Apply capital budgeting, valuation, investment analysis, and risk judgments at Day 3 breadth level.
Capital budgeting and valuation questions on CFE Day 3 usually ask whether a proposed action makes financial sense under uncertainty. The case may provide a partial calculation, ask for an interpretation, or require a quick setup using supplied facts. The expected response is compact, but it still needs judgment about cash flows, assumptions, risk, and strategic fit.
The main danger is false precision. A net present value, payback period, valuation multiple, or sensitivity result is only as useful as the assumptions behind it. A strong answer explains what the number means and what could make it unreliable.
This lesson focuses on investment and valuation decisions that can be handled at Day 3 breadth level. You should be ready to identify relevant cash flows, remove irrelevant or sunk costs, interpret supplied analysis, and recommend whether the decision should proceed, be revised, or require further information.
| Area | Day 3 use |
|---|---|
| Capital budgeting | Decide whether an investment creates value after considering cash flows, timing, risk, and constraints. |
| Valuation | Interpret an estimated value, valuation input, or purchase price in light of assumptions and evidence. |
| Investment analysis | Compare alternatives using contribution, relevant cost, payback, NPV, IRR, or strategic factors as appropriate. |
| Financial risk | Identify uncertainty in volume, margin, discount rate, financing, exchange exposure, concentration, or execution. |
A short investment response should focus on incremental cash flows. Include amounts that change because of the decision. Exclude sunk costs, allocated fixed costs that do not change, accounting depreciation unless it affects tax or cash, and financing costs if the valuation method already captures financing through the discount rate.
Common inclusions are:
| Cash flow item | Include when |
|---|---|
| Initial outlay | The asset, project, acquisition, or setup cost is required to proceed. |
| Working capital | Inventory, receivables, payables, or deposits change because of the decision. |
| Operating savings or margins | The proposal changes revenues, variable costs, labour, maintenance, or overhead cash flows. |
| Tax effects | The case facts support a tax shield, taxable gain, or cash tax consequence. |
| Terminal value or salvage | The asset or project has a disposal value or residual value at the end of the period. |
| Avoided costs | The cost would be incurred if the proposal is rejected and avoided if accepted. |
State assumptions briefly. If the case omits the discount rate, useful life, renewal risk, or expected volume, say how the missing information affects the reliability of the conclusion rather than refusing to conclude.
Candidates sometimes stop after calculating. A Day 3 response must interpret. For example, a positive NPV suggests the project may create value, but the recommendation still depends on financing capacity, assumption reliability, strategic fit, and risk tolerance. A short payback period helps liquidity but does not prove value creation if later costs or risks are ignored.
Use this interpretation discipline:
| Result | Strong interpretation |
|---|---|
| Positive NPV | Supports proceeding if assumptions are reasonable and funding is feasible. |
| Negative NPV | Suggests rejection or redesign unless qualitative benefits justify the loss and are clearly supported. |
| Fast payback | Improves liquidity and risk recovery, but does not measure full project value. |
| High valuation multiple | May be justified by growth and risk profile, but can overstate value if comparables are weak. |
| Strong sensitivity to volume | The recommendation depends heavily on sales assumptions and should include a risk response. |
| Conflicting methods | Explain which method better fits the decision and why. |
Valuation questions often turn on inputs rather than formulas. If a case gives EBITDA, maintainable earnings, net assets, or a comparable multiple, ask whether the input represents the future cash-generating ability of the business. Non-recurring revenue, owner compensation adjustments, customer concentration, pending litigation, obsolete inventory, and capital expenditure needs may all change value.
In an acquisition case, separate value from price. A company may be valuable but still not worth the asking price after integration risk, financing cost, due diligence findings, and strategic alternatives are considered. Conversely, a low price may still be unattractive if the target creates operational distraction, covenant pressure, or reputational risk.
Risk analysis should identify the assumption that matters most. Do not list every possible uncertainty. Focus on the assumption that changes the conclusion: volume, selling price, margin, discount rate, construction cost, lease term, renewal probability, customer retention, currency rate, or financing availability.
When a sensitivity result is supplied, translate it into action. For example, if the project only remains attractive when sales reach 90 percent of forecast, the recommendation could require signed contracts, staged implementation, a pilot, supplier price guarantees, or exit rights.
Use this approach for a Day 3 capital or valuation issue:
The conclusion should be proportional. If the case asks for a quick assessment, do not write a full valuation report. State enough technical support to justify the recommendation and then move to the business implication.
| Pitfall | Correction |
|---|---|
| Including sunk costs. | Focus on future cash flows that change because of the decision. |
| Treating accounting profit as project cash flow. | Adjust for non-cash items, timing, working capital, and capital spending. |
| Overrelying on payback. | Use payback for liquidity insight, not as the only value measure. |
| Ignoring assumption risk. | Identify the variable that could reverse the recommendation. |
| Recommending a transaction because the price seems low. | Consider financing, integration, strategic fit, due diligence, and risk. |