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, the Group’s exposure to funding and liquidity, interest rate, foreign exchange and counterparty risks. 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 and interest cover. Group policies include a set of financing principles 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 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 five years with no more than 20 per cent of centrally managed debt maturing in a single year. As at 31 December 2009, the average centrally managed debt maturity was 6.6 years (2008: 5.1 years) and the highest proportion of centrally managed debt maturing in a single year was 18.4 per cent (2008: 18.3 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. £187 million of ECP was outstanding at 31 December 2009.
The Group repaid a €900 million bond in February 2009 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 by a new MYR250 million bond in August 2009. 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.
In November 2009, the terms of €481 million of the €1.0 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.
On 13 February 2008, the Group entered into an acquisition credit facility whereby lenders agreed to make available an amount of US$2 billion. On 1 May 2008, this facility was syndicated in the market and was redenominated into two euro facilities of €420 million and €860 million; €395 million and €759 million were outstanding as at 31 December 2008 respectively. The €395 million was repaid in September 2009 and €759 million was repaid in October 2009. The €759 million 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 the year ended 31 December 2008, the €1.8 billion revolving acquisition credit facility arranged in December 2007 was cancelled and replaced with the issue of €1.25 billion and £500 million bonds maturing in 2015 and 2024 respectively. In addition to this, the Group increased its €1 billion (5.375 per cent, maturity 2017) bond by an additional €250 million in 2008, bringing the total size of the bond to €1.25 billion.
In 2008, the Group also issued US$300 million and US$700 million bonds, maturing in 2013 and 2018 respectively, pursuant to Rule 144A and RegS under the US Securities Act. The Group also repaid US$330 million and £217 million bonds upon maturity in May and November 2008 respectively.
In addition, in 2008, the Group repurchased its Mexican 2011 MXN1,055 million UDI bond and refinanced it with a floating rate borrowing of MXN1,444 million.
The Group continues to have a central banking facility of £1.75 billion, with a final maturity date of March 2012, which was undrawn as at 31 December 2009.
The Group utilises cash pooling and zero balancing bank account structures in addition to inter-company loans and borrowings to ensure that there is the maximum mobilisation of cash within the Group. 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 2009 the ratings from Moody’s and S&P were Baa1/BBB+ (2008: Baa1/BBB+ ) and these ratings were maintained throughout the year. The strength of the ratings has underpinned the debt issuance during 2009 and 2008 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 US$1 billion bonds in the US bond market towards the end of 2008, as well as issues in the euro and sterling markets in 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 2009, cash and cash equivalents include £669 million invested in money market funds (2008: £458 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. At 31 December 2009, the currency profile of the Group’s gross debt, after taking into account derivative contracts, was 11 per cent (2008: 14 per cent) US dollar, 54 per cent (2008: 55 per cent) euro, 4 per cent (2008: 3 per cent) Canadian dollar, 6 per cent (2008: 2 per cent) sterling, 8 per cent (2008: 7 per cent) Australian dollar and 17 per cent (2008: 19 per cent) other currencies.
The Group faces currency exposures arising from the translation of profits earned in foreign currency subsidiaries and associates; 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. All 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 £122 million higher (2008: £187 million higher) and items recognised directly in other comprehensive income being £268 million higher (2008: £427 million higher). A 10 per cent weakening of functional currencies against non-functional currencies would result in pre-tax profit being £152 million lower (2008: £216 million lower) and items recognised directly in other comprehensive income being £328 million lower (2008: £519 million lower).
The exchange sensitivities on items recognised directly in other comprehensive income relates 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 gross interest cover to be between 5 and 9 and for 2009 it is 8.6 times (2008: 8.5 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 (50:50 +/- 10) and net (at least 50 per cent fixed in the short to the medium term) basis 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 2009, the relevant ratios of floating to fixed rate borrowings were 48:52 (2008: 45:55) on a gross basis and 30:70 (2008: 25:75) 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 £35 million lower (2008: £52 million lower). A 100 basis point decrease in interest rates, or less where applicable, would result in pre-tax profit being £34 million higher (2008: £52 million higher). The effect of these interest rate changes on items recognised directly in other comprehensive income is not material in either year.