Note 2 — Fair Value Measurement
Fair Value of Financial Assets
Financial assets carried at fair value as of December 31, 2013, were as follows:
| Level 1 | Level 2 | Level 3 | Total | |||||||||||||
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Cash and cash equivalents: |
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Cash equivalents |
$ | 1,443 | $ | — | $ | — | $ | 1,443 | ||||||||
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Other assets and deferred charges: |
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Auction rate securities |
— | — | 76 | 76 | ||||||||||||
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Mortgage-backed security |
— | — | 13 | 13 | ||||||||||||
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Marketable equity security |
4 | — | — | 4 | ||||||||||||
Financial assets carried at fair value as of December 31, 2012, were as follows:
| Level 1 | Level 2 | Level 3 | Total | |||||||||||||
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Cash and cash equivalents: |
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Cash equivalents |
$ | 2,100 | $ | — | $ | — | $ | 2,100 | ||||||||
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Other assets and deferred charges: |
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Auction rate securities |
— | — | 70 | 70 | ||||||||||||
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Mortgage-backed security |
— | — | 13 | 13 | ||||||||||||
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Marketable equity security |
4 | — | — | 4 | ||||||||||||
There were no transfers between the levels during the years ended December 31, 2013 and 2012.
RAI has investments in auction rate securities linked to corporate credit risk, investments in auction rate securities related to financial insurance companies, an investment in a mortgage-backed security and an investment in a marketable equity security. The unrealized gains and losses, net of tax, were included in accumulated other comprehensive loss in RAI’s consolidated balance sheets as of December 31, 2013 and 2012. The funds associated with the auction rate securities will not be accessible until a successful auction occurs or a buyer is found.
In determining if the difference between amortized cost and estimated fair value of the auction rate securities or the mortgage-backed security was deemed either temporarily or other-than-temporarily impaired, RAI evaluated each type of long-term investment using a set of criteria, including decline in value, duration of the decline, period until anticipated recovery, nature of investment, probability of recovery, financial condition and near-term prospects of the issuer, RAI’s intent and ability to retain the investment, attributes of the decline in value, status with rating agencies, status of principal and interest payments and any other issues related to the underlying securities. To assess credit losses, RAI uses historical default rates, debt ratings, credit default swap spreads and recovery rates. RAI has the intent and ability to hold these investments for a period of time sufficient to allow for the recovery in market value.
All of the fair values of the auction rate securities, classified as Level 3, are linked to the longer-term credit risk of a diverse range of corporations, including, but not limited to, manufacturing, financial and insurance sectors. The fair value was determined by utilizing an income approach model, which was based upon the weighted average present value of future cash payments, given the probability of certain events occurring within the market. RAI considers the market for its auction rate securities to be inactive. The income approach model utilized observable inputs, including LIBOR-based interest rate curves, corporate credit spreads and corporate ratings/market valuations. Additionally, unobservable factors incorporated into the model included default probability assumptions based on historical migration tables, various default recovery rates and how these factors changed as ratings on the underlying collateral migrated from one level to another. As related to the unobservable factors, substantial changes, relative to historical trends, of the levels of corporate defaults or default recovery rates would impact the fair value measurement of these securities. Maturity dates for the auction rate securities begin in 2017.
The fair value for the mortgage-backed security, classified as Level 3, utilized a market approach and was based upon the calculation of an overall weighted average valuation, derived from the actual, or modeled, market pricing of the specific collateral. The market approach utilized actual pricing inputs when observable and modeled pricing, based upon changes in observable market pricing, when unobservable. Substantial changes in the observable market pricing would directly impact the unobservable pricing and the fair value measurement of this security. RAI has deemed the market for its mortgage-backed security to be inactive. The maturity of the mortgage-backed security has been extended to March 2014, with the annual option to extend an additional year. Given the underlying collateral and RAI’s intent to continue to extend this security, it is classified as a noncurrent asset.
RAI determined the change in the fair value of the investment in a marketable equity security using quoted market prices as of December 31, 2013.
Financial assets classified as Level 3 investments were as follows:
| December 31, 2013 | December 31, 2012 | |||||||||||||||||||||||
| Cost | Gross Unrealized Loss(1) |
Estimated Fair Value |
Cost | Gross Unrealized Loss(1) |
Estimated Fair Value |
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Auction rate securities |
$ | 99 | $ | (23 | ) | $ | 76 | $ | 99 | $ | (29 | ) | $ | 70 | ||||||||||
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Mortgage-backed security |
20 | (7 | ) | 13 | 22 | (9 | ) | 13 | ||||||||||||||||
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| $ | 119 | $ | (30 | ) | $ | 89 | $ | 121 | $ | (38 | ) | $ | 83 | |||||||||||
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| (1) |
Unrealized losses, net of tax, are reported in accumulated other comprehensive loss in RAI’s consolidated balance sheets as of December 31, 2013 and 2012. |
The changes in the Level 3 investments were as follows:
| 2013 | 2012 | |||||||||||||||||||||||
| Auction Rate Securities | Auction Rate Securities | |||||||||||||||||||||||
| Gross | Estimated | Gross | Estimated | |||||||||||||||||||||
| Cost | Gain (Loss) | Fair Value | Cost | Gain (Loss) | Fair Value | |||||||||||||||||||
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Balance as of January 1 |
$ | 99 | $ | (29 | ) | $ | 70 | $ | 99 | $ | (36 | ) | $ | 63 | ||||||||||
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Unrealized gain |
— | 6 | 6 | — | 7 | 7 | ||||||||||||||||||
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Balance as of December 31 |
$ | 99 | $ | (23 | ) | $ | 76 | $ | 99 | $ | (29 | ) | $ | 70 | ||||||||||
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| 2013 | 2012 | |||||||||||||||||||||||
| Mortgage-Backed Security | Mortgage-Backed Security | |||||||||||||||||||||||
| Gross | Estimated | Gross | Estimated | |||||||||||||||||||||
| Cost | Gain (Loss) | Fair Value | Cost | Gain (Loss) | Fair Value | |||||||||||||||||||
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Balance as of January 1 |
$ | 22 | $ | (9 | ) | $ | 13 | $ | 25 | $ | (13 | ) | $ | 12 | ||||||||||
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Unrealized gain |
— | 2 | 2 | — | 4 | 4 | ||||||||||||||||||
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Redemptions |
(2 | ) | — | (2 | ) | (3 | ) | — | (3 | ) | ||||||||||||||
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Balance as of December 31 |
$ | 20 | $ | (7 | ) | $ | 13 | $ | 22 | $ | (9 | ) | $ | 13 | ||||||||||
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Fair Value of Nonfinancial Assets
The fair value of the trademarks measured on a nonrecurring basis, classified as Level 3, represent certain trademarks, for which impairment during the fourth quarter of 2013 reduced their book value to fair value. The fair value determinations utilized an income approach model and were based on a discounted cash flow valuation model under a relief-from-royalty methodology. This approach utilized unobservable factors, such as royalty rate, projected revenues and a discount rate, applied to the estimated cash flows. The determination of the discount rate was based on a cost of equity model, using a risk-free rate, adjusted by a stock beta-adjusted risk premium and a size premium.
Nonfinancial assets measured at fair value on a nonrecurring basis were as follows:
| Level 1 | Level 2 | Level 3 | Total | Total Loss | ||||||||||||||||
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Trademarks, November 30, 2013 |
$ | — | $ | — | $ | 312 | $ | 312 | $ | (32 | ) | |||||||||
Fair Value of Debt
The estimated fair value of RAI’s and RJR’s outstanding debt, in the aggregate, was $5.2 billion and $5.5 billion with an effective average annual interest rate of approximately 4.5% and 4.7%, as of December 31, 2013 and 2012, respectively. The fair values are based on available market quotes, credit spreads and discounted cash flows, as appropriate.
Interest Rate Management
From time to time, RAI and RJR have used interest rate swaps to manage interest rate risk on a portion of their respective debt obligations. In 2009, RAI and RJR entered into offsetting floating to fixed interest rate swap agreements in the notional amount of $1.5 billion with maturity dates ranging from June 1, 2012 to June 15, 2017. The floating to fixed interest rate swap agreements were entered into with the same financial institution that held a notional amount of $1.5 billion of fixed to floating interest rate swaps.
In September 2011, RAI and RJR terminated the original and offsetting interest rate swap agreements, each with a notional amount of $1.5 billion, and received a total of $186 million cash in exchange for foregoing the future cash inflows associated with these swaps. These actions did not change the effective fixed rate of interest associated with the underlying debt.
On September 17, 2013, RAI called for the redemption of, among other RAI notes, the $775 million outstanding principal amount of 7.625% notes due in 2016. Approximately $450 million of this outstanding principal amount was included in the interest rate swap agreements described above. A loss of $124 million on the early extinguishment for all redeemed notes, which includes $35 million of the unamortized portion of the interest rate swap agreement associated with the notes due in 2016, was included in other expense, net in the consolidated statements of income for the year ended December 31, 2013. As a result of these actions, at December 31, 2013, RAI had $700 million of previously swapped outstanding fixed rate debt with an effective rate of interest of approximately 3.8%.
In May 2012, RAI entered into forward starting interest rate contracts with an aggregate notional amount of $1 billion. RAI designated those derivatives as cash flow hedges of a future debt issuance, and they were determined to be highly effective at inception. The forward starting interest rate contracts mitigated RAI’s exposure to changes in the benchmark interest rate from the date of inception until the date of the forecasted transaction. On October 31, 2012, RAI completed the sale of $2.55 billion in aggregate principal amount of senior notes, consisting of $450 million of 1.05% senior notes due October 30, 2015, $1.1 billion of 3.25% senior notes due November 1, 2022 and $1 billion of 4.75% senior notes due November 1, 2042. The forward starting interest rate contracts were terminated, and $23 million in associated losses were settled with cash payments to the counterparties. The effective portion of the losses are recorded in accumulated other comprehensive loss in the consolidated balance sheet as of December 31, 2013 and 2012, and will be amortized over the life of the related debt. An insignificant portion of the loss was deemed to be ineffective and recorded in the consolidated statements of income for the year ended December 31, 2012.
The amortization of derivative instruments impacted the consolidated statements of income for the years ended December 31 as follows:
| 2013 | 2012 | 2011 | ||||||||||
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Interest and debt income |
$ | (24 | ) | $ | (32 | ) | $ | (47 | ) | |||
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Other expense (income), net |
(35 | ) | — | 4 | ||||||||