Kmart Inc. And Builders Square
Posted: 14 Feb 2002
Synopsis: In 1997, Kmart received an offer from retail buyout specialists Leonard Green & Partners for the purchase of Builders Square, its ailing 162-store home improvement chain. Green's offer included a $10 million cash payment, a warrant to purchase a 28% stake in the new entity in the future, and the assumption of approximately $1.5 billion in non-cancelable Builders Square lease obligations. Kmart would remain contingently liable for the lease payments if the new entity were to fail. The questions posed include: 1) what is the value of the Builders Square subsidiary? 2) is the Green offer a good deal for Kmart? and 3) should Kmart accept the offer or hold out for a higher offer or additional buyers?
Teaching Purpose: This case has two objectives. The instructor may choose to emphasize one or the other depending upon the level of the class. An advanced corporate finance class would concentrate on the first objective, which is to understand the transfer of value that occurs when a parent firm guarantees the debt of a subsidiary (in this case, the parent guarantees the subsidiary's lease payments). The magnitude of this transfer can be substantial, and can continue to affect the parent firm even when it no longer owns the subsidiary. In Kmart's case, the guarantees meant that even though Builders Square appeared by all accounts to be a negative net-present-value project, Kmart had an incentive to keep it operating. The presence of the guarantees also implied that the value that Kmart realized from the sale of the subsidiary depended not only on the amount of cash that initially changed hands, but on the ongoing skill and creditworthiness of the buyer. An introductory finance class would touch on the first objective, but spend more time on the second, which is to value Builders Square using multiples. The case provides an opportunity for the instructor to present a rigorous approach to defining the proper set of "comparable" firms, so that students can learn that the definition of "comparable" depends upon the valuation method (or multiple) being used.
Keywords: Valuation, options, valuing loan guarantees, leases, buyout, multiples-based valuation
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