What Is the Mid-Year Convention?
A standard DCF discounts year-one cash flow by one full year, year-two cash flow by two full years, and so on, implicitly assuming all cash lands on December 31. Real businesses collect cash every day, so the year-end assumption systematically over-discounts. The mid-year convention fixes this by treating each year's cash flow as if it arrives at the midpoint, on average, of that year.
Under the convention, discount periods shift from 1.0, 2.0, and 3.0 to 0.5, 1.5, and 2.5. Every cash flow is discounted for half a year less, so present values rise. The adjustment is small but meaningful, and most banking DCF templates include a toggle for it.
How the Math Works
The present value formula becomes PV = CF / (1 + r)^(t - 0.5) for each forecast year t. At a 10% discount rate, shaving half a year off every discount period lifts each cash flow's present value by a factor of 1.10^0.5, roughly 4.9%. A $100 million cash flow due in year three is worth $100 / 1.10^3 = $75.1 million under year-end convention but $100 / 1.10^2.5 = $78.8 million with mid-year discounting.
Terminal value treatment depends on the method. A perpetuity growth terminal value represents ongoing cash flows, so it is typically discounted using the mid-year period of the final forecast year. An exit multiple terminal value assumes a sale at the end of the forecast, a discrete event, so it is usually discounted using the full year-end period.
Why It Matters
The convention raises a DCF's output by roughly half a year of discounting, often 4% to 5% of total value at typical discount rates. On a $2 billion valuation that is an $80 to $100 million swing, large enough that sell-side bankers, who benefit from higher valuations for their clients, use mid-year discounting almost by default. Buyers and appraisers may prefer year-end convention for conservatism.
It is also a frequent technical interview topic. Strong candidates can explain why the adjustment exists, state the modified exponent, quantify the directional impact, and articulate why exit multiple terminal values are usually excluded from the mid-year treatment.
