bat plc annual report 2007 - Notes on the accounts: Notes 25-27

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25 Cash flow

Cash generated from operations

Profit before taxation includes charges in respect of Group restructuring costs referred to in note 3(e). These are also reflected in the movements in depreciation, amortisation, inventories, receivables, payables and provisions above, and in the proceeds on disposal of property, plant and equipment shown in the Group cash flow statement. The cash outflow in respect of the Group restructuring costs was £170 million (2006: £177 million), of which £190 million (2006: £220 million) is included in cash generated from operations above.

Cash flows from investing activities

(a) Proceeds on disposals of intangibles

The cash inflow in 2007 reflects the sale of the pipe tobacco trademarks, while the cash inflow in 2006 reflects the trademark transfer agreements with Philip Morris (note 3(f)).

(b) Purchases and disposals of investments

Purchases and disposals of investments (which comprise available-for-sale investments and loans and receivables) include an inflow in respect of current investments of £65 million for the year to 31 December 2007 (2006: £41 million outflow) and £6 million sales proceeds from non-current investments for the year to 31 December 2007 (2006: £4 million).

(c) Purchases of subsidiaries and minority interests

In 2007, the cash outflow reflects the acquisition of minority interests in the Group’s subsidiaries in Africa and Middle East, Europe and Asia-Pacific. In 2006, the cash outflow principally reflects the cost of acquiring minority interests in the Group’s Chilean subsidiary (note 9).

(d) Proceeds on disposal of subsidiaries

In 2007, the cash inflow principally reflects the proceeds on the Group’s disposal of its Belgian cigar factory and associated brands. In 2006, the proceeds principally reflect the sale of Toscano in Italy (note 3(f)).

Cash flows from financing activities

(a) In 2007, reductions in borrowings principally reflect the repayment of MYR450 million medium term notes along with repayment of bank loans, whilst new borrowings principally reflect MYR400 million medium term notes and MYR100 million commercial papers. In addition, €800 million of €1.7 billion bonds with a maturity of 2009 were replaced by €1 billion bonds with a maturity of 2017.

In 2006, reductions in borrowing principally reflect repayment of €1 billion floating rate notes, a deutschmark1 billion Eurobond and a €500 million Eurobond, whilst new borrowings principally reflected €600 million Eurobonds with a 2014 maturity, £325 million Eurobonds with a 2016 maturity and €525 million floating rate notes with a 2010 maturity.

(b) The movement relating to derivative financial instruments is in respect of derivatives taken out to hedge cash and cash equivalents and external borrowings, derivatives taken out to hedge inter-company loans and derivatives treated as net investment hedges. Derivatives taken out as cash flow hedges in respect of financing activities are also included in the movement relating to derivative financial instruments, while other such derivatives in respect of operating and investing activities are reflected along with the underlying transactions.

26 Disposals of businesses and assets

(a) As described in note 3(f), the Group agreed to sell its pipe tobacco trademarks on 20 February 2007, sold its Belgian cigar factory and associated brands on 3 September 2007, and on 1 October 2007 agreed to terminate its Chesterfield license agreement with Philip Morris in a number of countries in Southern Africa. During 2006, the Group’s Italian subsidiary sold its cigar business on 19 July, while a cigarette trademark transfer agreement with Philip Morris for some brands in certain countries was completed on 29 November.

(b) At 31 December 2007, the Group had non-core assets in various locations being actively marketed for sale, comprising plant, property and equipment of £30 million, inventories of £3 million and other assets of £3 million. These assets are expected to be sold during 2008. Trade and other payables of £2 million have been shown as liabilities directly associated with assets held for sale. The effect of the reclassification of these assets and liabilities on reported segments is shown in note 2.

27 Share-based payments

During the period ended 31 December 2007, the following material share-based payment arrangements existed, which are described below:

Notes:

(a) The granting of options under this scheme ceased with the last grant made in March 2004. Eligible individuals are entitled to participate in the Long Term Incentive Plan and Deferred Share Bonus Scheme.

(b) Nil-cost options exercisable three years from date of grant, with payout subject to performance conditions based on earnings per share relative to inflation (50 per cent of grant) and total shareholder return, combining the share price and dividend performance of the Company by reference to two comparator groups (50 per cent of grant). Participants are not entitled to dividends prior to the exercise of the options. For grants made in 2005 and thereafter, a cash equivalent dividend will accrue through the vesting period and will be paid on vesting.

(c) Free shares released three years from date of grant and may be subject to forfeit if participant leaves employment before the end of the three year holding period. Participants receive a separate payment equivalent to a proportion of the dividend during the holding period.

(d) Options granted by invitation at a 20 per cent discount to the market price. Options are exercisable at the end of a three year or five year savings contract. Participants are not entitled to dividends prior to the exercise of the options.

(e) Options exercisable three years from date of grant and subject to earnings per share performance condition relative to inflation. Participants are not entitled to receive dividends in the period prior to the exercise of the options.

(f) Free shares granted (maximum £3,000 in any year) subject to a three year holding period and may be subject to forfeit if the employee leaves within this period. Participants are entitled to receive dividends during the holding period which are reinvested to buy further shares.

During the period, the Company operated a Partnership Share Scheme, which was open to all eligible employees, where employees can allocate part of their pre-tax salary to purchase shares in British American Tobacco p.l.c. The maximum amount that can be allocated in this way to any individual is £1,500 in any tax year. The shares purchased are held in a UK-based trust and are normally capable of transfer to participants tax free after a five year holding period.

Further details on the operation of share-based payment arrangements can be found in the Remuneration Report.

Share option schemes

Details of the movements for equity-settled share option schemes during the years ended 31 December 2007 and 31 December 2006 covering the Share Option and Sharesave Schemes were as follows:

In addition to the above options, the movement in nil-cost equity-settled options from the Long Term Incentive Plan was as follows:

*During 2007, equity-settled awards in respect of 300,107 options were modified to a cash-settled basis, while a further 54,877 options were replaced by cash-settled awards.

The weighted average British American Tobacco p.l.c. share price at the date of exercise for share options exercised during the period was £16.03 (2006: £13.94). A detailed breakdown of the range of exercise prices for options outstanding for the years ended 31 December 2007 and 31 December 2006 is shown in the table below:

The weighted average fair value of equity-settled share option schemes’ shares granted during 2007 was £9.94 (2006: £9.39).

Assumptions used in the Black-Scholes models to determine the fair value of share options at grant date were as follows:

*Where two figures have been quoted for the Long Term Incentive Plan, the first number represents the March 2007 award and the second number the May 2007 award.

**Where two figures have been quoted for the Sharesave Schemes, the first number represents the assumptions for the three year savings contract and the second number for the five year savings contract.

Market condition features were incorporated into the Monte-Carlo models for the total shareholder return elements of the Long Term Incentive Plan, in determining fair value at grant date. Assumptions used in these models were as follows:

*Where two figures have been quoted for the Long Term Incentive Plan, the first number represents the March 2007 award and the second number the May 2007 award.

The expected British American Tobacco p.l.c. share price volatility was determined taking account of the daily share price movements over a five year period. The respective FMCG and FTSE 100 share price volatility and correlations were also determined over the same periods. The average expected term to exercise used in the models has been adjusted, based on management’s best estimate, for the effects of non-transferability, exercise restrictions and behavioural conditions, forfeiture and historical experience.

The risk-free rate has been determined from market yield curves for government gilts with outstanding terms equal to the average expected term to exercise for each relevant grant. The expected dividend yield was determined by calculating the yield from the last two declared dividends divided by the grant share price, adjusted for the Group’s announced change in dividend policy.

For grants containing earnings per share performance conditions, the payout calculation is based on the expectations published in analysts’ forecasts.

Other equity share-based payment arrangements (other than share options)

Details of the movements of other equity share-based payment arrangements during the years ended 31 December 2007 and 31 December 2006, covering the Deferred Share Bonus and Share Reward Schemes, were as follows:

*During 2007, equity-settled awards in respect of 235,819 shares were modified to a cash-settled basis, while a further 56,457 shares were replaced by cash-settled awards.

The shares outstanding for the year ended 31 December 2007 had a weighted average contractual life of 1.2 years (2006: 1.1 years).

The fair value for other equity share-based payment arrangements granted during the period was determined using the Black-Scholes model with the following input assumptions at their grant date:

The weighted average fair value of other equity share-based payment arrangements granted during 2007 was £14.02 (2006: £13.14).

Cash-settled share-based payment arrangements

The Group issues to certain employees cash-settled share-based payments that require the Group to pay the intrinsic value of these share-based payments to the employee at the date of exercise. The Group has recorded liabilities at the end of 2007 of £28 million (2006: £14.3 million) of which £6.3 million (2006: £3.5 million) was in respect of vested grants. Fair value was determined from the Black-Scholes and Monte-Carlo models, using assumptions revised at the balance sheet date for cash-settled share-based payment arrangements. The Group recorded total expenses of £23.9 million in 2007 (2006: £9.3 million).

Details of movements for cash-settled arrangements in respect of the Share Option Scheme during the years ended 31 December 2007 and 31 December 2006, were as follows:

In addition to the above, the movement in other nil-cost cash-settled arrangements during the years ended 31 December 2007 and 31 December 2006, covering the Long Term Incentive Plan and Deferred Share Bonus Scheme, were as follows:

* As explained in the sections for share option schemes and other equity share-based payment arrangements above, during 2007 awards in respect of 647,260 shares were changed from an equity-settled to a cash-settled basis.

Assumptions used to determine the fair value of cash-settled share-based payment arrangements at date of grant, can be found in the sections relating to share option schemes and other equity share-based payment arrangements.

The weighted average British American Tobacco p.l.c. share price at the date of exercise for cash-settled share-based arrangements exercised during the period was £16.37 (2006: £14.05). A detailed breakdown of the range of exercise prices for cash-settled share-based payment arrangements outstanding for the years ended 31 December 2007 and 31 December 2006 are shown in the table below:

Share-based payment expense

The amounts recognised in the Income Statement in respect of share-based payments were as follows:

As explained in the sections for share option schemes and other equity share-based payment arrangements, during 2007 certain awards were changed from an equity-settled to a cash-settled basis. The fair value of the old and new awards were calculated using the valuation basis set out in the relevant sections of this note and the British American Tobacco p.l.c. share price at the date of the change. This resulted in a net incremental charge of £3.2 million, which was reflected in a £6.4 million increase in the expense for cash-settled payments and a £3.2 million decrease in the expense for equity-settled payments. The other main cause of the higher charge for cash-settled payments in 2007 is the increase in the British American Tobacco p.l.c. share price over the year.