The Mid-Year Convention in a DCF

A standard discounted cash flow model assumes each year's cash flow arrives in one lump sum at year-end, so a cash flow one year out is discounted by a full year, two years out by two full years, and so on. But real cash, revenue collected, expenses paid, actually flows in throughout the year, roughly evenly, so treating it as arriving entirely on December 31 discounts it too harshly and understates its present value.

The fix is mechanically simple: instead of discounting year 1's cash flow by a full period, discount it by half a period; year 2's cash flow by 1.5 periods, and so on, shifting every discount period back by 0.5 years.

Worked example. Year-1 free cash flow is $100 million and the discount rate is 10%. Under the standard year-end convention, present value is $100 / 1.10^1 = \textdollar 90.9$ million. Under the mid-year convention, the discount period is 0.5 years instead of 1.0, so present value is $100 / 1.10^{0.5} = \textdollar 95.3$ million, about 4.8% higher, purely from timing the same cash flow half a year earlier.

The mid-year convention is applied to explicit-forecast cash flows and is sometimes also adjusted into the terminal value, though practitioners differ on whether the terminal value, which represents cash arriving far into perpetuity, should get the same half-year shift. Either way, it is a timing refinement, not a change to the cash flows themselves.