Answer the questions at the end of the case

Case 05-7

Ace Company

In June 2002, Ace Company, a U.S. SEC registrant, was in the process of raising $100 million of capital and is considering an offering of MEDS Equity Units (with a targeted issue date of June 23). The CFO of Ace Company tells you that each MEDS Equity Unit consists of:

• A forward stock purchase agreement, where the investor is obligated to purchase common stock of Ace Company in three years for $50. The number of shares to be purchased depends on the market price of Ace Company common stock at the time of settlement. The holder of the forward stock purchase agreement receives periodic contract adjustment payments.

• A note payable by Ace Company, with a maturity of three years and six months. The interest rate payable is fixed for the first three years, and it is reset and the note is remarketed to other investors at the end of three years. The note is pledged as collateral under the forward stock purchase agreement.

The CFO provides you with a copy of the prospectus summary (attached as Exhibit 1) and informs you that the investment bankers have confirmed that the interest rate on the note payable is equal to Ace Company’s market rate (i.e., if Ace Company issued the notes payable separately, there would be no premium or discount). The investment bankers also assert that the likelihood of a failed remarketing of the notes is remote. The last reported sales price of Ace Company’s common stock on the NYSE was $40.00.

Requirement: In deciding how to account for the issuance of the MEDS Equity Units, address the following issues:

• Should the components of an equity unit be accounted for separately? If so, how should the proceeds be allocated between the components of the units?

• Should the unit (if accounted for as a unit) or the components (if accounted for separately) be accounted for as a derivative, or should any embedded derivatives be accounted for separately?

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