--- title: "Capital budgeting methods; most reliable" subject: "Project Engineering" chapter: 6 key: "semester_7/project_engineering:capital-budgeting-methods-reliable" source: https://www.bctengineer.com/q/semester_7/project_engineering/capital-budgeting-methods-reliable site: BCT Engineering --- # Capital budgeting methods; most reliable Project Engineering · Chapter 6: Introduction to Project Financing - Asked in: 2074 Asoj, 1+2+2 marks - Video: [Capital Budgeting, Capital budgeting techniques, capital budgeting process, business finance bcom,](https://www.youtube.com/watch?v=96KRkBfnpQ0) — DWIVEDI GUIDANCE - 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-methods-reliable - Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6 ## Question Define capital budgeting and explain its importance. What are the methodologies of evaluating projects financially and which method is most reliable? ## Short answer Capital budgeting is the process of evaluating long-term investments with large, irreversible commitments. Methods include payback, ARR, NPV, IRR, and PI; discounting methods like NPV are preferred. NPV is most reliable because it uses all cash flows, considers time value of money, and directly measures wealth increase. ## Answer #### Capital budgeting 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. 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. #### Methods of evaluating projects financially | Method | Rule | |---|---| | Payback period | Accept if payback is less than the standard period | | Accounting rate of return (ARR) | Accept if ARR is more than the required rate | | Net present value (NPV) | Accept if NPV > 0 | | Internal rate of return (IRR) | Accept if IRR > required rate (MARR) | | Profitability index (PI) | Accept if PI > 1 | | Benefit-cost ratio | Accept if B/C > 1 | - **Payback period:** time to recover the initial investment; simple, but ignores the time value of money and cash flows after payback. - **ARR:** average profit / average investment; ignores the time value. - **NPV:** present value of inflows less outflows at the required rate. - **IRR:** the discount rate that makes NPV zero. - **PI:** PV of inflows / initial investment. - **B/C ratio:** PV of benefits / PV of costs. #### Most reliable method The **NPV method** is the most reliable. It uses all cash flows over the project life, considers the time value of money, directly measures the increase in the firm's wealth, and avoids the multiple-IRR and ranking problems. IRR and PI are also good, but they can give wrong ranking for mutually exclusive projects of different size or cash-flow pattern. ## Check yourself The answer's key points as multiple-choice questions, with the correct option and why. 1. What is a weakness of the payback period? A. It ignores the time value of money and cash flows after payback B. It needs a discount rate C. It uses all cash flows D. It is hard to compute Answer: A. Payback only measures recovery time, ignoring time value and later cash flows. (Key point: Payback weakness) 2. IRR is: A. The rate that makes NPV maximum B. The rate that makes NPV zero C. Average profit over average investment D. PV of benefits over PV of costs Answer: B. IRR is the discount rate at which NPV equals zero. (Key point: IRR meaning) 3. Profitability index is: A. Initial investment divided by PV of inflows B. NPV divided by life C. PV of inflows divided by initial investment D. Average profit divided by investment Answer: C. PI = PV of inflows / initial investment; accept if PI > 1. (Key point: PI) 4. Why is NPV regarded as the most reliable method? A. It ignores discounting B. It is the simplest C. It gives the same ranking as payback D. It uses all cash flows, considers time value and measures increase in firm wealth Answer: D. NPV uses all cash flows, time value, directly measures wealth gain and avoids multiple-IRR and ranking problems. (Key point: Most reliable method) ## Related in Project Engineering - [Capital budgeting importance and techniques](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-importance-techniques) — 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 - [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 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; NPV](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-importance-npv) — Project Engineering, chapter 6 - [Capital budgeting needs, steps, process](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-budgeting-needs-steps-process) — Project Engineering, chapter 6