Engineering Economic Analysis

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Interest and Equivalence

Going Up in Smoke

State governmentsthroughout the United States agreed to a large financialwindfall in 1998.

Tobaccocompanies agreed to pay in perpetuityto settle claims arisingfrom the health effects

of smoking. Payments over the first 25 years are estimated to be nearly $250 billion.

State officials announced they would earmark these funds for goals such as health

care, education and, of course, antismoking campaigns. But several states involved in the

settlement were chronically short of money and were desperate to plug budget deficits. If

only they could get their hands on the full value of that tobacco settlement now, instead of

waiting for the payments to dribble in year by year.

That's when someonehit on the idea ofrais-

ing instant money by issuing "tobacco bonds":

the states would sell bonds to investors and pay

them interest out of the tobacco settlement pay-

ments the states were receiving. State govern-

ments could get the whole sale price of the bond

up front; investors would get ongoing income

fromthe bond..

A growing number of states are now sell-

ing these bonds, and pocketing quick billions. To

attract buyers, however, the states have to pay

a high rate of interest on their tobacco bonds,

since investors view them as riskier than other

government-backed securities. Investors reason

that tobacco companies could go broke, after

all--especially if the no-smoking laws being

passed allover the country cause enough people

to snuff out their cigarette habit for good.

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