{"id":24225,"date":"2022-01-21T18:10:41","date_gmt":"2022-01-21T23:10:41","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=24225"},"modified":"2024-08-14T06:31:29","modified_gmt":"2024-08-14T11:31:29","slug":"mid-year-convention-dcf","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/mid-year-convention-dcf\/","title":{"rendered":"The Mid-Year Convention and Mid-Year Discounting in a DCF with Stub Periods"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">The Mid-Year Convention and Mid-Year Discounting in a DCF with Stub Periods<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/mid-year-convention-dcf\/#Mid-Year_Convention_Definition\">Mid-Year Convention Definition<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/mid-year-convention-dcf\/#How_the_Terminal_Value_Changes_with_the_Mid-Year_Convention\">How the Terminal Value Changes with the Mid-Year Convention<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/mid-year-convention-dcf\/#Should_You_Always_Use_the_Mid-Year_Convention\">Should You Always Use the Mid-Year Convention?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/mid-year-convention-dcf\/#The_Mid-Year_Convention_with_Stub_Periods\">The Mid-Year Convention with Stub Periods<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/mid-year-convention-dcf\/#The_Mid-Year_Convention_and_Stub_Period_in_the_Terminal_Value_Calculation\">The Mid-Year Convention and Stub Period in the Terminal Value Calculation<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/mid-year-convention-dcf\/#The_Mid-Year_Convention_and_the_Stub_Period_in_a_DCF_Final_Thoughts\">The Mid-Year Convention and the Stub Period in a DCF: Final Thoughts<\/a><\/li><\/ul><\/nav><\/div>\n\n<blockquote>\n<h2><span class=\"ez-toc-section\" id=\"Mid-Year_Convention_Definition\"><\/span>Mid-Year Convention Definition<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p> When you use the mid-year convention in a discounted cash flow (DCF) analysis, you assume that the company\u2019s cash flows arrive halfway through each year rather than at the end, more accurately reflecting reality and boosting the company\u2019s implied value in the DCF.<\/p><\/blockquote>\n<p>The mid-year convention is an additional feature of <a href=\"https:\/\/www.mergersandinquisitions.com\/dcf-model\/\" target=\"_blank\" rel=\"noopener\">DCF models<\/a> often used by <a href=\"https:\/\/www.mergersandinquisitions.com\/investment-banking\/\" target=\"_blank\" rel=\"noopener\">investment banks<\/a> and <a href=\"https:\/\/www.mergersandinquisitions.com\/equity-research\/\" target=\"_blank\" rel=\"noopener\">equity research teams<\/a>.<\/p>\n<p><a href=\"https:\/\/samples-breakingintowallstreet-com.s3.amazonaws.com\/Mastery\/08-17-Mid-Year-Stub-Discount-Simple-DCF.xlsx\" target=\"_blank\" rel=\"noopener\">Click here to get a sample Excel file with a simple DCF model that illustrates the mid-year convention<\/a>.<\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<p>You can see how it differs from the &#8220;standard convention&#8221; below:<\/p>\n<p><img decoding=\"async\" class=\"alignnone wp-image-24229 size-full\" title=\"Mid-Year Convention vs. Standard Convention in a DCF\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF.png\" alt=\"Mid-Year Convention vs. Standard Convention in a DCF\" width=\"1333\" height=\"263\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF.png 1333w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF-300x59.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF-1024x202.png 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF-768x152.png 768w\" sizes=\"(max-width: 1333px) 100vw, 1333px\" \/><\/p>\n<p>In a standard DCF model, you project a company\u2019s <a href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/unlevered-free-cash-flow\/\">Unlevered Free Cash Flow<\/a> over 5-10 years, estimate its <a href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/dcf-terminal-value\/\">Terminal Value<\/a> at the end of that period, and discount everything to Present Value.<\/p>\n<p>You then compare that Present Value figure to the company\u2019s current Enterprise Value (or back into the implied share price and compare that to the current share price) to determine if the company is valued appropriately.<\/p>\n<p>When you discount the company\u2019s future cash flows to their Present Value, you use periods such as 1, 2, 3, and 4 in a standard DCF analysis:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24226 size-full\" title=\"Standard Discount Periods in a DCF\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/01-Standard-Discount-Periods.png\" alt=\"Standard Discount Periods in a DCF\" width=\"964\" height=\"319\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/01-Standard-Discount-Periods.png 964w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/01-Standard-Discount-Periods-300x99.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/01-Standard-Discount-Periods-768x254.png 768w\" sizes=\"(max-width: 964px) 100vw, 964px\" \/><\/p>\n<p>In other words, to calculate the Present Value (PV) of a Free Cash Flow generated in Year 3, you use this formula:<\/p>\n<p>PV of Year 3 FCF = Free Cash Flow in Year 3 \/ ( (1 + Discount Rate) ^ 3)<\/p>\n<p>You can see this formula in Excel in the image below:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24227 size-full\" title=\"Standard Discount Formula\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/02-Standard-Discount-Formula.png\" alt=\"Standard Discount Formula\" width=\"954\" height=\"233\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/02-Standard-Discount-Formula.png 954w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/02-Standard-Discount-Formula-300x73.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075045\/02-Standard-Discount-Formula-768x188.png 768w\" sizes=\"(max-width: 954px) 100vw, 954px\" \/><\/p>\n<p>But that\u2019s <strong>not<\/strong> accurate because a period of \u201c3.000\u201d implies that all the company\u2019s FCF in Year 3 is generated <em>at the end of Year 3<\/em>.<\/p>\n<p>In reality, though, the company generates cash flow <strong>every day<\/strong>, and <em>on average<\/em>, that cash flow is distributed throughout the year (with exceptions for highly seasonal companies).<\/p>\n<p>So, it is more accurate to use discount periods such as 0.5, 1.5, 2.5, and 3.5 when you calculate the Present Value of Free Cash Flows:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24228 size-full\" title=\"Mid-Year Convention Impact on Free Cash Flow Discounting\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075044\/03-Mid-Year-Convention-Free-Cash-Flow.png\" alt=\"Mid-Year Convention Impact on Free Cash Flow Discounting\" width=\"954\" height=\"288\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075044\/03-Mid-Year-Convention-Free-Cash-Flow.png 954w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075044\/03-Mid-Year-Convention-Free-Cash-Flow-300x91.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075044\/03-Mid-Year-Convention-Free-Cash-Flow-768x232.png 768w\" sizes=\"(max-width: 954px) 100vw, 954px\" \/><\/p>\n<p>Using these discount periods in a DCF is known as the \u201cMid-Year Convention\u201d because you\u2019re assuming that the cash flows arrive midway through each year.<\/p>\n<p><strong>The company\u2019s Implied Value increases because the cash flows arrive earlier, and money today is worth more than money tomorrow.<\/strong><\/p>\n<p>To implement the mid-year convention, you discount each cash flow manually using the Present Value formula above, with discount periods based on 0.5 rather than whole numbers.<\/p>\n<p>Here is the traditional method vs. the Mid-Year Convention:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24229 size-full\" title=\"Mid-Year Convention vs. Standard Convention in a DCF\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF.png\" alt=\"Mid-Year Convention vs. Standard Convention in a DCF\" width=\"1333\" height=\"263\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF.png 1333w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF-300x59.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF-1024x202.png 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/04-Mid-Year-vs-Standard-Convention-DCF-768x152.png 768w\" sizes=\"(max-width: 1333px) 100vw, 1333px\" \/><\/p>\n<p>The PV of each Unlevered Free Cash Flow increases because it\u2019s generated earlier.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"How_the_Terminal_Value_Changes_with_the_Mid-Year_Convention\"><\/span><strong>How the Terminal Value Changes with the Mid-Year Convention<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>If you use the Multiples Method to calculate the Terminal Value in a DCF (e.g., assign a Terminal EBITDA Multiple to the company\u2019s <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebitda\/\" target=\"_blank\" rel=\"noopener\">EBITDA<\/a> in its final projected year), nothing changes.<\/p>\n<p>That\u2019s because the Terminal Multiple always applies to the company\u2019s financial metrics in the final projected year <em>at the end of that year<\/em> \u2013 regardless of when the cash flows in the projected period are generated.<\/p>\n<p>However, if you calculate the Terminal Value using the Perpetuity Growth method and use the <strong>mid-year convention<\/strong>, you need to use a discount period half a year earlier to discount the Terminal Value to its <a href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/present-value\/\" target=\"_blank\" rel=\"noopener\">Present Value<\/a>.<\/p>\n<p>Under this method, the Terminal Value is based on the company\u2019s <em>cash flows<\/em>, and with the mid-year convention applied, these cash flows are generated halfway through each year.<\/p>\n<p>Therefore, if the DCF projection period is 10 years, the Terminal Value is as of <em>Year 9.5<\/em> rather than <em>Year 10.0<\/em> under the mid-year convention and the Perpetuity Growth method.<\/p>\n<p>So, you use 9.5 rather than 10.0 in the Present Value formula, resulting in a higher implied value:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24230 size-full\" title=\"Mid-Year Convention - Terminal Value Differences\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/05-Mid-Year-Convention-Terminal-Value-Differences.png\" alt=\"Mid-Year Convention - Terminal Value Differences\" width=\"814\" height=\"407\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/05-Mid-Year-Convention-Terminal-Value-Differences.png 814w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/05-Mid-Year-Convention-Terminal-Value-Differences-300x150.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/05-Mid-Year-Convention-Terminal-Value-Differences-768x384.png 768w\" sizes=\"(max-width: 814px) 100vw, 814px\" \/><\/p>\n<p>You could adjust these calculations to make them comparable, but it\u2019s rarely the time and effort since the discrepancy is small (~2-3%).<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Should_You_Always_Use_the_Mid-Year_Convention\"><\/span><strong>Should You Always Use the Mid-Year Convention?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>While many banks use the mid-year convention in DCF models, it is <strong>not<\/strong> always appropriate.<\/p>\n<p>For example, if a retailer earns most of its sales in Q4 of the year due to the holiday shopping season, the bulk of its Free Cash Flow probably <em>is<\/em> generated at the end of the year.<\/p>\n<p>You may not want to use periods of 1.0, 2.0, etc., as they would imply that 100% of the FCF gets generated on December 31, but you could use periods such as 0.75 or 0.80 to \u201cweight\u201d the FCF generation slightly earlier.<\/p>\n<p>You would not want to use 0.5, 1.5, 2.5, etc., for the discount periods because this company\u2019s sales and FCF are not evenly distributed over the entire year.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"The_Mid-Year_Convention_with_Stub_Periods\"><\/span><strong>The Mid-Year Convention with Stub Periods<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Another trickier feature also results from timing differences: <strong>stub periods<\/strong>.<\/p>\n<p>When you value a company, <strong>much of its cash flow for the first projected year has already been generated<\/strong> (unless you\u2019re valuing it on January 1).<\/p>\n<p>So, you should <strong>reduce<\/strong> the cash flow for Projected Year 1 by the amount that the company has <em>already<\/em> generated.<\/p>\n<p>For example, if it\u2019s April 30, the company is expected to generate $300 in FCF for the year, and it has <em>already<\/em> generated $100, you subtract the $100 and use $200 for the FCF for the first period in a DCF:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24231 size-full\" title=\"Stub Period - Deduction for Cash Flow\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/06-Stub-Period-Deduction.png\" alt=\"Stub Period - Deduction for Cash Flow\" width=\"473\" height=\"182\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/06-Stub-Period-Deduction.png 473w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075043\/06-Stub-Period-Deduction-300x115.png 300w\" sizes=\"(max-width: 473px) 100vw, 473px\" \/><\/p>\n<p>But you <em>also<\/em> need to change the <strong>discount periods<\/strong> because April 30 to December 31 represents about 2\/3 of the year.<\/p>\n<p>This interval between April 30 and December 31 is called the <strong>stub period<\/strong>.<\/p>\n<p>To determine the discount period for this <strong>stub period<\/strong>, you take the remaining days of the year and divide by the total days in the year.<\/p>\n<p>There are 245 days between April 30 and December 31 and 365 total days in the year, assuming it\u2019s not a leap year.<\/p>\n<p>Since 245 \/ 365 = 0.671, 0.671 will be the <strong>discount period<\/strong> for this first year.<\/p>\n<p><em>Without<\/em> the mid-year convention, the first discount period in a DCF will be 0.671 rather than 1.000, the next period will be 1.671 rather than 2.000, and the next one will be 2.671 rather than 3.000.<\/p>\n<p>You subtract the already-generated cash flow only in the first period.<\/p>\n<p>The projected cash flow in all the subsequent years is the same because no cash flow for Years 2, 3, and beyond has been generated as of April 30 of Year 1.<\/p>\n<p>Here\u2019s what it looks like in Excel:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24232 size-full\" title=\"Stub Periods - FCF Deductions and Discount Periods\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075042\/07-Stub-Period-Deduction-Discount-Periods.png\" alt=\"Stub Periods - FCF Deductions and Discount Periods\" width=\"988\" height=\"390\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075042\/07-Stub-Period-Deduction-Discount-Periods.png 988w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075042\/07-Stub-Period-Deduction-Discount-Periods-300x118.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075042\/07-Stub-Period-Deduction-Discount-Periods-768x303.png 768w\" sizes=\"(max-width: 988px) 100vw, 988px\" \/><\/p>\n<p>You can also combine the stub period with the mid-year convention.<\/p>\n<p>If you do this, the first discount period will be the stub period fraction divided by 2.<\/p>\n<p>Continuing with the April 30 example, dividing by 0.671 by 2 produces 0.336.<\/p>\n<p>By doing this, you\u2019re assuming that the cash flow arrives <strong>midway<\/strong> between <strong>today<\/strong> \u2013 April 30 \u2013 and the <strong>end of the year<\/strong> \u2013 December 31.<\/p>\n<p>\u201cMidway between April 30 and December 31\u201d \u00a0means an exact date of August 31.<\/p>\n<p><strong>In each period AFTER that first one, you take the normal discount period and subtract 0.5.<\/strong><\/p>\n<p>Here are the normal and mid-year discount periods for a valuation date of April 30:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24233 size-full\" title=\"Mid-Year Convention and Stub Discount Periods\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/08-Mid-Year-Convention-Stub-Period-Discount-Periods.png\" alt=\"Mid-Year Convention and Stub Discount Periods\" width=\"1355\" height=\"467\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/08-Mid-Year-Convention-Stub-Period-Discount-Periods.png 1355w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/08-Mid-Year-Convention-Stub-Period-Discount-Periods-300x103.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/08-Mid-Year-Convention-Stub-Period-Discount-Periods-1024x353.png 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/08-Mid-Year-Convention-Stub-Period-Discount-Periods-768x265.png 768w\" sizes=\"(max-width: 1355px) 100vw, 1355px\" \/><\/p>\n<p>You do <strong>NOT<\/strong> keep dividing the \u201cNormal Discount Period\u201d by 2 \u2013 that\u2019s only in Year 1!<\/p>\n<p><strong>If you divided the Year 2 &#8220;Normal Discount Period&#8221; by 2, you\u2019d be assuming that the Year 2 cash flow arrives midway between April 30 of Year 1 and December 31 of Year 2.<\/strong><\/p>\n<p><strong>In other words, you\u2019d be incorrectly assuming that the <em>Year 2 cash flow<\/em> arrives on March 1 of Year 2.<\/strong><\/p>\n<p>But that\u2019s not what happens!<\/p>\n<p>Assuming that the Year 2 cash flow is evenly distributed, it should arrive on June 30 of Year 2 \u2013 \u00a0midway through <em>that year<\/em>.<\/p>\n<p>By using the correct discount period of 1.171 for Year 2, you\u2019re saying:<\/p>\n<p><strong>\u201cToday is April 30 of Year 1. We don\u2019t get any Year 2 cash flows in Year 1, so let\u2019s add the whole stub period of 0.671. We do get cash flows in Year 2, but they arrive midway through the year, so let\u2019s add 0.5 to reflect that we get them midway through Year 2. 0.671 + 0.500 = 1.171.\u201d<\/strong><\/p>\n<p>If you move forward another year, you add 0.671 for the remainder of Year 1, 1.000 for all of Year 2, and 0.500 for the cash flows that arrive midway through Year 3.<\/p>\n<p>That produces 2.171 for the mid-year discount period for Year 3, as shown above.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"The_Mid-Year_Convention_and_Stub_Period_in_the_Terminal_Value_Calculation\"><\/span><strong>The Mid-Year Convention and Stub Period in the Terminal Value Calculation<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>This <strong>stub period<\/strong> affects the PV of Terminal Value calculation because it <em>reduces<\/em> the time between today\u2019s date and the end of the projection period.<\/p>\n<p>So, if the stub period is 0.671, as in the example above, and you\u2019re <em>not<\/em> using the mid-year convention, you use 9.671 rather than 10.000 to discount the Terminal Value under both methods:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24234 size-full\" title=\"Stub Period Impact on Terminal Value\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/09-Stub-Period-Terminal-Value.png\" alt=\"Stub Period Impact on Terminal Value\" width=\"809\" height=\"383\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/09-Stub-Period-Terminal-Value.png 809w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/09-Stub-Period-Terminal-Value-300x142.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075041\/09-Stub-Period-Terminal-Value-768x364.png 768w\" sizes=\"(max-width: 809px) 100vw, 809px\" \/><\/p>\n<p>But if you use the stub period and the mid-year convention together, the discount periods are as follows:<\/p>\n<ul>\n<li><strong>Multiples Method:<\/strong> Still 9.671<\/li>\n<li><strong>Perpetuity Growth Method:<\/strong>171<\/li>\n<\/ul>\n<p>Once again, you need to \u201cmove back\u201d half a year under the Perpetuity Growth Method since it\u2019s based on the company\u2019s cash flows, which arrive halfway through each year under the mid-year convention.<\/p>\n<p>You can see the impact below:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24235 size-full\" title=\"Mid-Year Convention and Stub Period Impact on Terminal Value\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075040\/10-Mid-Year-Convention-Stub-Period-Terminal-Value.png\" alt=\"Mid-Year Convention and Stub Period Impact on Terminal Value\" width=\"811\" height=\"454\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075040\/10-Mid-Year-Convention-Stub-Period-Terminal-Value.png 811w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075040\/10-Mid-Year-Convention-Stub-Period-Terminal-Value-300x168.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075040\/10-Mid-Year-Convention-Stub-Period-Terminal-Value-768x430.png 768w\" sizes=\"(max-width: 811px) 100vw, 811px\" \/><\/p>\n<h2><span class=\"ez-toc-section\" id=\"The_Mid-Year_Convention_and_the_Stub_Period_in_a_DCF_Final_Thoughts\"><\/span><strong>The Mid-Year Convention and the Stub Period in a DCF: Final Thoughts<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>If you find these concepts confusing, we recommend <strong>skipping them<\/strong> and simplifying your models.<\/p>\n<p>The mid-year convention will never change the results of a DCF by more than a few small percentage points.<\/p>\n<p>Stub periods can potentially make a bigger difference, but they are unlikely to do so for most standard companies.<\/p>\n<p>They would matter if something unusual happened in the first portion of the first projected year that is <em>not<\/em> expected to recur in the second portion, such as a significant acquisition or <a href=\"https:\/\/breakingintowallstreet.com\/kb\/ma-and-merger-models\/divestitures\/\" target=\"_blank\" rel=\"noopener\">divestiture<\/a>.<\/p>\n<p>These features are <strong>bells and whistles<\/strong> in the DCF: nice to have but not essential in making investment decisions or client recommendations.<\/p>\n<p>Finally, these topics are <strong>unlikely<\/strong> to come up in interview questions unless you\u2019ve had significant work experience or <a href=\"https:\/\/www.mergersandinquisitions.com\/financial-modeling\/\" target=\"_blank\" rel=\"noopener\">financial modeling exposure<\/a>.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this tutorial, you&#8217;ll learn about the mid-year convention in DCF models, as well as stub periods, and how to combine these concepts in the FCF projections and Terminal Value calculations.<\/p>\n","protected":false},"featured_media":29308,"template":"","class_list":["post-24225","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-discounted-cash-flow-analysis-dcf"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/24225","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/29308"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=24225"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}