenditures that were
projected to exceed $1 billion in 2006
• Expanding investment in R&D and late-stage
trials
 Funding Needs
• The company expected to continue this • As of December 31, 2005, MoGen had $6.5
strategy and had projected to complete a billion remaining in the authorized share
purchase of Genix, Inc., in 2006 for repurchase plan, of which management
approximately $2 billion in cash expected to spend $3.5 billion in 2006
• This acquisition was designed to help MoGen • With internally generated sources of funds
capitalize on Genix’s expertise in the expected to be $5 billion (net income plus
discovery, development, and manufacture of depreciation), MoGen would fall well below
human therapeutic antibodies the $10 billion expected uses of funds for
2006
• The stock repurchase program
• Due to the highly uncertain nature of its • Thus, management estimated that an
operations, MoGen had never issued offering size of about $5 billion would cover
dividends to shareholders but instead had MoGen’s needs for the coming year
chosen to pursue a stock repurchase program • Through various share repurchase programs
authorized by the board of directors, MoGen
• Senior management felt that this
had repurchased $4.4 billion, $4.1 billion, and
demonstrated a strong belief in the
company’s future and was an effective way to $1.8 billion of MoGen common stock in 2005,
return cash to shareholders without being 2004, and 2003, respectively
held to the expectation of having a regular
dividend payout
• Due to strong operational and financial
performance over the past several years,
MoGen had executed several billion dollars
worth of stock repurchases, and it was
management’s intent to continue
repurchases over the next few years
 Convertible Debt
• A convertible bond was considered a hybrid
security, because it had attributes of both debt
and equity
• From an investor’s point of view, a convert
provided the safety of a bond plus the upside
potential of equity
• The safety came from receiving a fixed income
stream in the form of the bond’s coupon
payments plus the return of principal
• The upside potential came from the ability to
convert the bond into shares of common stock
• Thus, if the stock price should rise above the
conversion price, the investor could convert and
receive more than the principal amount
• Because of the potential to realize capital
appreciation via the conversion feature, a
convert’s coupon rate was always set lower than
what the issuing company would pay for straight
debt
• Thus, when investors bought a convertible bond,
they received less income than from a
comparable straight bond, but they gained the
chance of receiving more than the face value if
the bond’s conversion value exceeded the face
value
• To illustrate, consider a convertible bond issued
by BIO, Inc., with a face value of $1,000 and a
maturity of five years
• Assume that the convert carries a coupon rate of
4% and a conversion price of $50 per share and
that BIO’s stock was selling for $37.50 per share
at the time of issuance
• The coupon payment gives an investor $40 per
year in interest (4% × $1,000), and the conversion
feature gives investors the opportunity to
exchange the bond for 20 shares (underlying
shares) of BIO’s common stock ($1,000 ÷ $50)
• Because BIO’s stock was selling at $37.50 at
issuance, the stock price would need to
appreciate by 33% (conversion premium) to
reach the conversion price of $50
• For example, if BIO’s stock price were to
appreciate to $60 per share, investors could
convert each bond into 20 shares to realize the
bond’s conversion value of $1,200
 Convertible Debt
• On the other hand, if BIO’s stock price failed to reach
$50 within the five-year life of the bond, the investors
would not convert, but rather would choose to
receive the bond’s $1,000 face value in cash
• Because the conversion feature represented a right,
rather than an obligation, investors would postpone
conversion as long as possible even if the bond was
well “in the money”
• Suppose, for example, that after three years BIO’s
stock had risen to $60
• Investors would then be holding a bond with a
conversion value of $1,200; which is to say, if
converted they would receive the 20 underlying
shares worth $60 each
• With two years left until maturity, however, investors
would find that they could realize a higher value by
selling the bond on the open market, rather than
converting it
• For example, the bond might be selling for $1,250;
$50 higher than the conversion value
• Such a premium over conversion value is typical,
because the market recognizes that convertibles have
unlimited upside potential, but protected downside
• Unlike owning BIO stock directly, the price of the
convertible bond cannot fall lower than its bond
value—the value of the coupon payments and
principal payment—but its conversion value could
rise as high as the stock price will take it
• Thus, as long as more upside potential is possible, the
premium price will exist, and investors will have the
incentive to sell their bonds, rather than convert
them prior to maturity
• If BIO paid a dividend on its stock and if the dividend
cash flow exceeded the coupon payment, investors
might convert prior to maturity in order to capture
the higher cash flow afforded by owning the stock
• Academics modeled the value of a convertible as the
sum of the straight bond value plus the value of the
conversion feature
• This was equivalent to valuing a convert as a bond
plus a call option or a warrant
• Although MoGen did not have any warrants
outstanding, there was an active market in MoGen
options (Exhibit 3)
• Over the past five years, MoGen’s stock price had
experienced modest appreciation with considerable
variation (Exhibit 4)
 MoGen’s Financial Strategy
• As of December 31, 2005, the company had
approximately $4 billion of long-term debt on the
books (Exhibit 5)
• About $2 billion of the debt was in the form of
straight debt with the remaining $1.8 billion as
seven-year convertible notes
• The combination of industry and company-specific
risks had led MoGen to keep its long-term debt at or
below 20% of total capitalization
• There was a common belief that because of the
industry risks, credit-rating agencies tended to
penalize biotech firms by placing a “ceiling” on their
credit ratings
• MoGen’s relatively low leverage, however, allowed it
to command a Standard and Poor’s (S&P) rating of
A+, which was the highest rating within the industry
• Based on discussions with S&P, MoGen management
was confident that the company would be able to
maintain its rating for the $5 billion new straight debt
or convertible issuance
• For the current market conditions, Merrill Lynch had
estimated a cost to MoGen of 5.75%, if it issued
straight five-year bonds
• See Exhibit 6 for capital market data
• MoGen’s seven-year convertible notes had been
issued in 2003 and carried a conversion price of
$90.000 per share
• Because the stock price was currently at $77.98 per
share, the bondholders had not yet had the
opportunity to exercise the conversion option
• Thus, the convertibles had proven to be a low-cost
funding source for MoGen, as it was paying a coupon
of only 1.125%
• If the stock price continued to remain below the
conversion price, the issue would not be converted
and MoGen would simply retire the bonds in 2010
(or earlier, if called) at an all-in annual cost of 1.125%
 MoGen’s Financial Strategy
• On the other hand, if the stock price appreciated
substantially by 2010, then the bondholders would
convert and MoGen would need to issue 11.1 shares per
bond outstanding or approximately 20 million new
shares. Issuing the shares would not necessarily be a bad
outcome, because it would amount to issuing shares at
$90 rather than at $61, the stock price at the time of
issuance
• Like most convertibles, MoGen’s seven-year notes were
callable
• This meant that MoGen had the right to buy back the
bonds at a given call price at a 10% or 15% premium over
face value
• The call provision was often used as a means to force the
bondholders to convert their bonds into stock
• For example, assume a bond was callable at “110” (10%
over face value) and the underlying stock price had
appreciated so that the bond price had risen to a 20%
premium over face value. If the company called the bond
at 110, investors would choose to convert, to keep the
20% premium rather than accept the 10% call premium
from the company
• Interest expense for convertibles was tax deductible just
like interest on straight bonds
• Thus, the 1.125% coupon rate would represent an after-
tax cost of about 0.78%, for a 40% tax rate
• Convertible bondholders had no voting rights prior to
converting the bonds into equity
• The impact of conversion was reported in fully diluted
earnings per share that was computed using the potential
shares outstanding, including shares issued in the event
of a conversion
• Since its initial public offering (IPO), MoGen had avoided
issuing new equity, except for the small amounts of new
shares issued each year as part of management’s
incentive compensation plan
• The addition of these shares had been more than offset,
however, by MoGen’s share repurchase program, so that
shares outstanding had fallen from 1,280 million in 2004,
to 1,224 million in 2005
• Repurchasing shares served two purposes for MoGen: (1)
It had a favorable impact upon EPS by reducing the
shares outstanding; and (2) It served as a method for
distributing cash to shareholders
• Although MoGen could pay dividends, management
preferred the flexibility of repurchasing shares
• If MoGen were to institute a dividend, there was always
the risk that the dividend might need to be decreased or
eliminated during hard times which, when announced,
would likely result in a significant drop of the stock price
 Merrill Lynch Equity-Linked
Origination Team
• The U.S. Equity-Linked Origination
Team was part of Merrill Lynch’s Equity
Capital Markets Division that resided in
the Investment Banking Division
• The team was the product group that
focused on convertible, corporate
derivative, and special equity
transaction origination for Merrill
Lynch’s U.S. corporate clients
• As product experts, members worked
with the industry bankers to educate
clients on the benefits of utilizing
equity-linked instruments
• They also worked closely with
derivatives and convertible traders, the
equity and equity-linked sales teams,
and institutional investors including
hedge funds, to determine the market
demand for various strategies and
securities
• Members had a high level of expertise
in tax, accounting, and legal issues
• The technical aspects of equity-linked
securities were rigorous, requiring
significant financial modeling skills,
including the use of option pricing
models, such as Black-Scholes and
other proprietary versions of the
model used to price convertible bonds
• Within the equities division and
investment banking, the team was
considered one of the most technically
capable and had proven to be among
the most profitable businesses at
Merrill Lynch
 Pricing Decision
• Dar Maanavi was excited by the prospect that
Merrill Lynch would be the lead book runner of
the largest convertible offering in history
• At $5 billion, MoGen’s issue would represent
more than 12% of the total proceeds for
convertible debt in the United States during 2005
• Although the convert market was quite liquid and
the Merrill Lynch team was confident that the
issue would be well received, the unprecedented
size heightened the need to make it as
marketable as possible
• Maanavi knew that MoGen wanted a maturity of
five years, but was less certain as to what he
should propose regarding the conversion
premium and coupon rate
• These two terms needed to be satisfactory to
MoGen’s senior management team while at the
same time being attractive to potential investors
in the marketplace
• Exhibit 7 shows the terms of the offering that
had already been determined
• Most convertibles carried conversion premiums
in the range of 10% to 40%
• The coupon rates for a convertible depended
upon many factors, including the conversion
premium, maturity, credit rating, and the
market’s perception of the volatility of the issuing
company’s stock
• Issuing companies wanted low coupon rates and
high conversion premiums, whereas investors
wanted the opposite: high coupons and low
conversion premiums
• Companies liked a high conversion premium,
because it effectively set the price at which its
shares would be issued in the future
• For example, if MoGen’s bond was issued with a
conversion price of $109, it would represent a
40% conversion premium over its current stock
price of $77.98
• Thus, if the issue were eventually converted, the
number of MoGen shares issued would be 40%
less than what MoGen would have issued at the
current stock price
• Of course, a high conversion premium also
carried with it a lower probability that the stock
would ever reach the conversion price
 Pricing Decision
• To compensate investors for this reduced upside
potential, MoGen would need to offer a higher
coupon rate
• Thus, the challenge for Maanavi was to find the
right combination of conversion premium and
coupon rate that would be acceptable to MoGen
management as well as desirable to investors
• There were two types of investor groups for
convertibles: fundamental investors and hedge
funds
• Fundamental investors liked convertibles,
because they viewed them as a safer form of
equity investment
• Hedge fund investors viewed convertibles as an
opportunity to engage in an arbitrage trading
strategy that typically involved holding long
positions of the convertible and short positions
of the common stock
• Companies preferred to have fundamental
investors, because they took a longer-term view
of their investment than hedge funds
• If the conversion premium was set above 40%,
fundamental investors tended to lose interest
because the convertible became a more
speculative investment with less upside potential
• Thus, if the conversion premium were set at 40%
or higher, it could be necessary to offer an
abnormally high coupon rate for a convertible
• In either case, Maanavi thought a high conversion
premium was not appropriate for such a large
offering
• It could work for a smaller, more volatile stock,
but not for MoGen and not for a $5 billion
offering
• Early in his conversations with MoGen, Maanavi
had discussed the accounting treatment required
for convertibles
• Recently, most convertibles were being
structured to use the “treasury stock method,”
which was desirable because it reduced the
impact upon the reported fully diluted EPS
 Pricing Decision
• To qualify for the treasury stock method the • In light of MoGen management’s objectives,
convertible needed to be structured as a net Maanavi decided to propose a conversion
settled security premium of 25%, which was equivalent to
• This meant that investors would always receive conversion price of $97.00
cash for the principal amount of $1,000 per bond, • MoGen management would appreciate that the
but could receive either cash or shares for the conversion premium would appeal to a broad
excess over $1,000 upon conversion segment of the market, which was important for
• The alternative method of accounting was the if- a $5 billion offering
converted method, which would require MoGen • On the other hand, Maanavi knew that
to compute fully diluted EPS, as if investors management would be disappointed that the
received shares for the full amount of the bond conversion premium was not higher
when they converted; which is to say the new • Management felt that the stock was selling at a
shares equaled the principal amount divided by depressed price and represented an excellent buy
the conversion price per share • In fact, part of the rationale for having the stock
• The treasury stock method, however, would repurchase program was to take advantage of the
allow MoGen to report far fewer fully diluted stock price being low
shares for EPS purposes because it only included
shares representing the excess of the bond’s
conversion value over the principal amount
• Because much of the issue’s proceeds would be
used to fund the stock repurchase program,
MoGen’s management felt that using the
treasury stock method would be a better
representation to the market of MoGen’s likely
EPS, and therefore agreed to structure the issue
accordingly (see “conversion rights” in Exhibit 7)
 Pricing Decision
• Maanavi suspected that management
would express concern that a 25%
premium would be sending a bad signal to
the market: a low conversion premium
could be interpreted as management’s lack
of confidence in the upside potential of the
stock
• For a five-year issue, the stock would only
need to rise by 5% per year to reach the
conversion price by maturity
• If management truly believed the stock had
strong appreciation potential, then the
conversion premium should be set much
higher
• If Maanavi could convince MoGen to
accept the 25% conversion premium, then
choosing the coupon rate was the last
piece of the pricing puzzle to solve
• Because he was proposing a mid-range
conversion premium, investors would be
satisfied with a modest coupon
• Based on MoGen’s bond rating, the
company would be able to issue straight
five-year bonds with a 5.75% yield
• Therefore, Maanavi knew that the
convertible should carry a coupon rate
noticeably lower than 5.75%
• The challenge was to estimate the coupon
rate that would result in the debt being
issued at exactly the face value of $1,000
per bond
• Although the conversion premium would
be determined in advance of the issuance,
the conversion price would be determined
based on the stock price on the issuance
day
• For example, a 25% conversion premium
would lead to a conversion price of $100, if
MoGen’s stock price were to rise to $80 on
the date of issuance
 Selected Terms of Convertible Senior Notes
• Notes Offered: $5,000,000,000 principal amount of Convertible Senior Notes due February 1, 2011

• The annual interest rate of _______ would be payable semiannually in arrears in cash on January 1 and July 1 of each year,
beginning July 1, 2006

• Holders will be able to convert their notes prior to the close of business on the business day before the stated maturity date
based on the applicable conversion rate

• The conversion rate will be ____ shares of common stock per $1,000 principal amount. This is equivalent to a conversion price
of ____ per share of common stock

• Upon conversion, a holder will receive an amount in cash equal to the lesser of (i) the principal amount of the note, and (ii) the
conversion value. If the conversion value exceeds the principal amount of the note on the conversion date, MoGen will deliver
cash or common stock or a combination of cash and common stock for the conversion value in excess of $1,000

• Ranking: The notes will rank equal in right of payment to all of MoGen’s existing and future unsecured indebtedness and senior
in right to payment to all of MoGen’s existing and future subordinated indebtedness

• Use of Proceeds: We estimate that the net proceeds from this offering will be approximately $4.9 billion after deducting
estimated discounts, commissions, and expenses. We intend to use the net proceeds for our share repurchase program as well
as for working capital and general corporate purposes
 Synopsis and Objectives
• In 2006, Merrill Lynch became the lead book
runner for a $5 billion convertible bond issue for
MoGen, Inc.
• This was the single, largest convertible bond
issuance in history and required a considerable
amount of effort on the part of Merrill Lynch’s
Equity Derivatives Group to convince MoGen’s
management to choose Merrill Lynch over its
competitors
• The case is focused on Merrill Lynch’s choice of
the conversion premium and coupon rate to
propose to MoGen management
• Understand the concept of valuing a convertible
as the sum of a straight bond plus the conversion
option
• Valuing the conversion option as a call option
requires the estimation of the Black-Scholes
model, with the volatility being a particularly
challenging input
• Matching a company’s business risk with the type
of financing: equity, debt, or convertible debt
• In that regard, MoGen presents the interesting
financial challenge of needing a significant
amount of funds for 2006 for a variety of uses,
but particularly for its share repurchase plan,
which was estimated as $3.5 billion for 2006
• Deals with the financial-engineering issues
associated with using derivatives to increase
MoGen’s conversion premium from 11% (the
actual premium) to 50%
• Provides a strong reinforcement of option-pricing
principles by demonstrating how an investment
bank can reconstruct a security by taking long or
short positions in puts or call options
 Discussion Question

How important is it for MoGen to get $5 billion

of external funding in 2006?

Could the company cut back on its share

repurchase program, for example, to reduce the
funds needed?
 Discussion Question

What are the pros and cons of issuing

convertible debt via straight debt or equity?
 Discussion Question
The case states a convertible bond can be valued as the sum of a
straight bond plus a call option. Starting with the current stock
price of $77.98 per share, how can you use the Black-Scholes
model to estimate the value of the conversion option with a 25%
conversion premium for one share of MoGen stock?

Be prepared to explain your choice for the stock price, exercise

price, risk-free rate, time to maturity, dividend yield, and volatility

How should you convert this option value per share into to the
option value for a bond with $1,000 face value?
 Discussion Question
What is the value of the straight bond component?
What coupon rate should Manaavi propose in order
for the convert to sell at exactly $1,000 per bond?
What discount rate did you use to value the straight
bond component?
Conceptually, what should happen to the coupon
rate if Manaavi were to propose a 15% conversion
premium? a 40% conversion premium?
 Discussion Question

As MoGen’s CEO, what do like and not like about

this proposal from Merrill Lynch? In particular,
do you like the 25% conversion premium? the
coupon rate?
 Discussion Question

Using the actual terms for the 2011 and 2013

notes, compute the respective straight bond
values and conversion option values to verify
that they sum to $1,000 per bond
 Discussion Question

What implied volatility do you find for the 2011

notes?
What about for the 2013 notes?
 Discussion Question

How could Merrill Lynch use financial

engineering to change the conversion premiums
of the 2011 and 2013 notes to 50%?

Think about what financial engineering MoGen

would need to do to change the convertible
bond into a straight one
 Discussion Question

In other words, what transaction when combined with

the convertible would effectively remove the
conversion option component to create a financially
engineered straight bond?

Then as a second step, think about what could be done

to change the straight bond into the equivalent of a
convertible bond with a 50% conversion premium)
 Discussion Question

How much do you estimate this sort of

transaction would cost MoGen?

Why take this approach as opposed to simply

designing the issue with a 50% conversion
premium in the first place?
How would you describe MoGen’s business model and
current operating environment?
• MoGen’s choice of financing • Both activities have
in terms of the underlying significant risks that are
business risk of a company endemic to biotech
• It is important to establish a businesses
solid understanding of the • MoGen’s share repurchase
business before addressing serves as a transition to
the task of how to finance it MoGen’s financing strategy
• The biotech industry relies
heavily upon research and
development (R&D), as well
as the ability to get a new
drug to market
 How would you describe MoGen’s
financing strategy?
• The risks of the biotech business • Share repurchase program is a
are driving all of MoGen’s financial very good match for a biotech
decisions: debt policy, dividend company like MoGen
policy, and share repurchase • The company can distribute cash
program to its shareholders when profits
• Debt is relatively low because allow, but without making an
higher debt levels would result in explicit (debt) or implicit
debt rating decreases and (dividends) promise to the market
therefore higher interest rates
• Similarly, the company chooses to
pay no dividends because of the
risk of being forced to cut the
dividend during the difficult times
that invariably arise in a biotech
business
 What are MoGen’s uses of funds for 2006?
How important is the share repurchase program to MoGen’s
choice to issue a convertible bond?
• Share repurchase program as a • Thus, MoGen could
critical use of funds for 2006 significantly reduce its funding
• The primary advantage of needs by postponing the share
share repurchases using repurchases and possibly fund
dividends is that management the remaining shortfall with
can turn share repurchases off straight debt
and on as allowed by cash flow • If MoGen management
• The other projected uses of continues with the share
funds, however, are largely repurchase plan, however
driven by business issues that plan, however, see several
are not as flexible for advantages of using the
management convertible bond as MoGen’s
funding choice
• Most of the $5 billion raised
will be used to repurchase
shares ($3.5 billion)
 How can we use the Black-Scholes pricing model to value the
conversion option component of the convertible?

• Technical aspect of pricing the • Other key points of emphasis will be

convertible and, in particular, to the estimation of volatility and
choosing the correct input values for translation of the conversion premium
the Black-Scholes pricing model to into the stock price and exercise price
estimate the value of the conversion
option
• A key conceptual point will be valuing
the conversion option at the bond
level, rather than at the share level
 What coupon rate did you get for a 25%
conversion premium?
• Solving for the • How low the coupon
coupon rate on the rate is, relative to the
straight bond discount rate of
component such that 5.75%
the total value of the
convertible sums to
$1,000 per bond
• A key point of
emphasis will be the
discount rate used to
value the bond cash
flows
 Epilogue
• The actual terms of • How Merrill Lynch
MoGen’s deal with designed this bond
particular emphasis hedge plus warrant
upon the low transaction?
conversion premiums
and coupon rates
• How Merrill Lynch
was able to alter the
effective conversion
premium by having
MoGen buy and sell
warrants with
 Discussion Question

How would you describe MoGen’s business

model and current operating environment?
 Discussion Question

How would you describe MoGen’s financing

strategy?
 Discussion Question

What are MoGen’s uses of funds for 2006?

How important is the share repurchase program

to MoGen’s choice to issue a convertible bond?
 Discussion Question

How can we use the Black-Scholes pricing model

to value the conversion option component of
the convertible?
 Discussion Question

What coupon rate did you get for a 25%

conversion premium? (Optional: For a 15%
premium? for a 40% premium?)
 Discussion Question
Why did MoGen agree to issue a convertible with the
“wrong” terms?

Merrill Lynch viewed them as the sweet spot in the

convertible market, the terms that would attract the most
interest and therefore the best price for MoGen

Merrill Lynch also knew that it could use derivatives to

change the terms for MoGen, so that it was viewed as a
two-step process from the beginning
 Discussion Question

Does it appear that Merrill Lynch priced the

2011 and 2013 notes appropriately?
 Does it appear that Merrill Lynch priced the
2011 and 2013 notes appropriately?
• The actual terms of the convertible • The bond-plus-option framework
were noticeably different than what works well for the actual terms and, in
was proposed in the case. MoGen’s particular, that the implied volatility
stock price had fallen to $71.93, the for the 2011 and 2013 notes is very
coupon rates were lower, and the close to the value
conversion premiums were
substantially lower. All of which makes
it a valuable exercise to run through
the pricing of the 2011 and 2013
notes to reinforce the pricing principle
 How can we change MoGen’s financially engineered straight
bond into a convertible bond with a 50% conversion premium?

• A good way to begin this analysis is that a convertible can be

valued as the sum of a straight bond plus a warrant/option
• Therefore, for each convertible bond issued by MoGen, the
company is short a bond and short a bundle of call options
• The short options can be nullified, if MoGen buys call options with
the same terms (exercise price and maturity)
• The combination of the convertible plus the call options is
equivalent to having issued a straight bond
• Finally, a new synthetic convertible can be created by MoGen
selling warrants with a strike price set at a 50% conversion
premium; which is to say, 50% higher than the stock price at time
of issuance
 How much should MoGen pay to buy the call options? How
much should MoGen realize from the sale of the warrants?

• Understanding the concepts behind the hedge

is important, but the pricing is the key to
seeing that there is no free lunch for MoGen.
No matter how it is done, MoGen ultimately
must pay for the higher conversion premium
• Using the Black-Scholes model,
 Business Risk
• Biotech and pharmaceutical companies • The company planned to invest in its
spend billions of dollars on R&D on the production capabilities in Puerto Rico
theory that a small percentage of the as well as build new facilities in Ireland
R&D will produce highly lucrative • In addition to its R&D efforts, MoGen
results was active in the market to acquire
• In truth, many of the highest value smaller biotech companies in addition
drugs had been discovered somewhat to licensing the rights to produce and
accidentally, while pursuing a different market drugs from independent
line of research sources
• The FDA approval process was • Viagra, for example, was originally
expensive and often stretched over developed for cardiovascular diseases
years, and there was a possibility that before being marketed by Pfizer for
the drug might not be approved at any erectile dysfunction
point in the process
• And finally, the revenues reaped from
successful drugs carried the risk of
competition from biosimilars
• MoGen appears to have had a
successful strategy for managing its
business risks
• The company was carrying a large R&D
 MoGen’s Financial Policies
• MoGen’s financial policies • The company had spent
were driven by its business over $10 billion over the
risks previous three years for
• The uncertainty of its various share repurchase
profits kept debt levels programs and had $6.5
relatively low and had also billion remaining in its
kept management from current program, of which
declaring a dividend $3.5 billion was expected to
be spent in 2006
• As an alternative
mechanism for returning
cash to its shareholders,
MoGen had implemented a
share repurchase program
over the past few years
• Share repurchase programs
were a key financial
 Uses of Funds for 2006
• The various uses of funds presented in the case
highlight the capital-
intensive nature of the biotech industry
• Money was needed for R&D, the drug approval
process, acquisition of new technologies, and
investment in production facilities
• All of those cash flow uses were associated with
remaining competitive within the biotech industry
• MoGen could potentially postpone some of the
expenditures, but each likely had a positive net
present value (NPV) such that changes in these plans
would probably be greeted unfavorably by the stock
market
• In addition to its operational needs, MoGen had a
substantive financial use of funds in the form of the
stock repurchase program
• Relative to the operational uses of funds, the
repurchase program was more discretionary as
postponing or reducing the share repurchases would
not compromise MoGen’s fundamental business
strategy
• It could, however, result in a share price decline,
given that the market was probably expecting a
significant repurchase for 2006 based on MoGen’s
track record for 2003 to 2005
• To eliminate the repurchases for 2006 would signal a
change in management’s view that MoGen stock
represented a good buy; which is to say that the
stock price was no longer at an attractive level to
purchase
• Such news would almost certainly prompt a fall in the
stock price and could compromise the pricing of the
convertible if investors were to worry about future
price support for the stock from MoGen
• MoGen could avoid the issue altogether, if sufficient
uses of funds could be eliminated
• For example, if the company could postpone the
capital expenditures for production scale up ($1
billion) and postpone the projected share
repurchases ($3.5 billion), MoGen could avoid issuing
new securities for 2006
• MoGen had set an expectation regarding share
repurchases over the past three years and that the
investment in production sounds like a reasonable
proposal that was almost certainly a positive NPV and
therefore should be undertaken
 Uses of Funds for 2006
• The share repurchases add value to MoGen
shareholders by reducing the shares outstanding
and propping up earnings per share (EPS)
• Managing the number of shares outstanding
could become more important if MoGen’s
outstanding convertible of $1.8 billion (case
Exhibit 5) were to be converted at a future date
• MoGen had alternatives for raising external funds
including straight debt and common stock
• Neither of those alternatives, however, was as
compatible with the share repurchase program as
the convertible
• Straight debt would have offered the advantage
of simplicity plus the tax savings associated with
the interest payments
• It also carried the risk of prompting a lower debt
rating as well as the increased risk of financial
distress, particularly for a biotech company like
MoGen
• Based on data for public corporations, issuing
common stock is typically the least likely source
of funds chosen. Issuing common stock, however,
would reduce MoGen’s financial leverage and
increase its financial slack for future debt offering
• Case Exhibit 4 shows that MoGen’s stock had just
recently rebounded to outperform the S&P500
• Thus, management would prefer to postpone
selling stock until it had appreciated more during
the next few years
• Moreover, incurring the issuance costs associated
with a stock offering only to turn around and use
the funds to repurchase shares was not a logical
financing strategy
• MoGen was probably attracted to convertible
debt as low-cost debt that could neutralize much
of the dilution effect by using the proceeds to
repurchase shares immediately
• This strategy was becoming popular at the time in
part because of the very low coupon rates that
companies could get on the convertible debt
while at the same time selling forward the
company’s stock at a premium price
• That was music to the ears of MoGen’s senior
management
 Pricing the Conversion Option
• This is an exercise in using the Black-Scholes
model to price a call
option using inputs that correspond to the terms
of the convertible bond
• A good structure for this part of the class is to
simply list the input variables for Black-Scholes
and go through each in order for the convertible
• MoGen’s stock price of $77.98 as the underlying
asset value of the option
• T ranslating the per-share call option value to the
value of the conversion option for a $1,000 bond
• The conversion price can be used to find the
number of shares per bond received upon
conversion
• A key lesson of the case is the ability to use the
model at the correct scale; i.e., either to value a
bundle of options within a bond or to value a
single option
• Considerable discussion can ensue for any and all
of the input values, but usually realize that
volatility is critical to the option value while at
the same time being the most difficult input to
estimate
• The choices are to use either the historical
volatility of 27% or an implied volatility from
MoGen’s traded options
• Implied volatilities to be about 23% for the long-
term call options
• The implied volatilities are more reliable than
historical values as they are derived from market
prices that are forward-looking
• The longer maturity call options give more
appropriate estimates than the short-term
options, since Maanavi’s task is to price a five-
year option
 Pricing the Straight Bond and the
Convertible
• Since the maturity (five years) and face value ($1,000) are
known, we only need the coupon rate and appropriate
discount rate to estimate the value of the straight debt
• Maanavi’s task is to set the coupon rate such that the
convertible will sell
for full value; which is to say, $1,000 per bond
• With the conversion premium estimated as $162, the
coupon should be set so that the bond value equals the
remaining value of $838
• A key learning point is the appropriate discount rate to
use for the bond’s cash flows
• Since MoGen’s outstanding debt has an A+ rating, we
should assume that new debt would carry the same
rating and hence, the same yield
• The case states that the yield of A-rated corporate debt
was 5.75%, a number that is very similar to the average
A-rated yield reported in case Exhibit 6 of 5.79%
• Using a discount rate of 5.75% will only give a bond value
of $838 if the coupon rate is noticeably less than 5.75%
• A 1.96% coupon creates a debt value of $838, which
when added to the conversion option value gives $1,000
• The coupon rate would be set lower if the market
perceived a higher volatility than 23%
• For example, if the market believed the five-year volatility
to be 24.5%, the same as estimated for the long-term
puts, the conversion option value rises to $173 and the
coupon rate would need to be lowered to 1.73%
• Ultimately, it comes down to how badly investors want to
own MoGen’s new convertibles
• If demand is high, the price will rise such that investors
are implicitly paying for a relatively high volatility
• If demand is low, investors may be able to get the bonds
at a low implied volatility
• The pricing estimation using a 15% conversion premium
to reinforce the pricing concepts
• A 15% conversion premium has a conversion option value
of $206 per bond, which implies a coupon rate of 0.95%
to give a straight debt value of $794
• Once again, should see that the lower conversion
premium is synonymous with the option being closer to
the money and therefore carrying a higher value
• As the option component is increased, the bond
component must be decreased by lowering the coupon
rate
• This illustrates why convertibles have lower coupon rates
than straight debt and why the convertible coupon could
be extremely low if the conversion premium were also
very low
 Epilogue
• Merrill Lynch proposed two tranches of • MoGen effectively had sold a
$2.5 billion each convertible with a 50% conversion
• As of 2006, this was the largest premium
convertible issue in history • In addition, the tax law allowed MoGen
• It was easier to find sufficient demand to report an interest expense of 5.75%
for $2.5 billion of five-year converts per year, because the U.S. Internal
and $2.5 billion of seven-year converts Revenue Service (IRS) viewed the
than for a single issue of $5 billion hedged bond separately from the
warrants, which allowed MoGen to
• Merrill Lynch’s choice of low coupon report the interest cost at the market
rates and low conversion premiums yield
• After some discussion and guessing as
to why the issue was structured this
way, bond hedge and warrant
transactions
• How the banker could change the
conversion premium of the issue with
these transactions or with payoff
diagrams how the call options created
a straight bond and the warrants
created a new convertible
• Epilogue for Two-Class Format
• If the case is being taught over two class periods, the instructor
should distribute Exhibit TN1 along with study Questions 5, 6,
and 7 as the assignment for the following class period. Only a few
minutes of class time will be needed to point out that Merrill
Lynch structured the issue as two tranches, both of which had
low coupons and low conversion premiums. “Your task for the
next class is to consider why Merrill Lynch structured the issue
that way and how you could use financial engineering to create a
convertible with a 50% conversion premium.”
• Case Analysis for Two-Class Period
• This section adds detail to the second class period when the
instructor is following the two-class teaching plan outlined above.
Merits of the Convertible’s Structure
• The I-banker is not just a technician who
manipulates
Black-Scholes models, but rather acts as
the intermediary that sells a
corporation’s securities to the
marketplace
• The key to a banker’s success is
knowing the market and its participants
• Who wants convertible bonds from
biotech companies?
• How much appetite does the market
have for such issues at this point in time?
• Where is the sweet spot of the market?
• How should MoGen’s convertible be
structured to guarantee the highest
demand and, hence, the best possible
price for the client?
• Merrill Lynch answered those questions
by structuring five-year and seven-year
bonds with low conversion premiums
• In 2006, those were the terms that
Maanavi saw as the “sweet spot” of the
market: where Merrill Lynch could most
easily place the large issue at the most
favorable price for MoGen
• At the same time the conversion terms
(cash for principal and choice of cash or
shares for above principal) satisfied
financial accounting standards (FAS)
requirements for reporting the
convertible using the treasury stock
method, which was important to MoGen
management
• On the other hand, Maanavi knew that
the low conversion premium would not
please MoGen’s management who
wanted the conversion premium to be as
high as possible to reduce the dilution
effect
• Thus, Merrill Lynch proposed a two-step
process whereby the low conversion
premium of the original issued
convertible would simultaneously be
financially altered to look like a 50%
 Pricing of the 2011 and 2013
• Since MoGen’s stock price had changed by the time the
actual issuance took place and the actual terms of the
deal were different from the case facts, it is a useful
exercise for the check for consistency of the pricing using
the same format Compute the conversion option value
and the straight bond value
• Although the stock price had dropped and the conversion
premiums and coupon rates were lower than suggested
in the case, the valuation framework is the same
• The discount rate for the bond cash flows remains as
5.75% regardless of the actual coupon rate chosen
• The valuation demonstrates that what MoGen gave up in
bond value, it gained in option value
• Once it was decided to use a low conversion premium,
which raised the option value, it was necessary to use a
low coupon rate to lower the bond value and maintain a
total value of $1,000
• The volatilities are reported as 25%, somewhat higher
than implied by MoGen’s options as reported
• The 25% represents the volatility necessary to get a value
of exactly $1,000 per bond
• The fact that 25% gives $1,000 for both the 2011 and
2013 notes suggests that the number is consistent with
how Merrill Lynch priced the issue
• Alternatively, could also use a lower volatility such as
used in
• A lower volatility will give a lower conversion option and,
hence, both the 2011 and 2013 note value estimates will
be below $1,000
• Should take the opportunity to ask the class: Does it
seems reasonable that the market would have paid a
similar premium for both notes, or is it more reasonable
to conclude that we have made a mistake with the
model?
• Consider the merits of assuming the market to be
inefficient, rather than assuming the volatility estimate as
the likely culprit for the mispricing
• The 2011 and 2013 notes must be priced consistently in a
well-functioning capital market It is less important that
25% volatility number as “the truth” of the market’s view
of MoGen’s stock price uncertainty
• The simple valuation approach of adding bond value to
option value ignores call features, issue discounts, and
other attributes of the notes that affect the market value
of a convertible bond
• Moreover, the plain vanilla Black-Scholes model is a
rough cut at the conversion option value
• Despite all those shortcomings in the valuation
framework, however, the market prices of the 2011 and
2013 notes should be consistent in an efficient capital
market
 Financial Engineering of the
Convertible
• Financial engineering represents • Finally, by selling warrants with
the key learning point for the the same maturities, but with
class: A strike prices equal to 50% over the
convertible bond is a derivative current market price, MoGen
security that can be decomposed would have created a new
into its convertible bond with a 50%
components for purposes of conversion premium
pricing, but also for purposes of • As shown in Figure 1, a
financially convertible bond has a payoff
engineering equal to its face value as long as
• In this case, Merrill Lynch could its conversion value is less than
issue the convertible with any the face value of $1,000
conversion premium that was
most marketable at the time
• Then, MoGen could nullify the
conversion option of the
convertible by purchasing call
options with the same maturity
and exercise price
 Financial Engineering of the
Convertible
• The final position for MoGen is • The warrants carry a higher
conceptually equivalent to a conversion price and a lower
convertible bond with a 50% number of conversion shares
conversion premium per bond than the original
• The financially engineered convertible
convertible does have different • Therefore, in terms of the
cash flows in different states of payoff diagram, the current
the world conversion value of the
• For example, investors will financially engineered
need to pay the exercise price convertible is lower than the
to MoGen in order to exercise original convertible; which is
the warrants to say that the 50% conversion
premium means that investors
• No such cash flow would have are buying a conversion option
occurred for the original that is further out of the
convertible money
 Valuing the Bond Hedge and Warrant
Transactions
• The pricing of the bond hedge is straightforward. Hedging the bond amounts to
simply offsetting the conversion option, which was already valued in Exhibit TN6
for the 2011 and 2013 notes. Moreover, the strike prices of the conversion options
were already defined as $79.84 for the 2011 notes and
$79.48 for the 2013 notes. Therefore, MoGen need only purchase the correct
number of call options with those characteristics to offset the existing conversion
option.
• This requires students to shift their thinking from pricing a bond as a bundle of
stock options to valuing individual call options. Each convertible bond has a
number of underlying shares available upon conversion. Even if bondholders are
not entitled to receive shares, the cash received will be valued based on the
conversion value, which is the conversion rate times the share price. For the 2011
notes, the conversion price of $79.84 translates into a conversion rate of 12.525
shares per bond. Because 2.5 million of the 2011 notes were issued, the total
number of conversion options equals 31.312 million (2.5 million bonds × 12.525
shares per bond). Therefore, MoGen should purchase 31.3 million call options with
a maturity of five years and a strike price of $79.84.
• Some students will see immediately that whether we talk about the conversion
• Critical assumptions
• -16- UV1055
• A variety of assumptions are necessary to conduct any analysis, but in
this case the volatility assumption was critical to valuing the conversion options,
the call options and the warrants. The volatility estimate is always important to
option pricing, and it is always the least precisely measured of all the Black-
Scholes inputs. In this case, the traded options gave implied volatilities that were
close to the historical measure of volatility. It is often the case, however, that those estimates differ as the implied volatilities embody a forward-
looking viewpoint, which can differ substantially from historical price variations.
• Some students might recognize that the Black-Scholes model is not a perfect fit for modeling the conversion option. In particular, Black-Scholes uses a
risk-free rate, because the exercise price payment is considered to be riskless in the model. This fits well with the options market, where a
clearinghouse demands that accounts post margin to significantly reduce counterparty risk. For a convertible bond where the face value is the exercise
price, the face value is valued in the market according to the credit risk of the issuer. MoGen carried an A rating on its debt so that its debt carried a
yield to maturity of 5.75% compared to 4.46% for five-year Treasury bonds. If we used MoGen’s cost of debt in lieu of the risk-free rate, Black-Scholes
would have given a higher option value.
• The Black-Scholes model also neglects the dilution effect upon stock price. In fact, researchers have argued that the dilution effect, as well as the
decision by investors of how and when to convert, would impact the market value of a warrant, making the valuation equation much more complex
than the usual Black-Scholes model.2
• Epilogue
• The instructor should use Exhibit TN2 as a handout to illustrate that the actual transactions implemented by Merrill Lynch corresponded to the
analysis above. The actual cost to MoGen was higher than suggested by the analysis due to fees from Merrill Lynch, which won 75% of the bond hedge
business in addition to being the lead book runner for the notes.
• In addition to the many advantages of the convertible described in the case and this note, the bond hedge created a tax advantage for MoGen. The IRS
allowed issuers of convertibles to expense the interest cost for straight debt, if the convertible was fully hedged so that it acted like a straight bond. The
tax law was silent about adding an additional derivative on top of the hedged convertible, which meant that the warrant issuance was irrelevant to
MoGen’s ability to claim an annual interest charge equal to 5.750%, rather than the actual coupon rates of 0.125% and 0.375%.
• Selected Terms of MoGen, Inc.’s Convertible Senior Notes
• $2,500,000,000 principal amount of 0.125% Convertible Senior Notes due 2011 and $2,500,000,000 principal amount of
0.375% Convertible Senior Notes due 2013.
• 0.125% per year, with respect to the 2011 notes, and 0.375% per year, with respect to the 2013 notes, in each case
payable semiannually in arrears in cash on January 1 and July 1 of each year, beginning July 1, 2006.
• Holders will be able to convert their notes prior to the close of business on the business day before the stated maturity
date based on the applicable conversion rate.
• The initial conversion rate for the 2011 notes is 12.525 shares of common stock per $1,000 principal amount of 2011
notes. This is equivalent to an initial conversion price of approximately $79.84 per share of common stock. The initial
conversion rate for the 2013 notes is 12.581 shares of common stock per $1,000 principal amount of 2013 notes. This is
equivalent to an initial conversion price of approximately $79.48 per share of common stock.
• Upon conversion, a holder will receive an amount in cash equal to the lesser of (i) the principal amount of the note, and
(ii) the conversion value. If the conversion value exceeds the principal amount of the note on the conversion date, MoGen
will deliver cash or common stock or a combination of cash and common stock for the conversion value in excess of
$1,000.
• The notes will rank equal in right of payment to all of MoGen’s existing and future unsecured indebtedness and senior in
right to payment to all of MoGen’s existing and future subordinated indebtedness.
• We estimate that the net proceeds from this offering will be approximately $4.9 billion after deducting estimated
discounts, commissions, and expenses. We intend to use (1) approximately $3.0 billion of the net proceeds from this
offering on or about the closing date to purchase shares of our common stock under our common stock repurchase
program, including through one or more block trades with one or more of the initial purchasers and/or their affiliates. The
remaining net proceeds will be added to our working capital and will be used for general corporate purposes.
• At the end of those transactions, MoGen had
effectively issued a straight bond plus warrants. If
investors chose to purchase a bond plus the
appropriate number of warrants, they would own
the equivalent of an MoGen convertible bond with a
50% conversion premium ($107.9/$71.93). MoGen
paid $1.38 billion to buy the call options and netted
approximately $860 million, selling the warrants for
an all-in cost of $520 million to raise the conversion
premium to 50% on $5 billion of bonds.