Mid-Year Convention Basics, Explained

The mid-year convention adjusts the discount factor to reflect that a company generates cash flows continuously throughout the year, not in a lump sum at year-end. Instead of discounting a year-t cash flow with (1 + r)^t, you use (1 + r)^(t - 0.5), as if the cash arrived at the midpoint of the year. This is applied to every cash flow, including the terminal value, to prevent systematically understating present value.

Directionally, the convention increases enterprise value, typically by 3-5% relative to end-of-year discounting, because each cash flow is discounted over a shorter period.

Follow-up pressure:

• If you apply mid-year to the explicit period but forget to apply it to the terminal value, what specific error does that introduce and how large is it for a WACC of 10%?
• Suppose you are valuing a business with highly seasonal cash flows, with 70% of cash arriving in the fourth quarter. Would the simple mid-year convention still be appropriate, or would you adjust? How?