Module II· DCF — Mechanics & FCFBasic
Question
What is the mid-year convention and why is it used?
Answer
Mechanics
Cash flows arise evenly across the year and, on average, fall at mid-year. Discount factor: `1 / (1+WACC)^(t−0.5)` instead of `^t`.
Effect
A higher present value per cash flow, because the period is 0.5 years shorter.
Example
Inputs:
- Year-1 FCF: $100m
- WACC: 8%
Calculation:
```
End-of-Year: $100 / (1.08)^1 = $92.6m
Mid-Year: $100 / (1.08)^0.5 = $96.2m
```
When to use it
- Industrial companies with an even cash-flow profile: a good fit.
- Seasonal businesses (retail with a Q4 peak): end-of-year is more honest.