24 Financial instruments
Management of financial risks
One of the principal responsibilities of Treasury is to manage the financial risks arising from the Group’s underlying operations. Specifically, Treasury manages, within an overall policy framework set by the Group’s Main Board and Corporate Finance Committee (CFC), the Group’s exposure to funding and liquidity, interest rate, foreign exchange and counterparty risks. The Group’s treasury position is monitored by the CFC which meets regularly throughout the year and is chaired by the Group Finance Director. The approach is one of risk reduction within an overall framework of delivering total shareholder return.
The Group defines capital as net debt (see note 21) and equity (see note 20). The only externally imposed capital requirement for the Group is interest cover as described under interest rate risk below. The Group assesses its financial capacity by reference to cash flow, net debt and interest cover. Group policies include a set of financing principles and key performance indicators including the monitoring of credit ratings, interest cover and liquidity. These provide a framework within which the Group’s capital base is managed and, in particular, the policies on dividends (as a percentage of long-term sustainable earnings) and share buy-back are decided. The key objective of the financing principles is to appropriately balance the interests of equity and debt holders in driving an efficient financing mix for the Group.
The Group manages its financial risks in line with the classification of its financial assets and liabilities in the Group’s balance sheet and related notes.
The Group’s management of specific risks is dealt with as follows:
It is the policy of the Group to maximise financial flexibility and minimise refinancing risk by issuing debt with a range of maturities, generally matching the projected cash flows of the Group and obtaining this financing from a wide range of providers. The Group has a target average centrally managed debt maturity of at least 5 years with no more than 20 per cent of centrally managed debt maturing in a single rolling year. As at 31 December 2010, the average centrally managed debt maturity was 7.4 years (2009: 6.6 years) and the highest proportion of centrally managed debt maturing in a single rolling year was 12.5 per cent (2009: 18.4 per cent). It is Group policy that short-term sources of funds (including drawings under the £1 billion Euro commercial paper (ECP) programme) are backed by undrawn committed lines of credit and cash. The ECP programme was undrawn at 31 December 2010 (2009: £187 million outstanding).
In December 2010, the Group negotiated a new central banking facility of £2 billion with a final maturity date of December 2015. This facility is provided by 22 banks. The existing central banking facility of £1.75 billion, with a final maturity date of March 2012 was cancelled at the same time. The new facility was undrawn as at 31 December 2010.
On 25 June 2010, the terms of €470 million of the €1 billion bond maturing in 2011 were modified by extending the maturity to 2020; at the same time, the Group issued an additional €130 million bond with a maturity of 2020. In addition, €413 million of the Group’s €750 million bond maturing in 2012 was purchased and cancelled. At the same time, the Group issued a new £275 million bond with a maturity of 2040.
In May 2010, the Group repaid a €525 million bond. The repayment was financed from debt issued in November 2009.
In 2010, the Group’s subsidiary in Brazil received proceeds of £410 million (2009: £293 million) from short term borrowings in respect of advance payments on leaf export contracts and repaid £297 million (2009: £241 million) in the year.
In November 2009, the terms of €481 million of the €1 billion bond maturing in 2013 were modified by extending the maturity to 2021. At the same time, the Group issued an additional €169 million bond with a maturity of 2021. In addition, £199 million of the £350 million bond maturing in 2013 was purchased and cancelled; at the same time the Group issued a new £500 million bond with a maturity of 2034.
In September 2009 and October 2009, the Group repaid its €359 million and €759 million credit facilities used to finance the acquisition of Tekel in 2008. The €759 million facility was refinanced by a new €700 million term loan facility with a maturity date of 31 October 2012 with an option to extend it to October 2013, at the discretion of the banking participants in the syndicated facility. In December 2010, the €700 million term loan facility was partly prepaid and the remaining term loan facility of €450 million was extended to October 2013 with the Group able to negotiate improved pricing.
In February 2009, the Group repaid a €900 million bond which was financed by bond issues during 2008 and cash generated from operations. In May 2009, the Group repaid Malaysian ringgit (MYR) 100 million which was refinanced in August 2009 by a new MYR250 million bond, due 2014. The additional proceeds were used to repay MYR150 million in November 2009. During 2009, the Group also issued a new £250 million bond maturing in June 2022.
The Group utilises cash pooling and zero balancing bank account structures in addition to intercompany loans and borrowings to ensure that there is the maximum mobilisation of cash within the Group. The key objectives of Treasury in respect of cash and cash equivalents are to protect the principal value of cash and cash equivalents, to concentrate cash at the centre to minimise the required long-term debt issuance, and to optimise the yield earned. The amount of debt issued by the Group is determined by forecasting the net debt requirement after the mobilisation of cash.
The Group continues to target investment-grade credit ratings; as at 31 December 2010 the ratings from Moody’s and S&P were Baa1/BBB+ (2009: Baa1/BBB+) and these ratings were maintained throughout the year. The strength of the ratings has underpinned the debt issuance during 2010 and 2009 and, despite the impact of the turbulence in financial markets, the Group is confident of its ability to successfully access the debt capital markets, as demonstrated with the issue of bonds in the euro and sterling markets in 2010 and 2009.
As part of its short-term cash management, the Group invests in a range of cash and cash equivalents, including money market funds, which are regarded as highly liquid and are not exposed to significant changes in fair value. These are kept under continuous review as described in the credit risk section below. At 31 December 2010, cash and cash equivalents include £642 million invested in money market funds (2009: £669 million).
Subsidiary companies are funded by share capital and retained earnings, loans from the central finance companies on commercial terms, or through local borrowings by the subsidiaries in appropriate currencies. All contractual borrowing covenants have been met and none of them is expected to inhibit the Group’s operations or funding plans.
The Group is subject to exposure on the translation of the net assets of foreign currency subsidiaries and associates into its reporting currency, sterling. The Group’s primary balance sheet translation exposures are to the US dollar, Canadian dollar, euro, Danish krone, Turkish lira, South African rand, Russian rouble, Brazilian real and Australian dollar. These exposures are kept under continuous review. The Group’s policy on borrowings is to broadly match the currency of these borrowings with the currency of cash flows arising from the Group’s underlying operations. Within this overall policy, the Group aims to minimise all balance sheet translation exposure where it is practicable and cost-effective to do so through matching currency assets with currency borrowings. The main objective of these policies is to protect shareholder value by increasing certainty and minimising volatility in earnings per share. At 31 December 2010, the currency profile of the Group’s gross debt, after taking into account derivative contracts, was 13 per cent (2009: 11 per cent) US dollar, 47 per cent (2009: 54 per cent) euro, 3 per cent (2009: 4 per cent) Canadian dollar, 11 per cent (2009: 6 per cent) sterling, 10 per cent (2009: 8 per cent) Australian dollar and 16 per cent (2009: 17 per cent) other currencies.
The Group faces currency exposures arising from the translation of profits earned in foreign currency subsidiaries and associates and joint ventures; these exposures are not normally hedged. Exposures also arise from:
(i) foreign currency denominated trading transactions undertaken by subsidiaries. These exposures comprise committed and highly probable forecast sales and purchases, which are offset wherever possible. The remaining exposures are hedged within the Treasury policies and procedures with forward foreign exchange contracts and options, which are designated as hedges of the foreign exchange risk of the identified future transactions; and
(ii) forecast dividend flows from subsidiaries to the centre. To ensure cash flow certainty, the Group hedges such flows using forward foreign exchange contracts designated as net investment hedges of the foreign exchange risk arising from the investments in these subsidiaries.
IFRS 7 requires a sensitivity analysis that shows the impact on the income statement and on items recognised directly in other comprehensive income of hypothetical changes of exchange rates in respect of non-functional currency financial assets and liabilities held across the Group. All other variables are held constant although, in practice, market rates rarely change in isolation. Financial assets and liabilities held in the functional currency of the Group’s subsidiaries, as well as non-financial assets and liabilities and translation risk, are not included in the analysis. The Group considers a 10 per cent strengthening or weakening of the functional currency against the non-functional currency of its subsidiaries as a reasonably possible change. The impact is calculated with reference to the financial asset or liability held as at the year end, unless this is unrepresentative of the position during the year.
A 10 per cent strengthening of functional currencies against non-functional currencies would result in pre-tax profit being £36 million higher (2009: £24 million lower) and items recognised directly in other comprehensive income being £273 million higher (2009: £268 million higher). A 10 per cent weakening of functional currencies against non-functional currencies would result in pre-tax profit being £44 million lower (2009: £26 million higher) and items recognised directly in other comprehensive income being £333 million lower (2009: £328 million lower).
The exchange sensitivities on items recognised directly in other comprehensive income relate to hedging of certain net asset currency positions in the Group, but does not include sensitivities in respect of exchange on non-financial assets, as well as on cash flow hedges in respect of future transactions debt.
Interest rate risk
The objectives of the Group’s interest rate risk management policy are to lessen the impact of adverse interest rate movements on the earnings, cash flow and economic value of the Group and to safeguard against any possible breach of its financial covenants. Additional objectives are to minimise the cost of hedging and the associated counterparty risk.
The Group targets an interest cover ratio, as calculated under its key central banking facilities, of greater than 5 and for 2010 it is 11.2 times (2009: 9.9 times). The only externally imposed capital requirement the Group has is in respect of its centrally managed banking facilities, which require a gross interest cover of 4.5.
In order to manage its interest rate risk, the Group maintains both floating rate and fixed rate debt. The Group sets targets (within overall guidelines) for the desired ratio of floating to fixed rate debt on both a gross and net basis (at least 50 per cent fixed on a net basis in the short to the medium-term) as a result of regular reviews of market conditions and strategy by the Corporate Finance Committee and the board of the main central finance company. At 31 December 2010, the relevant ratios of floating to fixed rate borrowings were 33:67 (2009: 48:52) on a gross basis and 9:91 (2009: 30:70) on a net basis. Underlying borrowings are arranged on both a fixed rate and a floating rate basis and, where appropriate, the Group uses derivatives, primarily interest rate swaps, to vary the fixed and floating mix. The interest rate profile of liquid assets is taken into account in determining the net interest rate exposure.
IFRS 7 requires a sensitivity analysis that shows the impact on the income statement and on items recognised directly in other comprehensive income of hypothetical changes of interest rates in respect of financial assets and liabilities of the Group. All other variables are held constant although, in practice, market rates rarely change in isolation. For the purposes of this sensitivity analysis, financial assets and liabilities with fixed interest rates are not included. The Group considers a 100 basis point change in interest rates a reasonably possible change except where rates are less than 100 basis points. In these instances it is assumed that the interest rates increase by 100 basis points and decrease to zero for the purpose of performing the sensitivity analysis. The impact is calculated with reference to the financial asset or liability held as at the year end, unless this is unrepresentative of the position during the year.
A 100 basis point increase in interest rates would result in pre-tax profit being £12 million lower (2009: £35 million lower). A 100 basis point decrease in interest rates, or less where applicable, would result in pre-tax profit being £8 million higher (2009: £34 million higher). The effect of these interest rate changes on items recognised directly in other comprehensive income is not material in either year.
The Group has no significant concentrations of customer credit risk. Subsidiaries have policies in place requiring appropriate credit checks on potential customers before sales commence. The process for monitoring and managing credit risk once sales to customers have been made varies depending on local practice in the countries concerned.
Certain territories have bank guarantees, other guarantees and credit insurance provided in the Group’s favour in respect of Group trade receivables, the issuance and terms of which are dependent on local practices in the countries concerned.
All derivatives are subject to ISDA agreements or equivalent documentation.
Cash deposits and other financial instruments give rise to credit risk on the amounts due from the related counterparties. Generally the Group targets a long term counterparty credit rating of at least A/A2. However the Group recognises that due to the need to operate over a large geographic footprint, sovereign risk can be the determining factor on the suitability of a counterparty. From time to time the Group may invest in short dated corporate commercial paper and for this, the Group identifies specific counterparties with a minimum short-term rating of A1/P1.
Counterparty credit risk is managed on a global basis by limiting the aggregate amount and duration of exposure to any one counterparty, taking into account its credit rating. The credit ratings of all counterparties are reviewed regularly.
The Group ensures that it has sufficient counterparty credit capacity of requisite quality to undertake all anticipated transactions throughout its geographic footprint, while at the same time ensuring that there is no geographic concentration in the location of counterparties.
The maximum exposure to the credit risk of financial assets at the balance sheet date is reflected by the carrying values included in the Group’s balance sheet. In addition, the Group has issued guarantees to third parties, part of which has been recognised on the balance sheet in accordance with IAS 39. The unrecognised portion of these guarantees amounts to £64 million (2009: £84 million).
The Group is exposed to equity price risk on equity investments held by the Group, which are included in available-for-sale investments on the Group balance sheet, but the quantum of such is not material.
In order to qualify for hedge accounting, the Group is required to document prospectively the relationship between the item being hedged and the hedging instrument. The Group is also required to demonstrate an assessment of the relationship between the hedged item and the hedging instrument, which shows that the hedge will be highly effective on an ongoing basis. This effectiveness testing is reperformed periodically to ensure that the hedge has remained, and is expected to remain highly effective.
Fair value estimation
The fair values of financial assets and liabilities with maturities of less than one year, other than derivatives, are assumed to approximate their book values. For other financial instruments which are measured at fair value in the balance sheet, the basis for fair values is described below.
Fair value hierarchy
The following table presents the Group’s financial assets and liabilities that are measured at fair value in accordance with the IFRS 7 classification hierarchy:
|Assets at fair value|
|Available-for-sale investments (note 15)||6||55||26||87|
|Derivatives relating to|
|– interest rate swaps (note 16)||139||139|
|– cross-currency swaps (note 16)||16||16|
|– forward foreign currency contracts (note 16)||109||109|
|– others (note 16)||4||5||9|
|Assets at fair value||10||324||26||360|
|Liabilities at fair value|
|Derivatives relating to|
|– interest rate swaps (note 16)||8||8|
|– cross-currency swaps (note 16)||51||51|
|– forward foreign currency contracts (note 16)||248||248|
|– others (note 16)||12||12|
|Liabilities at fair value||319||319|
|Assets at fair value|
|Available-for-sale investments (note 15)||5||54||24||83|
|– interest rate swaps (note 16)||108||108|
|– cross-currency swaps (note 16)||15||15|
|– forward foreign currency contracts (note 16)||118||118|
|– others (note 16)||4||4||8|
|Assets at fair value||9||299||24||332|
|Liabilities at fair value|
|– interest rate swaps (note 16)||1||1|
|– cross-currency swaps (note 16)||79||79|
|– forward foreign currency contracts (note 16)||127||127|
|– others (note 16)||14||14|
|Liabilities at fair value||221||221|
Level 1 financial instruments are traded in an active market and fair value is based on quoted prices at the year end. This category includes listed equity shares of £9 million (2009: £8 million).
Level 2 financial instruments are not traded in an active market but the fair values are based on quoted market prices, broker dealer quotations, or alternative pricing sources with reasonable levels of price transparency. Level 2 financial instruments include certain money market securities and most OTC derivatives.
The fair values of level 3 financial instruments have been determined using a valuation technique where at least one input (which could have a significant effect on the instrument’s valuation) is not based on observable market data. Level 3 financial instruments primarily consist of an equity investment in an unquoted entity which is valued using the discounted cash flows of estimated future dividends. The valuation assumes the following:
- future dividends grow by 2 per cent (2009: 2 per cent) and a 100 basis points decrease in the growth rate would result in the valuation being £2 million lower (2009: £2 million lower); and
- discount rate of 8 per cent (2009: 8 per cent) and a 100 basis points decrease in the discount rate would result in the valuation being £4 million higher (2009: £4 million higher).
The following table presents the changes in level 3 financial instruments:
|Beginning of year||24||24|
|Gains included in other comprehensive income||3||2|
|Differences on exchange||(1)||(2)|
|End of year||26||24|