24 Financial instruments

The accounting policy change in 2005 reflected the application of IAS32 and IAS39 on financial instruments from 1 January 2005. The £42 million reduction in equity at that date reflected:

• the measurement of available-for-sale investments at fair value: £16 million gain;
  
• the recognition of derivative financial instruments and derecognition of deferred losses on derivatives: £65 million loss; and
  
• deferred tax asset of £10 million and deferred tax liability of £3 million in respect of the above adjustments.

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. Derivative contracts are only entered into to facilitate the management of these risks.

The Group's management of specific risks is dealt with as follows:

Liquidity risk

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. Furthermore, it is the policy that short term sources of funds (including drawings under US dollar and euro commercial paper programmes) are backed by undrawn committed lines of credit and cash.

During 2006, the Group's central banking facility at £1.75 billion was extended on existing terms under a one year extension option to a term of five years (plus a further one year extension option).

The Group continues to target investment-grade credit ratings; as at end 2006, the ratings from Moody's and S&P were Baa1/BBB+ (end 2005: Baa1/BBB+). The strength of the ratings has underpinned the success of the debt issuance during 2005 and 2006 and the Group continues to enjoy full access to the debt capital markets.

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.

Currency risk

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 and South African rand. These exposures are kept under continuous review and the Group's policy is to minimise all balance sheet translation exposure where it is practicable and cost effective to do so. The exposures are managed by matching currency assets with currency borrowings. At 31 December 2006, the currency profile of the Group's gross debt, after taking into account derivative contracts, was 25 (2005: 26) per cent US dollar, 48 (2005: 44) per cent euro, 5 (2005: 5) per cent Canadian dollar, 1 (2005: 12) per cent sterling, 12 (2005: 5) per cent Australian dollar and 9 (2005: 8) 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:

1. 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


2. 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.

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.

In order to manage its interest rate risk, the Group maintains both floating rate and fixed rate debt. The desired ratio of fixed to variable rate debt is determined as a result of regular reviews of market conditions and strategy by Treasury and the board of the main central finance company. At 31 December 2006, the ratio of floating to fixed rate borrowings was 58:42 (2005: 55:45). 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.

Credit risk

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.

Cash deposits and other financial instruments give rise to credit risk on the amounts due from bank counterparties. 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 counterparties are reviewed regularly.

Price risk

The Group is exposed to equity price risk on equity investments held by the Group. These are classified on the consolidated balance sheet as available-for-sale investments. The Group is not exposed to commodity price risk.

Hedge accounting

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 on-going basis. This effectiveness testing is reperformed periodically to ensure that the hedge has remained, and is expected to remain highly effective.

Fair value estimation

Derivative financial instruments

The fair values of derivatives are determined based on market data (primarily yield curves, implied volatilities and exchange rates) to calculate the present value of all estimated flows associated with each derivative at the balance sheet date. In the absence of sufficient market data, fair values have been based on the quoted market price of similar derivatives.

Other financial instruments

The fair values of financial assets and liabilities with maturities of less than one year are assumed to approximate to their book values. For financial assets and liabilities with maturities of more than one year, fair values are based on quoted market prices, market prices of comparable instruments at the balance sheet date or discounted cash flow analysis.

 25 Cash flow

Cash generated from operations

Profit before taxation includes charges in respect of Group restructuring costs referred to in note 3e.These are also reflected in the movements in depreciation, 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 £177 million (2005: £143 million), of which £220 million (2005: £143 million) is included in cash generated from operations above.

Cash flows from investing activities

(a) Proceeds on disposals of intangibles
The cash inflows in 2006 and 2005 principally reflect the sale of brands (note 3f).

(b) Purchases and disposals of investments
Purchases and disposals of investments (which comprise available-for-sale investments and loans and receivables) include an outflow in respect of current investments of £41 million for the year to 31 December 2006 (2005: £7 million decrease) and £4 million sales proceeds from non-current investments for the year to 31 December 2006 (2005: £15 million).

(c) Purchases of subsidiaries and minority interests
In 2006, the cash outflow principally reflects the cost of acquiring minority interests in the Group's Chilean subsidiary. In 2005, the cash outflow principally reflected the purchase of Restomat AG in Switzerland net of £6 million cash and cash equivalents in the acquired company (note 26).

(d) Proceeds on disposal of subsidiaries
In 2006, the proceeds principally reflect the sale of Toscano in Italy (note 26).

(e) Purchases of associates
The outflow in 2005 reflects the increase in the shareholding in Skandinavisk Tobakskompagni AS (note 11).

Cash flows from financing activities

1. In 2006 reductions in borrowings principally reflect repayment of €1 billion floating rate notes, a deutschmark 1 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.
   
   In 2005, reductions in borrowings principally reflect repayment of a US$400 million Eurobond, € 300 million floating rate notes and a deutschmark 500 million Eurobond, whilst new borrowings principally reflect a € 750 million Eurobond with a 2012 maturity.
   
   
2. 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 intercompany 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 Business combinations and disposals

1. The Group ceased to be the controlling company of British American Racing (Holdings) Ltd. (BAR) on 8 December 2004 when BAR went into administration. The Group consequently ceased to consolidate BAR from that date. On 7 January 2005, BARH Ltd., a newly formed joint venture between British American Tobacco and Honda Motor Co. Ltd. acquired the BAR business. On 4 October 2005, the Group announced that it had agreed the sale of its 55% shareholding in BARH to Honda and the sale was completed on 20 December 2005. For the period from 7 January 2005 to 20 December 2005, BARH was equity accounted, reflecting shared control with Honda.
   
   These transactions resulted in a net gain of £5 million in 2005, included in other operating income in profit from operations (note 3f).
   
   
2. On 25 November 2005, the Group acquired Restomat AG, the largest operator of cigarette vending machines in Switzerland, for a cash consideration of £25 million. The net assets acquired were £10 million of non-current assets and £15 million of current assets (including £6 million of cash and cash equivalents) less £2 million of non-current liabilities and £5 million of current liabilities. The acquisition resulted in goodwill of £7 million. In the period from 1 January 2005 to 25 November 2005, the profit from operations and the profit for the period was £2 million.
   
   
3. As described in note 3f , the Group's Italian subsidiary sold its cigar business on 19 July 2006.
   
   
4. In August 2006, the Group purchased minority interests in its subsidiary in Chile for a cost of £91 million, raising the Group shareholding from 70.4 per cent to 96.4 per cent . The goodwill arising on this transaction was £80 million and the minority interests in Group equity were reduced by £ 11 million.