Question

GeoTech Company will be holding an IPO of two million shares tomorrow. Market expectations are high for this IPO. The company is expected to pay $1.00 per share starting one year from now. The dividends are then expected to grow at a supernormal rate of 25% for three years, before dropping down to 15% for three more years, and then to 7% afterwards. The 7% growth is then expected to continue for the foreseeable future. What is the gross dollar amount that will be raised from this IPO if the required return for similar issues is 16%? Hint: The first dividend is $1.00.   

Answer 1

The three stage dividend discount model accounts for an aggressive growth in initial period, followed by an incremental increase or decrease and an eventual stabilization at a more moderte growth rate that assumed to continue for the life of the company.

It is calculated as D1/(1+r)+D1*(1+g1)/(1+r)^2+D1*(1+g1)^2/(1+r)^3+D1*(1+g1)^3/(1+r)^4+D1*(1+g1)^3*(1+g2)/(1+r)^5+D1*(1+g1)^3*(1+g2)^2/(1+r)^6+D1*(1+g1)^3*(1+g2)^3/(1+r)^7+((D1*(1+g1)^3*(1+g2)^3*(1+g3))/(r-g3))/(1+r)^7, where D1 is dividend paid next year, r is required rate of return and g1,g2 and g3 are growth rate of dividends in three stages.

So, On Substituting, we get,

(1/1.16)+(1*1.25/1.16^2)+(1*1.25^2/1.16^3)+(1*1.25^3/1.16^4)+(1*1.25^3*1.15/1.16^5)+(1*1.25^3*1.15^2/1.16^6)+(1*1.25^3*1.15^3/1.16^7)+((1*1.25^3*1.15^3*1.07)/(16%-7%))/1.16^7

= $19.547

Given that the IPO has 2 million shares outstanding. So, Gross Dollar amount that will be raised from the IPO= 2*19.547= $39.09 Million.