---
title: "Capital budgeting; ARR numerical, Rs 100000"
subject: "Project Engineering"
chapter: 6
key: "semester_7/project_engineering:capital-budgeting-arr-numerical-c72"
source: https://www.bctengineer.com/q/semester_7/project_engineering/capital-budgeting-arr-numerical-c72
site: BCT Engineering
---

# Capital budgeting; ARR numerical, Rs 100000

Project Engineering · Chapter 6: Introduction to Project Financing

- Asked in: 2072 Chaitra, 1+2+2 marks
- Video: [16.ARR Calculation When Scrap & Working Capital is given from Capital Budgeting-Financial Management](https://www.youtube.com/watch?v=YgKyIKj1kvg) — Devika's Commerce & Management Academy
- Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14
- Page: https://www.bctengineer.com/q/semester_7/project_engineering/capital-budgeting-arr-numerical-c72
- Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6

## Question

Define capital budgeting decision. Explain its importance. Calculate ARR of a project with an initial cost of Rs 100000 and a salvage value of Rs 20000 after 5 years. The stream of income in years 1 to 5 are Rs 15,000; 20,000; 25,000; and 20,000 (as printed; four values given for five years). Tax rate is 25%. Assume a suitable method of depreciation.

## Short answer

Using straight-line depreciation (Rs 16,000 per year), average annual profit after tax is Rs 3,000 and average investment is Rs 60,000, yielding an ARR of 5.00%.

## Answer

#### Capital budgeting decision and its importance

**Capital budgeting** is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns. The capital budgeting decision is the choice to accept, reject or rank such investments.

**Importance:**

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

#### ARR calculation

Assumptions: the income given is the annual income before depreciation and tax; the printed list has only four values for five years, so the **year-5 income is taken as Rs 20,000** (the same as year 4); depreciation is by the **straight-line method**.

$$
\text{Annual depreciation} = \frac{100{,}000 - 20{,}000}{5} = 16{,}000
$$

| Year | Income | Depreciation | Profit before tax | Tax 25% | Profit after tax |
|---|---|---|---|---|---|
| 1 | 15,000 | 16,000 | -1,000 | -250 | -750 |
| 2 | 20,000 | 16,000 | 4,000 | 1,000 | 3,000 |
| 3 | 25,000 | 16,000 | 9,000 | 2,250 | 6,750 |
| 4 | 20,000 | 16,000 | 4,000 | 1,000 | 3,000 |
| 5 | 20,000 | 16,000 | 4,000 | 1,000 | 3,000 |
| Total | 100,000 | 80,000 | 20,000 | 5,000 | 15,000 |

(The negative tax in year 1 is the tax saving from the loss, set off against the other years' profit.)

$$
\begin{aligned}
\text{Average annual profit} &= \frac{15{,}000}{5} = 3{,}000\\
\text{Average investment} &= \frac{100{,}000 + 20{,}000}{2} = 60{,}000\\
ARR &= \frac{3{,}000}{60{,}000} \times 100 = 5.00\%
\end{aligned}
$$

**Answer: ARR = 5.00%** (on average investment). The project is accepted only if this is more than the firm's required rate of return.

## Check yourself

The answer's key points as multiple-choice questions, with the correct option and why.

1. Straight-line depreciation for cost 100,000, salvage 20,000, 5 years is:
   A. 20,000
   B. 16,000
   C. 24,000
   D. 8,000
   Answer: B. (100,000 - 20,000)/5 = 16,000 per year. (Key point: Depreciation)

2. In year 1 (income 15,000, depreciation 16,000, tax 25%), profit after tax is:
   A. -1,000
   B. 4,000
   C. -750
   D. 11,250
   Answer: C. PBT = -1,000; tax = -250; PAT = -750. (Key point: Profit after tax)

3. Average investment here is:
   A. 100,000
   B. 80,000
   C. 40,000
   D. 60,000
   Answer: D. (100,000 + 20,000)/2 = 60,000. (Key point: Average investment)

4. The ARR is:
   A. 5.00%
   B. 15.00%
   C. 25.00%
   D. 3.00%
   Answer: A. Average PAT = 15,000/5 = 3,000; ARR = 3,000/60,000 = 5%. (Key point: ARR result)

## Related in Project Engineering

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