When Matt concocted his cleaning compound, some twenty years ago, all that his wife, Edith, and he were trying to do was to come up with a sweeter, gentler, yet tougher, cleaning product. Little did he realize that someday he would be the proud owner of a multi-million dollar firm debating whether or not to sell stock to the public? After having peddled vacuum cleaners and floor wax products at state fairs and trade shows throughout the Midwest, Matt and Edith Short realized that there was a dire need for a cleaning and polishing product that was free from harsh chemicals, environmentally friendly, and tough on dirt and grime. So Matt spent many hours in his garage at their country home in Appleton, Wisconsin, experimenting with various oils, cleansing agents, and extracts until he finally came up with what he proudly calls, "The perfect cleaner and polish." It was the pure citrus oil made from the peels of Valencia oranges that did the trick. Not only was the mixture sweet smelling, it was an effective solvent and degreaser which worked wonders on their kitchen cabinets at home. So spurred on by their close friends, the Shorts formed their company. Citrus Glow (which they later changed to Citrus Glow International), in December of 1984 and took their dog and pony show on the road. Initially they sold their products mainly through "word of mouth" advertising at state fairs, and home and garden shows, but later with the help of their 3 children, Dan, Joe, and Lisa, they used direct response television, direct mail, and e-commerce channels to help grow the company's revenues at a phenomenal rate. When the Home Shopping Network agreed to let them show off their merchandise about 5 years ago, major retailers like Wal-Mart and Costco took notice and started stocking Citrus Glow products on their shelves. Within twenty years, their sales had grown to over $500 million and their production facilities were beginning to feel the strain. Their product line had expanded to include air fresheners, soap bars, liquid soaps, spot removers, and a variety of cleaning tools. Through all this success, the Shorts always focused on customer need and satisfaction, always encouraging their customers to provide them with feedback and testimonials. Their latest addition, i.e. an industrial-strength cleanser and wood protector, seemed to be gaining wide acceptance both in the United States and overseas. Matt, who was nearing 75 years of age, knew that they would need to raise significant amounts of capital if they wanted to keep growing and expanding their product line. Still actively involved in the business, he had asked the rest of his family for their suggestions regarding the possibility of going public by issuing an initial public offering (IPO). Lisa and Joe strongly supported the idea because they felt that with competitors coming up with substitute products, they needed to stay ahead of the game. Dan, on the other hand, disagreed and recommended that they outsource the production and concentrate on their marketing efforts. He preferred that the fim stay private, thereby, relying less on extemal capital and retaining control. After carefully weighing all the factors, Matt decided to explore the possibility of raising the money via an IPO. "Dan, Lisa, and Joe," he said, "the three of you have MBAS from some of the most prestigious business schools in the country. I'm sure you guys can figure out WHAT WE ARE REALLY WORTH! I hate to depend totally on the investment banking folks to come up with the right price. Why don't the three of you put your heads together and figure out what is the minimum price that we should sell our stock for if we were to go public. Let's say we sell 30 million shares. I'm sure we can find a way of retaining control of a large portion of the shareholding and still raise the much- needed cash. Dan's point of loss of control is a good one, but I am not in favor of outsourcing production. Our success has come from our quality and that would likely be jeopardized if we let others produce the product." So Dan, Joe, and Lisa got to work. They realized that they would need industry and competitors' financial data. Table 1 presents key valuation data for 3 of their major publicly traded competitors in the personal and household products industry sector. Table 2 and 3 present Citrus Glow International's 3-year income statements and balance sheets respectively. Having worked on various valuation projects for a major consulting fim, Dan was a strong advocate of the use of comparables approach for valuing common stock. His method involved using price-eamings and price-sales ratios of comparable firms in conjunction with current values for the firm's earnings and sales respectively. Joe's old finance professor, Dr Larry Brown, on the other hand, had indoctrinated him in the art of common stock valuation via discounting of future dividends. "Use multiple- stage growth rate scenarios in conjunction with industry benchmarks, when valuing growth companies." was Dr Brown's advice. Accordingly, John decided to use a multiple-stage growth model to value the fim's equity. Lisa preferred to use the free cash flow model whereby the firm's total value was estimated as the sum of its discounted-free cash flows. Free cash flows were estimated by subtracting the fim's net capital spending and change in net working capital from the year's operating cash flows and were discounted at the firm's overall cost of capital (or 2 weighted average cost of capital). Lisa based her calculation on the free cash flows in 2014. She assumed that the fim's free cash flows would grow at a rate of 30% uring the first year, 20% during the second year, and then finally settle down to a long-term growth rate of 6% thereafter. The firm's market value of equity was calculated by subtracting out the firm's outstanding debt owed to creditors (i.e. long-term debt) from the overall value. Since their debt is not traded in the market, she used the book value of debt. "What will we do if our three estimates are totally different?" asked Lisa looking rather concerned. "We'll have to go back to the drawing table and examine our inputs," said the ever- resourceful Dan, We'll each have to be within a reasonable ballpark, or Dad's going to flip!" Questions: 1. What are advantages and disadvantages of going public? Do you agree with Dan's concerns or do you concur with the other members of the Short family regarding the issuance of an IPO? Explain why. 2. Dan used their 2014 earnings and sales, to be consistent with the ways the price ratios were calculated for competitors. If Dan took average price from estimation based on price-eamings ratio and price-sales ratio, what is Dan's price estimate using the comparables approach? What are the pros and cons of Dan's preferred approach? 3. What is Joe's price estimate if he were to use a 3-stage growth model with growth assumptions of 30% for the first 3 years, followed by 20% for the next two years, and a long-term growth assumption of 6% thereafter. Assume that the firm pays a dividend of $1.50 per share at the end of the first year after IPO. Joe decided to use CAPM to estimate the cost of equity. He assumed a risk-free rate of 4%, a market risk premium of 8%, and the average beta of the three competitors. 4. Lisa decided to use interest rate on their long term debt to proxy for cost of debt. To calculate the weighted average cost of capital, she relies on book values of equity and debt in 2014. She also used CAPM to estimate the cost of equity and used the same inputs as Joe did. She estimated net capital spending in 2014 as the sum of depreciation in 2014 and the change in fixed asset (from 2013). Based on her approach, what would Citrus Glow's selling prices per share be if they were to issue 30 million shares? How far off was her estimation from her brothers"? Why? 3 5. Based on all three estimates, how much per share do you think that Citrus Glow is really worth? Explain your rationale. Table 1: Key Valuation Ratios for Top 3 Competitors ompany A Company B Company C 22.8 Price/Earnings Price/Sales Dividend Yield 6 23.6 24.6 2.9 2.8 2.9 1.8 1.6 1.7 Beta 1.2 1.3 1.15 Recent Price $62.47 $57.29 $57.30 Table 2: Citrus Glow International's 3-year Income Statements 2012 2013 2014 Revenue 300,250,000 400,150,000 500,000.000 COGS (excluding depreciation) 147,122,500 184,069.000 255,000,000 Gross Profit 153,127,500 216,081,000 245,000,000 4,206,746 7,042,640 9,703,125 Depreciation Operating Expenses Earnings Before Interest & Taxes 87,072,500 141.653.100 140.000.000 61,848,254 67,385,260 95.296,875 8,006,250 Interest Expense Earnings Before Taxes 1,876,865 5,165,760 59,971,389 62.219.500 87,290,625 Income Taxes 23,988,556 24,887.800 34,916.250 Net Income 35,982,833 37.331,700 52.374.375 Table 3: Citrus Glow International's 3-year Balance Sheet 2012 2013 2014 Current Assets 45,573,081 57.621,600 64.687,500 Fixed Assets 42.067,459 70,426,400 97.031.250 Total Assets 87,640,541 128,048.000 161,718,750 Current Liabilities 3,128,108 8,609,600 13,343,750 Long-term Debt (@ 14% per year) 12,512,432 34,438,400 53.375,000 Owners' Equity 72,000,000 85,000,000 95,000,000 Total Liabilities and Owners' Equity 87,640,541 128.048.000 161,718,750