Capital Resources and Liquidity

Cash Flow Analysis

The following summarizes our cash flows for each of the three years ended December 31, 2007, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements:

														Amount Change
(in millions)		2007				2006				2005				2007				2006
Net cash provided by operating activities		$	1,871			$	1,617			$	1,420			$	254			$	197
Net cash used in investing activities			(1,612	)			(143	)			(295	)			(1,469	)			152
Net cash used in financing activities			(619	)			(1,428	)			(2,962	)			809				1,534
Effect of exchange rate changes on cash and cash equivalents			60				31				(59	)			29				90
(Decrease) increase in cash and cash equivalents			(300	)			77				(1,896	)			(377	)			1,973
Cash and cash equivalents at beginning of period			1,399				1,322				3,218				77				(1,896	)
Cash and cash equivalents at end of period		$	1,099			$	1,399			$	1,322			$	(300	)		$	77

Cash, cash equivalents and Short-term investments reported in our Consolidated Financial Statements were as follows (in millions):

		2007			2006
Cash and cash equivalents		$	1,099		$	1,399
Short-term investments			–			137
Total Cash, cash equivalents and Short-term investments		$	1,099		$	1,536

For the year ended December 31, 2007, net cash provided by operating activities, increased $254 million from 2006 primarily due to the following:

• $348 million increase in pre tax income before restructuring, depreciation, other provisions and net gains.
• $108 million increase in other liabilities primarily reflecting the absence of the prior year payment of $106 million related to the MPI litigation.
• $57 million increase reflecting lower pension contributions to our U.S. pension plans.
• $30 million increase as a result of lower restructuring payments due to minimal activity in 2007.
• $114 million decrease due to year-over-year inventory growth of $54 million primarily related to increased product launches in 2007, as well as a $60 million increase in equipment on operating leases reflecting higher operating lease install activity.
• $73 million decrease due to a lower net run-off of finance receivables.
• $49 million decrease primarily due to higher accounts receivable reflecting increased revenue, partially offset by $110 million year-over-year benefit from increased receivables sales.
• $45 million decrease due to lower benefit accruals, partially offset by higher accounts payable due to the timing of payments to vendors and suppliers.

For the year ended December 31, 2006, net cash provided by operating activities, increased $197 million from 2005 primarily as a result of the increased net income of $232 million, as well as the following additional items:

• $173 million increase due to lower inventories.
• $87 million increase due to lower net tax payments including a $34 million refund associated with the settlement of the 1999 to 2003 IRS tax audit.
• $62 million decrease due to a lower net run-off of finance receivables.
• $51 million decrease due to higher restructuring payments related to previously reported actions.
• $96 million decrease due to a lower year-over-year reduction in other current and long-term assets.
• $77 million decrease due to a reduction in other current and long-term liabilities, primarily reflecting a $106 million payment relating to the previously disclosed MPI legal matter.

For the year ended December 31, 2007, net cash used in investing activities, increased $1,469 million from 2006 primarily due to the following:

• $1,386 million increase due to $1,615 million in 2007 acquisitions primarily comprised of $1,568 for GIS and its additional acquisitions and $30 million for Advectis, Inc., as compared to $229 million in acquisitions in 2006 comprised of Amici, LLC and XMPie, Inc.
• $153 million increase reflecting the absence of the 2006 $122 million distribution related to the sale of investments held by Ridge Re* and the $21 million distribution from the liquidation of our investment in Xerox Capital LLC.
• $57 million increase due to higher 2006 proceeds from sales of land, buildings and equipment, which included the sale of our corporate headquarters and a parcel of vacant land.
• $65 million increase due to higher capital and internal use software investments in 2007.
• $162 million decrease due to a reduction in escrow and other restricted investments in 2007, as we continue to run-off our secured borrowing programs.

For the year ended December 31, 2006, net cash from investing activities increased $152 million from 2005 primarily as a result of the following:

• $354 million increase due to proceeds from the net sale of short-term investments in 2006 of $107 million, as compared to the net purchases of $247 million in 2005, as 2005 represented the initial year we purchased short-term investments to supplement our investment income.
• $77 million increase due to proceeds from the sale of our Corporate headquarters and other excess land and buildings.
• $48 million increase due to proceeds from divestitures and investments, reflecting:
• $122 million related to the sale of investments held by Ridge Re* in 2006.
• $21 million distribution from the liquidation of our investment in a subsidiary trust in 2006.
• $96 million of proceeds from the sale of Integic in 2005.
• Partially offsetting these items were the following:
• $229 million due to payments related to the acquisition of Amici, LLC and XMPie, Inc.
• $57 million increase in capital expenditures and internal use software.
• Lower cash generation of $42 million due to a lower net reduction of escrow and other restricted investments.

* In March 2006 Ridge Re, a wholly owned subsidiary included in discontinued operations, executed an agreement to complete its exit from the insurance business. As a result of this agreement and pursuant to a liquidation plan, excess cash held by Ridge Re was distributed back to the Company (Refer to Note 19 – Divestitures and Other Sales in the Consolidated Financial Statements for further information).

For the year ended December 31, 2007, net cash used in financing activities, decreased $809 million from 2006 primarily due to the following:

• $538 million decrease due to higher net cash proceeds from unsecured debt. This reflects the May 2007 issuance of the $1.1 billion Senior Notes, the issuances of two zero coupon bonds in 2007 resulting in net proceeds of approximately $400 million, and the net drawdown of $600 million under the 2007 Credit Facility. These higher net proceeds were partially offset by the March 2006 issuance of the $700 million Senior Notes and the August 2006 issuance of an additional $650 million of Senior Notes, as well as, higher repayments on other unsecured debt in 2007 as compared to 2006.
• $437 million decrease due to lower purchases under our share repurchase program as cash was invested in acquisitions.
• $100 million decrease relating to the 2006 payment of our liability to Xerox Capital LLC in connection with their redemption of Canadian deferred preferred shares.
• $278 million increase due to higher net repayments of secured financing. (refer to Note 4 – Receivables, net in the consolidated financial statements for further information).

For the year ended December 31, 2006, net cash used in financing activities decreased $1.5 billion from 2005 primarily as a result of the following:

• $2,463 million lower usage primarily resulting from the 2005 net repayments on term and other unsecured debt, of $1,187 million, as contrast to the 2006 net borrowings of term and other unsecured debt of $1,276 million. The 2006 net borrowings primarily reflect the 2016 Senior Notes borrowing of $700 million in March 2006, 2017 Senior Notes borrowing of $500 million in August 2006 and the 2009 Senior Notes borrowing of $150 million in August 2006.
• $42 million due to higher proceeds from the issuance of common stock, resulting from increases in exercised stock options.
• Partially offsetting these items were the following:
• $636 million higher cash usage for the acquisition of common stock under the authorized share repurchase programs.
• $269 million higher net repayments on secured borrowings.
• $100 million payment of liability to Xerox Capital LLC in connection with their redemption of Canadian deferred preferred shares in February 2006.

Financing Activities
Customer Financing Activities and Secured Debt: We provide equipment financing to the majority of our customers. Because the finance leases allow our customers to pay for equipment over time rather than at the date of installation, we maintain a certain level of debt to support our investment in these customer finance leases. We currently fund our customer financing activity through cash generated from operations, cash on hand, borrowings under bank credit facilities, and proceeds from capital markets offerings.

We have arrangements in certain international countries and domestically through the acquisition of GIS, in which third party financial institutions originate lease contracts directly with our customers. In these arrangements, we sell and transfer title of the equipment to these financial institutions. Generally, we have no continuing ownership rights in the equipment subsequent to its sale; therefore, the related receivable and debt are not included in our Consolidated Financial Statements.

The following represents total finance assets associated with our lease or finance operations as of December 31, 2007 and 2006, respectively (in millions):

		2007			2006
Total Finance receivables, net (1)		$	8,048		$	7,844
Equipment on operating leases, net			587			481
Total Finance Assets, net		$	8,635		$	8,325

(1) Includes (i) billed portion of finance receivables, net, (ii) finance receivables, net and (iii) finance receivables due after one year, net as included in the Consolidated Balance Sheets as of December 31, 2007 and 2006.

Refer to Note 4 – Receivables, Net in the Consolidated Financial Statements for further information regarding our third party secured funding arrangements and a comparison of finance receivables to our financing-related debt as of December 31, 2007 and 2006. As of December 31, 2007, approximately 5% of total finance receivables were encumbered as compared to 31% at December 31, 2006.

The following table summarizes our debt as of December 31,

(in millions)		2007			2006
Debt secured by finance receivables		$	275		$	2,059
Capital leases			19			28
Total Secured Debt			294			2,087
Senior Notes			5,781			4,224
Subordinated debt			19			19
2007 Credit Facility			600			–
Other Debt			770			815
Total Unsecured Debt			7,170			5,058
Total Debt		$	7,464		$	7,145

At December 31, 2007, approximately 4% of total debt was secured by finance receivables and other assets compared to 29% at December 31, 2006.

Credit Facility: In April 2007, we amended and restated our $1.25 billion unsecured revolving credit facility that was originally entered into in April 2006. The amended and restated 2007 Credit Facility (“2007 Credit Facility”) increased the maximum amount available for borrowing to $2 billion and includes a $300 million letter of credit subfacility. As of December 31, 2007, we had borrowings of $600 million and no outstanding letters of credit under the 2007 Credit Facility.

Refer to Note 11 – Debt in the Consolidated Financial Statements for further information regarding our 2007 Credit Facility.

Liquidity, Financial Flexibility and Other Financing Activity
Liquidity: We manage our worldwide liquidity using internal cash management practices, which are subject to (1) the statutes, regulations and practices of each of the local jurisdictions in which we operate, (2) the legal requirements of the agreements to which we are a party and (3) the policies and cooperation of the financial institutions we utilize to maintain and provide cash management services.

As of December 31, 2007, we had $1.1 billion of cash and cash equivalents and borrowing capacity under our 2007 Credit Facility of $1.4 billion. Our ability to maintain positive liquidity going forward depends on our ability to continue to generate cash from operations and access the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

Share Repurchase Programs: The Board of Directors has authorized programs for the repurchase of the Company’s common stock totaling $2.5 billion as of December 31, 2007. Since launching this program in October 2005, we have repurchased 137 million shares, totaling approximately $2.1 billion of the $2.5 billion authorized through December 31, 2007. In January 2008, the Board of Directors authorized an additional $1 billion for share repurchase.

Refer to Note 17 – Shareholders’ Equity – “Treasury Stock” in the Consolidated Financial Statements for further information regarding our share repurchase programs.

Dividends: In the fourth quarter of 2007, the Board of Directors declared a 4.25 cent per share dividend on common stock payable January 31, 2008 to shareholders of record on December 31, 2007.

Loan Covenants and Compliance: At December 31, 2007, we were in full compliance with the covenants and other provisions of the 2007 Credit Facility, the senior notes and the Loan Agreement. Failure to be in compliance with any material provision or covenant of these agreements could have a material adverse effect on our liquidity and operations and our ability to continue to fund our customers’ purchase of Xerox equipment. We have the right to prepay any outstanding loans or to terminate the 2007 Credit Facility without penalty.

Refer to Note 11 – Debt and Note 4 – Receivables, Net in the Consolidated Financial Statements for additional information regarding the senior notes and Loan agreement, respectively.

Financial Instruments: Refer to Note 13 – Financial Instruments in the Consolidated Financial Statements for additional information regarding our derivative financial instruments.

Capital Markets Offerings and Other: In 2007, we raised net proceeds of $1.5 billion through the issuance of Senior Notes due in 2012 and zero coupon bond transactions. Refer to Note 11 – Debt in the Consolidated Financial Statements for additional information regarding these transactions.

Credit Ratings: Our credit ratings, which are periodically reviewed by major rating agencies, have substantially improved and we are currently rated investment grade by all major rating agencies. As of January 31, 2008 the ratings were as follows:

		Senior Unsecured Debt		Outlook		Comments
Moody’s (1)		Baa2		Positive		The Moody’s rating was upgraded from Baa3 in November 2007, with a positive outlook.
Standard & Poors (“S&P”) (2)		BBB-		Stable		The S&P rating was upgraded from BB+ to investment grade, BBB-, in May 2007. Outlook is stable.
Fitch (3)		BBB		Stable		The Fitch rating was upgraded from BBB- and a stable outlook was affirmed in December 2007.

(1) On November 15, 2007, Moody’s raised its long term rating of Xerox to Baa2 from Baa3, with a positive outlook. The following ratings were impacted: Senior Unsecured Debt to Baa2 from Baa3; Trust Preferred Securities to Baa3 from Ba1; Xerox Credit Corp Senior Unsecured Debt to Baa2 from Baa3.

(2) In May 2007, S&P upgraded the Senior Unsecured and Corporate Credit ratings from BB+ to BBB-, investment grade, with a stable outlook. At the same time, S&P upgraded the ratings on Subordinated Debt from BB- to BB+ and Preferred Stock from B+ to BB. The ratings upgrade followed our announcement that we completed our tender offer for GIS.

(3) On December 10, 2007, Fitch upgraded Xerox’s Issuer Default Rating to BBB from BBB-, with a stable outlook. The following ratings were also impacted: Senior Unsecured Debt to BBB from BBB-; Senior Unsecured Credit Facility to BBB from BBB- and Trust Preferred Securities to BBB- from BB.

Contractual Cash Obligations and Other Commercial Commitments and Contingencies:

At December 31, 2007, we had the following contractual cash obligations and other commercial commitments and contingencies (in millions):

		2008			2009			2010			2011			2012			Thereafter
Long-term debt, including capital lease obligations (1)		$	525		$	1,552		$	707		$	808		$	1,721		$	2,151
Minimum operating lease commitments (2)			266			212			169			129			90			158
Liability to subsidiary trust issuing preferred securities (3)			–			–			–			–			–			632
Retiree Health Payments			105			114			119			123			127			635
Purchase Commitments
Flextronics (4)			716			–			–			–			–			–
EDS Contracts (5)			290			150			17			16			16			15
Other (6)			4			3			1			–			–			–
Total contractual cash obligations		$	1,906		$	2,031		$	1,013		$	1,076		$	1,954		$	3,591

(1) Refer to Note 11 – Debt in our Consolidated Financial Statements for additional information and interest payments related to long-term debt (amounts above include principal portion only).

(2) Refer to Note 6 – Land, Buildings and Equipment, Net in our Consolidated Financial Statements for additional information related to minimum operating lease commitments.

(3) Refer to Note 12  – Liability to Subsidiary Trust Issuing Preferred Securities in our Consolidated Financial Statements for additional information and interest payments (amounts above include principal portion only).

(4) Flextronics: We outsource certain manufacturing activities to Flextronics and are currently in the first year of the 2007 master supply agreement. This agreement is for three years with two additional one year extension periods at our option.

(5) EDS Contract: We have an information management contract with Electronic Data Systems Corp. (“EDS”) to provide services to us for global mainframe system processing, application maintenance and support, desktop services and helpdesk support, voice and data network management and server management. On July 1, 2004, we extended the contract through June 30, 2009. There are no minimum payments required under the contract. We can terminate the current contract for convenience with six months notice, as defined in the contract, with no termination fee and with payment to EDS for costs incurred as of the termination date. Should we terminate the contract for convenience, we have an option to purchase the assets placed in service under the EDS contract. On January 1, 2008, the portion of the contract for global mainframe processing was extended to December 31, 2013.

(6) Other Purchase Commitments: We enter into other purchase commitments with vendors in the ordinary course of business. Our policy with respect to all purchase commitments is to record losses, if any, when they are probable and reasonably estimable. We currently do not have, nor do we anticipate, material loss contracts.

Pension and Other Post-retirement Benefit Plans: We sponsor pension and other post-retirement benefit plans that may require periodic cash contributions. Our 2007 cash fundings for these plans were $298 million for pensions and $102 million for other post-retirement plans. Our anticipated cash fundings for 2008 are approximately $130 million for pensions and approximately $100 million for other post-retirement plans. Cash contribution requirements for our domestic tax qualified pension plans are governed by the Employment Retirement Income Security Act (“ERISA”) and the Internal Revenue Code. Cash contribution requirements for our international plans are subject to the applicable regulations in each country. The expected 2008 pension contributions do not include contributions to the domestic tax-qualified plans because these plans currently exceed the ERISA minimum funding requirements for the plans’ 2007 plan year. However, once the January 1, 2008 actuarial valuations and projected results as of the end of the 2008 measurement year are available, the desirability of additional contributions will be assessed. Based on these results, we may voluntarily decide to contribute to these plans, even though no contribution is required. In prior years, after making this assessment, we decided to contribute $158 million and $228 million in 2007 and 2006, respectively, to our domestic tax qualified plans in order to make them 100% funded on a current liability basis under the ERISA funding rules.

Our other post-retirement benefit plans are non-funded and are almost entirely related to domestic operations. Cash contributions are made each year to cover medical claims costs incurred in that year. The amounts reported in the above table as retiree health payments represent our estimated future benefit payments.

Fuji Xerox: We purchased products from Fuji Xerox totaling $1.9 billion, $1.7 billion, and $1.5 billion in 2007, 2006 and 2005, respectively. Our purchase commitments with Fuji Xerox are in the normal course of business and typically have a lead time of three months. We anticipate that we will purchase approximately $2.2 billion of products from Fuji Xerox in 2008. Related party transactions with Fuji Xerox are discussed in Note 7 – Investments in Affiliates, at Equity in the Consolidated Financial Statements.

Brazil Tax and Labor Contingencies: At December 31, 2007, our Brazilian operations were involved in various litigation matters and have been the subject of numerous governmental assessments related to indirect and other taxes as well as disputes associated with former employees and contract labor. The tax matters, which comprise a significant portion of the total contingencies, principally relate to claims for taxes on the internal transfer of inventory, municipal service taxes on rentals and gross revenue taxes. We are disputing these tax matters and intend to vigorously defend our position. Based on the opinion of legal counsel and current reserves for those matters deemed probable of loss, we do not believe that the ultimate resolution of these matters will materially impact our results of operations, financial position or cash flows. The labor matters principally relate to claims made by former employees and contract labor for the equivalent payment of all social security and other related labor benefits, as well as consequential tax claims, as if they were regular employees. As of December 31, 2007, the total amounts related to the unreserved portion of the tax and labor contingencies, inclusive of any related interest, amounted to approximately $1.1 billion, with the increase from the December 31, 2006 balance of $960 million primarily related to indexation, interest and currency. In connection with the above proceedings, customary local regulations may require us to make escrow cash deposits or post other security of up to half of the total amount in dispute. As of December 31, 2007 we had $200 million of escrow cash deposits for matters we are disputing and there are liens on certain Brazilian assets with a net book value of $64 million and additional letters of credit of approximately $84 million. Generally, any escrowed amounts would be refundable and any liens would be removed to the extent the matters are resolved in our favor. We routinely assess all these matters as to probability of ultimately incurring a liability against our Brazilian operations and record our best estimate of the ultimate loss in situations where we assess the likelihood of an ultimate loss as probable.

Other Contingencies and Commitments: As more fully discussed in Note 16 – Contingencies in the Consolidated Financial Statements, we are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and the Employee Retirement Income Security Act (“ERISA”). In addition, guarantees, indemnifications and claims may arise during the ordinary course of business from relationships with suppliers, customers and nonconsolidated affiliates. Nonperformance under a contract including a guarantee, indemnification or claim could trigger an obligation of the Company. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. Should developments in any of these areas cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

Unrecognized Tax Benefits: As of December 31, 2007, we had $303 million of unrecognized tax benefits. This represents the tax benefits associated with various tax positions taken, or expected to be taken, on domestic and international tax returns that have not been recognized in our financial statements due to uncertainty regarding their resolution. The resolution or settlement of these tax positions with the taxing authorities is at various stages and therefore we are unable to make a reliable estimate of the eventual cash flows by period that may be required to settle these matters. In addition, certain of these matters may not require cash settlement due to the existence of credit and net operating loss carryforwards as well as other offsets, including the indirect benefit from other taxing jurisdictions that may be available.