After several years of rapid expansion, the Spero Company approached the State National Bank for a \(\$ 1\) million loan. The bank was willing to lend the money at an interest rate of 10 percent per year. Spero Company then approached an individual investor who was willing to provide the same funds for only 8 percent per year provided that the Spero Company gave the investor an option to purchase 20,000 shares of Spero Company \(\$ 5\)-parvalue common stock for \(\$ 20\) per share at any time within 5 years of the initial date of the loan.

Spero weighed both opportunities and decided to borrow from the investor. At the time of the loan, the common shares had a market price of \(\$ 15\) per share. Five years after the

initial date of the loan, the investor exercised the option and purchased 20,000 shares for \(\$ 20\) each. At that time, the market price of the common shares was \(\$ 45\) each.
a Did the use of the "detachable warrants" (the technical name for the option granted to the investor) reduce the Spero Company's cost of borrowing?
b How should the loan and annual interest payments of \(\$ 80,000\) be recorded in the books of the Spero Company to reflect the economic reality of the transaction.
c How might the exercise of the warrants (and the purchase of the 20,000 shares) be recorded?
d Did exercise of the option dilute the owners' equity of the other shareholders on the date the option was exercised?
e What disclosures during the life of the loan do you think appropriate? Why?