Creating Value from Financial Engineering  661 believes the bonds are undervalued (and because in this case bonds are simi- lar to equity, this must also mean that shares are undervalued). For example, when the Swiss-Swedish engineering company ABB announced a €775 mil- lion bond buyback in July 2004, its share price increased 4 percent on the day of the announcement. The stock market apparently saw the buyback as fur- ther evidence that the company was on a trajectory to recover from an earlier financial crisis. Divestitures of Noncore Businesses As discussed in Chapter 28, companies should regularly monitor whether there are businesses in their portfolio for which they are no longer the best owner. Such businesses could generate more value in the hands of new owners—for example, because of a buyer’s distinctive skills, better governance, superior insight and foresight, or strong synergies with their existing businesses. Ide- ally, portfolio monitoring should form an integral part of a cash deployment process where companies match investment needs across business with fund- ing opportunities from debt, equity financing, and divestitures, also keeping in mind payouts to shareholders. In recent years, BP, General Electric, and other companies have divested more than $40 billion in noncore assets, restructuring their corporate port- folios as well as strengthening their balance sheets. Similarly, Royal Philips divested significant parts of its portfolio, such as its lighting business, freeing up cash for investments in organic growth and acquisitions in its core health- care businesses. Such examples underline the importance of always consider- ing divestitures in cash deployment because they form an important source of funds as well as value creation. Creating Value from Financial Engineering Managing a company’s capital structure with financial instruments beyond straight debt and equity—our definition of financial engineering—typically involves complex and sometimes even exotic instruments such as synthetic leasing, mezzanine finance, securitization, commodity-linked debt, commod- ity and currency derivatives, and balance sheet insurance. In general, capital markets do a good job of pricing even complex financial instruments, and companies will have difficulty boosting their share prices by accessing so- called cheap funding, no matter how complex the funding structures are. Nev- ertheless, financial engineering can create shareholder value under specific conditions, both directly (through tax savings or lower costs of funding) and indirectly (for example, by increasing a company’s debt capacity so it can raise funds to capture more value-creating investment opportunities). However, 662  Capital Structure, Dividends, and Share Repurchases such benefits need to outweigh any potential unintended consequences that inevitably arise with the complexity of financial engineering. This section considers three of the more common tools of financial engi- neering: derivative instruments that transfer company risks to third parties, off-balance-sheet financing that detaches funding from the company’s credit risk, and hybrid financing that offers new risk/return financing combinations. Derivative Instruments With derivative instruments, such as forwards, swaps, and options, a com- pany can transfer particular risks to third parties that can carry these risks at a lower cost. For example, many airlines hedge their fuel costs with deriva- tives to be less exposed to sudden changes in oil prices. Of course, this does not make airlines immune to prolonged periods of high oil prices, because the derivative positions must be renewed at some point. But derivatives at least give the airlines some time to prepare business measures such as cost cuts or price increases. Derivatives are not relevant to all companies, and there are many exam- ples where the complexity around the use of derivatives has been badly man- aged.49 In general, derivatives are useful tools for financial managers when risks are clearly identified, derivative contracts are available at reasonable prices because of liquid markets, and the total risk exposures are so large that they could seriously harm a corporation’s health. Off-Balance-Sheet Financing A wide range of instruments fall under the umbrella of off-balance-sheet fi- nancing. These include, for example, real estate investment trusts (REITs), se- curitization, project finance, synthetic leases, and operating leases. Although the variety of these instruments is huge, they have a common element: com- panies effectively raise debt funding without carrying all the debt on their own balance sheets. Although they are still referred to as off-balance-sheet financing, new standards for U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) require that most of these instruments be recognized in the balance sheet, as is also the case since 2019 for operating leases and rentals. In most cases, off-balance-sheet financing is used to capture tax advan- tages. For example, many of the largest hotel companies in the United States don’t own most of the hotels they operate. Instead, the hotels themselves are owned by other companies, often structured as partnerships or REITs. Unlike corporations, partnerships and REITs don’t pay U.S. income taxes; taxes are 49 In the 1990s, some high-profile scandals—for example, at Metallgesellschaft and Orange County, California—underlined the need for such caution.