Union Pacific 2005 Annual Report Download - page 41

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Determination of Fair Value – We determined the fair values of our derivative financial instrument positions at
December 31, 2005 and 2004 based upon current fair values as quoted by recognized dealers or developed based
upon the present value of expected future cash flows discounted at the applicable U.S. Treasury rate, LIBOR, or
swap spread.
Sensitivity Analyses – The sensitivity analyses that follow illustrate the economic effect that hypothetical changes in
interest rates could have on our results of operations and financial condition. These hypothetical changes do not
consider other factors that could impact actual results.
Interest Rate Fair Value Hedges – We manage our overall exposure to fluctuations in interest rates by adjusting the
proportion of fixed and floating rate debt instruments within our debt portfolio over a given period. We generally
manage the mix of fixed and floating rate debt through the issuance of targeted amounts of each as debt matures
or as we require incremental borrowings. We employ derivatives as one of the tools to obtain the targeted mix. In
addition, we also obtain flexibility in managing interest costs and the interest rate mix within our debt portfolio
by evaluating the issuance of and managing outstanding callable fixed-rate debt securities.
At December 31, 2005 and 2004, we had variable-rate debt representing approximately 10% and 9%,
respectively, of our total debt. If variable interest rates average one percentage point higher in 2006 than our
December 31, 2005 variable rate, which was approximately 7%, our interest expense would increase by
approximately $7 million. If variable interest rates averaged one percentage point higher in 2005 than our
December 31, 2004 variable rate, which was approximately 5%, our interest expense would have increased by
approximately $8 million. These amounts were determined by considering the impact of the hypothetical interest
rates on the balances of our variable-rate debt at December 31, 2005 and 2004, respectively.
Swaps allow us to convert debt from fixed rates to variable rates and thereby hedge the risk of changes in the
debt’s fair value attributable to the changes in the benchmark interest rate (LIBOR). We accounted for the swaps
as fair value hedges using the short-cut method pursuant to FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities; therefore, we did not record any ineffectiveness within our Consolidated
Financial Statements. As of December 31, 2005 and 2004, we had interest rate swaps hedging debt of $750 million.
Market risk for fixed-rate debt is estimated as the potential increase in fair value resulting from a
hypothetical one percentage point decrease in interest rates as of December 31, 2005, and amounts to
approximately $535 million at December 31, 2005. Market risk resulting from a hypothetical one percentage point
decrease in interest rates as of December 31, 2004, amounted to approximately $599 million at December 31,
2004. We estimated the fair values of our fixed-rate debt by considering the impact of the hypothetical interest
rates on quoted market prices and current borrowing rates.
Interest Rate Cash Flow Hedges – We report changes in the fair value of cash flow hedges in accumulated other
comprehensive income until the hedged item affects earnings.
In 2004, we entered into treasury lock transactions, which are accounted for as cash flow hedges. These
treasury lock transactions resulted in a payment of $11 million that is being amortized on a straight-line basis over
10 years, ending September 30, 2014. The unamortized portion of the payment is recorded as a $6 million
after-tax reduction to common shareholders’ equity as part of accumulated other comprehensive loss at
December 31, 2005. As of December 31, 2005 and 2004, we had no interest rate cash flow hedges outstanding.
Fuel Cash Flow Hedges – Fuel costs are a significant portion of our total operating expenses. In 2005 and 2004, our
primary means of mitigating the impact of adverse fuel price changes was our fuel surcharge programs. However,
we may use swaps, collars, futures and/or forward contracts to further mitigate the impact of adverse fuel price
changes. We hedged 120 million gallons of fuel during 2004 using collars with average cap, floor, and ceiling
prices of $0.74, $0.64, and $0.86 per gallon, respectively. At December 31, 2004, there were no fuel hedges
outstanding, and we did not have any fuel hedges in place during 2005.
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