TN40 MoGen Inc

8/10/2019 TN40 MoGen Inc

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4 Case 40 MoGen, Inc.

. :o& im(ortant is it "or MoGen to get #$ billion o" e ternal "!nding in 2006; Co!ld thecom(any c!t bac on its share re(!rchase (rogram, "or e am(le, to red!ce the "!ndsneeded;

2. 5hat are the (ros and cons o" iss!ing con%ertible debt %ia straight debt or e'!ity;3. The case states a con%ertible bond can be %al!ed as the s!m o" a straight bond (l!s a call

o(tion. /tarting &ith the c!rrent stoc (rice o" #


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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 MoGens business model and current operating environment?(10 minutes)

This '!estion hel(s set the bac gro!nd "or st!dents to !ltimately thin abo!t MoGen)schoice o" "inancing in terms o" the !nderlying b!siness ris o" a com(any. It is im(ortantto 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 mar et. -oth acti%ities ha%e signi"icant ris s thatare endemic to biotech b!sinesses. /t!dents &ill o"ten mention MoGen)s sharere(!rchase (rogram d!ring this disc!ssion, &hich ser%es as a transition to disc!ssingMoGen)s "inancing strategy.

2. How would you describe MoGens inancing strategy? (10 minutes)

/t!dents sho!ld see that the ris s 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 isrelati%ely lo& beca!se higher debt le%els &o!ld res!lt in debt rating decreases andthere"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 thatin%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 li e MoGen. The com(any candistrib!te cash to its shareholders &hen (ro"its allo&, b!t &itho!t ma ing an e (licit8debt9 or im(licit 8di%idends9 (romise to the mar et.

!. "#at are MoGens uses o unds or 200$? How important is t#e s#are repurc#ase program to MoGens 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 thatmanagement 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"le ible "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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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 asMoGen)s "!nding choice.

%. How can we use t#e &lac' c#oles pricing model to value t#e conversion optioncomponent 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%ertibleand, in (artic!lar, to choosing the correct in(!t %al!es "or the -lac /choles (ricingmodel 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 e ercise (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!(onrate 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 bondcash "lo&s. /t!dents may be s!r(rised at ho& lo& the co!(on rate is, relati%e to thedisco!nt rate o" $.


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Case 40 MoGen, Inc. Case 40 MoGen, Inc.

?nderstanding the conce(ts behind the hedge is im(ortant, b!t the (ricing is the ey toseeing that there is no "ree l!nch "or MoGen. No matter ho& it is done, MoGen !ltimatelym!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 "romselling 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 as s st!dents to thin abo!t the basic %al!ation "rame&or as &ell as theey %al!e dri%ers o" the deal. 5hile it is a good a((ro imation 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(tioncom(onent ma es %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 &arranttransactions.

Case #na%ysis !o" One C%ass (%an

This section adds detail to the one class teaching (lan o!tlined abo%e.

MoGen-s business $ode%

s (art o" the biotech ind!stry, MoGen had a %ariety o" inherent ris s that sho!ld bee%ident to the st!dents1 dr!g disco%ery, dr!g a((ro%al, and har%esting the %al!e o" e isting dr!gs.-iotech and (harmace!tical com(anies s(end billions o" dollars on B + on the theory that asmall (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, there%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 ris s. Thecom(any &as carrying a large B + (ort"olio, as &ell as many highly s!ccess"!l dr!gs already

on the mar et. 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 themar et to ac'!ire smaller biotech com(anies in addition to licensing the rights to (rod!ce andmar et dr!gs "rom inde(endent so!rces.

iagra, "or e am(le, &as originally de%elo(ed "or cardio%asc!lar diseases be"ore being mar eted by A"iDer "or erectile dys"!nction.

+isc!ssionF!estion


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Case 40 MoGen, Inc. =

MoGen-s !inancia% po%icies

MoGen)s "inancial (olicies &ere dri%en by its b!siness ris s. The !ncertainty o" its (ro"itse(t debt le%els relati%ely lo& and had also e(t management "rom declaring a di%idend. s analternati%e mechanism "or ret!rning cash to its shareholders, MoGen had im(lemented a sharere(!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 inits c!rrent (rogram, o" &hich #3.$ billion &as e (ected to be s(ent in 2006.

ses o! !unds !o" )//0

The %ario!s !ses o" "!nds (resented in the case highlight the ca(ital intensi%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 someo" the e (endit!res, b!t each li ely had a (ositi%e net (resent %al!e 8NA 9 s!ch that changes inthese (lans &o!ld (robably be greeted !n"a%orably by the stoc mar et.

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 notcom(romise MoGen)s "!ndamental b!siness strategy. It co!ld, ho&e%er, res!lt in a share (ricedecline, gi%en that the mar et &as (robably e (ecting a signi"icant re(!rchase "or 2006 based onMoGen)s trac record "or 2003 to 200$. To eliminate the re(!rchases "or 2006 &o!ld signal achange in management)s %ie& that MoGen stoc re(resented a good b!yH &hich is to say that thestoc (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 e am(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!ingne& sec!rities "or 2006. Most st!dents &ill arg!e, ho&e%er, that MoGen had set an e (ectationregarding share re(!rchases o%er the (ast three years and that the in%estment in (rod!ctionso!nds li e a reasonable (ro(osal that &as almost certainly a (ositi%e NA and there"ore sho!ld

be !nderta en. Many st!dents &ill also arg!e that share re(!rchases add %al!e to MoGenshareholders by red!cing the shares o!tstanding and (ro((ing !( earnings (er share 8*A/9.

+isc!ssionF!estion 2

+isc!ssion

F!estion 3


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Managing the n!mber o" shares o!tstanding co!ld become more im(ortant i" MoGen)so!tstanding con%ertible o" # .> billion 8case * hibit $9 &ere to be con%erted at a "!t!re date.

MoGen had alternati%es "or raising e ternal "!nds incl!ding straight debt and commonstoc . 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 theta 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(anyli e MoGen. -ased on data "or (!blic cor(orations, iss!ing common stoc is ty(ically the leastli ely so!rce o" "!nds chosen. Iss!ing common stoc , ho&e%er, &o!ld red!ce MoGen)s "inancialle%erage and increase its "inancial slac "or "!t!re debt o""ering. Case * hibit 4 sho&s thatMoGen)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 ne t "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!traliDem!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(aniesco!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

This is an e ercise in !sing the -lac /choles model to (rice a call o(tion !sing in(!tsthat corres(ond to the terms o" the con%ertible bond. good str!ct!re "or this (art o" the class isto sim(ly list the in(!t %ariables "or -lac /choles and go thro!gh each in order "or thecon%ertible. /t!dents &ill li ely begin &ith MoGen)s stoc (rice o" #


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Case 40 MoGen, Inc.

estimate. The choices are to !se either the historical %olatility o" 2


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("icing the st"aight bond and the conve"tib%e

The straight debt %al!ation is (resented in Exhibit TN3 . /ince the mat!rity 8"i%e years9and "ace %al!e 8# ,0009 are no&n, &e only need the co!(on rate and a((ro(riate disco!nt rateto estimate the %al!e o" the straight debt. Maana%i)s tas is to set the co!(on rate s!ch that thecon%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 theremaining %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 carrythe same rating and hence, the same yield. The case states that the yield o" rated cor(orate debt&as $., &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 mar et (ercei%eda higher %olatility than 237. or e am(le, i" the mar et belie%ed the "i%e year %olatility to be24.$7, the same as estimated "or the long term (!ts, the con%ersion o(tion %al!e rises to #


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Case 40 MoGen, Inc. 3

To end the class the instr!ctor sho!ld distrib!te Exhibit TN1 and disc!ss the act!al termso" the deal. I" there are in%estment ban ers in the class, they &ill not be s!r(rised that MerrillLynch (ro(osed t&o tranches o" #2.$ billion each. s o" 2006, this &as the largest con%ertibleiss!e in history. It &as easier to "ind s!""icient demand "or #2.$ billion o" "i%e year con%erts and#2.$ billion o" se%en year 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 hedgeand &arrant transactions. +e(ending on the time a%ailable the instr!ctor can either a((eal toint!ition as to ho& the ban er co!ld change the con%ersion (remi!m o" the iss!e &ith thesetransactions or the instr!ctor can '!ic ly demonstrate &ith (ayo"" diagrams ho& the call o(tionscreated a straight bond and the &arrants created a ne& con%ertible. The instr!ctor sho!ld mentionthat 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" $.


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time; 5here is the s&eet s(ot o" the mar et; :o& sho!ld MoGen)s con%ertible be str!ct!red tog!arantee the highest demand and, hence, the best (ossible (rice "or the client;

Merrill Lynch ans&ered those '!estions by str!ct!ring "i%e year and se%en year bonds&ith lo& con%ersion (remi!ms. In 2006, those &ere the terms that Maana%i sa& as the Js&eets(ot o" the mar et1 &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 choiceo" cash or shares "or abo%e (rinci(al9 satis"ied "inancial acco!nting standards 8 /9re'!irements "or re(orting the con%ertible !sing the treas!ry stoc method, &hich &as im(ortantto 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&o ste( (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 li e a $07 (remi!m to MoGen.

("icing o! the )/11 and )/1 notes

The strength o" the t&o class 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 e ercise "or the st!dents to chec "or consistency o" the (ricing !sing the same "ormat (resented in ExhibitsTN and TN3 1 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 20 3 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 isthe same. /t!dents sho!ld recogniDe that the disco!nt rate "or the bond cash "lo&s remains as$.


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Case 40 MoGen, Inc. $

similar (remi!m "or both notes, or is it more reasonable to concl!de that &e ha%e made a mista e

&ith the model; This '!estion (resses the st!dents to consider the merits o" ass!ming the mar etto be ine""icient, rather than ass!ming the %olatility estimate as the li ely c!l(rit "or themis(ricing.

It is im(ortant "or st!dents to tr!st that the 20 and 20 3 notes m!st be (ricedconsistently in a &ell "!nctioning ca(ital mar et. It is less im(ortant that st!dents belie%e the2$7 %olatility n!mber as Jthe tr!th o" the mar et)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!edisco!nts, and other attrib!tes o" the notes that a""ect the mar et %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 mar et (rices o" the

20 and 20 3 notes sho!ld be consistent in an e""icient ca(ital mar et.

&inancia% enginee"ing o! the conve"tib%e

inancial engineering re(resents the ey learning (oint "or the class1 con%ertible bondis a deri%ati%e sec!rity that can be decom(osed into its com(onents "or (!r(oses o" (ricing, b!talso "or (!r(oses o" "inancially engineering. In this case, Merrill Lynch co!ld iss!e thecon%ertible &ith any con%ersion (remi!m that &as most mar etable at the time. Then, MoGenco!ld n!lli"y the con%ersion o(tion o" the con%ertible by (!rchasing call o(tions &ith the samemat!rity and e ercise (rice. rom a trading strategy %ie&(oint, MoGen &o!ld be short thecon%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 stri e (rices e'!al to $07 o%er thec!rrent mar et (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"inancial engineering 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.

+isc!ssionF!estion 3 "or

Class 2

Con%ersion %al!e 8/toc (rice Con%ersion shares9

Aayo"" atMat!rity

# ,000

#0 #$00 # ,000 # ,$00


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Case 40 MoGen, Inc. $ #=.>$ #=.>$ #=.>$ #=.>$ #=.>$ #=.>$ #=.>$ # ,00=.>$

Mar et %al!e1 co!(ons #>$Mar et %al!e1 "ace %al!e #3>

Con%ertible bond %al!e R -ond %al!e Con%ersion o(tion %al!eCon%ertible bond %al!e R #>3> # 62Con%ertible bond %al!e R # ,000


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Case 40 MoGen, Inc. 2 Case 40 MoGen, Inc.

* hibit TN6 8contin!ed9

)/1 NotesMat!rity


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Case 40 MoGen, Inc. 2=

* hibit TN

TN40 MoGen Inc

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