--- title: "Capital budgeting; ARR/ROE; attract private sector" subject: "Project Engineering" chapter: 6 key: "semester_7/project_engineering:capital-budgeting-arr-roe-private-hydropower" source: https://www.bctengineer.com/q/semester_7/project_engineering/capital-budgeting-arr-roe-private-hydropower site: BCT Engineering --- # Capital budgeting; ARR/ROE; attract private sector Project Engineering · Chapter 6: Introduction to Project Financing - Asked in: 2070 Chaitra, 1+2+2 marks - 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-roe-private-hydropower - Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6 ## Question Define capital budgeting decision. Explain ARR or return on equity. Recommend appropriate measures that the Government should take to attract the private sector in hydropower projects. ## Short answer A capital budgeting decision accepts, rejects, or ranks long-term investments based on expected cash flows and return. ARR measures average annual profit after tax as a percentage of average investment; accept if above required rate. Recommended government measures: stable policy, one-window system, bankable PPAs, tax incentives, infrastructure, easy financing, and risk-sharing. ## Answer #### Capital budgeting decision **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 decision to accept, reject or rank such investments on the basis of their expected cash flows and return. #### ARR or return on equity **Accounting rate of return (ARR)** (also return on investment or return on equity) measures the average annual accounting profit as a percentage of the investment. $$ ARR = \frac{\text{Average annual profit after tax}}{\text{Average investment}} \times 100, \qquad \text{Average investment} = \frac{I_0 + S}{2} $$ Accept the project if ARR is more than the minimum required rate. It is simple and uses accounting data, but it ignores the time value of money and uses profit instead of cash flow. **Return on equity (ROE)** is similar: net profit after tax divided by shareholders' equity. **Example:** investment Rs 100, salvage Rs 20, average profit Rs 12 gives average investment = 60 and ARR = 12/60 = 20%. #### Measures the Government should take to attract the private sector in hydropower 1. Keep a **stable, clear policy and law** (Electricity Act, Hydropower Development Policy) that will not change suddenly. 2. A **one-window system** for licence, EIA, land and approvals, to reduce delay. 3. **Bankable PPAs** with fair tariff, annual escalation and payment guarantee by the Nepal Electricity Authority; a clear power export policy. 4. **Transmission lines and access roads** built by the government or shared in time. 5. **Tax incentives:** tax holiday, reduced royalty in early years, VAT and custom duty relief on equipment. 6. **Easy financing:** concessional long-term loans, hydropower bonds, a currency-risk hedging scheme and guarantees from the government. 7. **Land acquisition and security support**, and help with local community issues. 8. **Risk-sharing:** support for geological, hydrological and political risk, with insurance schemes. 9. **Transparent licensing** and protection of investors' rights, with dispute settlement. 10. **Local benefit sharing** (royalty to local government and shares to locals) to reduce local opposition. ## Check yourself The answer's key points as multiple-choice questions, with the correct option and why. 1. ARR is calculated as: A. Average annual profit after tax / average investment x 100 B. Total cash flow / initial cost C. Initial cost / annual cash flow D. PV of inflows / PV of outflows Answer: A. ARR = average annual profit after tax divided by average investment, times 100. (Key point: ARR formula) 2. Average investment equals: A. I0 only B. (I0 + S)/2 C. I0 x S D. I0 - S Answer: B. Average investment is the mean of initial investment and salvage value. (Key point: Average investment) 3. Investment Rs 100, salvage Rs 20, average profit Rs 12. ARR is: A. 12% B. 10% C. 20% D. 15% Answer: C. Average investment = 60, so ARR = 12/60 = 20%. (Key point: ARR example) 4. A limitation of ARR is that it: A. Uses cash flows with time value B. Cannot be computed C. Needs a discount rate D. Ignores time value of money and uses profit instead of cash flow Answer: D. ARR is simple but uses accounting profit and ignores time value. (Key point: ARR limitation) 5. Which measure best attracts private investors to hydropower? A. Bankable PPAs with fair tariff, escalation and payment guarantee B. Frequently changing policies C. Longer approval delay D. Removing tax incentives Answer: A. Bankable PPAs along with stable policy, one-window system and incentives reduce investor risk. (Key point: Private hydropower) ## Related in Project Engineering - [Capital budgeting; ARR numerical, Rs 100000](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-arr-numerical-c72) — Project Engineering, chapter 6 - [Sources of finance; ARR, payback, IRR, PI decision](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Aproject-finance-sources-investment-decision-c75) — Project Engineering, chapter 6 - [Finance sources; capital budgeting steps; NPV](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Asources-project-finance-steps-capital-budgeting) — Project Engineering, chapter 6 - [Capital budgeting; importance; NPV](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-importance-npv) — Project Engineering, chapter 6 - [Budgeting importance, types, capital budgeting](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Abudgeting-importance-types-capital-budgeting) — Project Engineering, chapter 6 - [Capital budgeting importance and techniques](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-importance-techniques) — Project Engineering, chapter 6 ## Related in other subjects - [HDP 2001 features and private sector](https://www.bctengineer.com/question.md?key=semester_7%2Fhydropower_engineering%3Ahdp-2001-private-sector) — Hydropower Engineering, chapter 1 - [Tendering and need in government sector](https://www.bctengineer.com/question.md?key=semester_8%2Fengineering_professional_practice%3Atendering-why-government) — Engineering Professional Practice, chapter 4 - [Hydropower project recommendation to government](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Ahydropower-multipurpose-bcr-60yr) — Engineering Economics, chapter 3 - [Institutions in Nepal's hydropower sector](https://www.bctengineer.com/question.md?key=semester_7%2Fhydropower_engineering%3Ainstitutional-setup-hydropower) — Hydropower Engineering, chapter 1, asked 2×