Discounting and value
Mid-year discounting
Discount cash flows from the middle of each year — and treat the terminal value consistently.
18 minadvancedMembers
Learning objectives
- Explain why the mid-year convention exists
- Apply mid-year discount factors to forecast cash flows
- Discount the terminal value consistently with the method used
- Quantify the effect of the convention on enterprise value
A standard DCF discounts each year's free cash flow as if it all arrived on the last day of the year. In reality a business collects cash throughout the year. The mid-year convention assumes, on average, cash arrives halfway through: year 1 is discounted 0.5 years, year 2 1.5 years, and so on.
The effect is to raise the present value of every forecast cash flow by a factor of (1 + WACC)^0.5 — about 4.4% at a 9% WACC.
DFₜ = 1 ÷ (1 + WACC)^(t − 0.5)
- t
- forecast year (1, 2, … n)
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