# Discounted cash flow business valuation: using the mid-year convention

You thought the discounted cash flow method was challenging enough. And what about the mid year convention?

Let’s review the basics. One of the central business valuation techniques under the income approach is the discounted cash flow method. It lets you calculate the business value based on three fundamentals:

• Business earnings forecast, usually annual cash flows.
• Discount rate which captures business risk.
• Long-term business value, known as the terminal value.

The standard discounting valuation formula assumes that the business cash flows occur at the end of each year. However, a business may generate a smooth income stream throughout the year.

The typical way to handle such situations is to discount the cash flows as if they occurred in the middle of the year. This calls for just one simple adjustment to your discounted cash flow valuation result, multiplication by this factor: where D is the firm’s discount rate. You can calculate the equity discount rate by using the Build-Up model. If the company is financed by both debt and equity capital, use the weighted average cost of capital (WACC) iterative procedure.

### Example: Comparing discounted cash flow valuations with and without the mid-year convention.

Consider a company with the following cash flow forecast:

Year Expected Cash Flow
Year 1 \$953,770
Year 2 \$1,012,310
Year 3 1,070,850
Year 4 1,129,400
Year 5 \$1,187,940

Let us assume that the firm’s discount rate is 30%. The estimated long-term earnings growth rate is 5.53% which gives us the business terminal value of \$5,124,129.

With these inputs prepared, we next calculate the present value of the business using the standard discounting and then adjusting the result for the mid-year convention as follows:

\$3,915,542