---
title: "Capital budgeting; importance; NPV"
subject: "Project Engineering"
chapter: 6
key: "semester_7/project_engineering:capital-budgeting-importance-npv"
source: https://www.bctengineer.com/q/semester_7/project_engineering/capital-budgeting-importance-npv
site: BCT Engineering
---

# Capital budgeting; importance; NPV

Project Engineering · Chapter 6: Introduction to Project Financing

- Asked in: 2071 Chaitra, 5 marks
- Video: [Net Present Value (NPV) explained](https://www.youtube.com/watch?v=N-lN5xORIwc) — The Finance Storyteller
- 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-importance-npv
- Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6

## Question

What is capital budgeting decision? Explain its importance. Discuss Net Present Value used in capital budgeting decision.

## Short answer

Capital budgeting involves selecting long-term investments; it's critical due to large, irreversible commitments affecting growth and risk. NPV is the difference between present value of cash inflows and outflows discounted at the cost of capital; accept if NPV>0, as it measures wealth increase and considers time value of money.

## 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.

#### 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.

#### Net present value

**Net present value (NPV)** is the difference between the present value of all cash inflows and the present value of all cash outflows, discounted at the required rate of return (cost of capital).

$$
NPV = \sum_{t=1}^{n}\frac{CF_t}{(1+k)^t} + \frac{S}{(1+k)^n} - I_0
$$

where $CF_t$ is net cash flow in year $t$, $k$ is the discount rate, $S$ is salvage value and $I_0$ is the initial investment.

- **Decision rule:** accept if NPV > 0; reject if NPV < 0; for mutually exclusive projects choose the highest NPV.
- **Advantages:** considers the time value of money, all cash flows and the size of the project; gives the gain in money terms; additive.
- **Limitations:** needs a correct discount rate; harder to explain; ranking can be misleading for projects of different size and life.

## Check yourself

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

1. NPV is:
   A. PV of all cash inflows less PV of all cash outflows at the required rate
   B. Sum of undiscounted inflows
   C. The discount rate making inflows zero
   D. Average profit divided by average investment
   Answer: A. NPV discounts cash flows at the cost of capital and subtracts outflows (including the initial investment). (Key point: NPV definition)

2. For mutually exclusive projects using NPV, you should:
   A. Choose the lowest positive NPV
   B. Choose the highest NPV
   C. Reject all positive NPV projects
   D. Choose the project with the smallest investment
   Answer: B. Accept if NPV > 0; among mutually exclusive projects pick the highest NPV. (Key point: NPV decision rule)

3. In the NPV formula, salvage value S is:
   A. Ignored
   B. Subtracted at year 0
   C. Discounted at (1+k)^n and added
   D. Added undiscounted
   Answer: C. Salvage received at the end of year n is discounted by (1+k)^n and added to PV of inflows. (Key point: NPV formula)

4. Which is a limitation of NPV?
   A. It ignores time value of money
   B. It ignores salvage value
   C. It cannot show gain in money terms
   D. It needs a correct discount rate and ranking can mislead for different size and life
   Answer: D. NPV depends on the discount rate and can mislead for projects of different size and life. (Key point: NPV limitations)

## Related in Project Engineering

- [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; ARR numerical, Rs 100000](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-arr-numerical-c72) — Project Engineering, chapter 6
- [Capital budgeting; ARR/ROE; attract private sector](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-arr-roe-private-hydropower) — 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 and its features](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-process-features) — 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

- [NPV and payback of a startup project](https://www.bctengineer.com/question.md?key=semester_7%2Fentrepreneurship_development%3Anpv-payback-startup-project) — Entrepreneurship Development, chapter 5
- [Decision procedure by critical value approach](https://www.bctengineer.com/question.md?key=semester_5%2Fprobability_and_statistics%3Adecision-critical-value-approach) — Probability and Statistics, chapter 6