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The period between the valuation date/transaction date and the beginning of the financial year is called a stub period. It is usually a fraction of a year or quarter. The stub period arises because valuations can be done throughout the year and not just at the end of a period.
A stub period can also arise if the valuation date and data of completion of the transaction are different.
The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality. Thus enters the midyear convention.
The midyear convention is the assumption that cash flows occur in the middle of the year.
Most DCF models assume that cash flows occur at the end of the year. This assumption causes the entire cash flows for the year to be discounted by a full year. A business whose cash flows occurs evenly during the year is penalized when you discount all its cash flows for an entire year. The midyear convention takes the midpoint of the year as the point in time that the year’s cash is received. The midyear convention discounts the first half of the period more than it should and the second half of the period less than it should – thereby averaging it out evenly. The midyear convention makes the midyear convention closer to reality and a better assumption for most companies.
The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality. Thus enters the midyear convention.
And thus enters the mid year convention! The midyear convention is the assumption that cash flows occur in the middle of the year.
In this article, we address what factors have the most weight on your decision to use a midyear convention?
The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality. Thus enters the midyear convention.