Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 5

Discounting—Beyond the Basics

Introduction

Midyear Convention

Midyear Discounting Convention

Midyear Capitalization Convention

Midyear Convention in the Two-stage Model

Seasonal Businesses

Matching Projection Periods to Financial Statement Dates: Partial First Year

Changing Risk over Time

Midyear Convention in Two-stage Model with Changing Risk

Duration of an Investment

Summary

INTRODUCTION

In Chapter 4 we discussed the basics of capitalizing and discounting. In this chapter we will discuss refining the discounting and capitalization process.

In Chapter 4 we treated the discounting process as if the cash flows were expected to be realized at the end of each year. But what if the cash flows are expected to be realized regularly in an almost even pattern throughout the year? Or what if the cash flows are expected to be realized in only a few months (e.g., the busy season in a seasonal business)? How do we modify the discounting process to account for these patterns of expected cash flows?

The discounting process can also be modified to account for changing risks over time.

Further, discounting can be used in conjunction with the cash flows to better measure the average timing of the cash flows. Duration is a useful tool in matching the maturity of the cash flows with the appropriate discount rate.

MIDYEAR CONVENTION

In our examples in Chapter 4, we had assumed that net cash flows would be received by investors at the end of each period. Even if a company realizes cash ...