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MoGen Inc Case Solution
The actual terms for the 2011 notes were that their time to maturity was 4 years and they offered a semi-annual coupon rate of 1.125%. Hence, plugging in the current stock price of $77.98 and a conversion price of $90 with a risk free rate of 4.46% will leave only the current value of the option. Utilizing the current value as reported in the balance sheet of $1.759 billion for a principle amount of $1.8 billion, we get a per bond value of $977.22. Hence the option value is taken to be as $22.78 per bond and the options per bond amount to 11.11 shares hence the per option value comes out to be only $2.05. Plugging in these values in the Black Scholes formula yields us an implied volatility of around 9% only. The lower volatility is mainly due to the fact that the 2011 notes have a shorter expiry date and that the per option value reported of $2.05 implies a lower volatility. If the option value was higher then it can be expected that the volatility will also be higher.
Following questions are answered in this case study solution
How important is it for MoGen to get $5 billion in external funding in 2006? Could the company cut repurchases (for example) to raise funds?
What are the pros and cons of issuing convertible debt via straight debt or equity?
The case states that a convertible bond can be valued as a straight bond plus a call option. How can you use Black Scholes 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 would you convert this option value per share into the option value for a bond with $1,000 face value?
What is the value of the straight bond component? What coupon rate should Manaavi propose in order to 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?
As MoGen's CEO, what do you like and not like about the Merrill Lynch proposal? In particular, do you like the 25% conversion premium? The coupon?
If you were to use the actual terms for the 2011 and 2013 notes, can you estimate an implied volatility for the option component of the 2011 notes? How about the 2013 notes?
Case Analysis for MoGen Inc
1. How important is it for MoGen to get $5 billion in external funding in 2006? Could the company cut repurchases (for example) to raise funds?
MoGen currently has around $5 billion in funds from internally generated sources. Its current plan for future expenditure includes many items which include expansion of production capacity to overcome outsourcing constraints, expansion of research & development and critical late-stage trials to sustain their new drug development, acquisition and licensing of many deals which will help them increase their patent portfolio in order to remain competitive and lastly the stock repurchase program to satisfy existing shareholders0. Many of the items listed in its plan are integral for MoGen to maintain competitiveness in the current market as it is extremely volatile and unpredictable with numerous regulations looming over it. Therefore it is very important for MoGen to gain the $5 billion in external funding.
One of the items for which MoGen plans to invest in is the share repurchase of around $3.5 billion. MoGen’s senior management believes that issuing dividends would pose more of a risk for the company due to its volatile industry and unpredictable cash flows. It reasons that by repurchasing shares, it can keep giving cash to shareholders in place of dividends thus keeping them happy and at the same time it can reduce the number of shares in issue thus effectively raising the earnings per share ratio. Should the company choose NOT to indulge in repurchases then it will lose the potentials benefits listed above as well as risking dissatisfaction with shareholders and investors alike as it will undervalue company EPS and will not give cash to shareholders. Hence, it seems unlikely that the company can cut any expenditure it plans for the future and therefore the $5 billion external financing is integral to its competitive growth and survival.
2. What are the pros and cons of issuing convertible debt via straight debt or equity?
A convertible debt is similar to a hybrid security as it has features of both straight debt with non-zero coupon payments and fresh equity. From an investors perspective, it is a safer investment as it provides a constant stream of cash flows, it has the safety of a bond with regards to its redemption face value which provides a floor for its bottom value and it has unlimited upside potential with regards to the conversion feature. As stock values can increase infinitely then so can the profit potential of convertible bonds. However, as the convertible debt has both features their coupon rates are normally set way below market coupon rates for a comparable straight bond. This is done to compensate for the added option value of conversion to equity. It is hence for this very reason that some companies prefer to issue convertibles so that they would have to pay a lower coupon payment if they are quite sure that their stock values will not rise. It is however a cyclical game as companies prefer having high stock prices but when issuing convertible bonds, they would not want the stock price to rise too much as it will imply a heavy issue cost of equity.
However, convertible bonds are usually callable at the same time which implies that the company can choose to call back the shares if it feels that its stock will be increasing above the conversion price in the coming future. This gives a security limit for entities with regards to the upside potential of a convertible bond. Hence convertible bonds which are callable at the same time often have more coupon rates than comparable convertible bonds to compensate for the call option. Additionally, the coupon payments on convertible bonds are tax deductible implying a lower cost of debt for the company when compared with the cost of issuing dividends via equity. Additionally, if the company issues convertible debt it signals confidence that the company’s stock price will NOT rise above the exercise price. Hence, it can act as a powerful signal to the stock market however the company must be careful at the same time as setting too high of a conversion premium might ward off potential investors.
3. The case states that a convertible bond can be valued as a straight bond plus a call option. How can you use Black Scholes 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 would you convert this option value per share into the option value for a bond with $1,000 face value?
A convertible bond can be thought of as a mixture between a straight bond with a call option to convert its face value of $1000 into a set number of shares. Hence the option to convert can be valued using the Black Scholes model which is used to value call and put options.
The first element of the Black Scholes model is the underlying stock price which can easily be estimated as the current stock price of MoGen Inc which is $77.98. One can argue that the stock price might be different at the actual time of issuing the convertible debt however, even if the stock price changes it will be close to the current stock price of $77.98.
The strike price is the price at which an option is exercised hence the exercise price will be the 25% conversion premium over the current stock price. Therefore the exercise price comes out to be $97.5 calculated as 125% of the current stock price.
The bond will be valid till February 1st 2011 hence they have a time to maturity of 5 years. The comparable risk free rate for a 5 year government bond is 4.46% hence this percentage will be used in the valuation model. We will not be using the comparable bond rates as those are not risk free rates. Dividend yield will not be used in the calculations as MoGen has never issued any dividends and does not have any foreseeable plans to issue any.
The volatility of the option could be modeled after the price variations in MoGen’s stock. As can be seen in exhibit 4, MoGen’s annualized volatility for price variations was 27% when compared with the market volatility of 14.9%. Options usually have volatilities between 20% and 80% and it is not uncommon for stock options to have volatilities in the lower bracket if the company stock in question faces a trend of pricing movements.
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