Question

Which of the following statements is CORRECT? a. Variable costs need to be considered in the analysis of a capital budgeting project, but not fixed costs. b. Variable costs and fixed costs need to be considered in the analysis of a capital budgeting project. c. The NPV criterion is preferable for evaluating expansion projects, while the IRR criterion is preferable for evaluating replacement projects. d. The IRR criterion is preferable for evaluating expansion projects, while the NVP criterion is preferable for evaluating replacement projects. e. None of the above.

Answer 1

Answer: b

Both variable and fixed costs should be considered in capital budgeting.

Variable costs directly vary with production units; this includes direct material cost, direct labor cost, variable overhead, etc.

Fixed costs are static irrespective of volume of production; this includes depreciation cost, salary of office staff, and rent of building.

These are required to calculate future net cash flows, which are discounted for present value.

Other options are not correct:

NPV and IRR both are required for expansion or replacement project but there may be conflict between these two methods. Incase of conflict NPV should be preferred than IRR.