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.
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:
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
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.