Discounting cash flows back to 2015--use mid-year discounting?
Hey all, quick question about DCF valuation. If you're valuing a company right now (mid-2015), do you discount cash flows back to 2015, or do you account for the fact that it's the middle of the year? In other words, should you discount back to 2015.5?
Thank you all in advance!
When are you predicting "the deal" closes?
Do you want to know what the company is in theory worth tomorrow or at the end of a sellside process?
Right now I'm looking to see what the company is worth tomorrow, which is why I'd think to use mid-year discounting--what's the appropriate way to approach this?
Stub-year fraction
You discount by the number of years in your period. It shouldn't matter when you start. If you know ahead of time that your discount period will be a fraction of a year (e.g. September 1, 2015 through February 28, 2026) then you utilize a fraction (e.g. 10.5 years).
Thanks guys, really appreciate the help.
Mid-Year Discount (Originally Posted: 03/03/2016)
Hi WSO Community,
I had a conceptual question related to the mid-year discount Definition.
In reading the Mid Year Discount definition posted on the WSO site, it reads, "To account for this, a mid-year discount is used to assume that all the cash comes in halfway through the year to average it out."
Why exactly would this be averaging out the cash flow cycle? Could someone please explain?
Thank you!
If you're valuing a company using a DCF and not using a mid-year convention, you effectively are saying that all cash flows are received at the end of the year. Also, you are understating the value of the company (assuming free cash flow is positive).
As we all know, a dollar of cash flow earned on 1/1/16 is more valuable than a dollar of cash flow earned on 12/31/16. Because we don't know exactly when every dollar is earned during the year, we use the mid-year convention (e.g. 6/30/16) instead of year-end, which effectively allows you to assume that free cash flow is generated equally throughout the year.
Valuation Date: 3/31/16
5-Year Projections Period 1: 12/31/16 Period 2: 12/31/17 Period 3: 12/31/18 Period 4: 12/31/19 Period 5: 12/31/20 Period 6 (stub): 3/31/21
Should the discount period for CF1 equal 0.25?
Formula is: (12/31/16-3/31/16)/365-0.5 = 0.25
Period 1 = 0.25 2 = 1.25 3 = 2.25 4 = 3.25 5 = 4.26 6 = 4.50
And the Residual Value in Terminal Year I'm using a discount period of 5.0.
Is this correctly calculating the mid-year discount period?
Thanks!
This is correct assuming you're using the full year for 2016. If you're only using the remaining 9 months, it is different.
Why is period 6 4.50? Shouldn't it be the average of (end of period 5) and (end of period 6)?
Otherwise looks good
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