Advanced Qs Flashcards
Explain why we use the mid-year convention in a DCF.
To represent the fact that a company’s cash flow doesn’t arrive 100& at the end of each year, instead it comes in evenly throughout each year
- without mid-year convention, use discount period numbers of 1 for the 1st year, 2 for the second year, 3 for 3rd year, etc
- with mid-year convention, use 0.5 for 1st year, 1.5 for the 2nd year.
Final result is that the mid-year convention produces higher values since the discount periods are all lower.
What’s the point of a “stub period” in a DCF? Can you give an example?
When valuing a company before or after the end of its fiscal year and there are 1+ quarters between he current date and the end of the fiscal year
Stub period example:
Its sep 30, company’s fiscal year ends dec 31
Would not be correct to assume FCF only starts on jan 1, so calculate FCF in that 3 month period use discount period of 0.25, and discount period 1.25 for the first full year, 2.25 etc.
What discount period numbers would you use for the mid-year convention if you had a stub period – e.g. Q4 of Year 1 – in a DCF?
Rule is, divide stub discount period by 2 and simply subtract 0.5 from normal discount periods for the future years.
How does the Terminal Value calculation change when we use the mid-year convention?
When discounting the TV back to its PV, use different numbers for the discount period depending on whether you’re using the multiples method or GGM
- MM: add 0.5 to final year discount number to reflect that you’re assuming the company gets sold at the end of the year.
- GGM: use final year discount as is, as you are assuming free CFs grow into perpetuity and that they are still received throughout the year rather than just at the end
What if you have a stub period and you’re using the mid-year convention – how does Terminal Value change then?
It’s the same as what’s described above – a stub period in the beginning does not make a difference
