Financial Instruments


A.	Debt

Credit Facilities

In December 2016, we entered into an amended and restated revolving credit agreement with a syndicate of banks providing for a five-year $1.0 billion senior unsecured revolving credit facility (the credit facility), which expires in December 2021. Subject to certain conditions, we have the right to increase the credit facility to up to $1.5 billion. The credit facility contains a financial covenant requiring us to not exceed a maximum total leverage ratio (the ratio of consolidated net debt as of the end of the period to consolidated Earnings Before Interest, Income Taxes, Depreciation and Amortization (EBITDA) for such period) of 3.50:1. Upon entering into a material acquisition, the maximum total leverage ratio increases to 4.00:1, and extends until the fourth full consecutive fiscal quarter ended immediately following the consummation of a material acquisition. The credit facility also contains a clause which adds back to Adjusted Consolidated EBITDA, any operational efficiency restructuring charge (defined as charges recorded by the company during the period commencing on October 1, 2016 and ending December 31, 2019, related to operational efficiency initiatives), provided that for any twelve-month period such charges added back to Adjusted Consolidated EBITDA shall not to exceed $100 million in the aggregate.

The credit facility also contains a financial covenant requiring that we maintain a minimum interest coverage ratio (the ratio of EBITDA at the end of the period to interest expense for such period) of 3.50:1. In addition, the credit facility contains other customary covenants.

We were in compliance with all financial covenants as of July 2, 2017, and December 31, 2016. There were no amounts drawn under the credit facility as of July 2, 2017, or December 31, 2016.

We have additional lines of credit and other credit arrangements with a group of banks and other financial intermediaries for general corporate purposes. We maintain cash and cash equivalent balances in excess of our outstanding short-term borrowings. As of July 2, 2017, we had access to $75 million of lines of credit which expire at various times throughout 2017 and 2018 and are generally renewed annually. We did not have any borrowings outstanding related to these facilities as of July 2, 2017, and December 31, 2016.

Commercial Paper Program and Other Short-Term Borrowings

In February 2013, we entered into a commercial paper program with a capacity of up to $1.0 billion. As of July 2, 2017, there was $100 million of commercial paper borrowings outstanding, with a weighted average interest rate of 1.4%. As of December 31, 2016, there was no commercial paper issued under this program. As of July 2, 2017, and December 31, 2016, we did not have any other short-term borrowings outstanding.

Senior Notes and Other Long-Term Debt

On November 13, 2015, we issued $1.25 billion aggregate principal amount of our senior notes (2015 senior notes), with an original issue discount of $2 million. On January 28, 2013, we issued $3.65 billion aggregate principal amount of our senior notes (the 2013 senior notes offering) in a private placement, with an original issue discount of $10 million.

The current portion of long-term debt was $750 million as of July 2, 2017, with a weighted-average interest rate of 1.875%. There was no current portion of long-term debt as of December 31, 2016.

The 2013 and 2015 senior notes are governed by an indenture and supplemental indenture (collectively, the indenture) between us and Deutsche Bank Trust Company Americas, as trustee. The indenture contains certain covenants, including limitations on our, and certain of our subsidiaries' ability to incur liens or engage in sale-leaseback transactions. The indenture also contains restrictions on our ability to consolidate, merge or sell substantially all of our assets. In addition, the indenture contains other customary terms, including certain events of default, upon the occurrence of which the 2013 and 2015 senior notes may be declared immediately due and payable.

Pursuant to the indenture, we are able to redeem the 2013 and 2015 senior notes, in whole or in part, at any time by paying a “make whole” premium, plus accrued and unpaid interest to, but excluding, the date of redemption. Pursuant to our tax matters agreement with Pfizer, we will not be permitted to redeem the 2013 senior notes due 2023 pursuant to this optional redemption provision, except under limited circumstances. Upon the occurrence of a change of control of us and a downgrade of the 2013 and 2015 senior notes below an investment grade rating by each of Moody's Investors Service, Inc. and Standard & Poor's Ratings Services, we are, in certain circumstances, required to make an offer to repurchase all of the outstanding 2013 and 2015 senior notes at a price equal to 101% of the aggregate principal amount of the 2013 and 2015 senior notes together with accrued and unpaid interest to, but excluding, the date of repurchase.

The components of our long-term debt are as follows:



	July 2,			December 31,
(MILLIONS OF DOLLARS)	2017			2016
1.875% 2013 senior notes due 2018	$	750		$	750
3.450% 2015 senior notes due 2020	500			500
3.250% 2013 senior notes due 2023	1,350			1,350
4.500% 2015 senior notes due 2025	750			750
4.700% 2013 senior notes due 2043	1,150			1,150
	4,500			4,500
Unamortized debt discount / debt issuance costs	(31		)	(32		)
Less current portion of long-term debt	(750		)	—
Long-term debt, net of discount and issuance costs	$	3,719		$	4,468

The fair value of our long-term debt, including the current portion of long-term debt, was $4,773 million and $4,565 million as of July 2, 2017, and December 31, 2016, respectively, and has been determined using a third-party matrix-pricing model that uses significant inputs derived from, or corroborated by, observable market data and Zoetis’ credit rating (Level 2 inputs).

The principal amount of long-term debt outstanding, as of July 2, 2017, matures in the following years:



									After
(MILLIONS OF DOLLARS)	2018		2019		2020		2021		2021		Total
Maturities	$	750	$	—	$	500	$	—	$	3,250	$	4,500

Interest Expense

Interest expense, net of capitalized interest, was $41 million and $82 million for the three and six months ended July 2, 2017, respectively, and $41 million and $84 million for the three and six months ended July 3, 2016, respectively. Capitalized interest was $1 million and $2 million for each of the three and six months ended July 2, 2017, and July 3, 2016, respectively.


B.	Derivative Financial Instruments

Foreign Exchange Risk

A significant portion of our revenue, earnings and net investment in foreign affiliates is exposed to changes in foreign exchange rates. We seek to manage our foreign exchange risk, in part, through operational means, including managing same-currency revenue in relation to same-currency costs and same-currency assets in relation to same-currency liabilities. Depending on market conditions, foreign exchange risk is also managed through the use of derivative financial instruments. These financial instruments serve to protect net income against the impact of the translation into U.S. dollars of certain foreign exchange-denominated transactions. The aggregate notional amount of foreign exchange derivative financial instruments offsetting foreign currency exposures was $1.1 billion and $1.2 billion, as of July 2, 2017, and December 31, 2016, respectively. The derivative financial instruments primarily offset exposures in the Australian dollar, Brazilian real, Canadian dollar, Chinese yuan, euro, and Japanese yen. The vast majority of the foreign exchange derivative financial instruments mature within 60 days and all mature within 180 days.

All derivative contracts used to manage foreign currency risk are measured at fair value and are reported as assets or liabilities on the condensed consolidated balance sheet. The company has not designated the foreign currency forward-exchange contracts as hedging instruments. We recognize the gains and losses on forward-exchange contracts that are used to offset the same foreign currency assets or liabilities immediately into earnings along with the earnings impact of the items they generally offset. These contracts essentially take the opposite currency position of that reflected in the month-end balance sheet to counterbalance the effect of any currency movement.

Interest Rate Risk

The company may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rates and to reduce its overall cost of borrowing. In anticipation of issuing fixed-rate debt, we may use forward-starting interest rate swaps that are designated as cash flow hedges to hedge against changes in interest rates that could impact expected future issuances of debt. To the extent these hedges of cash flows related to anticipated debt are effective, any unrealized gains or losses on the forward-starting interest rate swaps are reported in Accumulated other comprehensive loss and are recognized in income over the life of the future fixed-rate notes. When the company discontinues hedge accounting because it is no longer probable that an anticipated transaction will occur within the originally expected period of execution, or within an additional two-month period thereafter, changes to fair value accumulated in other comprehensive income are recognized immediately in earnings.

For the six months ended July 2, 2017, we entered into interest rate swaps with an aggregate notional value of $200 million, having a term of 10 years and an effective date and mandatory termination date in December 2017. In 2016, we entered into interest rate swaps with an aggregate notional value of $250 million, having a term of 10 years and an effective date and mandatory termination date in December 2017. We designated these swaps as cash flow hedges against interest rate exposure related principally to the anticipated future issuance of fixed-rate debt to be used primarily to refinance our 1.875% 2013 senior note due in 2018. In addition, in previous years we had entered into various forward-starting interest rate swap contracts that were designated as cash flow hedges and that were terminated upon issuance of fixed-rate notes. The deferred gains or losses related to the settlement of these contracts are reclassified from Accumulated other comprehensive loss into income over the period during which the hedged transactions affects earnings.

Fair Value of Derivative Instruments

The classification and fair values of derivative instruments are as follows:



		Fair Value of Derivatives
		July 2,			December 31,
(MILLIONS OF DOLLARS)	Balance Sheet Location	2017			2016
Derivatives Not Designated as Hedging Instruments
Foreign currency forward-exchange contracts	Other current assets	$	6		$	12
Foreign currency forward-exchange contracts	Other current liabilities	(8		)	(8		)
Total derivatives not designated as hedging instruments		(2		)	4

Derivatives Designated as Hedging Instruments:
Interest rate swap contracts	Other current assets	14			17
Total derivatives designated as hedging instruments		14			17

Total derivatives		$	12		$	21

We use a market approach in valuing financial instruments on a recurring basis. Our derivative financial instruments are measured at fair value on a recurring basis using Level 2 inputs in the calculation of fair value.

The amounts of net gains/(losses) on derivative instruments not designated as hedging instruments, recorded in Other (income)/deductions—net, are as follows:



	Three Months Ended					Six Months Ended
	July 2,		July 3,			July 2,			July 3,
(MILLIONS OF DOLLARS)	2017		2016			2017			2016
Foreign currency forward-exchange contracts	$	7	$	(13	)	$	(22	)	$	(12	)

These amounts were substantially offset in Other (income)/deductions—net by the effect of changing exchange rates on the underlying foreign currency exposures.

The amounts of unrecognized net losses on derivative instruments designated as cash flow hedges, recorded, net of tax, in Other comprehensive income/(loss), are as follows:



	Three Months Ended						Six Months Ended
	July 2,			July 3,			July 2,			July 3,
(MILLIONS OF DOLLARS)	2017			2016			2017			2016
Interest rate swaps	$	(1	)	$	(3	)	$	(1	)	$	(3	)

The net amount of deferred gains/(losses) that is expected to be reclassified from Accumulated other comprehensive loss into earnings over the next 12 months is insignificant.