- 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.
Mid-year convention adjustment
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|
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:
Business value, standard discounted cash flow method
Business value adjusted for the mid-year convention
The mid-year convention result gives the business value that is 14% higher than the standard discounting valuation.
The difference grows as the discount rate increases. This makes sense – the more risky the business, the greater the importance of receiving the cash flows as early as possible.