Discounted Cash Flow (DCF): WACC, Mid-Year Convention and Terminal Value

Build unlevered free cash flow

Start with operating profit after tax, add back noncash depreciation and amortization, subtract capital expenditure and subtract investment in operating working capital. Debt repayments and dividends are financing decisions, not deductions in this unlevered operating valuation.

UFCF = EBIT × (1 − tax rate) + D&A − CapEx − Δ operating NWC
Operating EV = Σ[UFCFₜ / (1 + WACC)^t] + PV(terminal value)

Choose end-of-year or mid-year discounting

End-of-year discounting places each annual cash flow at years 1, 2 and so on. Mid-year discounting places it at 0.5, 1.5 and so on, approximating cash generated throughout the year. Do not automatically shift the terminal value by half a year: decide whether it represents a year-end asset value or a continuing stream with mid-year timing.

End-of-year discount factorₜ = 1 / (1 + WACC)^t
Mid-year discount factorₜ = 1 / (1 + WACC)^(t − 0.5)

Worked example: a steady business

Assume UFCF is $5m annually for five years, WACC is 10% and perpetual growth is 2%. End-of-year terminal value is $5m × 1.02 / (10% − 2%) = $63.75m. Discounted forecast cash flows total $18.95m and terminal value contributes $39.58m, giving operating EV of approximately $58.53m.

If you move only the explicit forecast cash flows to mid-year timing while keeping terminal value at year five, the explicit-period value increases to approximately $19.88m. Your model must document its terminal timing convention.

Bridge enterprise value to equity value

For an operating-asset valuation, add non-operating cash at the valuation date, subtract debt and other senior claims, and include other non-operating assets consistently. Cash generated within the forecast is already valued through UFCF; adding its projected accumulation again to present enterprise value generally double counts it. Retention may still affect economic value through reinvestment returns, taxes, restrictions or agency costs.

Review the assumptions, not just the headline

WACC must exceed perpetual growth for the Gordon growth formula. Test terminal margins, reinvestment, growth and discount rates. Negative forecast growth is valid, but a negative-to-positive earnings series does not have a meaningful conventional CAGR. diophos supports DCF sensitivity and explicit discounting conventions.