FEDEX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)

(3)   Financing Arrangements

From time to time, we finance certain operating and investing activities, including acquisitions, through the issuance of commercial paper.  Our commercial paper program is backed by unused commitments under two revolving credit agreements totaling $1 billion and borrowings under the program reduce the amount available under these agreements.  One revolver provides for $750 million through September 28, 2006.  The second is a 364-day facility providing for $250 million through September 22, 2005.  At August 31, 2004, no commercial paper borrowings were outstanding and the entire amount under the credit facilities was available.  All of our credit agreements contain similar covenants and restrictions, none of which are expected to significantly affect our operations or ability to pay dividends.

(4) Stock Option Assumptions

We account for stock options using the intrinsic value method wherein compensation expense is recognized on stock options granted to employees only for the excess of the market price of our common stock at the date of grant over the option exercise price.  No compensation expense is recorded at the date of grant, as all of our options have an exercise price equal to the fair value of our stock on that date.

Some companies recognize compensation expense for the fair value of the option right itself.  We have elected not to adopt this accounting method because it requires the use of subjective valuation models, which we believe are not representative of the real value of the option to either FedEx or our employees.  However, we are required to disclose the pro forma effect of accounting for stock options using such a valuation method for all options granted in 1996 and thereafter.  We use the Black-Scholes option-pricing model to calculate the fair value of options for our pro forma disclosures.  The key assumptions for this valuation method include the expected life of the option, stock price volatility, risk-free interest rate, dividend yield, forfeiture rate and exercise price.  Many of these assumptions are judgmental and highly sensitive in the determination of pro forma compensation expense.  Following is a table of the key weighted-average assumptions used in the option valuation calculations for the options granted in the three-month periods ended August 31, 2004 and 2003, and a discussion of our methodology for developing each of the assumptions used in the valuation model:

Expected Lives.   This is the period of time over which the options granted are expected to remain outstanding. Generally, options granted have a maximum term of ten years. We examine actual stock option exercises to determine the expected life of the options. An increase in the expected term will increase compensation expense.

ExpectedVolatility.   Actual changes in the market value of our stock are used to calculate the volatility assumption. We calculate daily market value changes from the date of grant over a past period equal to the expected life of the options to determine volatility. An increase in the expected volatility will increase compensation expense.

Risk-Free Interest Rate.   This is the U.S. Treasury Strip rate posted at the date of grant having a term equal to the expected life of the option. An increase in the risk-free interest rate will increase compensation expense.

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Dividend Yield.   This is the annual rate of dividends per share over the exercise price of the option. An increase in the dividend yield will decrease compensation expense.

Forfeiture Rate.   This is the estimated percentage of options granted that are expected to be forfeited or canceled before becoming fully vested. This percentage is derived from historical experience. An increase in the forfeiture rate will decrease compensation expense. Our forfeiture rate is approximately 8%.

During the first quarter of 2005,2006, we made option grants of 2,311,6002,806,235 shares at a weighted-average exercise price of $73.05$89.66 per share, primarily in connection with our principal annual stock option grant. The weighted-average Black-Scholes value of these grants under the assumptions indicated above was $19.16$25.38 per option.

Total equity compensation shares outstanding or available for grant at August 31, 20042005 represented 6.8%6.6% of total outstanding common and equity compensation shares and equity compensation shares available for grant.

NEW ACCOUNTING PRONOUNCEMENTS.   In December 2004, the FASB issued SFAS 123R, “Share-Based Payment.” SFAS 123R is a revision of SFAS 123 and supersedes APB 25. The new standard requires companies to record compensation expense for stock-based awards using a fair value method and is effective for annual periods beginning after June 15, 2005 (effective in the first quarter of 2007 for FedEx). Compensation expense will be recorded over the requisite service period, which is typically the vesting period of the award. We plan to adopt this standard using the modified prospective method.

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FEDEX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)

The impact of the adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future, as well as the assumptions and the fair value model used to value them, and the market value of our common stock. We anticipate that the impact of SFAS 123R will approximate the pro forma results under SFAS 123 presented above (reducing earnings per diluted share in the first quarter of 2006 and 2005 by $0.04 and $0.03, respectively). SFAS 123R 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 standards. Based on historical experience, we do not expect the impact of adopting SFAS 123R to be material to our reported cash flows.

In March 2005, the FASB issued Financial Accounting Standards Board Interpretation No. (“FIN”) 47, “Accounting for Conditional Asset Retirement Obligations, an Interpretation of FASB Statement No. 143”. FIN 47 clarifies that liabilities associated with asset retirement obligations whose timing or settlement method are conditional upon future events should be recorded at fair value as soon as fair value is reasonably estimable. FIN 47 also provides guidance on the information required to reasonably estimate the fair value of the liability. FIN 47 will be effective for FedEx no later than May 31, 2006. Management is in the process of evaluating the impact, if any, FIN 47 will have on FedEx.

(5)   C(2)omputationComprehensive Income

The following table provides a reconciliation of net income reported in our financial statements to comprehensive income (in millions):

(3)Financing Arrangements

From time to time, we finance certain operating and investing activities, including acquisitions, through borrowings under our $1.0 billion revolving credit facility or the issuance of commercial paper. In July 2005, we executed a new $1.0 billion five-year revolving credit facility, which replaced and consolidated our prior revolving credit facilities. Borrowings under the credit facility will bear interest at short-term interest rates (based on the London Interbank Offered Rate (LIBOR), the Prime Rate or the Federal Funds Rate) plus a margin dependent upon our senior unsecured long-term debt ratings.

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FEDEX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)

Our commercial paper program is backed by unused commitments under the revolving credit facility and borrowings under the program reduce the amount available under the credit facility. At August 31, 2005, no commercial paper borrowings were outstanding and the entire amount under the credit facility was available. The revolving credit agreement contains certain covenants and restrictions, none of which are expected to significantly affect our operations or ability to pay dividends.

(4)Computation of Earnings Per Share

The calculation of basic and diluted earnings per common share for the three-month periods ended August 31 2004 and 2003 was as follows (in millions, except per share amounts):

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We have excluded from the calculation of diluted earnings per share approximately 3,195,035 antidilutive options for the three months ended August 31, 2005, as the exercise price of the options was greater than the average market price of common stock for the period.

(6)(5)          Employee Benefit Plans

We sponsor defined benefit pension plans covering a majority of our employees. The largest plan covers certain U.S. employees age 21 and over, with at least one year of service. Certain of our subsidiaries offer medical, dental, and vision coverage to eligible U.S. retirees and their eligible dependents. Net periodic benefit cost of the pension and postretirement healthcare plans for the three-month periods ended August 31 was as follows (in millions):

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FEDEX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)

No contributions were made during the first quarter of 2006 or 2005 to our principal U.S. domestic pension plans, and none are expectedplans. However, on September 1, 2005, we made voluntary, tax deductible contributions of $456 million to be required during the remainder of 2005.our principal U.S. domestic pension plans. During 2004,2005, we made primarily voluntary contributions of $335$460 million to our qualified pension plans. Although not required, weWe may elect to make further voluntary contributions to our qualified pension plans in 2005.

2006.

(7)(6)          Business Segment Information

We provide customers and businesses worldwide with a broad portfolio of transportation, e-commerce and business services.  We offer integrated business applicationsservices through operating companies that operate independentlycompete collectively and compete collectivelyare managed collaboratively under the respected FedEx brand.brands. Our operations are primarily represented by Federal Express Corporation (“FedEx Express,Express”), the world’s largest express transportation company; FedEx Ground Package System, Inc. (“FedEx Ground”), a leading provider of small-package ground delivery service;services; FedEx Freight Corporation (“FedEx Freight”), the largesta leading U.S. provider of regional less-than-truckload (“LTL”) freight services; and FedEx Kinko’s Office and Print Services, Inc. (“FedEx Kinko’s”), a leading provider of document solutions and business services. These businesses form the core of our reportable segments.  Other business units in the FedEx portfolio are FedEx Trade Networks, Inc. (“FedEx Trade Networks”), a global trade services company; FedEx Supply Chain Services, Inc. (“FedEx Supply Chain Services”), a contract logistics provider; FedEx Custom Critical, Inc. (“FedEx Custom Critical”), North America’s largest time-specific critical shipment carrier; Caribbean Transportation Services, Inc. (“Caribbean Transportation Services”), the leading provider of airfreight forwarding services between the U.S. and Puerto Rico, and FedEx Corporate Services, Inc.  (“FedEx Services”), a provider of customer-facing sales, marketing and information technology functions, primarily for FedEx Express and FedEx Ground.

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Our reportable segments include the following businesses:

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FEDEX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)

The following table provides a reconciliation of reportable segment revenues and operating income to our consolidated financial statement totals (in millions):

⁽¹⁾      The FedEx Kinko’s segment was formed followingFirst quarter 2006 includes a $75 million (before variable compensation effects) one-time, non-cash charge to adjust the acquisition of Kinko’s, Inc. on February 12, 2004.accounting for certain facility leases.

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(8)(7)   Commitments

As of August 31, 2004,2005, our purchase commitments for the remainder of 20052006 and annually thereafter under various contracts were as follows (in millions):

⁽¹⁾Primarily aircraft modifications.

⁽²⁾      Primarily vehicles, facilities, computers, printing and other equipment and advertising and promotions contracts.

The amounts reflected in the table above for purchase commitments represent noncancelable agreements to purchase goods or services. Such contractsCommitments to purchase aircraft in passenger configuration do not include thosethe attendant costs to modify these aircraft for certain purchases of aircraft, aircraft modifications, vehicles, facilities, computers, printing and other equipment and advertising and promotions contracts.cargo transport unless we have entered into non-cancelable commitments. Open purchase orders that are cancelable are not considered unconditional purchase obligations for financial reporting purposes.

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FEDEX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)

As of August 31, 2005, FedEx Express iswas committed to purchase 12 Airbus A300s, four Airbus A310s, four ATRsfive ATR-72s and ten Airbus A380s (a new high-capacity, long-range aircraft). The A310s and ATRs are expected to be delivered in 2005.  FedEx Express expects to take delivery of three A300s, two A310s and all of the ATR-72s in 2006. Five A300s and two A310s are expected to be delivered in 2007. The four remaining A300s are expected to be delivered in 2008. Three of the ten A380 aircraft are scheduled to be delivered in each of 2009, 2010 and 2011 and the remaining one in 2012. Deposits and progress payments of $27$33 million have been made toward these purchases and other planned aircraft-related transactions. In addition, we have committed to modify our DC10 aircraft for passenger-to-freighter and two-man cockpit configurations. Payments related to all of these activities are included in the table above. Aircraft and aircraft-related contracts are subject to price escalations.  Also, FedEx Express has entered into agreements to acquire eight MD11 aircraft, five Airbus A310s and one Airbus A300 to be received during 2005.  Because delivery of these aircraft is subject to certain conditions, they are not included in the table above.

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A summary of future minimum lease payments under capital leases andat August 31, 2005 is as follows (in millions):

A summary of future minimum lease payments under noncancelable operating leases (principally aircraft, retail locations and facilities) with an initial or remaining term in excess of one year at August 31, 20042005 is as follows (in millions):

While certain of our lease agreements contain covenants governing the use of the leased assets or require us to maintain certain levels of insurance, none of our lease agreements include material financial covenants or limitations.

FedEx Express makes payments under certain leveraged operating leases that are sufficient to pay principal and interest on certain pass-through certificates. The pass-through certificates are not direct obligations of, or guaranteed by, FedEx or FedEx Express.

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(9)FEDEX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)

(8)   Contingencies

During 2002 we recognized $119 million of compensation under the Air Transportation Safety and System Stabilization Act (the “Act”), of which $101 million was received.  In the fourth quarter of 2003, the Department of Transportation (“DOT”) asserted that we were overpaid by $31.6 million and has demanded repayment.  We have filed requests for administrative and judicial review.  We received an opinion from the District of Columbia U.S. Court of Appeals stating that most of the determinations that we requested were not yet ripe for decision and the Court will not rule prior to final determination by the DOT and exhaustion of administrative remedies.

We believe that we have complied with all aspects of the Act, that it is probable we will ultimately collect the remaining $18 million receivable and that we will not be required to pay any portion of the DOT’s $31.6 million demand.  We cannot be assured of the ultimate outcome; however, it is reasonably possible that a material reduction to the $119 million of compensation we have previously recognized under the Act could occur.  Based on the DOT’s assertion, the range for potential loss on this matter is zero to $49.6 million.

In light of our ongoing dispute with the DOT, we undertook a further review of our claim and amended our application in August 2004 to reclassify several items in our claim.  This amendment did not have a material effect on the total compensation we claimed under the Act.

Wage-and-Hour.   We are a defendant in a number of lawsuits filed in federal or California state courts containing various class-action allegations under California’s wage and hourfederal or California wage-and-hour laws. The plaintiffs in these lawsuits generally are hourly employees or contractors of FedEx operating companies who allege, among other things, that they were forced to work “off the clock” and were not provided work breaks or other benefits. The plaintiffs generally seek unspecified monetary damages, injunctive relief, or both.

To date, only one of these wage-and-hour cases, Foster v. FedEx Express, has been certified as a class action. We believeThe plaintiffs represent a class of hourly FedEx Express employees in California from October 14, 1998 to present. The plaintiffs allege that hourly employees are routinely required to work “off the claims in these casesclock” and are without merit.  not paid for this additional work. The court issued a ruling on December 13, 2004 granting class certification on all issues. The ruling, however, does not address whether we will ultimately be held liable. Trial has been scheduled for April 2006.

We have denied any liability with respect to these claims and intend to vigorously defend ourselvesourself in these cases. InHowever, it is reasonably possible that material losses could be incurred on one or more of these matters as these cases develop.

Independent Contractor.   FedEx Ground is involved in numerous purported class-action lawsuits and other proceedings in which the opinionthreshold issue is whether some or all of management,FedEx Ground’s owner-operators are in fact employees, rather than independent contractors. Adverse determinations in these matters could, among other things, entitle certain of our contractors to the aggregatereimbursement of certain expenses and to the benefit of wage-and-hour laws and result in employment and withholding tax liability if any, with respectfor FedEx Ground. On August 10, 2005, the Judicial Panel on Multi-District Litigation granted our motion to these claims will not materially adversely affect our financial position, resultstransfer and consolidate the majority of operations or cash flows.

During the first quarterclass-action lawsuits for administration of 2004, we receivedthe pre-trial proceedings by a favorable ruling fromsingle federal court – the U.S. District Court for the Northern District of Indiana.

We strongly believe that FedEx Ground’s owner-operators are properly classified as independent contractors and that we will prevail in Memphis overthese proceedings. Given the tax treatmentnature and preliminary status of jet engine maintenance costs.  The Court held thatthe claims, we cannot yet determine the amount or a reasonable range of potential loss in these costs were ordinary and necessary business expenses and properly deductible.  As a result of this decision, we recognized a one-time benefit of $26 million, net of tax, in the first quarter of 2004, primarily related to the reduction of accruals related to this matter and the recognition of interest earned on amounts previously paid to the IRS.  Thesematters, if any.

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adjustmentsOther.   affected both net interest expense ($30 million pre-tax) and income tax expense ($7 million).  Future periods are not expected to be materially affected by the resolution of this matter.  Although the IRS has appealed this ruling, we believe the District Court’s ruling will be upheld on appeal.

FedEx and its subsidiaries are subject to other legal proceedings that arise in the ordinary course of their business. In the opinion of management, the aggregate liability, if any, with respect to these other actions will not materially adversely affect our financial position, results of operations or cash flows.

(10)(9)   Supplemental Cash Flow Information

FedEx Express amended two leases for MD11 aircraft during the first quarter of 2004, which required FedEx Express to record $110 million in both fixed assets and long-term liabilities.

(11) Subsequent Event

On September 12, 2004, we acquired Parcel Direct, a division of a privately held company, for approximately $120 million in cash.  Parcel Direct is a leading parcel consolidator and will broaden our portfolio of services by allowing us to offer a cost effective option for delivering low-weight, less time-sensitive packages to U.S. residences through the U.S. Postal Service.  The financial results of Parcel Direct will be included in the FedEx Ground segment from the date of acquisition.  The transaction is not expected to materially affect our results of operations, financial position or cash flows.