Financial Review

MARKET PRICE RISK

The company and its reported results are exposed to financial market price movements. These risks principally arise from the interest and foreign exchange rate markets. In addition, through its UK defined benefit pension scheme (“the scheme” – see note 26), the company also has exposure to equity market price movements. The trustee directors are responsible for setting the risk management strategy for this scheme. During the year this scheme’s exposure to equity market price movements has markedly reduced. In early April 2006 the scheme’s assets were switched from being predominantly in equities (80%/20% equities/bonds) to being mostly in corporate bonds (20%/80% equities/bonds). A 10% movement in equity prices in any one year would give rise to a +/–£20 million movement in scheme assets and thus a corresponding movement in the underlying scheme deficit. Shortly after this asset switch, the scheme also undertook inflation and interest rate hedging actions. These actions, together with the closure of the scheme to future accrual with effect from 31 August 2006, were undertaken so as to increase the likelihood that the scheme’s assets (together with the company’s agreed future contributions) would be sufficient to meet its anticipated financial commitments to existing and future pensioners.

The company remains committed to funding the scheme’s existing IAS 19 pension scheme deficit, which at 31 December 2006 stood at £108 million (2005: £170 million). The company agreed a schedule of future company contributions with the scheme’s trustee in December 2005 that would eliminate this deficit by 2012.

INTEREST RATE RISK

The policy is to manage interest rate exposures on a 12-month rolling basis (measured quarterly). Unless otherwise agreed by the board, a minimum of 50% of the company’s estimated future interest rate exposures should be fixed (or capped) for a minimum period of nine months forward. Additionally, in the event that the company’s interest cover (measured by the ratio of adjusted operating profit to net interest payable) is forecast to fall below five times, any remaining un-hedged interest rate exposures for the forthcoming 12-month period should be immediately fixed (or capped).

Some 98% of the group’s net borrowings are currently at fixed rates of interest for 2007. Thereafter, in the event that interest rates rise or fall by 1% p.a. simultaneously across the group’s borrowings, the net interest payable by the group would then correspondingly increase or reduce by approximately £12.9 million on an annualised basis.

FOREIGN EXCHANGE RISK

Foreign exchange risk can arise as follows:

  1. from retranslation of overseas business profits into the sterling functional reporting currency of the company;
  2. from retranslation of assets and liabilities of overseas companies into the functional currency of the company;
  3. from cross-border trading transactions of group companies; and
  4. from the use of currency denominated borrowings and financial instruments used to finance business operations.

The company has a policy of not hedging foreign exchange translation risks outlined in 1 and 2 above. Further, the company has a policy of not hedging foreign exchange risks arising from cross-border trading activities given that these are immaterial.

The company policy is to fund its business operations centrally with borrowings that are substantially denominated (90% or greater) in the same actual or effective currencies*, and in the same proportion as the group’s forecast cash flows generated by the business.

*Actual or effective currency. The use of either actual currency borrowings or currency swaps is permitted. Currency swaps economically change the actual currency of borrowing into an effective amount, borrowed in a different currency. Currency swaps will be used in preference to actual currency borrowings when the all-in cost is cheaper than the alternative currency borrowings and/or they enable a closer match to the company’s debt maturity calendar.

CREDIT RISK

The company utilises financial instruments to manage financial risks that arise naturally from its business operations. Only group treasury personnel are authorised to deal such instruments on behalf of the company. The board has set strict policies for the use of such instruments. The company’s policy is to ensure that their use shall be:

  • strictly limited to the management of known or anticipated financial exposures which arise from the company’s existing or planned commercial operations;
  • only undertaken by suitably qualified or experienced group treasury staff;
  • undertaken only after efforts have been taken to avoid the need for use of such derivative instruments to manage the group’s financial exposures;
  • limited to the management of interest rate or foreign exchange exposures (i.e. no equity related or commodity hedging shall be undertaken without specific board approval);
  • undertaken only after the preparation of clear documentation which explains the purpose for the use of the specific derivative and its proposed financial accounting treatment;
  • capped by the maximum approved counterparty limit for that transaction; and
  • subject where relevant to detailed “hedge effectiveness” testing by group treasury, through to maturity of the transaction, if designated and documented as a “hedge” at the outset of the transaction.

The company further limits its exposure to credit risk on financial instruments by ensuring, where appropriate, that instruments used are subject to International Swaps and Derivatives Association market standard legal documentation.

The board also sets maximum counterparty approval limits for individual financial counterparties. These limits are reviewed and varied to take account of changes to the underlying credit rating of individual credit counterparties as required.

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