Note on Mogen Inc.
Mogen Inc, one of the early biotechnology firms in the industry established in 1985 is looking to
raise debt through convertible bonds. This note evaluates its need for the said amount, highlights
the pros and cons and evaluates the likely value, coupon rate and fair premium for the same.
Need for Funding
Mogen intends to invest about $10 billion for growth and shareholder payoffs as follows:
Heads Investment Amount ($ billion
Manufacturing 1
Research 3
Testing and trials 0.5
Acquisition and licensing 2
Share repurchase 3.5
Total 10
Since Mogen is a biotechnology firm whose value proposition is based on delivering next-gen
drugs; investment on research, testing and trials is important. Further, expansion is also
necessary to achieve the revenue targets for the firm. Share repurchase could have been an area
of cut back, however, this action would result in sending a negative signal to the market. Thus,
waiting on acquisition is the only possible hold up for Mogen. With its existing self-funding of
USD 5 billion, Mogen would atleast need USD 3 billion of external funding.
Advantages and Disadvantages
There are some inherent advantages of issuing a convertible debt instead of straight debt or
common stock. These advantages are listed below:
• Ability to raise capital at lower cost and to raise a higher amount without compromising
on credit rating
• Callability feature of a convertible debt giving the issuing firm ability to call back the
bond at a premium
• Limited impact on EPS since the new stock would be issued at a higher price as
compared to the original listing price
Nonetheless, these convertibles do have drawbacks as follows:
• Dilution of shareholding in the firm for the existing investors in case of bonds’
conversion to stocks
• Limited investor base - Hedge funds and fundamental investors are the two sources
• Hassle of getting to an agreeable price for all stakeholders – the firm, the investment bank
and the investors
Value of the Warrant
To value the warrant, we have used the Black Scholes Option Pricing Model. However, following
assumptions have been used to justify the usage of Black Scholes Model to price a warrant:
• Mogen has a stock repurchase program in place, which balances out the dilution caused by
the warrants. Therefore, we can consider warrant as an American Call option, which do not
cause any dilution.
• The holder of an American Call option will not exercise the Call option till maturity.
Therefore, we can use the Black Scholes Option Pricing model to calculate the price of an
American Option rather than a European option.
In order to calculate the price of the option, we need to first calculate the implied option volatility
of the underlying. We have used the option data provided in the case to come up with the implied
volatility of a comparable Call option (refer to Exhibit 1). The implied volatility is 22.28%. Using
the implied volatility along with the other Black Scholes inputs, we have calculated the price of
the European option, which comes out to be $15.34 (refer to Exhibit 2).
Now, at a conversion premium of 25%, the strike price is $77.98*(1+0.25) = $97.48. Therefore,
at a conversion premium of 25%, we will get $1000/$97.48 = 10.26 shares + 10.26 warrants. Hence
the value of the warrant/option is 10.26*$15.34 = $157.34.
Value of Straight Bond
The value of the convertible bond is $1000. Out of which the value of the embedded warrant/option
is $157.34. Therefore, value of the straight bond is $1000 - $157.34 = $842.66 (refer to Exhibit 3)
Coupon Rate
The coupon rate can be back calculated from the information at hand.
• The value of the straight bond = $842.66
• The discount rate is the yield to maturity = 5.75%
• Time to maturity = 5 years
• Frequency = Semi-annual
Therefore, the coupon rate comes out to be 2% (refer to Exhibit 4)
A 25% conversion premium along with 2% coupon rate is very high to attract the fundamental
investors in high numbers. Therefore, to attract more fundamental investors, which hold a long-
term view of their investments, the conversion premium should be less than 25%. If the conversion
premium is 15% or 20%, coupon rate can be set to 1% or 1.5% respectively (refer to Exhibit 5)
Exhibits
Exhibit 1: Implied Volatility Calculation
Black Scholes Model Inputs Option 1 Option 2 Option 3 Option 4
Price of Underlying Stock $77.98 $77.98 $77.98 $77.98
Strike Price $75.00 $80.00 $75.00 $80.00
Option Type Call Call Call Call
Observed Option Price $6.60 $3.85 $10.70 $7.75
Today's Date 10-01-2006 10-01-2006 10-01-2006 10-01-2006
Expiration Date 22-04-2006 22-04-2006 20-01-2007 20-01-2007
Risk Free Rate 4.46% 4.46% 4.46% 4.46%
Dividened Yield 0.00% 0.00% 0.00% 0.00%
Implied Volatility Option 1 Option 2 Option 3 Option 4
Option Implied Volatility 27.29% 26.27% 23.49% 22.28%
Exhibit 2: Option Valuation
Black Schole Model Inputs
Type of Option Call
Stock Price (S0) $77.98
Exercise (Strike) Price (K) $97.48
Time to Maturity (in years) (t) 5.00
Annual Risk Free Rate (r) 4.46%
Annualized Volatility (σ) 22.28%
Option Price $15.34
Black Schole Model Attributes
ln(S0/K) -0.223
2
(r+σ /2)t 0.347
σ√t 0.498
d1 0.249
d2 -0.249
N(d1) 0.598
N(d2) 0.402
N(-d1) 0.402
N(-d2) 0.598
e-rt 0.800
Exhibit 3: Value of Straight Bond
Value of Straight Bond
Face Value of Convertible Bond 1000
# of Stocks 10.3
Option Value 157.3
Value of Straight Bond $842.66
Exhibit 4: Coupon Rate Calculation
Time Period 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Cash Flows 10.06 10.06 10.06 10.06 10.06 10.06 10.06 10.06 10.06 1010.06
Discounted Cash Flows 9.78 9.51 9.25 8.99 8.75 8.51 8.27 8.04 7.82 763.74
Bond Value 843
Discount Rate (YTM) 5.75%
Coupon Rate 2.0%
Exhibit 5: Option Sensitivity
Black Schole Model Inputs
Conversion Premium 15% 20% 25% 30% 35%
Type of Option Call Call Call Call Call
Stock Price (S0) $77.98 $77.98 $77.98 $77.98 $77.98
Exercise (Strike) Price (K) $89.68 $93.58 $97.48 $101.37 $105.27
Time to Maturity (in years) (t) 5.00 5.00 5.00 5.00 5.00
Annual Risk Free Rate (r) 4.46% 4.46% 4.46% 4.46% 4.46%
Annualized Volatility (σ) 22.28% 22.28% 22.28% 22.28% 22.28%
Option Price $18.04 $16.64 $15.34 $14.13 $13.02
Value of Straight Bond + Coupon Rate
Conversion Premium 15% 20% 25% 30% 35%
Face Value of Convertible Bond 1000 1000 1000 1000 1000
# of Stocks 11.2 10.7 10.3 9.9 9.5
Option Value 201.2 177.8 157.3 139.4 123.7
Value of Straight Bond $798.80 $822.19 $842.66 $860.60 $876.35
Coupon Rate 1.0% 1.5% 2.0% 2.4% 2.8%
