Why is the mid-year convention used in a DCF analysis?

The mid-year convention is utilized in a DCF analysis primarily to account for cash flows occurring throughout the year rather than just at the end. When using the mid-year convention, the cash flows are spaced out evenly within the year, allowing for a more accurate reflection of when those cash flows are expected to be received. This methodology recognizes that not all cash flows occur at the year-end; instead, they are often generated continuously.

By applying the mid-year convention, cash flows are discounted back to the current date with an assumption that they start being received at the midpoint of the year. This provides a more precise and realistic estimate of the present value of those future cash flows, as it acknowledges the time value of money over the entire period rather than compressing it to just a single point in time.

This approach contrasts with other methods, such as generating cash flow at the very end of each year or simplifying the discounting process, which do not take into account the timing of cash flows throughout the year in the same nuanced way. Utilizing a full-year timeframe for valuation also fails to offer the granularity that the mid-year convention provides.