Case 40 MoGen, Inc.
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MOGEN, INC. Teaching Note
Synopsis and Objectives
In 2006, Merrill Lynch became the lead boo r!nner "or a #$ billion con%ertible bond iss!e "or MoGen, Inc. This &as the single, largest con%ertible bond iss!ance in history and re'!ired a considerable amo!nt o" e""ort on the (art o" Merrill Lynch)s Lynch)s *'!ity +eri%ati%es Gro!( to con%ince MoGen)s management to choose Merrill Lynch o%er its com(etitors. The case is "oc!sed on Merrill Lynch)s choice o" the con%ersion (remi!m and co!(on rate to (ro(ose to MoGen management. This (ricing decision re'!ires st!dents !nderstand the conce(t o" %al!ing a con%ertible as the s!m o" a straight bond (l!s the con%ersion o(tion. al!ing the con%ersion o(tion as a call o(tion re'!ires the estimation o" the -lac/choles model, &ith the %olatility being a (artic!larly challenging in(!t. n a strategic le%el, the case introd!ces st!dents to the conce(t o" matching a com(any)s b!siness ris &ith the ty(e o" "inancing1 e'!ity, e' !ity, debt, or con%ertible debt. In that regard, MoGen (resents the interesting "inancial challenge o" needing a signi"icant amo!nt o" "!nds "or 2006 "or a %ariety o" !ses, b!t (artic!larly "or its share re(!rchase (lan, &hich &as estimated as #3.$ billion "or 2006. The case is designed "or st!dents &ho already ha%e a basic no&ledge o" bond %al!ation and o(tion(ricing (rinci(les. -eca!se the case to!ches on both technical and strategic iss!es, it &ors &ell &ith !ndergrad!ate, M-, and eec!ti%e ed!cation a!diences. The instr!ctor may choose to teach the case in one class (eriod or t&o. or a oneclass e(erience, Exhibit TN1 ser%es as the e(ilog!e to hand o!t at the end o" class, &hereas "or a t&oclass e(erience Exhibit TN1 ser%es as a hando!t and the beginning (oint "or an assignment "or the "ollo&ing class. 5hen ta!ght o%er t&o classes, the second class deals &ith the "inancialengineering iss!es associated &ith !sing deri%ati%es to increase MoGen)s con%ersion (remi!m "rom 7 8the act!al (remi!m9 to $07. Th!s, the second class (ro%ides a strong rein"orcement o" o(tion(ricing (rinci(les by demonstrating ho& an in%estment ban can reconstr!ct a sec!rity by taing long or short (ositions in (!ts or call o(tions. Suggested uestions !o" #dvance #ssign$ent
or a oneclass teaching (lan1
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Case 40 MoGen, Inc.
. :o& im(or im(ortant tant is it "or MoGen MoGen to get #$ billion billion o" eternal eternal "!ndin "!nding g in 2006; 2006; Co!ld the com(any c!t bac on its share re(!rchase (rogram, "or eam(le, to red!ce the "!nds needed; 2. 5hat are are the (ros and and cons o" iss!in iss!ing g con%ertible con%ertible debt %ia straight straight debt debt or e'!ity; e'!ity; 3. The case states states a con%erti con%ertible ble bond can be %al!ed %al!ed as the the s!m o" a straigh straightt bond (l!s a call call o(tion. /tarting &ith the c!rrent stoc (rice o" #<<.=> (er share, ho& can yo! !se the -lac -lac/ /ch chol oles es mo mode dell to esti estima mate te the the %al! %al!ee o" the the con%e con%ers rsio ion n o(ti o(tion on &ith &ith a 2$7 2$7 con%ersion (remi!m "or one share o" MoGen stoc; -e (re(ared to e(lain yo!r choice "or the stoc (rice, eercise (rice, ris"ree rate, time to mat!rity, di%idend yield, and %olatility. :o& sho!ld yo! con%ert this o(tion %al!e (er share into to the o(tion %al!e "or a bond &ith #,000 "ace %al!e; 4. 5hat 5hat is the %al!e %al!e o" the straig straight ht bond com(onen com(onent; t; 5hat 5hat co!(on rate rate sho sho!ld !ld Manaa% Manaa%ii (ro(ose in order "or the con%ert to sell at eactly #,000 (er bond; 5hat disco!nt rate did yo! !se to %al!e the straight bond com(onent; Conce(t!ally, &hat sho!ld ha((en to the co!(on rate i" Manaa%i &ere to (ro(ose a $7 con%ersion (remi!m; a 407 con%ersion (remi!m; $. s MoGen)s MoGen)s C*, &hat &hat do lie and not lie lie abo!t this this (ro(osal (ro(osal "rom Merril Merrilll Lynch; Lynch; In (artic!lar, do yo! lie the 2$7 con%ersion (remi!m; (remi!m; the co!(on rate; or a t&oclass teaching (lan, the "ollo&ing '!estions can be distrib!ted along &ith Exhibit TN1 1 . ?sing the the act!al terms terms "or the the 20 and and 203 notes, notes, com(!te the the res(ecti%e res(ecti%e straight straight bond bond %al!es and con%ersion o(tion %al!es to %eri"y that they s!m to #,000 (er bond. 5hat im(lied %olatility do yo! "ind "or the 20 notes; 5hat abo!t "or the 203 notes; 2. :o& co!ld Merril Merrilll Lynch Lynch !se "inancial "inancial engineeri engineering ng to change the con%ersi con%ersion on (remi!ms (remi!ms o" the 20 and 203 notes to $07; 8:int1 Thin abo!t &hat "inancial engineering MoGen &o!ld need to do to change the con%ertible bond into a straight one. In other &ords, &hat transactio transaction n &hen combined &ith the con%ertible con%ertible &o!ld e""ecti% e""ecti%ely ely remo%e remo%e the con%ersion o(tion com(onent to create a "inancially engineered straight bond; Then as a second ste(, thin abo!t &hat co!ld be done to change the straight bond into the e'!i%alent o" a con%ertible bond &ith a $07 con%ersion (remi!m.9 3. :o& m!ch m!ch do yo! estima estimate te this sort sort o" transac transacti tion on &o!ld cost cost MoGen; MoGen; 5hy tae this this a((roach as o((osed to sim(ly designing the iss!e &ith a $07 con%ersion (remi!m in the "irst (lace;
Case 40 MoGen, Inc.
$
Suppo"ting Mic"oso!t Exce% Sp"eadsheet &i%es
or st!dents1
Case@40.ls
or instr!ctors1
TN@40.ls
Alease do not share the instr!ctor)s "ile &ith st!dents.
'ypothetica% Teaching (%ans
The "ollo&ing '!estions "orm a teaching (lan "or one >$min!te class. 1. How would you describe MoGen’s business model and current operating environment? (10 minutes)
This '!estion hel(s set the bacgro!nd "or st!dents to !ltimately thin abo!t MoGen)s choice o" "inancing in terms o" the !nderlying b!siness ris o" a com(any. It is im(ortant to establish a solid !nderstanding o" the b!siness be"ore addressing the tas o" ho& to "inance it. The biotech ind!stry relies hea%ily !(on research and de%elo(ment 8B+9, as &ell as the ability to get a ne& dr!g to maret. -oth acti%ities ha%e signi"icant riss that are endemic to biotech b!sinesses. /t!dents &ill o"ten mention MoGen)s share re(!rchase (rogram d!ring this disc!ssion, &hich ser%es as a transition to disc!ssing MoGen)s "inancing strategy. 2. How would you describe MoGen’s inancing strategy? (10 minutes)
/t!dents sho!ld see that the riss o" the biotech b!siness are dri%ing all o" MoGen)s "inancial decisions1 debt (olicy, di%idend (olicy, and share re(!rchase (rogram. +ebt is relati%ely lo& beca!se higher debt le%els &o!ld res!lt in debt rating decreases and there"ore higher interest rates. /imilarly, the com(any chooses to (ay no di%idends beca!se o" the ris o" being "orced to c!t the di%idend d!ring the di""ic!lt times that in%ariably arise in a biotech b!siness. /t!dents sho!ld realiDe that a share re(!rchase (rogram is a %ery good match "or a biotech com(any lie MoGen. The com(any can distrib!te cash to its shareholders &hen (ro"its allo&, b!t &itho!t maing an e(licit 8debt9 or im(licit 8di%idends9 (romise to the maret. !. "#at are MoGen’s uses o unds or 200$? How important is t#e s#are repurc#ase program to MoGen’s c#oice to issue a convertible bond? (10 minutes)
This '!estion is designed to "oc!s the class on the share re(!rchase (rogram as a critical !se o" "!nds "or 2006. The (rimary ad%antage o" share re(!rchases !sing di%idends is that management can t!rn share re(!rchases o"" and on as allo&ed by cash "lo&. The other (roEected !ses o" "!nds, ho&e%er, are largely dri%en by b!siness iss!es that are not as "leible "or management. /t!dents sho!ld notice that most o" the #$ billion raised &ill be !sed to re(!rchase shares 8#3.$ billion9. Th!s, MoGen co!ld signi"icantly red!ce its "!nding needs by (ost(oning the share re(!rchases and (ossibly "!nd the remaining
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Case 40 MoGen, Inc.
short"all &ith straight debt. I" MoGen management contin!es &ith the share re(!rchase (lan, ho&e%er, st!dents sho!ld see se%eral ad%antages o" !sing the con%ertible bond as MoGen)s "!nding choice. %. How can we use t#e &lac'c#oles pricing model to value t#e conversion option component o t#e convertible? (20 minutes)
M!ch o" the class time &ill be de%oted to the technical as(ect o" (ricing the con%ertible and, in (artic!lar, to choosing the correct in(!t %al!es "or the -lac/choles (ricing model to estimate the %al!e o" the con%ersion o(tion. ey conce(t!al (oint &ill be %al!ing the con%ersion o(tion at the bond le%el, rather than at the share le%el. ther ey (oints o" em(hasis &ill be the estimation o" %olatility and translation o" the con%ersion (remi!m into the stoc (rice and eercise (rice. *. "#at coupon rate did you get or a 2*+ conversion premium? (20 minutes)
This '!estion relates to the second ste( in %al!ing the con%ertible1 sol%ing "or the co!(on rate on the straight bond com(onent s!ch that the total %al!e o" the con%ertible s!ms to #,000 (er bond. ey (oint o" em(hasis &ill be the disco!nt rate !sed to %al!e the bond cash "lo&s. /t!dents may be s!r(rised at ho& lo& the co!(on rate is, relati%e to the disco!nt rate o" $.<$7. The instr!ctor may also &ant to as "or the co!(on rate "or a di""erent con%ersion (remi!m to rein"orce the (ricing conce(t. $. ,pilogue. (10 minutes)
The instr!ctor sho!ld end the class by distrib!ting co(ies o" Exhibit TN1. +isc!ssion (oints &ill center on the act!al terms o" MoGen)s deal &ith (artic!lar em(hasis !(on the lo& con%ersion (remi!ms and co!(on rates. The instr!ctor can concl!de the class &ith a disc!ssion abo!t ho& Merrill Lynch &as able to alter the e""ecti%e con%ersion (remi!m by ha%ing MoGen b!y and sell &arrants &ith di""ering strie (rices. Exhibit TN) is designed as a hando!t to sho& ho& Merrill Lynch designed this bond hedge (l!s &arrant transaction. The "ollo&ing '!estions "orm a teaching (lan "or t&o >$min!te classes. *ay one
1. How would you describe MoGen’s business model and current operating environment? (10 minutes) 2. How would you describe MoGen’s inancing strategy? (10 minutes) !. "#at are MoGen’s uses o unds or 200$? How important is t#e s#are repurc#ase program to MoGen’s c#oice to issue a convertible bond? (10 minutes) %. How can we use t#e &lac'c#oles pricing model to value t#e conversion option component o t#e convertible? (20 minutes)
Case 40 MoGen, Inc.
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*. "#at coupon rate did you get or a 2*+ conversion premium? (-ptional /or a 1*+ premium? or a %0+ premium?) (20 minutes) $. ,pilogue. (10 minutes) The instr!ctor sho!ld end the class by distrib!ting co(ies o" Exhibit TN1 as the "ocal (oint to disc!ss the act!al terms o" MoGen)s deal &ith (artic!lar em(hasis on the lo& con%ersion (remi!m. Then, the instr!ctor sho!ld distrib!te st!dy F!estions $ and 6 as the str!ct!re "or the second class. *ay t+o
1. "#y did MoGen agree to issue a convertible wit# t#e wrong terms? (10 minutes)
This '!estion (rom(ts the st!dents to thin abo!t the big (ict!re "or sec!rity iss!ance be"ore addressing the many technical (ricing iss!es. The terms in Exhibit TN1 &ere o""ered, beca!se Merrill Lynch %ie&ed them as the s&eet s(ot in the con%ertible maret, the terms that &o!ld attract the most interest and there"ore the best (rice "or MoGen. Merrill Lynch also ne& that it co!ld !se deri%ati%es to change the terms "or MoGen, so that it &as %ie&ed as a t&oste( (rocess "rom the beginning. 2. oes it appear t#at Merrill 3ync# priced t#e 2011 and 201! notes appropriately? (1* minutes)
The act!al terms o" the con%ertible &ere noticeably di""erent than &hat &as (ro(osed in the case. MoGen)s stoc (rice had "allen to #<.=3, the co!(on rates &ere lo&er, and the con%ersion (remi!ms &ere s!bstantially lo&er. ll o" &hich maes it a %al!able eercise to r!n thro!gh the (ricing o" the 20 and 203 notes to rein"orce the (ricing (rinci(les "rom class one. /t!dents &ill be (leased to see that the bond(l!so(tion "rame&or &ors &ell "or the act!al terms and, in (artic!lar, that the im(lied %olatility "or the 20 and 203 notes is %ery close to the %al!e deri%ed in the "irst class. !. How can we c#ange MoGen’s inancially engineered straig#t bond into a convertible bond wit# a *0+ conversion premium? (20 minutes)
good &ay to begin this analysis is to remind the st!dents that a con%ertible can be %al!ed as the s!m o" a straight bond (l!s a &arranto(tion. There"ore, "or each con%ertible bond iss!ed by MoGen, the com(any is short a bond and short a b!ndle o" call o(tions. The short o(tions can be n!lli"ied, i" MoGen b!ys call o(tions &ith the same terms 8eercise (rice and mat!rity9. The combination o" the con%ertible (l!s the call o(tions is e'!i%alent to ha%ing iss!ed a straight bond. inally, a ne& synthetic con%ertible can be created by MoGen selling &arrants &ith a strie (rice set at a $07 con%ersion (remi!mH &hich is to say, $07 higher than the stoc (rice at time o" iss!ance. The instr!ctor may choose to "rame the disc!ssion &ith the !se o" (ayo"" diagrams to ill!strate the "inancial engineering. %. How muc# s#ould MoGen pay to buy t#e call options? How muc# s#ould MoGen reali4e rom t#e sale o t#e warrants? (20 minutes)
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Case 40 MoGen, Inc.
+isc!ssion F!estion
?nderstanding the conce(ts behind the hedge is im(ortant, b!t the (ricing is the ey to seeing that there is no "ree l!nch "or MoGen. No matter ho& it is done, MoGen !ltimately m!st (ay "or the higher con%ersion (remi!m. ?sing the -lac/choles model, the class &ill see that the cost o" b!ying the call o(tions is higher than the %al!e recei%ed "rom selling the &arrants 8ass!ming the same n!mber o" e'!i%alent shares9. *. "#at are t#e critical assumptions embedded in t#is deal? (10 minutes)
This '!estion ass st!dents to thin abo!t the basic %al!ation "rame&or as &ell as the ey %al!e dri%ers o" the deal. 5hile it is a good a((roimation to model a con%ertible as straight debt (l!s an o(tion com(onent, the -lac/choles model does not consider iss!es, s!ch as the dil!tion e""ect and the call "eat!re o" the bond. Moreo%er, the o(tion com(onent maes %olatility a ey %al!e dri%er "or the model that needs care"!l scr!tiny. 6. ,pilogue. (10 minutes) Exhibit TN) e(lains ho& Merrill Lynch im(lemented the bond hedge and &arrant transactions.
Case #na%ysis !o" OneC%ass (%an
This section adds detail to the oneclass teaching (lan o!tlined abo%e. MoGen-s business $ode%
s (art o" the biotech ind!stry, MoGen had a %ariety o" inherent riss that sho!ld be e%ident to the st!dents1 dr!g disco%ery, dr!g a((ro%al, and har%esting the %al!e o" eisting dr!gs. -iotech and (harmace!tical com(anies s(end billions o" dollars on B+ on the theory that a small (ercentage o" the B+ &ill (rod!ce highly l!crati%e res!lts. In tr!th, many o" the highest %al!e dr!gs had been disco%ered some&hat accidentally, &hile (!rs!ing a di""erent line o" research. The + a((ro%al (rocess &as e(ensi%e and o"ten stretched o%er years, and there &as a (ossibility that the dr!g might not be a((ro%ed at any (oint in the (rocess. nd "inally, the re%en!es rea(ed "rom s!ccess"!l dr!gs carried the ris o" com(etition "rom biosimilars. MoGen a((ears to ha%e had a s!ccess"!l strategy "or managing its b!siness riss. The com(any &as carrying a large B+ (ort"olio, as &ell as many highly s!ccess"!l dr!gs already on the maret. The com(any (lanned to in%est in its (rod!ction ca(abilities in A!erto Bico as &ell as b!ild ne& "acilities in Ireland. In addition to its B+ e""orts, MoGen &as acti%e in the maret to ac'!ire smaller biotech com(anies in addition to licensing the rights to (rod!ce and maret dr!gs "rom inde(endent so!rces.
iagra, "or eam(le, &as originally de%elo(ed "or cardio%asc!lar diseases be"ore being mareted by A"iDer "or erectile dys"!nction.
+isc!ssion Case 40 MoGen, Inc. F!estion 2
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MoGen-s !inancia% po%icies
MoGen)s "inancial (olicies &ere dri%en by its b!siness riss. The !ncertainty o" its (ro"its e(t debt le%els relati%ely lo& and had also e(t management "rom declaring a di%idend. s an alternati%e mechanism "or ret!rning cash to its shareholders, MoGen had im(lemented a share re(!rchase (rogram o%er the (ast "e& years. /t!dents sho!ld recogniDe that the share re(!rchase (rograms &ere a ey "inancial strategy "or MoGen. The com(any had s(ent o%er #0 billion o%er the (re%io!s three years "or %ario!s share re(!rchase (rograms and had #6.$ billion remaining in its c!rrent (rogram, o" &hich #3.$ billion &as e(ected to be s(ent in 2006. ses o! !unds !o" )//0 +isc!ssion F!estion 3
The %ario!s !ses o" "!nds (resented in the case highlight the ca(italintensi%e nat!re o" the biotech ind!stry. Money &as needed "or B+, the dr!g a((ro%al (rocess, ac'!isition o" ne& technologies, and in%estment in (rod!ction "acilities. ll o" those cash "lo& !ses &ere associated &ith remaining com(etiti%e &ithin the biotech ind!stry. MoGen co!ld (otentially (ost(one some o" the e(endit!res, b!t each liely had a (ositi%e net (resent %al!e 8NA9 s!ch that changes in these (lans &o!ld (robably be greeted !n"a%orably by the stoc maret. In addition to its o(erational needs, MoGen had a s!bstanti%e "inancial !se o" "!nds in the "orm o" the stoc re(!rchase (rogram. Belati%e to the o(erational !ses o" "!nds, the re(!rchase (rogram &as more discretionary as (ost(oning or red!cing the share re(!rchases &o!ld not com(romise MoGen)s "!ndamental b!siness strategy. It co!ld, ho&e%er, res!lt in a share (rice decline, gi%en that the maret &as (robably e(ecting a signi"icant re(!rchase "or 2006 based on MoGen)s trac record "or 2003 to 200$. To eliminate the re(!rchases "or 2006 &o!ld signal a change in management)s %ie& that MoGen stoc re(resented a good b!yH &hich is to say that the stoc (rice &as no longer at an attracti%e le%el to (!rchase. /!ch ne&s &o!ld almost certainly (rom(t a "all in the stoc (rice and co!ld com(romise the (ricing o" the con%ertible i" in%estors &ere to &orry abo!t "!t!re (rice s!((ort "or the stoc "rom MoGen. MoGen co!ld a%oid the iss!e altogether, i" s!""icient !ses o" "!nds co!ld be eliminated. or eam(le, i" the com(any co!ld (ost(one the ca(ital e(endit!res "or (rod!ction scale !( 8# billion9 and (ost(one the (roEected share re(!rchases 8#3.$ billion9, MoGen co!ld a%oid iss!ing ne& sec!rities "or 2006. Most st!dents &ill arg!e, ho&e%er, that MoGen had set an e(ectation regarding share re(!rchases o%er the (ast three years and that the in%estment in (rod!ction so!nds lie a reasonable (ro(osal that &as almost certainly a (ositi%e NA and there"ore sho!ld be !ndertaen. Many st!dents &ill also arg!e that share re(!rchases add %al!e to MoGen shareholders by red!cing the shares o!tstanding and (ro((ing !( earnings (er share 8*A/9.
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Case 40 MoGen, Inc.
Managing the n!mber o" shares o!tstanding co!ld become more im(ortant i" MoGen)s o!tstanding con%ertible o" #.> billion 8case *hibit $9 &ere to be con%erted at a "!t!re date. MoGen had alternati%es "or raising eternal "!nds incl!ding straight debt and common stoc. Neither o" those alternati%es, ho&e%er, &as as com(atible &ith the share re(!rchase (rogram as the con%ertible. /traight debt &o!ld ha%e o""ered the ad%antage o" sim(licity (l!s the ta sa%ings associated &ith the interest (ayments. It also carried the ris o" (rom(ting a lo&er debt rating as &ell as the increased ris o" "inancial distress, (artic!larly "or a biotech com(any lie MoGen. -ased on data "or (!blic cor(orations, iss!ing common stoc is ty(ically the least liely so!rce o" "!nds chosen. Iss!ing common stoc, ho&e%er, &o!ld red!ce MoGen)s "inancial le%erage and increase its "inancial slac "or "!t!re debt o""ering. Case *hibit 4 sho&s that MoGen)s stoc had E!st recently rebo!nded to o!t(er"orm the /A$00. Th!s, management &o!ld (re"er to (ost(one selling stoc !ntil it had a((reciated more d!ring the net "e& years. Moreo%er, inc!rring the iss!ance costs associated &ith a stoc o""ering only to t!rn aro!nd and !se the "!nds to re(!rchase shares &as not a logical "inancing strategy. MoGen &as (robably attracted to con%ertible debt as lo&cost debt that co!ld ne!traliDe m!ch o" the dil!tion e""ect by !sing the (roceeds to re(!rchase shares immediately. This strategy &as becoming (o(!lar at the time in (art beca!se o" the %ery lo& co!(on rates that com(anies co!ld get on the con%ertible debt &hile at the same time selling "or&ard the com(any)s stoc at a (remi!m (rice. That &as m!sic to the ears o" MoGen)s senior management. ("icing the conve"sion option +isc!ssion F!estion 4
This is an eercise in !sing the -lac/choles model to (rice a call o(tion !sing in(!ts that corres(ond to the terms o" the con%ertible bond. good str!ct!re "or this (art o" the class is to sim(ly list the in(!t %ariables "or -lac/choles and go thro!gh each in order "or the con%ertible. /t!dents &ill liely begin &ith MoGen)s stoc (rice o" #<<.=> as the !nderlying asset %al!e o" the o(tion. Many st!dents, ho&e%er, &ill ha%e di""ic!lty translating the (ershare call o(tion %al!e to the %al!e o" the con%ersion o(tion "or a #,000 bond. /t!dents &ill e%ent!ally recogniDe that the con%ersion (rice can be !sed to "ind the n!mber o" shares (er bond recei%ed !(on con%ersion. ey lesson o" the case is the ability to !se the model at the correct scaleH i.e., either to %al!e a b!ndle o" o(tions &ithin a bond or to %al!e a single o(tion. Exhibit TN sho&s the o(tion calc!lations both on a (ershare basis and on a (erbond basis. s st!dents s!ggest %al!es "or each o" the in(!ts "or the -lac/choles model, the instr!ctor can record the %al!es on the board to create something lie Exhibit TN . Considerable disc!ssion can ens!e "or any and all o" the in(!t %al!es, b!t st!dents !s!ally realiDe that %olatility is critical to the o(tion %al!e &hile at the same time being the most di""ic!lt in(!t to
Case 40 MoGen, Inc.
estimate. The choices are to !se either the historical %olatility o" 2<7 or an im(lied %olatility "rom MoGen)s traded o(tions. Exhibit TN2 sho&s the im(lied %olatilities to be abo!t 237 "or the longterm call o(tions. /t!dents !s!ally agree that the im(lied %olatilities are more reliable than historical %al!es as they are deri%ed "rom maret (rices that are "or&ardlooing. /t!dents sho!ld also agree that the longer mat!rity call o(tions gi%e more a((ro(riate estimates than the shortterm o(tions, since Maana%i)s tas is to (rice a "i%eyear o(tion.
2
Case 40 MoGen, Inc.
("icing the st"aight bond and the conve"tib%e +isc!ssion F!estion $
The straight debt %al!ation is (resented in Exhibit TN3 . /ince the mat!rity 8"i%e years9 and "ace %al!e 8#,0009 are no&n, &e only need the co!(on rate and a((ro(riate disco!nt rate to estimate the %al!e o" the straight debt. Maana%i)s tas is to set the co!(on rate s!ch that the con%ertible &ill sell "or "!ll %al!eH &hich is to say, #,000 (er bond. 5ith the con%ersion (remi!m estimated as #62, the co!(on sho!ld be set so that the bond %al!e e'!als the remaining %al!e o" #>3>. ey learning (oint is the a((ro(riate disco!nt rate to !se "or the bond)s cash "lo&s. /ince MoGen)s o!tstanding debt has an rating, &e sho!ld ass!me that ne& debt &o!ld carry the same rating and hence, the same yield. The case states that the yield o" rated cor(orate debt &as $.<$7, a n!mber that is %ery similar to the a%erage rated yield re(orted in case *hibit 6 o" $.<=7. ?sing a disco!nt rate o" $.<$7 &ill only gi%e a bond %al!e o" #>3> i" the co!(on rate is noticeably less than $.<$7. In "act, as sho&n in Exhibit TN3, a .=67 co!(on creates a debt %al!e o" #>3>, &hich &hen added to the con%ersion o(tion %al!e gi%es #,000. /t!dents sho!ld recogniDe that the co!(on rate &o!ld be set lo&er i" the maret (ercei%ed a higher %olatility than 237. or eam(le, i" the maret belie%ed the "i%eyear %olatility to be 24.$7, the same as estimated "or the longterm (!ts, the con%ersion o(tion %al!e rises to #<3 and the co!(on rate &o!ld need to be lo&ered to .<37. ?ltimately, it comes do&n to ho& badly in%estors &ant to o&n MoGen)s ne& con%ertibles. I" demand is high, the (rice &ill rise s!ch that in%estors are im(licitly (aying "or a relati%ely high %olatility. I" demand is lo&, in%estors may be able to get the bonds at a lo& im(lied %olatility. s time allo&s, the instr!ctor may &ant to redo the (ricing estimation !sing a $7 con%ersion (remi!m to rein"orce the (ricing conce(ts. $7 con%ersion (remi!m has a con%ersion o(tion %al!e o" #206 (er bond, &hich im(lies a co!(on rate o" 0.=$7 to gi%e a straight debt %al!e o" #<=4. nce again, st!dents sho!ld see that the lo&er con%ersion (remi!m is synonymo!s &ith the o(tion being closer to the money and there"ore carrying a higher %al!e. s the o(tion com(onent is increased, the bond com(onent m!st be decreased by lo&ering the co!(on rate. This ill!strates &hy con%ertibles ha%e lo&er co!(on rates than straight debt and &hy the con%ertible co!(on co!ld be etremely lo& i" the con%ersion (remi!m &ere also %ery lo&.
Epi%ogue !o" OneC%ass &o"$at
3 Case 40 MoGen, Inc. +isc!ssion F!estion "or Class 2 To end the class the instr!ctor sho!ld distrib!te Exhibit TN1 and disc!ss the act!al terms o" the deal. I" there are in%estment baners in the class, they &ill not be s!r(rised that Merrill Lynch (ro(osed t&o tranches o" #2.$ billion each. s o" 2006, this &as the largest con%ertible iss!e in history. It &as easier to "ind s!""icient demand "or #2.$ billion o" "i%eyear con%erts and #2.$ billion o" se%enyear con%erts than "or a single iss!e o" #$ billion. /t!dents may be s!r(rised at Merrill Lynch)s choice o" lo& co!(on rates and lo& con%ersion (remi!ms. "ter some disc!ssion and g!essing as to &hy the iss!e &as str!ct!red this &ay, the instr!ctor sho!ld dis(lay or distrib!te Exhibit TN) &ith the details o" the bond hedge and &arrant transactions. +e(ending on the time a%ailable the instr!ctor can either a((eal to int!ition as to ho& the baner co!ld change the con%ersion (remi!m o" the iss!e &ith these transactions or the instr!ctor can '!icly demonstrate &ith (ayo"" diagrams ho& the call o(tions created a straight bond and the &arrants created a ne& con%ertible. The instr!ctor sho!ld mention that a"ter all the d!st settled, MoGen e""ecti%ely had sold a con%ertible &ith a $07 con%ersion (remi!m. In addition, the ta la& allo&ed MoGen to re(ort an interest e(ense o" $.<$7 (er year, beca!se the ?./. Internal Be%en!e /er%ice 8IB/9 %ie&ed the hedged bond se(arately "rom the &arrants, &hich allo&ed MoGen to re(ort the interest cost at the maret yield.
Epi%ogue !o" T+oC%ass &o"$at
I" the case is being ta!ght o%er t&o class (eriods, the instr!ctor sho!ld distrib!te Exhibit TN1 along &ith st!dy F!estions $, 6, and < as the assignment "or the "ollo&ing class (eriod. nly a "e& min!tes o" class time &ill be needed to (oint o!t that Merrill Lynch str!ct!red the iss!e as t&o tranches, both o" &hich had lo& co!(ons and lo& con%ersion (remi!ms. JKo!r tas "or the net class is to consider &hy Merrill Lynch str!ct!red the iss!e that &ay and ho& yo! co!ld !se "inancial engineering to create a con%ertible &ith a $07 con%ersion (remi!m.
Case #na%ysis !o" T+oC%ass (e"iod
This section adds detail to the second class (eriod &hen the instr!ctor is "ollo&ing the t&oclass teaching (lan o!tlined abo%e. Me"its o! the conve"tib%e-s st"uctu"e
This '!estion is designed to hel( st!dents (!t on their mareting hats as an in%estment baner. The Ibaner is not E!st a technician &ho mani(!lates -lac/choles models, b!t rather acts as the intermediary that sells a cor(oration)s sec!rities to the maret(lace. The ey to a baner)s s!ccess is no&ing the maret and its (artici(ants. 5ho &ants con%ertible bonds "rom biotech com(anies; :o& m!ch a((etite does the maret ha%e "or s!ch iss!es at this (oint in
4
Case 40 MoGen, Inc.
+isc!ssion F!estion 2 "or Class 2
time; 5here is the s&eet s(ot o" the maret; :o& sho!ld MoGen)s con%ertible be str!ct!red to g!arantee the highest demand and, hence, the best (ossible (rice "or the client; Merrill Lynch ans&ered those '!estions by str!ct!ring "i%eyear and se%enyear bonds &ith lo& con%ersion (remi!ms. In 2006, those &ere the terms that Maana%i sa& as the Js&eet s(ot o" the maret1 &here Merrill Lynch co!ld most easily (lace the large iss!e at the most "a%orable (rice "or MoGen. t the same time the con%ersion terms 8cash "or (rinci(al and choice o" cash or shares "or abo%e (rinci(al9 satis"ied "inancial acco!nting standards 8/9 re'!irements "or re(orting the con%ertible !sing the treas!ry stoc method, &hich &as im(ortant to MoGen management. n the other hand, Maana%i ne& that the lo& con%ersion (remi!m &o!ld not (lease MoGen)s management &ho &anted the con%ersion (remi!m to be as high as (ossible to red!ce the dil!tion e""ect. Th!s, Merrill Lynch (ro(osed a t&oste( (rocess &hereby the lo& con%ersion (remi!m o" the original iss!ed con%ertible &o!ld sim!ltaneo!sly be "inancially altered to loo lie a $07 (remi!m to MoGen. ("icing o! the )/11 and )/1 notes
The strength o" the t&oclass teaching (lan is that it allo&s "or rein"orcement o" the (ricing (rinci(les. /ince MoGen)s stoc (rice had changed by the time the act!al iss!ance too (lace and the act!al terms o" the deal &ere di""erent "rom the case "acts, it is a !se"!l eercise "or the st!dents to chec "or consistency o" the (ricing !sing the same "ormat (resented in Exhibits TN and TN31 Com(!te the con%ersion o(tion %al!e and the straight bond %al!e. Exhibit TN0 s!mmariDes the in(!ts "or the con%ersion o(tion %al!es and straight debt %al!es "or the 20 and 203 notes. ltho!gh the stoc (rice had dro((ed and the con%ersion (remi!ms and co!(on rates &ere lo&er than s!ggested in the case, the %al!ation "rame&or is the same. /t!dents sho!ld recogniDe that the disco!nt rate "or the bond cash "lo&s remains as $.<$7 regardless o" the act!al co!(on rate chosen. The %al!ation demonstrates that &hat MoGen ga%e !( in bond %al!e, it gained in o(tion %al!e. nce it &as decided to !se a lo& con%ersion (remi!m, &hich raised the o(tion %al!e, it &as necessary to !se a lo& co!(on rate to lo&er the bond %al!e and maintain a total %al!e o" #,000.
There are a co!(le o" a((roaches the instr!ctor co!ld tae &ith res(ect to the %olatility ass!m(tion. or Exhibit TN0 the %olatilities are re(orted as 2$7, some&hat higher than im(lied by MoGen)s o(tions as re(orted in Exhibit TN2 and !sed in Exhibit TN . The 2$7 "ig!re re(resents the %olatility necessary to get a %al!e o" eactly #,000 (er bond. The "act that 2$7 gi%es #,000 "or both the 20 and 203 notes s!ggests that the n!mber is consistent &ith ho& Merrill Lynch (riced the iss!e. lternati%ely, the instr!ctor co!ld also !se a lo&er %olatility s!ch as !sed in Exhibit TN. lo&er %olatility &ill gi%e a lo&er con%ersion o(tion and, hence, both the 20 and 203 note %al!e estimates &ill be belo& #,000. t this (oint the instr!ctor sho!ld tae the o((ort!nity to as the class1 +oes it seems reasonable that the maret &o!ld ha%e (aid a
$ Case 40 MoGen, Inc. +isc!ssion F!estion 3 "or Class 2 similar (remi!m "or both notes, or is it more reasonable to concl!de that &e ha%e made a mistae &ith the model; This '!estion (resses the st!dents to consider the merits o" ass!ming the maret to be ine""icient, rather than ass!ming the %olatility estimate as the liely c!l(rit "or the mis(ricing. It is im(ortant "or st!dents to tr!st that the 20 and 203 notes m!st be (riced consistently in a &ell"!nctioning ca(ital maret. It is less im(ortant that st!dents belie%e the 2$7 %olatility n!mber as Jthe tr!th o" the maret)s %ie& o" MoGen)s stoc (rice !ncertainty. The sim(le %al!ation a((roach o" adding bond %al!e to o(tion %al!e ignores call "eat!res, iss!e disco!nts, and other attrib!tes o" the notes that a""ect the maret %al!e o" a con%ertible bond. Moreo%er, the (lain %anilla -lac/choles model is a ro!gh c!t at the con%ersion o(tion %al!e. +es(ite all those shortcomings in the %al!ation "rame&or, ho&e%er, the maret (rices o" the 20 and 203 notes sho!ld be consistent in an e""icient ca(ital maret. &inancia% enginee"ing o! the conve"tib%e
inancial engineering re(resents the ey learning (oint "or the class1 con%ertible bond is a deri%ati%e sec!rity that can be decom(osed into its com(onents "or (!r(oses o" (ricing, b!t also "or (!r(oses o" "inancially engineering. In this case, Merrill Lynch co!ld iss!e the con%ertible &ith any con%ersion (remi!m that &as most maretable at the time. Then, MoGen co!ld n!lli"y the con%ersion o(tion o" the con%ertible by (!rchasing call o(tions &ith the same mat!rity and eercise (rice. rom a tradingstrategy %ie&(oint, MoGen &o!ld be short the con%ertible bonds and long the call o(tions &ith a net obligation e'!i%alent to a straight bond. inally, by selling &arrants &ith the same mat!rities, b!t &ith strie (rices e'! al to $07 o%er the c!rrent maret (rice, MoGen &o!ld ha%e created a ne& con%ertible bond &ith a $07 con%ersion (remi!m. I" st!dents are "amiliar &ith (ayo"" diagrams, the instr!ctor can easily demonstrate the "inancialengineering conce(t. s sho&n in &igu"e 1 , a con%ertible bond has a (ayo"" e'!al to its "ace %al!e as long as its con%ersion %al!e is less than the "ace %al!e o" #,000. ig!re . Con%ertible bond (ayo"" to in%estors.
Aayo"" at Mat!rity
#,000
#0
#$00
#,000
#,$00
Con%ersion %al!e 8/toc (rice Con%ersion shares9
6
Case 40 MoGen, Inc.
Case 40 MoGen, Inc.
<
-eca!se MoGen has iss!ed the con%ertible, the (ayo""s are negati%e 8&igu"e )9. ig!re 2. Con%ertible bond (ayo"" to MoGen. Aayo"" at Mat!rity
#0 #0
#$00
#,000
#,$00
Con%ersion %al!e 8/toc (rice Con%ersion shares9
8#,0009
I" MoGen (!rchases call o(tions the !(side (otential o" the calls 8seen as the hea%ily dashed line9 o""sets the do&nside (otential o" the con%ertible 8&igu"e 9. ig!re 3. Con%ertible bond &ith call o(tions. Call o(tions
Aayo"" at Mat!rity
#0 #0
#$00
#,000
#,$00 Con%ersion %al!e 8/toc (rice Con%ersion shares9
8#,0009
>
Case 40 MoGen, Inc.
The net e(os!re becomes a straight bond as re(resented by the irreg!larly dashed line 8&igu"e 2 9. ig!re 4. Con%ertible bond &ith call o(tions. Aayo"" at Mat!rity Con%ersion %al!e 8/toc (rice Con%ersion shares9 #0 #0
#$00
#,000
#,$00
8#,0009 inancially *ngineered /traight +ebt
/elling &arrants at a higher eercise (rice as sho&n in &igu"e 3.
ig!re $. /traight debt &ith &arrants. Aayo"" at Mat!rity
Con%ersion %al!e 8/toc (rice Con%ersion shares9 #0 #0
#$00
#,000
#,$00
5arrants 8#,0009 /traight +ebt &ith 5arrants
The "inal (osition "or MoGen is conce(t!ally e'!i%alent to a con%ertible bond &ith a $07 con%ersion (remi!m. st!te st!dents &ill (oint o!t, ho&e%er, that the "inancially engineered con%ertible does ha%e di""erent cash "lo&s in di""erent states o" the &orld. or eam(le, in%estors &ill need to (ay the eercise (rice to MoGen in order to eercise the
= Case 40 MoGen, Inc. +isc!ssion F!estion 4 "or Class 2 &arrants. No s!ch cash "lo& &o!ld ha%e occ!rred "or the original con%ertible. /t!dents sho!ld note that the &arrants carry a higher con%ersion (rice and a lo&er n!mber o" con%ersion shares (er bond than the original con%ertible. There"ore, in terms o" the (ayo"" diagram, the c!rrent con%ersion %al!e o" the "inancially engineered con%ertible is lo&er than the original con%ertibleH &hich is to say that the $07 con%ersion (remi!m means that in%estors are b!ying a con%ersion o(tion that is "!rther o!t o" the money. 4a%uing the bond hedge and +a""ant t"ansactions
The (ricing o" the bond hedge is straight"or&ard. :edging the bond amo!nts to sim(ly o""setting the con%ersion o(tion, &hich &as already %al!ed in Exhibit TN0 "or the 20 and 203 notes. Moreo%er, the strie (rices o" the con%ersion o(tions &ere already de"ined as #<=.>4 "or the 20 notes and #<=.4> "or the 203 notes. There"ore, MoGen need only (!rchase the correct n!mber o" call o(tions &ith those characteristics to o""set the eisting con%ersion o(tion. This re'!ires st!dents to shi"t their thining "rom (ricing a bond as a b!ndle o" stoc o(tions to %al!ing indi%id!al call o(tions. *ach con%ertible bond has a n!mber o" !nderlying shares a%ailable !(on con%ersion. *%en i" bondholders are not entitled to recei%e shares, the cash recei%ed &ill be %al!ed based on the con%ersion %al!e, &hich is the con%ersion rate times the share (rice. or the 20 notes, the con%ersion (rice o" #<=.>4 translates into a con%ersion rate o" 2.$2$ shares (er bond. -eca!se 2.$ million o" the 20 notes &ere iss!ed, the total n!mber o" con%ersion o(tions e'!als 3.32 million 82.$ million bonds 2.$2$ shares (er bond9. There"ore, MoGen sho!ld (!rchase 3.3 million call o(tions &ith a mat!rity o" "i%e years and a strie (rice o" #<=.>4. /ome st!dents &ill see immediately that &hether &e tal abo!t the con%ersion o(tions in terms o" %al!e (er bond or %al!e (er share, the total %al!e &ill be the same. The instr!ctor may &ant to (ro%e this &ith the calc!lations sho&n in Exhibit TN5 &here the %al!e o" one call o(tion is m!lti(lied by 3.3 million to arri%e at the same total o(tion %al!e as com(!ted in Exhibit TN0 . Exhibit TN6 com(!tes the %al!e o" the &arrant iss!ances. The &arrants are chosen to ha%e the same mat!rities as the notes1 "i%e and se%en years. In "act, the only (arameter that di""ers "rom the call o(tions (!rchased by MoGen is the eercise (rice, &hich is set at a $07 (remi!m o%er the c!rrent stoc (rice.
/t!dents sho!ld notice that beca!se MoGen is iss!ing &arrants "or the same n!mber o" shares, b!t &ith a higher eercise (rice, the combined %al!e o" the bond (l!s 2.$ &arrants &ill "all short o" #,000 (er bond. Exhibits TN7 sho&s that MoGen)s allin cost "or the bond hedge (l!s &arrant iss!ance &as #$40 million, &hich means that the "inancially engineered con%ertible (ro%ided net (roceeds o" abo!t #4.$ billion to MoGen. MoGen co!ld ha%e iss!ed more &arrants
20
Case 40 MoGen, Inc.
+isc!ssion F!estion $ "or Class 2
to mae !( the di""erence, b!t that &o!ld ha%e increased the (otential share dil!tion. -y ee(ing the dil!tion "actor the same, MoGen &as e""ecti%ely b!ying call o(tions &ith a lo& strie (rice and selling calls&arrants one"orone, &ith a higher strie (rice. C"itica% assu$ptions %ariety o" ass!m(tions are necessary to cond!ct any analysis, b!t in this case the %olatility ass!m(tion &as critical to %al!ing the con%ersion o(tions, the call o(tions and the &arrants. The %olatility estimate is al&ays im(ortant to o(tion (ricing, and it is al&ays the least (recisely meas!red o" all the -lac/choles in(!ts. In this case, the traded o(tions ga%e im(lied %olatilities that &ere close to the historical meas!re o" %olatility. It is o"ten the case, ho&e%er, that those estimates di""er as the im(lied %olatilities embody a "or&ardlooing %ie&(oint, &hich can di""er s!bstantially "rom historical (rice %ariations. /ome st!dents might recogniDe that the -lac/choles model is not a (er"ect "it "or modeling the con%ersion o(tion. In (artic!lar, -lac/choles !ses a ris"ree rate, beca!se the eercise (rice (ayment is considered to be risless in the model. This "its &ell &ith the o(tions maret, &here a clearingho!se demands that acco!nts (ost margin to signi"icantly red!ce co!nter(arty ris. or a con%ertible bond &here the "ace %al!e is the eercise (rice, the "ace %al!e is %al!ed in the maret according to the credit ris o" the iss!er. MoGen carried an rating on its debt so that its debt carried a yield to mat!rity o" $.<$7 com(ared to 4.467 "or "i%eyear Treas!ry bonds. I" &e !sed MoGen)s cost o" debt in lie! o" the ris"ree rate, -lac/choles &o!ld ha%e gi%en a higher o(tion %al!e. The -lac/choles model also neglects the dil!tion e""ect !(on stoc (rice. In "act, researchers ha%e arg!ed that the dil!tion e""ect, as &ell as the decision by in%estors o" ho& and &hen to con%ert, &o!ld im(act the maret %al!e o" a &arrant, maing the %al!ation e'!ation m!ch more com(le than the !s!al -lac/choles model.2
Epi%ogue
The instr!ctor sho!ld !se Exhibit TN) as a hando!t to ill!strate that the act!al transactions im(lemented by Merrill Lynch corres(onded to the analysis abo%e. The act!al cost to MoGen &as higher than s!ggested by the analysis d!e to "ees "rom Merrill Lynch, &hich &on <$7 o" the bond hedge b!siness in addition to being the lead boo r!nner "or the notes. In addition to the many ad%antages o" the con%ertible described in the case and this note, the bond hedge created a ta ad%antage "or MoGen. The IB/ allo&ed iss!ers o" con%ertibles to e(ense the interest cost "or straight debt, i" the con%ertible &as "!lly hedged so that it acted lie 2 /ee, "or eam(le, +a%id C. *man!el, J5arrant al!ation and *ercise /trategy, 5ournal o /inancial ,conomics 8!g!st =>39.
Case 40 MoGen, Inc.
2
a straight bond. The ta la& &as silent abo!t adding an additional deri%ati%e on to( o" the hedged con%ertible, &hich meant that the &arrant iss!ance &as irrele%ant to MoGen)s ability to claim an ann!al interest charge e'!al to $.<$07, rather than the act!al co!(on rates o" 0.2$7 and 0.3<$7.
22
Case 40 MoGen, Inc.
*hibit TN MOGEN, INC.
/elected Terms o" MoGen, Inc.)s Con%ertible /enior Notes
Notes o!!e"ed
#2,$00,000,000 (rinci(al amo!nt o" 0.2$7 Con%ertible /enior Notes d!e 20 and #2,$00,000,000 (rinci(al amo!nt o" 0.3<$7 Con%ertible /enior Notes d!e 203.
Inte"est 8 pay$ent dates
0.2$7 (er year, &ith res(ect to the 20 notes, and 0.3<$7 (er year, &ith res(ect to the 203 notes, in each case (ayable semiann!ally in arrears in cash on an!ary and !ly o" each year, beginning !ly , 2006.
Conve"sion "ights
:olders &ill be able to con%ert their notes (rior to the close o" b!siness on the b!siness day be"ore the stated mat!rity date based on the a((licable con%ersion rate. The initial con%ersion rate "or the 20 notes is 2.$2$ shares o" common stoc (er #,000 (rinci(al amo!nt o" 20 notes. This is e'!i%alent to an initial con%ersion (rice o" a((roimately #<=.>4 (er share o" common stoc. The initial con%ersion rate "or the 203 notes is 2.$> shares o" common stoc (er #,000 (rinci(al amo!nt o" 203 notes. This is e'!i%alent to an initial con%ersion (rice o" a((roimately #<=.4> (er share o" common stoc. ?(on con%ersion, a holder &ill recei%e an amo!nt in cash e'!al to the lesser o" 8i9 the (rinci(al amo!nt o" the note, and 8ii9 the con%ersion %al!e. I" the con%ersion %al!e eceeds the (rinci(al amo!nt o" the note on the con%ersion date, MoGen &ill deli%er cash or common stoc or a combination o" cash and common stoc "or the con%ersion %al!e in ecess o" #,000.
9an:ing
The notes &ill ran e'!al in right o" (ayment to all o" MoGen)s eisting and "!t!re !nsec!red indebtedness and senior in right to (ayment to all o" MoGen)s eisting and "!t!re s!bordinated indebtedness.
se o! p"oceeds
5e estimate that the net (roceeds "rom this o""ering &ill be a((roimately #4.= billion a"ter ded!cting estimated disco!nts, commissions, and e(enses. 5e intend to !se 89 a((roimately #3.0 billion o" the net (roceeds "rom this o""ering on or abo!t the closing date to (!rchase shares o" o!r common stoc !nder o!r common stoc re(!rchase (rogram, incl!ding thro!gh one or more bloc trades &ith one or more o" the initial (!rchasers andor their a""iliates. The remaining net (roceeds &ill be added to o!r &oring ca(ital and &ill be !sed "or general cor(orate (!r(oses.
C#SE 2/
*hibit TN2 MOGEN, INC.
MoGen)s -ond :edge and 5arrant Transactions
MoGen iss!ed t&o tranches o" con%ertible debt 8MoGen &as selling at #<.=3 (er share91 )/11 Notes
)/1 Notes
Gross (roceeds 8# millions9
#2,$00
#2,$00
Co!(on rate
0.2$7
0.3<$7
Con%ersion (remi!m
.07
0.$7
Con%ersion (rice
#<=.>4
#<=.4>
MoGen remo%ed the con%ersion o(tion by (!rchasing call o(tions on its o&n shares1
)/11 Ca%%s
)/1 Ca%%s
*ercise (rice
#<=.>4
#<=.4>
N!mber o" shares 8millions9
3.32
3.4$4
5arrants &ere sold &ith eercise (rices o" $07 o%er the maret (rice1
*ercise (rice N!mber o" &arrants 8millions9
)/11 ;a""ants
)/1 ;a""ants
#0<.=0
#0<.=0
3.32
3.4$4
t the end o" those transactions, MoGen had e""ecti%ely iss!ed a straight bond (l!s &arrants. I" in%estors chose to (!rchase a bond (l!s the a((ro(riate n!mber o" &arrants, they &o!ld o&n the e'!i%alent o" an MoGen con%ertible bond &ith a $07 con%ersion (remi!m 8#0<.=#<.=39. MoGen (aid #.3> billion to b!y the call o(tions and netted a((roimately #>60 million, selling the &arrants "or an allin cost o" #$20 million to raise the con%ersion (remi!m to $07 on #$ billion o" bonds.
This teaching note &as &ritten by Aro"essor Oenneth M. *ades. Co(yright P 200> by the ?ni%ersity o" irginia +arden /chool o!ndation, Charlottes%ille, . ll rights reser%ed. 6o order copies7 send an email to salesQdardenb!siness(!blishing.com. 8o part o t#is publication may be reproduced7 stored in a retrieval system7 used in a spreads#eet7 or transmitted in any orm or by any means9electronic7 mec#anical7 p#otocopying7 recording7 or ot#erwise9wit#out t#e permission o t#e arden c#ool /oundation.
24
Case 40 MoGen, Inc.
*hibit TN3 MOGEN, INC.
Con%ersion (tion al!e
Mat!rity C!rrent stoc (rice Con%ersion (remi!m Con%ersion (rice Con%ersion shares
$ years #<<.=> 2$7 #=<.4> 0.26
<%ac:Scho%es Inputs pe" Sha"e 8no di%idend, *!ro(ean o(tion9
/1 ?nderlying asset (rice
R /toc (rice R #<<.=>
S1 *ercise (rice B "1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R Con%ersion (rice R #=<.4> R i%eyear Treas!ry yield R 4.467 R 237 8im(lied by call o(tions1 see Exhibit TN2 9 R $.00
Call o(tion %al!e R -lac/choles call %al!e R #$.> Con%ersion o(tion %al!e R call %al!e (er share shares (er bond R #$.> 0.26 R #62.3 <%ac:Scho%es Inputs pe"
/1 ?nderlying asset (rice
R /toc (rice Con%ersion shares R Con%ersion %al!e R #<<.=> 0.26 R #>00
S1 *ercise (rice B "1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R ace %al!e o" bond R #,000 82$7 con%ersion (remi!m9 R i%eyear Treas!ry yield R 4.467 R 237 8im(lied by call o(tions1 see Exhibit TN2 9 R $.00
Con%ersion o(tion %al!e R -lac/choles call %al!e R #62.3
Case 40 MoGen, Inc.
*hibit TN4 MOGEN, INC.
Im(lied olatilities o" MoGen)s A!t and Call (tions 8an!ary 0, 2006, MoGen stoc (rice R #<<.=>9
Exe"cise *ate
*ays to Matu"ity
Exe"cise ("ice
C%osing ("ice
Open Inte"est
4o%u$e
I$p%ied 4o%ati%ity
Call Call Call Call
04222006 04222006 020200< 020200<
02 02 3<$ 3<$
#<$ #>0 #<$ #>0
#6.60 #3.>$ #0.<0 #<.<$
3,6<< 6,444 6,=<4 =,<=0
$2 => 43 3
2<.$7 26.$7 23.$7 )).3=
A!t A!t A!t A!t
04222006 04222006 020200< 020200<
02 02 3<$ 3<$
#<$ #>0 #<$ #>0
#2.<0 #$.00 #4.6$ #6.=0
=,$2= >,$2 $,<$ 4,3>0
0 $ 0 0
2<.$7 2<.07 24.$7 24.$7
<%ac:Scho%es Mode%> Exa$p%e !o" ?anua"y )/, )//5 @6/ Ca%%
/1 ?nderlying asset (rice S1 *ercise (rice B "1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
#<<.=> #>0.00 4.4$7 )).3= .02<
Call %al!e
@5.61
:sing ;ut<=all ;arity A!t %al!e
#6.26
2$
26
Case 40 MoGen, Inc.
*hibit TN$ MOGEN, INC.
/traight +ebt al!e and Con%ertible -ond al!e
ace %al!e Co!(on rate +isco!nt rate
#,000 .=67 $.<$7 8MoGen)s debt yieldUsimilar to rated yield o" $.<=79
Kears R Co!(on (ayments ace %al!e Total cash "lo&s Maret %al!e1 co!(ons Maret %al!e1 "ace %al!e Maret %al!e1 total
0.$ #=.>$ #0.00 #=.>$
.0 #=.>$ #0.00 #=.>$
.$ #=.>$ #0.00 #=.>$
2.0 #=.>$ #0.00 #=.>$
2.$ #=.>$ #0.00 #=.>$
3.0 #=.>$ #0.00 #=.>$
3.$ #=.>$ #0.00 #=.>$
4.0 #=.>$ #0.00 #=.>$
4.$ $.0 #=.>$ #=.>$ #0.00 #,000.00 #=.>$ #,00=.>$
#>$ #<$3 #>3>
Con%ertible bond %al!e R -ond %al!e Con%ersion o(tion %al!e Con%ertible bond %al!e R #>3> #62 Con%ertible bond %al!e R #,000
C a se
4 0 M o G
en , In c .
$ 3 $
Case 40 MoGen, Inc.
*hibit TN6 MOGEN, INC.
al!ing the 20 and 203 Con%ertible Notes
)/11 Notes
Mat!rity Co!(on C!rrent stoc (rice Con%ersion (remi!m Con%ersion (rice Con%ersion shares
$.00 0.2$7 #<.=3 7 #<=.>4 2.$2$
<%ac:Scho%es Inputs 8no di%idend, *!ro(ean o(tion9
/1 ?nderlying asset (rice
R /toc (rice Con%ersion shares R Con%ersion %al!e R #<.=3 2.$2$ R #=0
S1 *ercise (rice B "1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R ace %al!e o" bond R #,000 87 con%ersion (remi!m9 R i%eyear Treas!ry yield R 4.467 R 2$7 8%al!e necessary to get #,000 (er bond9 R $.0
Con%ersion o(tion %al!e R -lac/choles call %al!e R #24.< -ond %al!e 80.2$7 co!(on9 R #<$> Con%ersion o(tion %al!e R #242 Con%ertible bond %al!e R #,000
8$ year, 0.2$7 co!(on9 8-lac/choles9
2<
2>
Case 40 MoGen, Inc.
*hibit TN6 8contin!ed9
)/1 Notes
Mat!rity Co!(on C!rrent stoc (rice Con%ersion (remi!m Con%ersion (rice Con%ersion shares
<.0 0.3<$7 #<.=3 0.$7 #<=.4> 2.$>
<%ac:Scho%es Inputs 8no di%idend, *!ro(ean o(tion9
/1 ?nderlying asset (rice
R /toc (rice Con%ersion shares R Con%ersion %al!e R #<.=3 2.$> R #=0$.00
S1 *ercise (rice B "1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R ace %al!e o" bond R #,000 80.$7 con%ersion (remi!m9 R $year Treas!ry yield R 4.467 R 2$7 8%al!e necessary to get #,000 (er bond9 R <.0
Con%ersion o(tion %al!e R -lac/choles call %al!e R #30= -ond %al!e 80.2$7 co!(on9 R Con%ersion o(tion %al!e R Con%ertible bond %al!e
R
#6=2 #30= #,00
8< year, 0.3<$7 co!(on9 8-lac/choles9
Case 40 MoGen, Inc.
*hibit TN< MOGEN, INC.
al!ing the :edging Transaction Ca%% Options !o" )/11 Notes
Mat!rity C!rrent stoc (rice *ercise (rice Con%ersion shares (er bond Total o(tions needed
$.0 #<.=3 #<=.>4 2.$2$ 3.33 million 82.$ million 2.$2$9
<%ac:Scho%es Inputs 8no di%idend, *!ro(ean o(tion9
/1 ?nderlying asset (rice S1 *ercise (rice B " 1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R #<.=3 R #<=.>4 87 con%ersion (remi!m9 R 4.467 8$year Treas!ry yield9 R 2$7 8im(lied %olatility, see Exhibit TN09 R $.0
Call o(tion %al!e R #=.3 3.33 R #604 million Call o(tion %al!e !sing Exhibit TN0 cost o" #242bond R 242 2.$ R #604 million Ca%% Options !o" )/1 Notes Mat!rity <.0 C!rrent stoc (rice #<.=3 *ercise (rice #<=.4> Con%ersion shares (er bond 2.$> Total o(tions needed 3.4$3 82.$ million 2.$>9
<%ac:Scho%es Inputs 8no di%idend, *!ro(ean o(tion9
/1 ?nderlying asset (rice S1 *ercise (rice B " 1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R #<.=3 R #<=.4> 80.$7 con%ersion (remi!m9 R 4.467 8$year Treas!ry yield9 R 2$7 8im(lied %olatility, see Exhibit TN09 R <.0
Call o(tion %al!e R #24.6 3.4$3 R #<<3 million Call o(tion %al!e !sing Exhibit TN0 cost o" #30=bond R 30= 2.$ R #<<3 million
2=
30
Case 40 MoGen, Inc.
*hibit TN> MOGEN, INC.
al!ing the 5arrant Iss!ance
;a""ants !o" )/11 Notes
Mat!rity C!rrent stoc (rice *ercise (rice Total o(tions needed
$.0 #<.=3 #0<.= 8$07 (remi!m9 3.33 million 8Exhibit TN59
<%ac:Scho%es Inputs 8no di%idend, *!ro(ean o(tion9
/1 ?nderlying asset (rice S1 *ercise (rice B " 1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R #<.=3 R #0<.= 8$07 (remi!m9 R 4.467 8$year Treas!ry yield9 R 2$7 8im(lied %olatility, see Exhibit TN09 R $.0
5arrant %al!e R #. 3.33 R #34> million ;a""ants !o" )/1 Notes
Mat!rity C!rrent stoc (rice *ercise (rice Total o(tions needed
<.0 #<.=3 #0<.= 8$07 (remi!m9 3.4$3 million 8Exhibit TN5 9
<%ac:Scho%es Inputs 8no di%idend, *!ro(ean o(tion9
/1 ?nderlying asset (rice S1 *ercise (rice B " 1 Bis"ree rate σ1 nn!aliDed %olatility τ1 Kears to e(iration
R #<.=3 R #0<.= 8$07 (remi!m9 R 4.467 8$year Treas!ry yield9 R 2$7 8im(lied %olatility, see Exhibit TN09 R <.0
5arrant %al!e R #6.2 3.4$3 R #$0 million
Case 40 MoGen, Inc.
*hibit TN= MOGEN, INC.
Cash lo&s "or MoGen Con%ertible -ond +eal
>ssuance o 2011 and 201! 8otes
#2.$ billion 20 notes #2.$ billion 203 notes #$.0 billion INL5
;urc#ase =all -ptions to 8ulliy =onversion -ption
#604 million "or 20 notes #<<3 million "or 203 notes #.3> billion ?TL5
>ssue "arrants wit# *0+ tri'e ;remiums
#34> million "or 20 notes #$0 million "or 203 notes #0.>6 billion INL5
Net p"oceeds A 3./ B 1.6 /.60 A @2.3 bi%%ion
3
