Does mid-year convention result in a higher or lower valuation?

Does mid-year convention result in a higher or lower valuation?

• A. Lower valuation
• B. Higher valuation
• C. No change in valuation
• D. Cannot determine

Answer: (B)

Timing of cash flows drives present value. With the mid-year convention, cash flows are assumed to arrive halfway through each year rather than at year-end. That moves cash flows closer to the present, so you discount for less time and each cash flow is worth more today. For example, a $100 cash flow expected in one year at a 10% rate has a present value of about $90.91 under end-of-year timing, but about $95.37 under mid-year timing. With multiple cash flows, the effect adds up, yielding a higher overall valuation under the mid-year convention. So, mid-year convention results in a higher valuation.

Timing of cash flows drives present value. With the mid-year convention, cash flows are assumed to arrive halfway through each year rather than at year-end. That moves cash flows closer to the present, so you discount for less time and each cash flow is worth more today. For example, a $100 cash flow expected in one year at a 10% rate has a present value of about $90.91 under end-of-year timing, but about $95.37 under mid-year timing. With multiple cash flows, the effect adds up, yielding a higher overall valuation under the mid-year convention. So, mid-year convention results in a higher valuation.