Case 40 MoGen, Inc.

MOGEN, INC.
Teaching Note
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 Lynchs Equity Derivatives Group
to convince MoGens management to choose Merrill Lynch over its competitors. The case is
focused on Merrill Lynchs choice of the conversion premium and coupon rate to propose to
MoGen management. This pricing decision requires students 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.
On a strategic level, the case introduces students to the concept of matching a companys
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.
The case is designed for students who already have a basic knowledge of bond valuation
and option-pricing principles. Because the case touches on both technical and strategic issues, it
works well with undergraduate, MBA, and executive education audiences. The instructor may
choose to teach the case in one class period or two. For a one-class experience, Exhibit TN1
serves as the epilogue to hand out at the end of class, whereas for a two-class experience Exhibit
TN1 serves as a handout and the beginning point for an assignment for the following class.
When taught over two classes, the second class deals with the financial-engineering issues
associated with using derivatives to increase MoGens conversion premium from 11% (the actual
premium) to 50%. Thus, the second class 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.
Suggested Questions for Advance Assignment
For a one-class teaching plan:

Case 40 MoGen, Inc.

1. 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?
2. What are the pros and cons of issuing convertible debt via straight debt or equity?
3. 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?
4. 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?
5. As MoGens 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?
For a two-class teaching plan, the following questions can be distributed along with
Exhibit TN1:
1. 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. What
implied volatility do you find for the 2011 notes? What about for the 2013 notes?
2. How could Merrill Lynch use financial engineering to change the conversion premiums
of the 2011 and 2013 notes to 50%? (Hint: Think about what financial engineering
MoGen would need to do to change the convertible bond into a straight one. 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.)
3. 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?

Case 40 MoGen, Inc.

Supporting Microsoft Excel Spreadsheet Files

For students:

Case_40.xls

For instructors:

TN_40.xls

Please do not share the instructors file with students.

Hypothetical Teaching Plans
The following questions form a teaching plan for one 85-minute class.
1. How would you describe MoGens business model and current operating environment?
(10 minutes)
This question helps set the background for students to ultimately think about MoGens
choice of financing in terms of the underlying business risk of a company. It is important
to establish a solid understanding of the business before addressing the task of how to
finance it. The biotech industry relies heavily upon research and development (R&D), as
well as the ability to get a new drug to market. Both activities have significant risks that
are endemic to biotech businesses. Students will often mention MoGens share
repurchase program during this discussion, which serves as a transition to discussing
MoGens financing strategy.
2. How would you describe MoGens financing strategy? (10 minutes)
Students should see that the risks of the biotech business are driving all of MoGens
financial decisions: debt policy, dividend policy, and share repurchase program. Debt is
relatively low because higher debt levels would result in debt rating decreases and
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. Students should realize that a share repurchase
program is a very good match for a biotech company like MoGen. The company can
distribute cash to its shareholders when profits allow, but without making an explicit
(debt) or implicit (dividends) promise to the market.
3. What are MoGens uses of funds for 2006? How important is the share repurchase
program to MoGens choice to issue a convertible bond? (10 minutes)
This question is designed to focus the class on the share repurchase program as a critical
use of funds for 2006. The primary advantage of share repurchases using dividends is that
management can turn share repurchases off and on as allowed by cash flow. The other
projected uses of funds, however, are largely driven by business issues that are not as
flexible for management. Students should notice that most of the $5 billion raised will be
used to repurchase shares ($3.5 billion). Thus, MoGen could significantly reduce its
funding needs by postponing the share repurchases and possibly fund the remaining

Case 40 MoGen, Inc.

shortfall with straight debt. If MoGen management continues with the share repurchase
plan, however, students should see several advantages of using the convertible bond as
MoGens funding choice.
4. How can we use the Black-Scholes pricing model to value the conversion option
component of the convertible? (20 minutes)
Much of the class time will be devoted to the technical aspect of pricing the convertible
and, in particular, to choosing the correct input values for the Black-Scholes pricing
model to 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. Other key
points of emphasis will be the estimation of volatility and translation of the conversion
premium into the stock price and exercise price.
5. What coupon rate did you get for a 25% conversion premium? (20 minutes)
This question relates to the second step in valuing the convertible: solving for the coupon
rate on the straight bond component such that 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. Students may be surprised at how low the coupon rate is, relative to the
discount rate of 5.75%. The instructor may also want to ask for the coupon rate for a
different conversion premium to reinforce the pricing concept.
6. Epilogue. (10 minutes)
The instructor should end the class by distributing copies of Exhibit TN1. Discussion
points will center on the actual terms of MoGens deal with particular emphasis upon the
low conversion premiums and coupon rates. The instructor can conclude the class with a
discussion about how Merrill Lynch was able to alter the effective conversion premium
by having MoGen buy and sell warrants with differing strike prices. Exhibit TN2 is
designed as a handout to show how Merrill Lynch designed this bond hedge plus warrant
transaction.
The following questions form a teaching plan for two 85-minute classes.
Day one
1. How would you describe MoGens business model and current operating environment?
(10 minutes)
2. How would you describe MoGens financing strategy? (10 minutes)
3. What are MoGens uses of funds for 2006? How important is the share repurchase
program to MoGens choice to issue a convertible bond? (10 minutes)
4. How can we use the Black-Scholes pricing model to value the conversion option
component of the convertible? (20 minutes)

Case 40 MoGen, Inc.

5. What coupon rate did you get for a 25% conversion premium? (Optional: For a 15%
premium? for a 40% premium?) (20 minutes)
6. Epilogue. (10 minutes)
The instructor should end the class by distributing copies of Exhibit TN1 as the focal
point to discuss the actual terms of MoGens deal with particular emphasis on the low conversion
premium. Then, the instructor should distribute study Questions 5 and 6 as the structure for the
second class.
Day two
1. Why did MoGen agree to issue a convertible with the wrong terms? (10 minutes)
This question prompts the students to think about the big picture for security issuance
before addressing the many technical pricing issues. The terms in Exhibit TN1 were
offered, because 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.
2. Does it appear that Merrill Lynch priced the 2011 and 2013 notes appropriately? (15
minutes)
The actual terms of the convertible were noticeably different than what was proposed in
the case. MoGens stock price had fallen to $71.93, the coupon rates were lower, and the
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 principles
from class one. Students will be pleased to see that the bond-plus-option framework
works well for the actual terms and, in particular, that the implied volatility for the 2011
and 2013 notes is very close to the value derived in the first class.
3. How can we change MoGens financially engineered straight bond into a convertible
bond with a 50% conversion premium? (20 minutes)
A good way to begin this analysis is to remind the students 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. The
instructor may choose to frame the discussion with the use of payoff diagrams to
illustrate the financial engineering.
4. How much should MoGen pay to buy the call options? How much should MoGen realize
from the sale of the warrants? (20 minutes)

Case 40 MoGen, Inc.

Discussion
Question 1

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, the class
will see that the cost of buying the call options is higher than the value received from
selling the warrants (assuming the same number of equivalent shares).
5. What are the critical assumptions embedded in this deal? (10 minutes)
This question asks students to think about the basic valuation framework as well as the
key value drivers of the deal. While it is a good approximation to model a convertible as
straight debt plus an option component, the Black-Scholes model does not consider
issues, such as the dilution effect and the call feature of the bond. Moreover, the option
component makes volatility a key value driver for the model that needs careful scrutiny.
6. Epilogue. (10 minutes)
Exhibit TN2 explains how Merrill Lynch implemented the bond hedge and warrant
transactions.
Case Analysis for One-Class Plan
This section adds detail to the one-class teaching plan outlined above.
MoGens business model
As part of the biotech industry, MoGen had a variety of inherent risks that should be
evident to the students: drug discovery, drug approval, and harvesting the value of existing drugs.
Biotech and pharmaceutical companies spend billions of dollars on R&D on the theory that a
small percentage of the R&D will produce highly lucrative results. In truth, many of the highest
value drugs had been discovered somewhat accidentally, while pursuing a different line of
research.1 The FDA approval process was expensive and often stretched over years, and there
was a possibility that the drug might not be approved at any 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 portfolio, as well as many highly successful drugs already
on the market. The company planned to invest in its production capabilities in Puerto Rico as
well as build new facilities in Ireland. In addition to its R&D efforts, MoGen was active in the
market to acquire smaller biotech companies in addition to licensing the rights to produce and
market drugs from independent sources.

1 Viagra, for example, was originally developed for cardiovascular diseases before being marketed by Pfizer for
erectile dysfunction.

Discussion
Case 40 MoGen,
Inc.
Question 2

MoGens financial policies

MoGens financial policies were driven by its business risks. The uncertainty of its profits
kept debt levels relatively low and had also kept management from declaring a dividend. As an
alternative mechanism for returning cash to its shareholders, MoGen had implemented a share
repurchase program over the past few years. Students should recognize that the share repurchase
programs were a key financial strategy for MoGen. The company had spent over $10 billion over
the previous three years for various share repurchase programs and had $6.5 billion remaining in
its current program, of which $3.5 billion was expected to be spent in 2006.
Uses of funds for 2006
Discussion
Question 3

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 MoGens 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
MoGens track record for 2003 to 2005. To eliminate the repurchases for 2006 would signal a
change in managements 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. Most students will argue, however, that 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. Many students will also argue that share repurchases add value to MoGen
shareholders by reducing the shares outstanding and propping up earnings per share (EPS).

10

Case 40 MoGen, Inc.

Managing the number of shares outstanding could become more important if MoGens
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 MoGens financial
leverage and increase its financial slack for future debt offering. Case Exhibit 4 shows that
MoGens 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 companys stock at a
premium price. That was music to the ears of MoGens senior management.
Pricing the conversion option
Discussion
Question 4

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. Students will likely begin with MoGens stock price of $77.98 as the underlying
asset value of the option. Many students, however, will have difficulty translating the per-share
call option value to the value of the conversion option for a $1,000 bond. Students will
eventually recognize that 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. Exhibit
TN3 shows the option calculations both on a per-share basis and on a per-bond basis.
As students suggest values for each of the inputs for the Black-Scholes model, the
instructor can record the values on the board to create something like Exhibit TN3. Considerable
discussion can ensue for any and all of the input values, but students usually realize that
volatility is critical to the option value while at the same time being the most difficult input to

Case 40 MoGen, Inc.

11

estimate. The choices are to use either the historical volatility of 27% or an implied volatility
from MoGens traded options. Exhibit TN4 shows the implied volatilities to be about 23% for
the long-term call options. Students usually agree that the implied volatilities are more reliable
than historical values as they are derived from market prices that are forward-looking. Students
should also agree that the longer maturity call options give more appropriate estimates than the
short-term options, since Maanavis task is to price a five-year option.

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Case 40 MoGen, Inc.

Pricing the straight bond and the convertible

Discussion
Question 5

The straight debt valuation is presented in Exhibit TN5. 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. Maanavis 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 bonds cash flows.
Since MoGens 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%. In fact, as shown in Exhibit TN5, a 1.96% coupon creates a debt
value of $838, which when added to the conversion option value gives $1,000.
Students should recognize that 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 MoGens 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.
As time allows, the instructor may want to redo 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, students 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 for One-Class Format

Case 40 MoGen,
Inc.
13
Discussion
Question 1 for
Class 2

To end the class the instructor should distribute Exhibit TN1 and discuss the actual terms
of the deal. If there are investment bankers in the class, they will not be surprised that Merrill
Lynch proposed two tranches of $2.5 billion each. As of 2006, this was the largest convertible
issue in history. It was easier to find sufficient demand for $2.5 billion of five-year converts and
$2.5 billion of seven-year converts than for a single issue of $5 billion.
Students may be surprised at Merrill Lynchs choice of low coupon rates and low
conversion premiums. After some discussion and guessing as to why the issue was structured this
way, the instructor should display or distribute Exhibit TN2 with the details of the bond hedge
and warrant transactions. Depending on the time available the instructor can either appeal to
intuition as to how the banker could change the conversion premium of the issue with these
transactions or the instructor can quickly demonstrate with payoff diagrams how the call options
created a straight bond and the warrants created a new convertible. The instructor should mention
that after all the dust settled, MoGen effectively had sold a convertible with a 50% conversion
premium. In addition, the tax law allowed MoGen to report an interest expense of 5.75% per
year, because the U.S. Internal Revenue Service (IRS) viewed the hedged bond separately from
the warrants, which allowed MoGen to report the interest cost at the market yield.
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 convertibles structure
This question is designed to help students put on their marketing hats as an investment
banker. The I-banker is not just a technician who manipulates Black-Scholes models, but rather
acts as the intermediary that sells a corporations securities to the marketplace. The key to a
bankers 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

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Case 40 MoGen, Inc.

Discussion
Question 2 for
Class 2

time? Where is the sweet spot of the market? How should MoGens 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 MoGens 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% premium to MoGen.
Pricing of the 2011 and 2013 notes
The strength of the two-class teaching plan is that it allows for reinforcement of the
pricing principles. Since MoGens 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 students to check for consistency of the pricing using the same format presented in Exhibits
TN3 and TN5: Compute the conversion option value and the straight bond value.
Exhibit TN6 summarizes the inputs for the conversion option values and straight debt
values for the 2011 and 2013 notes. 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. Students should recognize that 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.
There are a couple of approaches the instructor could take with respect to the volatility
assumption. For Exhibit TN6 the volatilities are reported as 25%, somewhat higher than implied
by MoGens options as reported in Exhibit TN4 and used in Exhibit TN3. The 25% figure
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, the instructor could also use a lower volatility such
as used in Exhibit TN3. A lower volatility will give a lower conversion option and, hence, both
the 2011 and 2013 note value estimates will be below $1,000. At this point the instructor should
take the opportunity to ask the class: Does it seems reasonable that the market would have paid a

Case 40 MoGen,
Inc.
15
Discussion
Question 3 for
Class 2

similar premium for both notes, or is it more reasonable to conclude that we have made a mistake
with the model? This question presses the students to consider the merits of assuming the market
to be inefficient, rather than assuming the volatility estimate as the likely culprit for the
mispricing.
It is important for students to trust that the 2011 and 2013 notes must be priced
consistently in a well-functioning capital market. It is less important that students believe the
25% volatility number as the truth of the markets view of MoGens 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 the key learning point for the class: A convertible bond
is a derivative security that can be decomposed into its components for purposes of pricing, but
also for purposes of financially engineering. In this case, Merrill Lynch could issue the
convertible with any 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. From a trading-strategy viewpoint, MoGen would be short the
convertible bonds and long the call options with a net obligation equivalent to a straight bond.
Finally, by selling warrants with the same maturities, but with strike prices equal to 50% over the
current market price, MoGen would have created a new convertible bond with a 50% conversion
premium.
If students are familiar with payoff diagrams, the instructor can easily demonstrate the
financial-engineering concept. As shown in Figure 1, a convertible bond has a payoff equal to its
face value as long as its conversion value is less than the face value of $1,000.
Figure 1. Convertible bond payoff to investors.
Payoff at
Maturity

$1,000

$0

$500

$1,000

$1,500

Conversion value (Stock price Conversion shares)

16

Case 40 MoGen, Inc.

Case 40 MoGen, Inc.

17

Because MoGen has issued the convertible, the payoffs are negative (Figure 2).
Figure 2. Convertible bond payoff to MoGen.
Payoff at
Maturity

$0
$0

$500

$1,000

$1,500

Conversion value (Stock price Conversion shares)

($1,000)

If MoGen purchases call options the upside potential of the calls (seen as the heavily
dashed line) offsets the downside potential of the convertible (Figure 3).
Figure 3. Convertible bond with call options.
Call options

Payoff at
Maturity

$0
$0

$500

$1,000

$1,500
Conversion value (Stock price Conversion shares)

($1,000)

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Case 40 MoGen, Inc.

The net exposure becomes a straight bond as represented by the irregularly dashed line
(Figure 4).
Figure 4. Convertible bond with call options.
Payoff at
Maturity
Conversion value (Stock price Conversion shares)
$0
$0

($1,000)

$500

$1,000

$1,500

Financially Engineered Straight Debt

Selling warrants at a higher exercise price as shown in Figure 5.

Figure 5. Straight debt with warrants.
Payoff at
Maturity

Conversion value (Stock price Conversion shares)

$0
$0

$500

$1,000

$1,500

Warrants
($1,000)
Straight Debt with Warrants

The final position for MoGen is conceptually equivalent to a convertible bond with a
50% conversion premium. Astute students will point out, however, that the financially
engineered convertible does have different cash flows in different states of the world. For
example, investors will need to pay the exercise price to MoGen in order to exercise the

Case 40 MoGen,
Inc.
19
Discussion
Question 4 for
Class 2

warrants. No such cash flow would have occurred for the original convertible. Students should
note that the warrants carry a higher conversion price and a lower number of conversion shares
per bond than the original convertible. Therefore, in terms of the payoff diagram, the current
conversion value of the financially engineered convertible is lower than the original convertible;
which is to say that the 50% conversion premium means that investors are buying a conversion
option that is further out of the 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 options in
terms of value per bond or value per share, the total value will be the same. The instructor may
want to prove this with the calculations shown in Exhibit TN7 where the value of one call
option is multiplied by 31.3 million to arrive at the same total option value as computed in
Exhibit TN6.
Exhibit TN8 computes the value of the warrant issuances. The warrants are chosen to
have the same maturities as the notes: five and seven years. In fact, the only parameter that
differs from the call options purchased by MoGen is the exercise price, which is set at a 50%
premium over the current stock price.
Students should notice that because MoGen is issuing warrants for the same number of
shares, but with a higher exercise price, the combined value of the bond plus 12.5 warrants will
fall short of $1,000 per bond. Exhibits TN9 shows that MoGens all-in cost for the bond hedge
plus warrant issuance was $540 million, which means that the financially engineered convertible
provided net proceeds of about $4.5 billion to MoGen. MoGen could have issued more warrants

20

Case 40 MoGen, Inc.

Discussion
Question 5 for
Class 2

to make up the difference, but that would have increased the potential share dilution. By keeping
the dilution factor the same, MoGen was effectively buying call options with a low strike price
and selling calls/warrants one-for-one, with a higher strike price.
Critical assumptions
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 MoGens 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
2 See, for example, David C. Emanuel, Warrant Valuation and Exercise Strategy, Journal of Financial
Economics (August 1983).

Case 40 MoGen, Inc.

21

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 MoGens ability to claim an
annual interest charge equal to 5.750%, rather than the actual coupon rates of 0.125% and
0.375%.

22

Case 40 MoGen, Inc.

Exhibit TN1
MOGEN, INC.
Selected Terms of MoGen, Inc.s Convertible Senior Notes
Notes offered

$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.

Interest & payment dates

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.

Conversion rights

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.

Ranking

The notes will rank equal in right of payment to all of MoGens existing and
future unsecured indebtedness and senior in right to payment to all of
MoGens 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 (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.

CASE 40
Exhibit TN2
MOGEN, INC.
MoGens Bond Hedge and Warrant Transactions
MoGen issued two tranches of convertible debt (MoGen was selling at $71.93 per share):

Gross proceeds ($ millions)

Coupon rate
Conversion premium
Conversion price

2011 Notes
$2,500
0.125%
11.0%
$79.84

2013 Notes
$2,500
0.375%
10.5%
$79.48

MoGen removed the conversion option by purchasing call options on its own shares:

Exercise price
Number of shares (millions)

2011 Calls
$79.84
31.312

2013 Calls
$79.48
31.454

Warrants were sold with exercise prices of 50% over the market price:

Exercise price
Number of warrants (millions)

2011 Warrants
$107.90
31.312

2013 Warrants
$107.90
31.454

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.

This teaching note was written by Professor Kenneth M. Eades. Copyright 2008 by the University of Virginia
Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.

24

Case 40 MoGen, Inc.

Exhibit TN3
MOGEN, INC.
Conversion Option Value
Maturity
Current stock price
Conversion premium
Conversion price
Conversion shares

5 years
$77.98
25%
$97.48
10.26

Black-Scholes Inputs per Share

(no dividend, European option)
S: Underlying asset price

= Stock price = $77.98

X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

= > Conversion price = $97.48

= > Five-year Treasury yield = 4.46%
= > 23% (implied by call options: see Exhibit TN4)
= 5.00

Call option value = Black-Scholes call value = $15.8

Conversion option value = call value per share shares per bond = $15.8 10.26 = $162.3
Black-Scholes Inputs per Bond
(no dividend, European option)
S: Underlying asset price

= Stock price Conversion shares = Conversion value

= $77.98 10.26
= $800

X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

= > Face value of bond = $1,000 (25% conversion premium)

= > Five-year Treasury yield = 4.46%
= > 23% (implied by call options: see Exhibit TN4)
= 5.00

Conversion option value = Black-Scholes call value = $162.3

Case 40 MoGen, Inc.

Exhibit TN4
MOGEN, INC.
Implied Volatilities of MoGens Put and Call Options
(January 10, 2006, MoGen stock price = $77.98)
Exercise
Date

Days to
Maturity

Exercise
Price

Closing
Price

Open
Interest

Volume

Implied
Volatility

Call
Call
Call
Call

04/22/2006
04/22/2006
01/20/2007
01/20/2007

102
102
375
375

$75
$80
$75
$80

$6.60
$3.85
$10.70
$7.75

3,677
6,444
6,974
9,790

52
98
143
3

27.5%
26.5%
23.5%
22.5%

Put
Put
Put
Put

04/22/2006
04/22/2006
01/20/2007
01/20/2007

102
102
375
375

$75
$80
$75
$80

$2.70
$5.00
$4.65
$6.90

9,529
8,512
5,175
4,380

10
5
10
0

27.5%
27.0%
24.5%
24.5%

Black-Scholes Model: Example for January 20, 2007 $80 Call

S: Underlying asset price
X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

$77.98
$80.00
4.45%
22.5%
1.027

Call value

$7.81

Using PutCall Parity

Put value

$6.26

25

26

Case 40 MoGen, Inc.

Exhibit TN5
MOGEN, INC.
Straight Debt Value and Convertible Bond Value
Face value
Coupon rate
Discount rate

$1,000
1.96%
5.75% (MoGens debt yieldsimilar to A-rated yield of 5.79%)

Years =>
Coupon payments
Face value
Total cash flows
Market value: coupons
Market value: face value
Market value: total

0.5
$9.85
$0.00
$9.85

1.0
$9.85
$0.00
$9.85

1.5
$9.85
$0.00
$9.85

2.0
$9.85
$0.00
$9.85

2.5
$9.85
$0.00
$9.85

3.0
$9.85
$0.00
$9.85

3.5
$9.85
$0.00
$9.85

4.0
$9.85
$0.00
$9.85

4.5
5.0
$9.85
$9.85
$0.00 $1,000.00
$9.85 $1,009.85

$85
$753
$838

Case 40 MoGen, Inc.

Convertible bond value = Bond value + Conversion option value

Convertible bond value =
$838
+
$162
Convertible bond value =
$1,000

535

Case 40 MoGen, Inc.

Exhibit TN6
MOGEN, INC.
Valuing the 2011 and 2013 Convertible Notes
2011 Notes
Maturity
Coupon
Current stock price
Conversion premium
Conversion price
Conversion shares

5.00
0.125%
$71.93
11%
$79.84
12.525

Black-Scholes Inputs
(no dividend, European option)
S: Underlying asset price

= Stock price Conversion shares = Conversion value

= $71.93 12.525
= $901

X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

=> Face value of bond = $1,000 (11% conversion premium)

=> Five-year Treasury yield = 4.46%
=> 25% (value necessary to get $1,000 per bond)
= 5.0

Conversion option value = Black-Scholes call value = $241.7

Bond value (0.125% coupon) = $758
Conversion option value = $242
Convertible bond value = $1,000

(5 year, 0.125% coupon)

(Black-Scholes)

27

28

Case 40 MoGen, Inc.

Exhibit TN6 (continued)

2013 Notes
Maturity
Coupon
Current stock price
Conversion premium
Conversion price
Conversion shares

7.0
0.375%
$71.93
10.5%
$79.48
12.581

Black-Scholes Inputs
(no dividend, European option)
S: Underlying asset price

= Stock price Conversion shares = Conversion value

= $71.93 12.581
= $905.00

X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

=> Face value of bond = $1,000 (10.5% conversion premium)

=> 5-year Treasury yield = 4.46%
=> 25% (value necessary to get $1,000 per bond)
= 7.0

Conversion option value = Black-Scholes call value = $309

Bond value (0.125% coupon) =
Conversion option value
=
Convertible bond value

$692
$309
$1,00
1

(7 year, 0.375% coupon)

(Black-Scholes)

Case 40 MoGen, Inc.

Exhibit TN7
MOGEN, INC.
Valuing the Hedging Transaction
Call Options for 2011 Notes
Maturity
Current stock price
Exercise price
Conversion shares per bond
Total options needed

5.0
$71.93
$79.84
12.525
31.313 million (2.5 million 12.525)

Black-Scholes Inputs
(no dividend, European option)
S: Underlying asset price
X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

= $71.93
= $79.84 (11% conversion premium)
= 4.46% (5-year Treasury yield)
= 25% (implied volatility, see Exhibit TN6)
= 5.0

Call option value = $19.3 31.313 = $604 million

Call option value using Exhibit TN6 cost of $242/bond = 242 2.5 = $604 million
Call Options for 2013 Notes
Maturity
7.0
Current stock price
$71.93
Exercise price
$79.48
Conversion shares per bond
12.581
Total options needed
31.453 (2.5 million 12.581)
Black-Scholes Inputs
(no dividend, European option)
S: Underlying asset price
X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

= $71.93
= $79.48 (10.5% conversion premium)
= 4.46% (5-year Treasury yield)
= 25% (implied volatility, see Exhibit TN6)
= 7.0

Call option value = $24.6 31.453 = $773 million

Call option value using Exhibit TN6 cost of $309/bond = 309 2.5 = $773 million

29

30

Case 40 MoGen, Inc.

Exhibit TN8
MOGEN, INC.
Valuing the Warrant Issuance
Warrants for 2011 Notes
Maturity
Current stock price
Exercise price
Total options needed

5.0
$71.93
$107.9 (50% premium)
31.313 million (Exhibit TN7)

Black-Scholes Inputs
(no dividend, European option)
S: Underlying asset price
X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

= $71.93
= $107.9 (50% premium)
= 4.46% (5-year Treasury yield)
= 25% (implied volatility, see Exhibit TN6)
= 5.0

Warrant value = $11.1 31.313 = $348 million

Warrants for 2013 Notes
Maturity
Current stock price
Exercise price
Total options needed

7.0
$71.93
$107.9 (50% premium)
31.453 million (Exhibit TN7)

Black-Scholes Inputs
(no dividend, European option)
S: Underlying asset price
X: Exercise price
Rf: Risk-free rate
: Annualized volatility
: Years to expiration

= $71.93
= $107.9 (50% premium)
= 4.46% (5-year Treasury yield)
= 25% (implied volatility, see Exhibit TN6)
= 7.0

Warrant value = $16.2 31.453 = $510 million

Case 40 MoGen, Inc.

Exhibit TN9
MOGEN, INC.
Cash Flows for MoGen Convertible Bond Deal
Issuance of 2011 and 2013 Notes
$2.5 billion 2011 notes
$2.5 billion 2013 notes
$5.0 billion INFLOW
Purchase Call Options to Nullify Conversion Option
$604 million for 2011 notes
$773 million for 2013 notes
$1.38 billion OUTFLOW
Issue Warrants with 50% Strike Premiums
$348 million for 2011 notes
$510 million for 2013 notes
$0.86 billion INFLOW
Net proceeds = 5.0 1.38 + 0.86 = $4.5 billion

31