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DCF 6: Mid-Year Discounts and Stub Periods
Terms in this set (5)
1. Explain why we use the mid-year convention in a DCF.
• You use it to represent the fact that a company's cash flow does not arrive 100% at the end of each year - instead it comes in evenly throughout each year
• With the mid-year convention, we would instead use discount period numbers of 0.5 for the first year, 1.5 for the second year, 2.5 for the third year, and so on
• The end result is that the mid-year convention produces higher values since the discount periods are all lower
2. What's the point of a "stub period" in a DCF? Can you give an example?
• You use a stub period when you're valuing a company before or after the end of its fiscal year and there are 1 or more quarters in between the current date and the end of the fiscal year
• For example, it's currently September 30th and the company's fiscal year ends on December 31st
— In this case it wouldn't be correct to assume that Free Cash Flow only starts on January 1st of the next year, because there are still 3 months between now and the end of the year and the company still generates FCF in those 3 months
— To account for these 3 months, use 0.25 for the discount period, and then use 1.25 for the discount period for the first full year of the model, 2.25 for the next year and so on.
3. 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?
• Divide the stub discount period by 2, and then you simply subtract 0.5 from the "normal" discount period for the future years
• Need to find the mid-year discount period for the stub period (that's why you divide by 2)
• Also, you are still receiving cash flow midway through that first year, so you still use 0.5 for the period (that's why you subtract 0.5)
• It's about when you receive that cash flow in Year, from the perspective of the start of Year 1 - and then you add the total amount of time that passes between now and the start of Year 1
4. How does the Terminal Value calculation change when we use the mid-year convention?
• When you're discounting the Terminal Value back to its present value, you use different numbers for the discount period depending on whether you're using the Multiples Method or Gordon Growth Method
• Multiples Method: add 0.5 to the final year discount number to reflect that you're assuming the company gets sold at the end of the year
• Gordon Growth Method: use the final year discount number as is, because you're assuming the free cash flows grow into perpetuity and that they are still received throughout the year rather than just at the end
5. What if you have a stub period and you're using the mid-year convention - how does Terminal Value change then?
• It is the same as the previous answer - a stub period in the beginning does not make a difference
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