Capital budgeting represents one of the many tools used by banks to choose investments that will generate the highest rates of return. It assesses the potential profitability of proposed investments. The banking industry has market, credit and operational risks that are highly regulated. Any investment decision by banks must, therefore, take these and other factors into consideration through the capital budgeting process.
What is Capital Budgeting?
Banks and other organizations have limited capital available at any given time. Capital budgeting aims to find the best use of the available capital to maximize the return. The banking industry has numerous investment opportunities because other types of organizations with capital budgeting assessments come to banks for financing. Like any other enterprise, the bank has to assess the feasibility of every proposal by analyzing the net present value, risk and payback period for the proposed investment.
Net Present Value
Investment decisions utilize the net present value to identify cash flows by the cost of the investment from the sum of the cash flows present values. If the bank has a proposed investment with a positive NPV, the bank will consider the investment attractive and further analyze the specifics of the investment. NPV only considers the value of future cash flows in today’s dollars. Therefore, NPV is not a complete tool for analyzing the risks associated with investments. Banks will typically use NPV to make an initial assessment about an investment, but not to ultimately make investment decisions.
Risk assessment is one of the most important tools in capital budgeting. Banks have to properly assess risks because of the wide range of factors that can influence the success of any investment. The risk measure applied by banks should take into consideration the different assets, divisions and products the bank currently holds. Although each investment has an individual risk profile, the combination of the risks from all of the banks investments can help mitigate the bank's overall risk profile.
The payback period for most projects outside of the banking industry is anywhere between one and 10 years. Public projects often have even longer payback periods. Most of the investments a bank makes also have long payback periods. Mortgages, long-term projects and long-term bonds offered by banks typically have payback periods of 10 or more years. While these investments generate revenues for the bank over time, banks also want to consider other short-term investments that offer higher returns as part of the bank's overall capital budgeting.