What is the mid-year convention in a DCF, and what does it do to the value?

Explain that cash arrives through the year, so year one is discounted half a year, year two 1.5 years, and so on. Value rises about 4.9% at a 10% WACC, and an exit-multiple terminal value stays at year end.

The numbers, step by step

The example from the answer: $100 of year-one cash flow at a 10% WACC, then the stub from the follow-up.

Year one, discounted a full year$100 ÷ 1.10

$90.91

Year one, discounted half a year$100 ÷ 1.10^0.5

$95.35

Lift from half a year less1.10^0.5 − 1

4.9%

Stub midpoint, a quarter year left0.25 ÷ 2

0.125 years

Next full year's midpoint0.25 + 0.5

0.75 years

What the interviewer listens for

• Do you explain why cash is assumed to arrive mid-year?
• Do you give the discount periods: 0.5, 1.5 and so on?
• Do you say value goes up, and roughly by how much?
• Do you treat the two terminal value methods differently?

Common mistakes

• Saying the convention lowers value.Discounting for less time raises every present value.
• Pulling an exit-multiple terminal value to mid-year, which overstates it because a sale happens at year end.
• Thinking it changes the cash flows.Only the discount periods change.

Likely follow-ups

• Does it change the terminal value formula?No. Only the discount period changes, to N minus 0.5 for perpetuity growth under the common convention.
• How does it work with a stub period?The first period becomes half the stub. With a quarter of a year left, the stub's cash is discounted 0.125 years and the next full year 0.75 years.
• Is the mid-year convention more accurate?For most companies, yes, since cash comes in through the year. A business that earns most of its cash in one season needs its own timing.

More finance technicals

• Terminal value makes up most of your enterprise value. Is that a problem?
• A company with no debt, worth $10 billion with 100 million shares at $100, borrows $1 billion at 6% to pay a special dividend. What happens to its WACC, enterprise value, equity value and share price?
• Walk me through a DCF.
• What is WACC and how do you calculate it?
• What is the difference between enterprise value and equity value?

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