Web.config

How does asp.net decide which web.config to use? I have a web app & a web service. I have it configured as d:\webproject, with the webapp & websvc directories under this directory. In IIS, I added d:\webproject as a virtual directory, and the other 2 directories are under this directory (I pushed the "create" button for each of them). I have multiple versions of this application, and this seemed easier to keep them together. I have the web.config under the webproject directory, so that both the other 2 directories can reference it. It makes it easier to install this way, and seems to be getting the variables. I am being told that this is the "wrong way" and "things won't work". Is this correct? Also, in the webapp.vbproj file it has these lines:

<File
RelPath = "Web.config"
BuildAction = "Content"
/>

Is this saying that at execution, it will look in the current directory only? I tried changing it to "..\web.config" but it gave me errors.