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Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following should be read in conjunction with the financial statements and the related notes that appear elsewhere in this document. All dollar amounts in the tables in this discussion are stated in millions of U.S. dollars, except per-share amounts, unless otherwise indicated.

Overview

Texas Instruments makes, markets and sells high-technology components; more than 30,000 customers all over the world buy our products. We have three separate business segments: 1) Semiconductor; 2) Sensors & Controls; and 3) Educational & Productivity Solutions. Semiconductor is by far the largest of these business segments. It accounted for over 85 percent of our revenue in 2004, and historically it averages a higher growth rate than the other two business segments, although the semiconductor market is characterized by wide swings in growth rates from year to year. We were the world’s third-largest semiconductor company in 2004 in terms of revenue, according to Gartner, Inc., an industry analyst.

In our Semiconductor segment, we focus primarily on technologies that make it possible for a variety of consumer and industrial electronic equipment to process both analog and digital signals in real time. These technologies are known as analog semiconductors and digital signal processors, or DSPs, and together they account for about three-fourths of our Semiconductor revenue. Almost all of today’s digital electronic equipment requires some form of analog or digital signal processing.

Analog semiconductors process “real world” inputs, such as sound, temperature, pressure and visual images, conditioning them, amplifying them and converting them into digital signals. They also assist in the management of power distribution and consumption, aspects critical to today’s portable electronic devices. Generally, analog products require less capital-intensive factories to manufacture than digital products.

Our analog semiconductors consist of custom products and standard products. Custom products are designed for specific applications for specific customers. Standard products include application-specific standard products (designed for a specific application and usable by multiple customers) and high-performance standard catalog products (usable in multiple applications by multiple customers). These standard products are characterized by differentiated features and specifications, as well as relatively high margins. Many standard analog products tend to have long life spans. Both custom and standard products are proprietary and difficult for competitors to imitate. Analog products also include commodity products, which are sold in high volume and into a broad range of applications, and generally are differentiated by price and availability. We are one of the world’s largest suppliers of analog semiconductors.

DSPs use complex algorithms and compression techniques to alter and improve a data stream. These products are ideal for applications that require precise, real-time processing of real-world analog signals that have been converted into digital form. Their power efficiency is important for battery-powered devices.

Our DSPs include both custom and standard products. Custom products are designed for specific applications (such as wireless cell phones, very fast modems that connect users to the Internet via cable or phone lines, or consumer electronics such as digital music players and digital cameras). Standard products are sold into a broad range of applications, and like custom products, are difficult for competitors to imitate. We are the world’s largest supplier of DSPs.

In addition to analog semiconductors and DSPs, Digital Light Processing™ (DLP™) products have become strong contributors to our Semiconductor segment. DLP products are micro-electromechanical systems that use optical semiconductors to digitally manipulate light. In 2004, DLP products accounted for more than 5 percent of TI’s revenue.

We own and operate semiconductor manufacturing sites in the Americas, Japan, Europe and Asia. During 2004, we broke ground on a new semiconductor manufacturing complex in Texas. We plan to construct the building and infrastructure ahead of market demand, followed by stages of equipment installation as demand increases. When completed, the new facility will build some of the world’s most advanced semiconductor devices on 300-millimeter wafers.

Our facilities require substantial investment to construct and are largely fixed-cost assets once in operation. Because we own most of our manufacturing capacity, a significant portion of our operating costs are fixed. In general, these costs do not decline with reductions in customer demand or our utilization of our manufacturing capacity, and can adversely affect profit margins as a result. Conversely, as product demand rises and factory utilization increases, the fixed costs are spread over increased output, which should improve profit margins.

As part of our manufacturing strategy, we outsource a portion of our product manufacturing to outside suppliers (foundries and assembly/test subcontractors), which reduces the amount of capital expenditures and subsequent depreciation required to meet customer demands, as well as fluctuations in profit margins. Outside foundries provided about 20 percent of our total capacity needs in 2004.

The semiconductor market is characterized by constant and typically incremental innovation in product design and manufacturing technologies. We make significant investments in research and development (R&D). Products resulting from our R&D investments in 2004 did not contribute materially to revenue in the year, but should benefit us in future years. In general, new semiconductor products are shipped in limited quantities initially, and will then ramp into high volumes over time. Prices and manufacturing costs tend to decline over time as products and technologies mature.

In our Sensors & Controls segment, products include sensors, electrical and electronic controls, and radio frequency identification (RFID) systems. Our primary markets are automotive and industrial. Other targeted markets include heating, ventilation, air conditioning, refrigeration and industrial control systems. This business segment represented about 10 percent of our revenue in 2004.

Our Educational & Productivity Solutions (E&PS) segment is a leading supplier of graphing handheld calculators. It also provides our customers with business and scientific calculators and a wide range of advanced classroom tools and professional development that enables students and teachers to interactively explore math and science. Our products are marketed primarily through retailers and to schools through instructional dealers. This business segment represented about 5 percent of our revenue in 2004.

As discussed more fully below, one factor affecting our financial results in 2004 was the accrual for the TI employee profit sharing plan. For 2004, the accrual was determined by a formula that considers both revenue growth rate and operating margin. For the years 2001 through 2003, our profit sharing formula did not result in any profit sharing.

We expect profit sharing accruals in 2005 to decline. In 2005, payment for the TI employee profit sharing plan will be determined based on a different formula than was used in 2004. The 2005 plan provides for profit sharing to be paid based solely upon our operating margin for the full calendar year. This new formula more closely aligns with industry practices and is expected to result in more consistent profit sharing accruals. We will continue to accrue profit sharing based on how we expect the Company to perform for the year in total. The accrual in a given quarter is based on our expectations at that time as to annual performance. Under the new plan, a minimum threshold of 10 percent operating margin must be achieved before any profit sharing is paid. Profit sharing at 10 percent operating margin will be 2 percent of eligible payroll. The maximum amount of profit sharing available under the plan is 20 percent of eligible payroll, and would only be paid when our operating margin meets or exceeds 35 percent for a full calendar year. By way of example, if the new formula were the basis for the 2004 accrual, we would have accrued about $100 million in profit sharing in 2004 compared with the $243 million that was actually accrued.

Results of Operations

2004 Results Compared with 2003

We delivered excellent growth and improved profitability in 2004 despite a second half that was dampened by inventory adjustments. In the third and fourth quarters of 2004, distributors and other customers adjusted their semiconductor inventories. In response, we took action beginning in the third quarter to sharply reduce factory loadings, which has resulted in exiting the year with $100 million lower inventory levels than in the third quarter.

For the year, our revenue was $12,580 million, up $2746 million or 28 percent due to broad-based growth in the Semiconductor segment.

In the Sensors & Controls segment, revenue for 2004 increased 12 percent from 2003 due to higher broad-based demand. In the E&PS segment, revenue for 2004 increased 7 percent from 2003 on the strength of higher shipments for new graphing calculator products.

Diluted earnings per share (EPS) for the year were $1.05 compared with $0.68 in 2003.

A separate discussion of operating results by segment is presented below.

Details of Financial Results

Gross profit of $5626 million, or 44.7 percent of revenue, increased 42 percent from 2003 primarily due to higher revenue.

R&D expense of $1978 million, or 15.7 percent of revenue, increased 13 percent primarily due to increased product development in Semiconductor, especially for wireless.

Selling, general and administrative (SG&A) expense of $1441 million, or 11.5 percent of revenue, increased 15 percent due to increased levels of marketing, especially for Semiconductor products and, to a lesser degree, higher profit sharing accruals.

For the year, operating profit of $2207 million, or 17.5 percent of revenue, increased 129 percent due to higher gross profit.

In 2004, $243 million was accrued for the TI employee profit sharing plan, including $90 million in cost of revenue, $81 million in SG&A and $72 million in R&D. No profit sharing was accrued in 2003.

Other income (expense) net (OI&E) of $235 million decreased by $89 million due to lower investment gains that were partially offset, in descending order, by the partial settlement of matters related to grants from the Italian government regarding our former memory business operations, higher interest income generated from higher cash balances and higher interest rates, and the resolution of an open sales-tax item associated with our divested defense electronics business. In 2003, OI&E included pre-tax investment gains of $203 million from the sale of our remaining 57 million shares of Micron Technologies, Inc. (Micron) common stock.

For the year, interest expense of $21 million decreased $18 million due to our lower debt level, which primarily resulted from our redemption of $400 million of notes that matured in the third quarter of 2004.

For the year, net income was $1861 million, or $1.05 per share, as compared with $1198 million, or $0.68 per share for 2003.

The effective annual tax rate for 2004 of 23 percent differs from the 35 percent corporate statutory rate due to the effect of non-U.S. tax rates and, to a lesser extent, various tax benefits such as for export sales and research activities. The rate reflects the reinstatement of the federal research tax credit that was signed into law on October 4, 2004. The rate does not reflect the impact of any potential repatriation of cash under the American Jobs Creation Act of 2004 (the Jobs Creation Act). (See Note 18 to financial statements for the current status of our assessment of the impact of this new tax law.)

The effective annual tax rate in 2003 was 4 percent compared with 23 percent in 2004. This difference was primarily due to the reversal in 2003 of the $223 million valuation allowance on deferred tax assets generated in 2002 by the write-down of the investment in Micron stock. The tax rate impact of higher profit was mostly offset by increases in tax benefits and credits.

We have not recorded a deferred U.S. tax liability in connection with the Jobs Creation Act. This is because our annual financial statements are presented based upon the tax laws in effect as of December 31, 2004, and at that time, it was our intention to continue to indefinitely reinvest a portion of our undistributed earnings of non-U.S. subsidiaries.

For the year, our orders of $12,447 million increased 20 percent due to Semiconductor. Semiconductor orders of $10,788 million increased 22 percent, reflecting broad-based demand.

Semiconductor

Semiconductor revenue of $10,941 million increased 31 percent from 2003, due to increased shipments resulting from broad-based demand, led by 40 percent growth in wireless revenue, 40 percent growth in high-performance analog revenue and 79 percent growth in DLP product revenue. Revenue from analog products and DSPs represents 75 percent of total Semiconductor revenue for both 2004 and 2003. From an end-equipment perspective, higher shipments into the wireless market provided the most significant source of growth, as wireless revenue increased more than $1 billion to a record $3.8 billion for the year. Almost $500 million of the wireless revenue growth came from the emerging market for third-generation (3G) cell phones. Higher DLP shipments reflect the significant share gains in both of its primary markets—front projectors and high-definition televisions.

Semiconductor gross profit of $4967 million, or 45.4 percent of revenue, increased $1495 million primarily due to higher revenue.

For the year, operating profit was $2050 million, or 18.7 percent of revenue, up $1081 million due to higher gross profit.

Analog revenue increased 28 percent from 2003 primarily due to higher shipments as a result of growth in demand for high-performance analog products and wireless products. High-performance analog revenue for the year grew 40 percent due to broad-based demand. In 2004, about 40 percent of total Semiconductor revenue came from analog.

DSP revenue increased 35 percent from 2003 primarily due to strong demand for wireless products, and, to a lesser extent, catalog and broadband products. The emerging market for 3G handsets was a major contributor to the growth in demand for DSP products for wireless. In 2004, about 35 percent of total Semiconductor revenue came from DSP.

Our remaining Semiconductor revenue increased 30 percent primarily due to demand for DLP products. Revenue from DLP products increased 79 percent for the year. In 2004, DLP products were more than 5 percent of Semiconductor revenue, while reduced instruction set computing (RISC) microprocessors (designed to provide very fast computing, typically for a specialized application such as servers), standard logic, microcontrollers and royalties were under 5 percent each.

Results for our Semiconductor products sold into key end equipments were as follows:

In total, we estimate that our Semiconductor revenue came from the following broad markets: communications (including wireless and broadband communications) was about 50 percent of Semiconductor revenue in 2004; computing (including computers and peripherals) was about 30 percent; digital consumer was about 10 percent; automotive was about 5 percent; and industrial and other was about 5 percent.

Semiconductor orders for 2004 increased 22 percent to $10,788 million due to broad-based demand.

Sensors & Controls

Sensors & Controls revenue for 2004 was a record $1127 million, up 12 percent due to higher shipments resulting from broad-based demand.

For the year, gross profit was $423 million, or 37.5 percent of revenue, an increase of $50 million due to higher revenue.

Operating profit was a record $281 million, or 24.9 percent of revenue, an increase of $30 million due to higher gross profit.

Education Technology (E&PS)

E&PS revenue for 2004 was a record $518 million, up 7 percent primarily due to increased shipments resulting from higher demand for new graphing calculator products.

For the year, gross profit of $292 million, or 56.4 percent of revenue, increased $25 million primarily due to higher revenue.

Operating profit was a record $176 million, or 34.0 percent of revenue, an increase of $19 million due to higher gross profit.

2003 Compared with 2002

In 2003, our revenue was $9834 million, up 17 percent from 2002 due to growth in Semiconductor that was led by demand for DSPs across the wireless, digital consumer and broadband markets. Revenue increased throughout the year, accelerating in the second half particularly in Semiconductor as demand increased for a broad range of DSP and analog products.

In 2003, Semiconductor revenue increased 20 percent from 2002, primarily due to strong demand for DSP products and TI market-share gains in both DSP and analog. From an end-equipment perspective, higher shipments into the wireless market provided the most significant source of growth as wireless revenue increased 32 percent for the year. In Sensors & Controls, revenue for 2003 increased 5 percent from 2002 due to higher demand for sensor products in the automotive market. In E&PS, revenue for 2003 decreased 2 percent from 2002 as customers reduced their inventories.

Cost of revenue for 2003 was $5872 million or 59.7 percent of revenue, compared with $5313 million or 63.4 percent of revenue in 2002. Cost of revenue as a percent of revenue decreased due to greater utilization of our fixed-cost manufacturing assets in our Semiconductor operations.

Gross profit was $3962 million, or 40.3 percent of revenue, an increase of 29 percent from 2002 due to the impact of higher revenue and, to a lesser extent, greater utilization of our fixed-cost manufacturing assets in our Semiconductor operations, partially offset by increased restructuring charges of $77 million relating to manufacturing efficiencies in the Semiconductor business and moving certain production lines in the Sensors & Controls business from Attleboro, Massachusetts, to other sites located closer to our customers. The restructuring charges were primarily for severance and benefit costs.

R&D expense of $1748 million increased 8 percent from 2002 due to increased product development in Semiconductor, primarily for wireless.

SG&A expense of $1249 million increased 7 percent from 2002 primarily due to higher Semiconductor marketing expense.

In 2003, operating profit of $965 million, or 9.8 percent of revenue, increased 235 percent from 2002 due to higher gross profit.

Other income (expense) net (OI&E) of $324 million increased by $901 million from 2002. Of the increase, $841 million was related to our investment in Micron stock, which we received in connection with the sale of our memory business unit to Micron in 1998. In the fourth quarter of 2002, we recorded a $638 million impairment write-down of our holdings of Micron stock. As previously noted, we sold a portion of our Micron stock in the third quarter of 2003 for a pre-tax gain of $106 million, and we sold our remaining shares in the fourth quarter of 2003 for a pre-tax gain of $97 million.

For the year, interest expense was $39 million, down from $57 million in 2002 due to our lower debt level.

Our effective tax rate in 2003 of 4 percent differed from the 35 percent corporate statutory rate due to (in decreasing order) the reversal of the $223 million valuation allowance associated with the deferred tax asset generated by the write-down of the Micron stock in the fourth quarter of 2002, the effect of non-U.S. tax rates, and various tax benefits such as those for research activities and export sales. Exclusive of the impact of the Micron valuation allowance, the tax rate was 22 percent. We had an income tax benefit of $2 million in 2002. This benefit was driven by (in decreasing order) our net operating loss in 2002, plus various tax benefits such as for research activities and export sales generated in that year, offset by the recording of the valuation allowance of $223 million associated with the write-down of the Micron stock. Income tax rates are not meaningful in years in which we have a tax benefit.

In 2003, net income was $1198 million, or $0.68 cents per share, an increase of $1542 million from 2002. Within the increase, $993 million was due to the impact of the Micron stock-related actions including the associated tax impact, and $440 million was due to higher operating profit.

Orders of $10,344 million increased 23 percent from 2002, and Semiconductor orders of $8854 million increased 27 percent, reflecting broad-based demand for DSP and analog products.

Earnings per share for the year were $0.68, including a $0.20 per share contribution from the sale of Micron stock.

Semiconductor

For 2003, Semiconductor revenue was $8360 million, up 20 percent from 2002 primarily due to increased shipments. The increased shipments were the result of stronger demand for a broad range of our DSP products and, to a lesser extent, market share gains in both DSP and analog markets. The semiconductor market was particularly robust in the second half of the year. The results of our Semiconductor business in the second half of the year reflected this stronger market environment.

Semiconductor gross profit of $3472 million, or 41.5 percent of revenue, increased by $913 million from 2002 primarily due to higher revenue and, to a lesser extent, greater manufacturing utilization.

Operating profit was $969 million, or 11.6 percent of revenue, up $715 million from 2002 due to higher gross profit.

Analog revenue increased 13 percent from 2002 due to increased shipments resulting from higher demand for a broad range of our high-performance analog products. In 2003, about 40 percent of total Semiconductor revenue came from analog.

DSP revenue increased 36 percent for the year primarily due to higher demand in the wireless market, and to a lesser extent, higher shipments resulting from increased demand in the digital consumer and broadband communications markets. In 2003, about 35 percent of total Semiconductor revenue came from DSP.

For the year, our remaining Semiconductor revenue increased 14 percent from 2002 due to higher shipments resulting from increased demand for, in decreasing order, DLP products, RISC microprocessors and standard logic products, and higher royalties. These gains more than offset a decline in microcontrollers that was due to decreased shipments resulting from lower demand for TI products in this area.

2003 results for our Semiconductor products sold into key end equipments were as follows:

In total, we estimate that our 2003 Semiconductor revenue came from the following broad markets: communications (including wireless and broadband communications) was about 45 percent of Semiconductor revenue in 2003; computing (including computers and peripherals) was about 30 percent; digital consumer was about 10 percent; industrial and other was about 10 percent; and automotive was about 5 percent.

For the year, orders increased 27 percent to $8854 million due to higher broad-based demand for analog and DSP products.

Sensors & Controls

For 2003, Sensors & Controls revenue was $1009 million, up 5 percent from 2002 due to higher demand for sensor products in the automotive market.

Gross profit was $373 million, an increase of $44 million from 2002 due to reduced manufacturing costs.

Operating profit was $251 million, or 24.9 percent of revenue, an increase of $37 million from 2002. The gains in operating profit were due to higher gross profit.

Educational & Productivity Solutions

For 2003, E&PS revenue was $485 million, down 2 percent from 2002 as customers reduced their inventories of our products.

Gross profit of $267 million increased by $6 million from 2002 due to product cost reductions.

Operating profit was $157 million, or 32.3 percent of revenue, an increase of $3 million from 2002 due to higher gross profit.

Financial Condition

At the end of 2004, total cash (cash and cash equivalents plus short-term investments and long-term cash investments) was $6358 million, an increase of $694 million from the end of 2003. During 2004, we used $907 million in cash to repurchase $753 million of our common stock and to pay $154 million in dividends. In 2003, we repurchased $284 million of TI common stock and paid $147 million in dividends.

Accounts receivable of $1696 million increased $245 million from the end of 2003 due to higher Semiconductor revenue. Days sales outstanding were 48 at the end of 2004, compared with 47 at the end of 2003.

Inventory at the end of 2004 was $1256 million. Actions taken toward the end of the year caused inventory to decline by $100 million from the third to fourth quarter. Inventory increased by $272 million compared with the end of 2003 as we built inventory to support higher shipment levels and to improve our performance in customer service metrics. Days of inventory at the end of 2004 were 62, up from 56 days at the end of 2003.

Depreciation in 2004 was $1479 million, an increase of $50 million.

Liquidity and Capital Resources

Our primary source of liquidity is our cash and cash equivalents, short-term investments, and long-term cash investments totaling $6358 million. Another source of liquidity is authorized borrowings of $500 million for commercial paper, backed by a 364-day revolving credit facility, which is currently not utilized.

At the end of the fourth quarter, our debt-to-total-capital ratio was 0.03, down from 0.07 at the end of 2003 due to retirement of debt.

For the year, cash flow from operations increased $995 million to $3146 million, up 46 percent, primarily due to higher net income adjusted for noncash items and gains on sales of equity investments.

Net cash used in investing activities was $1161 million for 2004, up from $842 million for 2003 primarily due to increased capital expenditures. For the year, capital expenditures of $1298 million increased by $498 million. Our capital expenditures in 2004 were primarily for equipment used in assembly and test operations, and for 90-nanometer wafer fabrication. In 2004, $135 million in cash was received from net sales of cash investments compared with net purchases of $670 million in 2003. In 2003, we received cash of $778 million from equity sales, primarily from the sale of Micron stock. In addition, our 2003 acquisition of Radia Communications, Inc. used approximately $128 million of cash.

For 2004, net cash used in financing activities was $1150 million, up from $439 million in 2003, primarily reflecting increased repurchases of our common stock. We used $753 million of cash to repurchase approximately 30.1 million shares of our common stock in 2004, compared with $284 million used to repurchase approximately 13.9 million shares of our common stock in 2003. Also, the increase in the amount of dividends paid in 2004 reflects the increase in the quarterly dividend rate to $0.025 per share that was announced in the third quarter of 2004.

In the third quarter of 2004, our Board of Directors authorized the repurchase of $1 billion of our common stock using existing cash holdings. This authorization is in addition to previously announced stock repurchase authorizations. In the first quarter of 2005, our Board of Directors authorized the repurchase of an additional $2 billion of the Company’s common stock.

Long-Term Contractual Obligations

The Company believes it has the necessary financial resources to fund its working capital needs, capital expenditures, dividend payments and other business requirements for at least the next 12 months.

Critical Accounting Policies

In preparing its consolidated financial statements in conformity with accounting principles generally accepted in the United States, the Company uses statistical analyses, estimates and projections that affect the reported amounts and related disclosures and may vary from actual results. The Company considers the following accounting policies to be both those that are most important to the portrayal of its financial condition and that require the most subjective judgment. If actual results differ significantly from management’s estimates and projections, there could be an effect on the Company’s financial statements.

Revenue Recognition

Revenue from sales of the Company’s products is recognized upon shipment or delivery, depending upon the terms of the sales order, provided that persuasive evidence of a sales arrangement exists, title and risk of loss have transferred to the customer, the sales amount is fixed and determinable and collection of the revenue is reasonably assured. A portion of TI’s sales are to distributors. TI recognizes revenue from sales of the Company’s products to distributors upon delivery of product to the distributors.

The Company reduces revenue based on estimates of future credits to be granted to customers. Credits are granted for reasons such as product returns due to quality issues, prompt payment discounts, volume-based incentives, and other special pricing arrangements.

Distributor revenue is recognized net of allowances, which are quarterly management estimates based on analysis of historical data, market conditions and contract terms. These allowances recognize the impact of credits granted to distributors under certain programs common in the semiconductor industry whereby distributors are allowed to return a limited amount of product or receive certain price adjustments in accordance with contractual terms agreed between the distributor and the Company.

Royalty revenue is recognized upon sale by the licensee of royalty-bearing products, as estimated by the Company, and when realization of payment is considered probable by management. Estimates are based on historical experience and analysis of annual sales results of licensees. Estimates are periodically adjusted as a result of reviews of reported results of licensees, which reviews may take the form of an independent audit. Where warranted, revenue from licensees may be recognized on a cash basis.

In addition, the Company monitors collectibility of accounts receivable primarily through review of the accounts receivable aging. When facts and circumstances indicate the collection of specific amounts or from specific customers is at risk, the Company assesses the impact on amounts recorded for bad debts and, if necessary, will record a charge in the period such determination is made.

Inventory Valuation Allowances

Inventory is valued net of allowances for unsalable or obsolete raw materials, work-in-process and finished goods. Allowances are determined quarterly by comparing inventory levels of individual materials and parts to historical usage rates, current backlog and estimated future sales and by analyzing the age of inventory, in order to identify specific components of inventory that are judged unlikely to be sold. In addition to this specific identification process, statistical allowances are calculated for remaining inventory based on historical write-offs of inventory for salability and obsolescence reasons. Inventory is written off in the period in which disposal occurs. Actual future write-offs of inventory for salability and obsolescence reasons may differ from estimates and calculations used to determine valuation allowances due to changes in customer demand, customer negotiations, technology shifts and other factors.

Income Taxes

In determining income for financial statement purposes, the Company must make certain estimates and judgments in the calculation of tax expense and the resultant tax liabilities and in the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense.

In the ordinary course of global business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws. The Company recognizes potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on an estimate of the ultimate resolution of whether, and the extent to which, additional taxes will be due. Although the Company believes the estimates are reasonable, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the historical income tax provisions and accruals.

As part of its financial process, the Company must assess the likelihood that its deferred tax assets can be recovered. If recovery is not likely, the provision for taxes must be increased by recording a reserve in the form of a valuation allowance for the deferred tax assets that are estimated not to be ultimately recoverable. In this process, certain relevant criteria are evaluated including the existence of deferred tax liabilities that can be used to absorb deferred tax assets, the taxable income in prior carryback years that can be used to absorb net operating losses and credit carrybacks, and taxable income in future years. The Company’s judgment regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors. These changes, if any, may require material adjustments to these deferred tax assets and an accompanying reduction or increase in net income in the period when such determinations are made.

In addition to the risks to the effective tax rate described above, the effective tax rate reflected in forward-looking statements is based on current enacted tax law. Significant changes during the year in enacted tax law could affect these estimates.

Impairment of Long-Lived Assets

TI reviews long-lived assets for impairment when certain indicators are present that suggest the carrying amount may not be recoverable. This review process primarily focuses on intangible assets from business acquisitions, property, plant and equipment, and software for internal use or embedded in products sold to customers. Factors considered include the under-performance of a business compared to expectations and shortened useful lives due to planned changes in the use of the assets. Recoverability is determined by comparing the carrying amount of long-lived assets to estimated future undiscounted cash flows. If future undiscounted cash flows are less than the carrying amount of the long-lived assets, an impairment charge would be recognized for the excess of the carrying amount over fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cashflow technique. Additionally, in the case of assets that will continue to be used by the Company in future periods, a shortened life may be utilized if appropriate, resulting in accelerated amortization or depreciation based upon the expected net realizable value of the asset at the date the asset will no longer be utilized by the Company. Actual results may vary from estimates due to, among other things, differences in operating results, shorter asset useful lives and lower market values for excess assets.

Changes in Accounting Standards

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payments” (Statement 123(R)), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” issued in 1995. The Company currently accounts for share-based payments to employees (which include stock options) using the intrinsic value method of APB No. 25, “Accounting for Stock Issued to Employees” and, as such, generally recognizes no compensation cost for employee stock options. This new standard requires companies to adopt the fair value methodology of valuing stock options and recognizing that valuation in the financial statements from the date of grant. Accordingly, the adoption of Statement 123(R)’s fair value method will have a significant impact on the Company’s result of operations, although it will have no impact on the Company’s overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will partially depend on levels of share-based payments granted in the future. However, had the Company adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure as shown in Note 1 to the financial statements (see Effects of Stock-based Compensation). Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. The Company has elected to adopt the provisions of this standard on a modified prospective application method effective July 1, 2005.

In December 2004, the FASB also issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4,” which will become effective for the Company beginning January 1, 2006. This standard clarifies that abnormal amounts of idle facility expense, freight, handling costs and wasted material should be expensed as incurred and not included in overhead. In addition, this standard requires that the allocation of fixed production overhead costs to inventory be based on the normal capacity of the production facilities. The Company is currently evaluating the potential impact of this issue on its financial position and results of operations, but does not believe the impact of the change will be material.

On October 22, 2004, a new tax law was enacted, the American Jobs Creation Act of 2004 (the “Jobs Creation Act”), which raised a number of issues with respect to accounting for income taxes. (See Note 18 to financial statements for more detailed discussion of the impact of the Jobs Creation Act.) In response, on December 21, 2004, the FASB issued two FASB Staff Positions (FSP), FSP 109-1—“Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004” and FSP 109-2—“Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” which became effective for the Company upon issuance.

The Jobs Creation Act provides a deduction for income from qualified domestic production activities, which will be phased in from 2005 through 2010 that is intended to replace the existing extra-territorial income exclusion for foreign sales. In FSP 109-1, the FASB decided the deduction for qualified domestic production activities should be accounted for as a special deduction under FAS No. 109, rather than as a rate reduction. Accordingly, any benefit from the deduction will be reported in the period in which the deduction is claimed on the tax return and no adjustments to deferred taxes at December 31, 2004, is required.

The Jobs Creation Act also creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations and uncertainty remains as to how to interpret numerous provisions in the Act. FSP 109-2 addresses when to reflect in the financial statements the effects of the one-time tax benefit on the repatriation of foreign earnings. Under SFAS No. 109, companies are normally required to reflect the effect of new tax law changes in the period of enactment. FSP 109-2 provides companies additional time to determine the amount of earnings, if any, that are intended to repatriate under the Jobs Creation Act’s provisions. Currently we are analyzing whether, and to what extent, foreign earnings that have not yet been remitted to the U.S. may be repatriated. Based on analysis to date, however, it is reasonably possible that the Company may repatriate some amount up to $1.6 billion, with the respective tax liability ranging up to $0.2 billion.

See Changes in Accounting Standards in Note 1 to financial statements for discussion of other changes in accounting standards.

Quantitative and Qualitative Disclosures about Market Risk

The U.S. dollar is the functional currency for financial reporting. In this regard, the Company uses forward currency exchange contracts to minimize the adverse earnings impact from the effect of exchange rate fluctuations on the Company’s non-U.S. dollar net balance sheet exposures. For example, at year-end 2004, the Company had forward currency exchange contracts outstanding of $270 million (including $139 million to buy euros, $28 million to buy Taiwan dollars, and $28 million to sell Japanese yen). Similar hedging activities existed at year-end 2003. Because most of the aggregate non-U.S. dollar balance sheet exposure is hedged by these exchange contracts, a hypothetical 10 percent plus or minus fluctuation in non-U.S. currency exchange rates would not be expected to have a material earnings impact, e.g., based on year-end 2004 balances and rates, a pretax currency exchange gain or loss of $1 million.

The Company’s long-term debt has a fair value, based on current interest rates, of approximately $394 million at year-end 2004 ($871 million at year-end 2003). Fair value will vary as interest rates change. The following table presents the aggregate maturities and historical cost amounts of the debt principal and related weighted-average interest rates by maturity dates at year-end 2004:

Total long-term debt historical cost amount at year-end 2004 and 2003 was $379 million and $826 million.

The Company had interest rate swaps that changed the characteristics of the interest payments on the underlying notes ($50 million of 7.0% notes which matured on August 15, 2004, $300 million of 6.125% notes due 2006 and $43 million of 8.75% notes due 2007) from fixed-rate payments to short-term LIBOR-based variable rate payments in order to achieve a mix of interest rates on the Company’s long-term debt which, over time, is expected to moderate financing costs. The effect of these interest rate swaps was to decrease interest expense by $19 million in 2004. The year-end 2004 effective interest rates for the notes, including the effect of the swaps, was approximately 1.52% for the $300 million of notes due 2006 and 6.30% for the $43 million of notes due 2007. These swaps are sensitive to interest rate changes. For example, if short-term interest rates increase (decrease) by one percentage point from year-end 2004 rates, annual pretax interest expense would increase (decrease) by $3 million.

The Company’s cash equivalents are debt securities with original maturities equal to or less than three months. Short-term investments are debt securities with original maturities greater than three months with remaining maturities or average lives of 13 months or less and, beginning in 2004, debt securities with remaining maturities or average lives greater than 13 months (see Note 2 to financial statements). Their aggregate fair value and carrying amount was $6117 million at year-end 2004 ($5409 million at year-end 2003). Fair value will vary as interest rates change. The following table presents the aggregate maturities or average lives of cash equivalents and short-term cash investments, and related weighted-average interest rates by maturity dates at year-end 2004:

Equity investments at year-end 2004 consisted of the following (types of investments at year-end 2003 were similar):

Marketable equity and debt investments are stated at fair value and marked-to-market through stockholders’ equity, net of tax. Impairments deemed to be other-than-temporary are expensed in the Statement of Operations. Changes in prices of the mutual fund investments are expected to offset related changes in deferred compensation liabilities such that a 10 percent increase or decrease in investment prices would not affect operating results.

Restructuring Actions

Semiconductor Restructuring Action: In the second quarter of 2003, the Company announced a restructuring action that is expected to affect about 900 jobs in Semiconductor manufacturing operations in the U.S. and international locations, as those operations continue to become more productive with fewer people. The total cost of this restructuring action is expected to be about $82 million, primarily for severance and benefits costs. When completed at the end of 2005, the projected savings from this restructuring action are estimated to be an annualized $67 million, predominantly comprised of payroll and benefit savings. As of December 31, 2004, a total of 875 employees have been terminated and total net pretax charges of $81 million have been recorded associated with this action. Charges are expected to be completed in 2005.

For more detailed information on the restructuring actions, see Note 16 to the financial statements.

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