The Group’s principal financial instruments, other than derivatives, comprise bank loans, bond issues, loan notes, finance leases and cash. The main purpose of these financial instruments is to raise finance for the Group’s operations. The Group also has various other financial instruments such as trade receivables and trade payables, which arise directly from its operations.
The Group also enters into derivative transactions, primarily interest rate swaps and forward currency contracts. The purpose is to manage the interest rate and currency risks arising from the Group’s operations and its sources of finance. It is, and has been throughout the period under review, the Group’s policy that no trading in financial instruments shall be undertaken.
The main risks arising from the Group’s financial instruments are interest rate risk, foreign currency risk, credit risk and liquidity risk. The Board reviews and agrees policies for managing each of these risks and they are summarised below.
The following table analyses by classification and category all of the Group’s financial instruments (excluding short term debtors, creditors and cash in hand) that are carried in the financial statements. The values represent both the carrying amounts and the fair value.
The aggregate bond value above of £953.1m includes the GBP value of the US$ denominated bonds at 31 December 2008. To remove the Group’s exposure to currency fluctuations it has entered into currency swaps which effectively hedge the movement in the underlying bond fair value. The interest rate swap is being used to hedge the exposure to changes in the fair value of GBP denominated bonds. The fair value of the currency and interest swaps are disclosed in note 15 – Financial assets in the current year.
The fair value of financial instruments has been calculated by discounting the expected future cash flows at prevailing interest rates, except for unlisted equity securities and investment loans. Unlisted equity securities and investment loans are held at amortised cost.
The Group’s exposure to the risk of changes in market interest rates relates primarily to the Group’s long term debt obligations with floating interest rates.
The Group’s policy is to manage its interest cost using a mix of fixed and variable rate debts. To manage this, the Group enters into interest rate swaps, in which the Group agrees to exchange, at specified intervals, the difference between fixed and variable rate interest amounts calculated by reference to an agreed upon notional principal amount. These swaps are designated to hedge underlying debt obligations.
In February 2008, Capita executed a series of interest rate callable swaps to convert from paying a rate based on 6 month LIBOR to fixed rate interest on its bonds (private placement debt) of £479m as follows: firstly, in respect of the 2 tranches totaling £100m maturing in 2009, swaps at a fixed rate of 5.22%; secondly, in respect of all other tranches – maturing between 2012 and 2017 – callable swaps (giving the counterparty the option to cancel the trades in September/December 2009 and semi-annually thereafter) at a weighted average fixed rate of 4.64%. At this time, 6 month LIBOR was 5.625% and prevailing market expectations suggested that swap rates would not fall below 4.64%. At the time the transactions were entered into 4.64% was considered to represent good value as a long term cost of funds.
Following the dramatic fall in interest rates at the end of 2008 and an increase in the implied volatilities, these callable swaps show a negative mark to market value of £32m at 31 December 2008. This represents a non-cash accounting loss in the year that will reverse as the mark to market valuation will tend towards zero as the swaps approach maturity or cancellation.
In addition to the private placement debt of £479m referred to above, as at 31 December 2008 the Group had a further £200m of private placement debt and a £245m revolving credit facility, both of which pay floating rate interest. This gives the Group as a whole a balanced interest rate risk profile through the use of both fixed and floating rate debt.
The interest rate profile of the financial assets and liabilities of the Group as at 31 December is as follows:
The effect of the interest rate swap and the currency swap on the bond debt is disclosed below. Bonds are classified as floating rate for £200.2m due to the effect of the interest and currency swaps. The remainder of £480.0m is classified as fixed rate due to the additional impact of the callable swaps.
The following table demonstrates the sensitivity to a reasonably possible change in interest rates, with all other variables held constant, of the Group’s profit before tax (through the impact on floating rate borrowings). There is no impact on the Group’s equity.
The Group has exposure to foreign currency risk where it has investments in overseas operations which are affected by foreign exchange movements. The Group is not generally exposed to significant foreign currency risk except in respect of its overseas operations in India which generate exposure to movements in the INR/GBP exchange rates. The Group seeks to mitigate the effect of this exposure by entering forward currency contracts (in the form of Non-deliverable Forward Contracts (NDFs)) to fix the GBP cost of highly probable forecast transactions denominated in INR.
It is the Group’s policy to negotiate the terms of the hedge derivatives to match the terms of the hedged items in order to maximise hedge effectiveness.
At 31 December 2008, the Group had cash flow hedges in place to match its forecast monthly INR costs in 2009 and each year up to and including 2019. These forecast INR costs have been determined on the basis of the underlying cash flows, associated with the delivery of services under signed contracts which run to 2019.
The following table demonstrates the sensitivity to a reasonably possible change in the INR/GBP exchange rate, with all other variables held constant, of the Group’s profit before tax and the Group’s equity due to changes in the fair value of the Group’s forward exchange contracts.
The Group has in issue fixed rate dollar and sterling bonds which it has hedged through a combination of interest rate and currency swaps.
At 31 December 2008 and 31 December 2007, the Group had an interest rate swap in place with a notional amount of £87.0m whereby it receives a fixed rate of interest of 6.44% and pays a variable rate based on 6 month LIBOR. The swap is being used to hedge the exposure to changes in the fair value of £87.0m of the Group’s 6.44% bonds.
At December 2008 and December 2007, the Group had in place currency swaps whereby it receives a fixed rate of interest and pays a variable rate based on 6 month LIBOR. The currency swaps are being used to hedge the exposure to changes in the fair value of £518.2m of the Group’s bonds, which have coupon rates ranging from 5.57% to 6.47%.
The swaps are being used to hedge the exposure to changes in the value of its US dollar issued bonds. The unsecured bonds, currency and interest rate swaps have the same critical terms including the amount and the date of maturity (see note 21). The Group may, at its option, upon notice of not less than 30 days and not more than 60 days, repay at any time all or part of the notes at no more than the present value of future payments. In addition, the Group has covenanted to maintain a specified consolidated leverage ratio and a consolidated net interest expense coverage ratio.
In February 2008, as noted above in the section on interest rate risk, the Group entered a series of callable interest rate swaps which have effectively fixed the interest rate on £480.0m of the Group’s bonds; this includes £75.0m issued at floating rates in 2005 not mentioned as being hedged above. These callable swaps have not been designated as hedging instruments.
As noted above, the Group holds a series of forward exchange currency contracts in the form of NDFs designated as hedges of highly probable forecast transactions in INR of the Group’s Indian operations.
The terms of the forward currency contracts have been negotiated to match the terms of the commitments.
The cash flow hedges in respect of the highly probable forecast monthly costs, based on long term contracts that the Group has in place, denominated in INR up to 2019 were assessed to be highly effective and as at 31 December 2008, a net unrealised gain of £25.7m (2007: £5.6m) less deferred tax of £7.2m (2007: £1.6m) was recognised in equity. The net gain recognised on cash flow hedges during the year was £20.9m (2007: £5.6m) whilst net gains of £0.8m (2007: £nil) were reclassified to the income statement and included in administrative expenses. The tax effect of the net movement in cash flow hedges during the year was a charge of £5.6m (2007: £1.6m).
The Group trades only with recognised, creditworthy third parties. It is the Group’s policy that all customers who wish to trade on credit terms are subject to credit verification procedures. In addition, receivable balances are monitored on an ongoing basis with the result that the Group’s exposure to bad debts is not significant.
With respect to credit risk arising from the other financial assets of the Group, which comprise cash and cash equivalents, available for sale financial investments, investment loan, financial assets at fair value through the income statement, investment in a joint venture and certain derivative instruments, the Group’s exposure to credit risk arises from default of the counterparty, there is no concentration of counterparty risk and the Group takes all reasonable steps to seek assurance from the associated parties to ensure that it can manage any risk identified appropriately.
The Group has a maximum exposure equal to the carrying amount of the above receivables and instruments.
The Group has a master netting arrangement in respect of its banking facilities resulting in the legal right of set-off for its overdraft and cash balances.
The Group monitors its risk to a shortage of funds using a daily cash management process. This process considers the maturity of both the Group’s financial investments and financial assets (e.g. accounts receivable, other financial assets) and projected cash flows from operations.
The Group’s objective is to maintain a balance between continuity of funding and flexibility through the use of bank overdrafts, bank loans, loan notes, bonds and finance leases.
The table below summarises the maturity profile of the Group’s financial liabilities at 31 December 2008 based on contractual payments.
The primary objective of the Group’s capital management is to ensure that it maintains a strong credit rating and healthy capital ratios to support its business and maximise shareholder value.
The Group manages its capital structure, and makes adjustments to it, in the light of changes in economic conditions. To maintain or adjust the capital structure, the Group may adjust the dividend payment to shareholders, return capital to shareholders or issue new shares. No changes were made in the objectives, policies or processes during the years ended 31 December 2008 and 31 December 2007.
The Group does not set a target level of gearing but uses capital opportunistically to add value for shareholders. The key discipline adopted by the Group is to widen the margin between the return on capital employed and the cost of that capital as shown in the business review .
The table below presents quantitative data for the components the Group manages as capital:
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