Executive Summary:

Basically, the case revolves around Merrill Lynch which is an Equity Linked capital market
group. Dar Manaavi, from Merrill Lynch is working on the proposal for convertible debt of Mogen.
Mogen Inc. issues $5 billion in convertible bonds. The company was a single-largest convertible
bond issuance in history. Merrill Lynch’s equity derivatives group needed to convince Mogen’s
management of the best coupon rate and conversion premium for Mogen and issuing the potential
investors. This pricing decision requires everyone to understand the concept of valuing of
convertible as a sum of a straight bond and the option.

Company Background

If we talk about MoGen it was founded in 1985, Mogen is the “first movers” in the
commercialization of emerging biotechnological innovations in the field of recombinant DNA
and molecular biology. RENGEN and MENGEN are the main “blockbuster” therapeutic drugs of
MoGen which deal with offsetting chemotherapy effects in the cancer patients. Due to these two
products, MoGen has been the emerging leader for the nascent biotechnology industry. Also in
2006, its extensive R&D expenditure resulted in a portfolio of five core products that focused on
supportive cancer care. By January 2006 MoGen portfolio of 5 core products that focused on
cancer care

MoGen has positive growth opportunities because:

1. High investment in R & D to diversify its product line.
2. Acquisition of another company is seen to create synergy with existing capabilities of
MoGen to support the revenue and income growth;
3. It has consistently registered 29% annual increase in sales for the last 5 years; and
4. EPS has shown improvement from $1.69 in 2003 to $2.97 in 2005
Sector Analysis
Though MoGen is the industry leader in biotech, the competitive landscape of the industry
includes firms such as Genentech, Amgen, Gilead Sciences and Celgene. The success of all the
companies depends upon extensive innovation in launching new R&D products.

 Uncertainty in new product launch

 Threat of follow on biologics or biosimilar due to several patents approaching expiration.
 FDA regulations and extensive testing resulting in long lead times in realization of huge
investment tied up in R&D.
 Increasing R&D expenditure. (12.6% growth in R&D over 2003)

Funding Needs
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
MoGen needs approximately $10 Billion in 2006 for Funding, of which 50% will be generated
internally. The Funds will be utilized for the following purposes:
 Expanding manufacturing, fill and finish capacity:
 Investment in R&D and late stage trials:
 Acquisition and Licensing:
 The Stock Repurchase Program: for the purpose of not diluting the Earning Per Shares as
the company has decreased its Shares outstanding from 1280 million in 2004 to 1224
million in 2005. Also Stock Repurchase acts as a subsitiute method of distributing
dividend cash payments. This saves company from the dividend’s upwards stickiness and
the company getting trapped in the risk of stock price fluctuations from the dividend
increase/decrease announcement.
Pros and Cons of issuing convertible debt
Question. What are the pros and cons of issuing convertible debt via straight debt or equity?

A convertible bond has attribute of both debt and equity.

For Investor
a) It provides a fixed stream of coupon payment thus adding to security unlike dividend in
the equity.
b) It provides the floor security (protected downside) in the form of the guarantee of
principle return. Even if the stock price appreciation doesn’t exceed the conversion value,
the investor could get the par value of the bond in the worst case scenario.
c) It provides the upside potential of the equity i.e the conversion premium if the stock
price>conversion price. Investor can gain from conversion which is more than the face
value of the bond.
d) Thus the conversion feature is the right, not an obligation of the investor.
e) Investors could gain premium over the conversion value. The convertible bond could be
sold in the open market at a higher price than the conversion premium due to market
demand.

For Issuing Company:

a) MoGen can still avail the interest deductibility advantage from the Convertible Bonds.
b) It provides lower coupon rate as compared to the equivalent straight bond because of the
added capital appreciation feature. This saves the interest expense resulting in the
financial distress in huge bond issue
c) Allows delay in dilution. MoGen management’s financial Strategy since its IPO has been
to avoid issuing equity as it doesn’t want to dilute its Earning Per Shares by increasing the
number of shares outstanding. Also the company aims to believe that higher incomes and
the future stock appreciation would offset the dilution at the time of maturity.
Valuation of convertible bond

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, and
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?

Value of convertible bond

Independent value of straight bond + Independent value of conversion option.

“The Black-Scholes Merton (BSM) model is a differential equation used to solve for options
prices. The Black Scholes call option formula is calculated by multiplying the stock price by the
cumulative standard normal probability distribution function. Thereafter, the net present value
(NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted
from the resulting value of the previous calculation”

The Black Scholes model requires five input variables:

1. the strike price of an option
2. the current stock price,
3. the time to expiration,
4. the risk-free rate,
5. Volatility.

In our model we have used:

 The current Stock Price of 77.98
 The Strike price as the conversion premium added to the current stock price
 The time to maturity is 5 in years
 The risk free rate of 4.46% is taken comparable with 5 year Treasury Bonds.
  Implied Volatility is calculated through iterations in the Black Scholes Model Formula
with the Call Price Data given in Exhibit 3 of the case. For iteration purposes, we can
take any of the 375 Call Exercise Price.

The Black-Scholes model makes certain assumptions:

 The option is European and can only be exercised at expiration.
 No dividends are paid out during the life of the option.
 Markets are efficient (i.e., market movements cannot be predicted).
 There are no transaction costs in buying the option.
 The risk-free rate and volatility of the underlying are known and constant.
 The returns on the underlying are normally distributed.
Note: The above picture shows the conversion premium of 25% resulting in coupon rate of
1.923%

 The Call Price is calculated using Black Scholes Model.

 The Number of shares issued at Strike price is Par value/Exercise Price
 Conversion Option Value is the sum of Call Price*Number of Shares issue per option.
 PV of the bond is Par Value less Conversion Option Value.
 Discount Rate of 5.75% is used as given in the case for YTM.
 Coupon Payments are calculated using the Annuity.
 Coupon rate is simply the Coupon Payment divided by Par Value.
Financial Analysis
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?
15% Conversion Premium

15% Conversion Premium will result in 0.886% Coupon rate. The advantages for this lower
conversion premium is that it provides greater upside equity potential for the investors and thus
have very lower coupon payment for the company. However the risk of dilution arises and the
management would be very much disappointed with this option as this lower premium would
give negative signal in the market about the management’s lack of confidence in the upside
potential of the stock This has advantages and disadvantages for both the issuing company and
investors.
25% Conversion Premium

MoGen is to have a convertible debt offering with 25% conversion premium and a coupon
rate1.923%. The advantage for investors is that the coupon rate is much lower than the YTM
(Yield to Maturity of 5.75%). However the conversion premium is not high to attract investors.

40% Conversion Premium

The Higher conversion premium is compensated for investors with 3.053% of the coupon rate.
This option would benefit the management the most they believed that MoGen stock is selling in
depressed price which the investors are benefited. For company a higher conversion premium is
better as it will be much less likely for the stock to reach it making it
a better offering for MoGen. However the negative side is that such high conversion premium
would result in demand shrink and liquidity of the issue which is a substantial amount of $ 5
billion.

Recommendation: Conclusion Remarks

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?

Yes according to our analysis the 25% conversion premium is the best and Maanvi can easily
convince the management over its reservations because:

1) Valuing the sentiments of the fundamental investors. Out of the two investor groups the
companies prefer to attract fundamental investors over the hedge funds because they look
into account the long term view of their investment. Hence if the conversion premium is set
too high then the issue of securities won’t be favorable for the fundamental investors with
higher speculations and lesser upside equity potential. Thus the higher conversion premium
for an issue as huge as 5 Billion, there is a substantial risk of volatility associated with the
premium of 40%. Adding to that, the company would have to offer a very high coupon rate
to the investors to offset the premium.
2) Treasury Stock Method for the structure of the convertible issue. With the lower
conversion premium management has the reservations to the dilution of EPS as the bond
will be converted quickly with little appreciation in prices. However the Treasury Stock
structure is already protecting the management by reporting only shares representing excess
of the bonds conversion value over the principal amount. Had management preferred the
option of if-converted method, then the shares would have been diluted with the full amount
of bond. But the management is already avoiding this option due to its share repurchase
policy. Hence the investor in the Treasury-Stock method would be more benefited from
lower conversion premium.
3) Stock price expectations.
The compound annualized growth rate in the stock prices for the period since 2001 till 2005
has been XXX%. The company previously issued convertible bonds in 2003 when stock
price was $61 and conversion price of $90. Five years down this has not been converted as
the stock market has not reached that price. This makes investors to be skeptic about the
stock appreciation and their aspects of equity upside potential. The coupon payment of 25%
is lesser than this option too.

Hence the option of 25% premium is optimum considering the size of the offering,
investor’s profile, their previous experiences and their expectations.