It gives us lots of pleasure to bring 3 rd edition of the CFP CM books. Its an earnest attempt done to simplified all topics keeping in mind the understanding and the examination, as CFP CM Exam is the most dynamic exam in the country, since lots of changes come day in day out due to changing marketing dynamics and regulatory requirement. In order to keep you abreast with these changes we have made special emphasis on online learning system also. How to read the study material: The chapter contains 1. Concept reading, 2. Check your progress 3. Assessment Test, 4. Online resources 1. Concepts Reading: Kindly make an attempt to understand the concept as such and not to read them as subjects. Concept reading will familiarize you with the required knowledge/approach to clear the exams. It also includes illustrations and concept checkers to give you the approach to solve all the practical problems 2. Check your progress: For most of the chapters Check your progress is given ,which will re-emphasize your learning. Solution of Check your progress is given at the end of every chapter. 3. Assessment test: Before you move to the next chapter you should take the assessment test and if you are scoring below 80% , then kindly again go through the concept again before moving to the next chapter. 4. Online Resources: After completing all the assessment test please go the online resources. How to use online resources: 1. Powerpoint Presentation: Summary of all the chapters is given in PPT format. This would help you to brush up the topics before attempting the online unit test 2. Unit Test: Before taking Full length online simulated test papers, you should again take the online unit test . 3. Simulated Test paper: Before you take the date of the exam, it is advisable to take the simulated test paper , if you get above 70% , then you can take the date of the exam at NSE. How to use IMS Proschool Study Program
Introduction to Financial Planning & Investment Planning 137 Limited Preview Edition This will help you to clear the exam in the first attempt. If you score below 70%, then please go through the concept book again and then take the simulated test paper 2. Other online resources: 1. News forum: Whenever you visit online please check the news forum first , this will keep you updated with all the new announcement and changes in the syllabus & examination structure etc. 2. Question & Answer Forum: If you have any doubt related to the questions given in the concept books and the questions appearing in the exam then please ask your question using this forum. You will get reply in three days from our faculty or from any other candidate who knows the answer . You can also give answer to any other questions to make the forum interactive 3. Share resources: If you come across any resources or questions which can be useful for other students then you can share using Share Resources Live Virtual Classroom (LVC) Live Virtual Classroom is one of the most advanced feature of IMS Proschool study program. This program is ideal for those who prefer real time learning of classroom, but have constraints in attending the classroom sessions. How to use LVC: Students those how are enrolled for this program, can see the online schedule on their online learning homepage. As per your suitability , you can register online for the classes. (Note: once register for particular class then you cannot attend same class again). Recorded sessions are also available. After registering for the class, you will get online invitation with user id and password to attend the class. With Best Wishes, Ankush Bhandari Product Manager IMS Proschool
Mr. Ravi is an investor who is going to meet his Financial Planner for advice. Before meeting him, he has noted down few questions that he would like to ask his financial Planner: 1. I want to go abroad for which I will need Rs.2 lacks after 5 years. How much I need to invest every year to get the required amount after 5 years (assuming a return of 12% p.a)?
2. How much I need to save every year to build a fund for my retirement expenses?
3. If I save Rs.5000 every month how much I will able to save in next 20 years for my daughter marriage?
These are some of the most common questions that you face day to day life. To answer these questions, knowing Basics of Time Value of Money or Financial Planning Mathematics is very important.
Time Value of Money: Concept and Calculation One of the most fundamental concepts in finance is that money has a time value. That is to say that money in hand today is worth more than money that is expected to be received in the future. This leads us to summarize the concept of time value: A Rupee today is worth more than a Rupee tomorrow." The purpose of this chapter is to introduce you to the concepts, terminology, and mathematics of the time value of money. Understanding this topic is crucial in understanding and calculating all sorts of financial questions in personal finance in general and investments in particular.
Time Value of Money for Even Cash flows Future Value (FV) This term refers to the value of a present cash flow (or series of cash flows) at a future date. Any cash flow that is scheduled to occur sometime later than today is referred to as a future value. Literally translated, future value means what would be worth of todays Rs 1 at some future point? For example, if an investment promises to pay Rs.100 one year from now, then the Rs.100 is the future value of the investment because that investment will be worth Rs.100 at that point in time. Or if you deposit Rs.500 every year for next ten years to get Rs.7000 after 10 years, then the Rs.7, 000 is the FV.
Present Value (PV) This term refers to the current (todays) value of a single or series of future cash flows. In other words, it is the amount that you would be willing to pay today in order to receive a cash flow (or a series of them) in the future. For example, if you invest Rs.50,000 and get Rs.100,000 after 5 years, then Rs.50,000 is the present value of the investment or if you deposit Rs.10,000 to get Rs.2000 for next 7 years, then Rs.10,000 is the present value.
Number of Periods (NPER) The total number of periods is a key variable in all time value of money questions. It is important to distinguish between the number of periods and the number of years. For example, when we refer to a 30-year Home Loan we are talking of 360 months or periods of repayment and not 30 years.
Payment (PMT) The payment is a series of cash flows. Typically, payment refers to all types of the cash flow in an annuity. For example, if you deposit Rs.500 every year for next 10 years to get Rs.20, 000. Then, Rs.500 is the payment (PMT). Common examples of Annuity/Payment are EMI, Pension, and Systematic Investment Plan (SIP) etc
Rate This is the rate that is used for compounding or discounting the future values or present values. For example, if you deposit Rs.10, 000 and earn 12% pa on your deposit, then 12% pa is the Rate.
Interest can be calculated in two ways:
a. Simple I nterest This is when interest is calculated only on the principal amount.
Where, SI = Simple Interest R = Rate of Interest T = Time period
For example, if you deposit Rs. 100 for 2 years at an interest rate of 8% p.a., then after one year, the interest you will earn would be: 100 x 8% = Rs. 8 and after 2 years : 100 x 8% x 2 =16
b. Compound Interest This is when the earned interest is also reinvested along with the principal and one receives interest on interest. For example, if you deposit Rs. 100 for 2 years at interest rate of 8% p.a., then after one year, the interest you will earn would be: 100 x 8% = Rs. 8
For the next year, you will not only earn interest on Rs. 100 but also on the interest that you earned in the first year i.e Rs. 8 and therefore you will earn interest on Rs. 108. 108 x 8% = Rs. 8.64
The generalized formula for calculating future value at compound interest can be stated as below:
FV = PV (1 + R) T = 100(1 + 8/100) ^2 = 108.64
SI =PV x R x T Note: In all the time value of money calculation, if rate is given 8% pa then it means 8%pa compounded annually (Unless, Simple interest is mentioned in the question)
How to Solve Time Value of Money (TMV) questions using Excel Functions:
Write the TMV terminology that you need to use to get the answer. For Example: After how many years your deposit of Rs.12, 000 will become Rs.20, 000 @15%. Answer: NPER Now Solve: 1. You need Rs.5,000 after 5 years. How much you need to deposit today? ___________ 2. You need Rs.500 every year for the next five years. How much you should deposit today? ______________ 3. You invest Rs.1, 000 every year for next 20 years. How much amount you will have after 20 years? ___________________ 4. How much you have to deposit every year to get Rs.5000 after 5 years @12% pa_______________ Benefits of Excel over Financial Calculator In the exam, you can use either Financial Calculator or Excel for solving TMV problems, but we strongly recommend students to use Excel to solve TMV problems because a. Easy to remember: All the formulas are given in Excel Fx b. Faster approach: c. Easy to verify d. Critical problem: Problems like Loan amortization are easy to solve on Excel sheet. e. Presentation Advantage: Financial calculations can be presented to the clients on Excel sheet f. Record keeping: All the calculation done on Excel sheet can be saved for future reference. More over for similar problems you just have to change the figures.
3. Select a Function: Select a function as per the requirement of Question. For example, if you want to find out the amount to deposit today so as to get Rs.10,000 after 5 years, then double click on PV:
Time Value of Money Calculations: 1. How much amount you have to deposit to get Rs.10, 00,000 after 10 years @12% pa.?
2. How many years will it take to make Rs.20,000 if you deposit Rs.5,000 per annum @15% pa.? Explanation: Nper =? Rate: 15% PV: -5000 FV: 20000
Ans: 9.9 years
Note: Whenever one is depositing/investing money , an outflow of cash occurs from ones pocket, then a negative sign precedes the amount. For example, in the above question, we have deposited Rs.100,000, so put negative sign before it i.e. -100,000. If you will receive some amount, then you dont have to put any sign before that, because any figure without sign is always considers as positive. For example in the 1st Example, we have put 1000,000 in FV rather than +1000,000.
3. At what rate of return will your investment of Rs.200,000 become Rs.500,000 in 12 years? Explanation: Rate:? NPER: 12 PV: -200000 FV: 500000
Ans: 7.9%
5.A Calculate the amount you will get after 5 years, if you deposit Rs.100 at the end of every year for five years at 12% pa. ? Explanation : FV = ? PMT: Rs.100 Rate: 12%
5.B Calculate the amount you will get if you deposit Rs.100 at the beginning of every year for five years @ 12% pa. Explanation: Rate: 12% NPER: 5 PMT: Rs.100 Type: 1
Note: In all Annuity/payment questions Type plays an important role. a. In the question no 5 A, when you deposit Rs.100 at the end of every year for 5 years, then in Type you have to put value 0 or simply omit it. This type of Annuity is called Ordinary Annuity b. In the question no. 5 B, when you deposit Rs.100 every year at the beginning for the next 5 years, and then in Type you have to put value 1. Type 1 means payment at the beginning of the year. This type of Annuity is called Annuity Due
Introduction to Financial Planning & Investment Planning 149 Limited Preview Edition Type 0 or 1 on Time Line A.
B.
When to use Type 1. Type is used only with annuity (PMT) Calculations 2. Whenever you invest regularly consider it at the end of the period and type 0 (Unless given in the question that investment at the beginning of period or investments starts from now/immediately) 3. Whenever you withdraw regularly , consider it at beginning of the period and use type 1 (Unless given in the question that withdrawal at the end of period is given)
5.C: How much amount you need to deposit to get Rs.20000 for ever @10% pa =Annuity amount/rate =20000/10% = 20000*100/10 = 200,000
Note: This type of Annuity is called Perpetual Annuity .This type of Annuity will provide you regular amount forever. In the above example, if you deposit Rs.200,000 @10% pa then, you will get Rs.20,000 forever.
Introduction to Financial Planning & Investment Planning 150 Limited Preview Edition Faster approach of solving TMV calculations on Excel sheets In the examination, you have to solve TMV problems frequently, that is why opening the Fx every time becomes time consuming. Another way of solving problem is to write the formulae Functions with in the cell of Excel : The table below shows various Excel Functions:
Solve questions using Excel Functions: How much amount you have to deposit today to get Rs.10,00,000 after 10 years @12% pa.?
6. . X is planning to send his daughter to college 18 years from now and will need Rs.100,000 at that time in order to pay for her tuition fee. Given annual rate of return of 8% per year, how much money he needs to invest every year to achieve the set goal? ___________________________
7. . X is planning to send his daughter to college 18 years from now and will need Rs.100,000 at that time in order to pay for her tuition fee. Given annual rate of return of 8% per year, how much money he needs to invest in the beginning of every year ( start now)to achieve the set goal?_________________________
8. You want to withdraw Rs.5,000 every year for next 20 years for your retirement expenses. Assuming an return of 10% pa , how much money you need have to achieve your goal? ____________________________
9. You require Rs.10,000 forever . How much you invest today @12% pa to get the required annuity?__________________________
10. Suppose that you are offered an investment that will cost Rs.925 and will pay you interest of Rs.80 per year for the next 20 years. Furthermore, at the end of the 20 years, the investment will pay Rs.1,000. If you purchase this investment, what is your compound average annual rate of return?_____________________________
Introduction to Financial Planning & Investment Planning 153 Limited Preview Edition TMV for Uneven cash flows Net Present Value: How much amount you have to deposit to get an annuity of Rs.1,000 every year for next 20 years @ 12% pa? To solve this question, you will use Present Value: = pv(12%, 20,1000) = Now, suppose you want to know how much you have to deposit to get Rs.4000 at the end of first year, 6000 at the end of second year, 8,000 at the end of third year & 10,000 at the end fourth year @12% pa? To solve the above problem, you cant use PV function as the cash flows are uneven. To get the present value of uneven cash flow, you have to use Net Present Value (NPV) function
Answer: 20,404.
I nternal Rate of Return: You are investing Rs.20,000 in a fund which will give back Rs.5000 for next five years. How much rate of return you are deriving from this investment? To answer this, you will use Rate =rate (5,5000,-20000) Now, suppose you are investing Rs.20,000 and will get Rs.6,000 after one year, Rs.8,000 after two years and Rs.10,000 after 3 years. How much rate of return you are getting in the above investment
Introduction to Financial Planning & Investment Planning 154 Limited Preview Edition To solve the above problem, you cant use Rate function as the cash flows are uneven. To get the rate of return of uneven cash flow, you have to use Internal Rate of Return (IRR) function
I llustrations: What is rate of return in an investment, where you deposit Rs.10,000 in first year and get RS.6,000 in third year,Rs.8,000 in 6 year and Rs.10,000 in seventh year.
Note: If for any period there is no investment/return, then put Zero in the year when you will not invest or get any amount.
1. If you make an investment of 1 lakh in a project initially and future cash flows at the end of every year are given as : 25000 15000 18000 17000 35000 25000 What is the rate of return you earned ?___________________________ 2. You have to make a following series of payments at the end of year (given rate of return 8 % pa) 12000 14000 18000 19000 29000 What amount should you deposit to take care of the payments ?______________________ 3. You have the option of receiving following payments at the end of each year:
a.Given the rate of return is 9 % which option would you choose ?___________________ b.If you had to make these payments which option you would choose ?_______________ Check Your Progress II I
Introduction to Financial Planning & Investment Planning 157 Limited Preview Edition As a financial planner, what option would you advice him to invest? Your decision will depend on how much annual return your client will get from the various options and this annual return is called Effective Annual rate of Return
CASE I Consider a stated annual rate of 10%. Compounded yearly, this rate will turn Rs.1000 into Rs.1100. However, if compounding occurs half yearly, Rs.1000 would grow to Rs.1102.50 by the end of the year, rendering an effective annual interest rate of 10.25%. Basically the effective annual rate is the annual rate of interest that accounts for the effect of compounding. Calculation: (1+ i/n) n -1 i = stated annual interest rate n = number of compounding periods =(1+0.1/2)^2 -1=0.1025 or 10.25% CASE I I Now suppose you are investing Rs.1000 every month in a Mutual Fund (SIP mode) for 1 year which gives a return12% pa. Note that the given return is annual, but you are investing monthly. Now if you apply rate = 12%/12 or 1%, (=fv (1%,12,-1000) it would be compounded every month and effective rates becomes = 12.68% (1 + (.12/12)) ^12 -1.Then you will get a return higher than the actual return. Therefore your monthly effective rate will be less than 1%, which after compounding 12 times in a year will become 12%. Monthly effective rate= (1 + R/100) ^ (1/npery) -1 (npery = no. of periods in a year). For the above calculation, monthly effective rate will be: = (1+ 12/100) ^ (1/12)-1 = (1.12)^(1/12)-1= .009489 or 0.9489% Then, future value of above mutual fund will be =fv (.9489%, 12,-1000) =12,646 Note: In the above question 10% will be nominal rate and 10.25% will be Annual Effective rate.
I nflation adjusted rate /Real rate of return How much did your investments really earn last year? You can calculate a rate of return, but if you dont adjust it for inflation, youre not getting the real rate of return. This is the difference between the nominal interest rate (before adjusting for inflation) and the real interest rate. You need to know the real rate, since that is the only number that means anything. Think of it this way: the nominal interest rate tells you the growth rate of your money, while the real interest rate tells you how much your purchasing power is growing. Growing Money For example, if you make a Rs.1,000 investment that earns 8% in one year, you end the year with Rs.1,080. In other words, your money has grown by Rs.80. This is called nominal rate of return. However if inflation is 3% for the year, your Rs.1,080 is only worth Rs.1,050. Inflation devalues your returns. Your real rate of return is approximately 5%. This is your inflation adjusted rate of return
Note: When to use effective rate of return? When ever annual rate is given but you are investing or withdrawing monthly/quarterly/daily/half yearly.For example you are investing Rs.1,000 monthly in a Mutual Fund with rate of return of 12% pa When not to use effective rate of return ? Whenever calculation involves products such home loan, car loan etc or any other products where it is mentioned that interest rate will be compounded .For example in National Saving Certificate (where 8% pa is compounded half yearly)
Introduction to Financial Planning & Investment Planning 159 Limited Preview Edition I llustration What is the real rate of return, if inflation rate is 5% and rate of returns for investments is 12%? = (1+.12/1+.05)-1 = .06667 or 6.6% Alternatively, Real rate of return = (interest rate inflation rate)/ (100+ inflation rate) Illustrations: (12-7)/(100+5) = 7/105 = .06667 or 6.6%
Bond Valuation: Bond Valuation and TMV A bond is a debt instrument issued with the purpose of raising capital by borrowing. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all bonds require a repayment of principal. A bond may be described in terms of par value ( the value stated on the face of the bond), coupon rate (interest rate payable to the bondholder) & maturity date ( the date when the principal amount is payable to the bondholder). For example, an issuer may sell a bond with a par value of Rs.1000, a coupon rate of 8% and maturity period of 5 years. The buyer of such bond would 1. You are taking a home loan of Rs.20 lac for 20 years at 12% pa. What will be your EMI? 2. You are investing in a mutual Fund Rs.1,000 monthly at 15% pa . What amount you will get after 5 years? 3. You are investing Rs.1,00,000 in a Bank Fixed Deposit for a term of 5 years at the rate of 9% pa ( Compounded Quarterly). What will be your maturity amount? 4. Rajendra has a retirement Fund of Rs.10 lac. How much annuity(Annuity Due) he can withdraw monthly for the next twenty years, if he is expecting the rate of return of 8% pa. 5. You are investing Rs.5,000 quarterly in a Mutual Fund SIP at the rate of return of 12% pa. How much amount you will get after 10 years? 6. You are investing in a fund which is giving a return of 12% pa. If inflation rate is 6%, then what would be real rate of return? Check Your Progress I V
To calculate the present value of the bond paying coupon half yearly you have to: 1. Divide rate by 2 i.e. 10%/2 = 5% 2. Multiply NPER by 2 i.e. 5 * 2 = 10 3. Divide Coupon by Rs.2 i.e 8/2 = 4 = pv (10%/2, 5*2,4,100)= 92.28
Zero Coupon Bond: In a Zero coupon bond, there will not be any coupon rate which means bond holder will not receive any regular payouts like Rs.8 in earlier question, but only Rs.100 or par value on maturity . Valuation of Zero Coupon Bond: A bond is available with a par value of Rs.100, maturing after 5 years. If you are expecting a yield of 10% pa, then how much will you pay for this bond? = PV(12%,5,,100)=56.74
Note: No value in PMT, because you will not get any regular amount in Zero Coupon bond.
Solution of Check your Progress 1. Sr.No Answer 1 Present value 2 Present value 3 Future value 4 PMT
2. Sr.no Answer Formula 1 161.051 =FV(10%,5,,-100) 2 -25024.90 =PV(8%,18,,100000) 3 8.043 =NPER(9%,,-1250,2500) 4 0.093 =RATE(18,,-20000,100000) 5 -6417.65 =PV(9%,10,1000) 6 -2670.20 =PMT(8%,18,,100000) 7 -2472.41 =PMT(8%,18,,100000,1) 8 -46824.600 =PV(10%,20,5000,,1) 9 83333.33 =10000/0.12 10 0.08 =RATE(20,80,-925,1000) 1. A bond (Face value Rs.1000) with 10 % coupon paying interest on a semi annual basis, is trading at 890 with maturity after 5 years . What is its Yield to Maturity (YTM) ? 2. You need a return of 12 % p.a. A 1000 rupee bond is trading at 925 with 3 years of maturity pays a coupon of 7%.At what price should you buy it ? 3. A bond with face value of 1000 coupon of 7.5% paying semi annually , will mature in 17.5 yrs.Similar bond in market with yield of 8 % would be available at what price ? 4. A Zero coupon bond of Rs.100 maturing after 4 years is available, how much price you will pay to buy the Bond , if your expected yield is 12%? 5. A Bond (face value Rs.1000), with 12% coupon paying interest on a quarterly basis, is trading at Rs.800 with maturity after 4 years. What is its Yield to Maturity? Check Your Progress V
Assessment Test: 1. Salim expects to pay out the following in next few years: to pay out these amounts how much should he have now, assuming an annual rate of 10%? End of Year 1: Rs. 25,000 End of Year 2: Rs. 22,000 End of Year 3: Rs. 19,000 End of Year 4: Rs. 16,000 End of Year 5: Rs. 13,000 a) 65908 b) 66905 c) 68868 d) 74184 2. A 10 year bond pays a coupon of 10% p.a. with interest paid semiannually. The Yield on the bond is 11%. Find its current price assuming Face Value of 1000. a) 956.91 b) 1,050.43 c) 986.36 d) 940.25 3. If the pre tax return on a security is 10.00%, the real post-tax return would amount to _______% if the inflation rate is 3% & income tax rate is 20%. a) 4.85% b) 3.51% c) 4.30% d) 3.12%
4. If you borrow Rs.500000 for a house @ 8.25% p.a.(compounding monthly) for 20 years, what is your monthly payment? a) 5,343 b) 4,260 c) 5,433 d) 3,134
5. In 1971, a breakfast used to cost Rs. 10. If the cost has increased to Rs. 55 now, what is the effective annual rate of inflation over the period from 1971 to 2010? a) 4.47% b) 6.63% c) 7.84% d) 450.00%
6. At an interest rate of 8%, compounded semi-annually, how long does it take a given sum to triple in value? a) 14.5 years b) 16 years c) 28 years d) 29 years
7. Chris wants Rs.300,000. She currently has a balance of Rs.100,000 and earns 8% per year, compounded quarterly. How long will it take for Chris to accumulate the money a) 13 years and 10 months b) 18 Years and 9 months c) 29 years d) 19 years
8. Which of the following selections has the lowest present value if the discount rate is 5%? The first cash flow occurs at the end of the first period, the second cash flow at the end of the second period, and so on. a) Rs.100; Rs.100; Rs.100; Rs.100 b) Rs.0; Rs.0; Rs.0; Rs.500 c) Rs.350; Rs.0; Rs.0; Rs.0 d) Rs.50; Rs.50; Rs.50; Rs.375
9. Arijit has taken a home loan of 30 lakhs @ 8.25% p.a. for 20 years. What is the EMI? a) 23416 b) 25387 c) 25006 d) 25,561
Introduction to Financial Planning & Investment Planning 167 Limited Preview Edition 10. A bond pays a coupon of 10% annually with interest paid semiannually. The bond has a duration of 6 years. The Yield on the bond is 11%. Find its current price assuming Face Value of 1000. a) 956.91 b) 1,050.43 c) 922.83 d) 986.36
11. If the pre tax return on a security is 8.00%, the real post-tax return would amount to _______% if the inflation rate is 3% & income tax rate is 20%. a) 2.97% b) 3.51% c) 3.30% d) 3.12%
12. If you want to spend a sum equivalent to Rs. 5000 p.a. for the next 5 years when the rate is 5% you need _________ today.
a) Rs. 22647 b) Rs. 20647 c) Rs. 21647 d) Rs. 23647
13. Raju wants to go on a foreign holiday at the end of every alternate year. It is expected to cost him Rs. 2 Lakh per trip. How much corpus will Raju require to invest so that he can take care of this requirement till perpetuity? Rate of return is 8%. (Round off to nearest lakh)
Lots of time investor would ask for an avenue having maximum returns with minimum risk. Is it possible for a Financial Planner to provide maximum return with minimum risk? , its like asking for S Class Mercedes with a CNG fittings! Chapter - 3 889999 Measurement of Risk
It gives us lots of pleasure to bring 3 rd edition of the CFP CM books. Its an earnest attempt done to simplified all topics keeping in mind the understanding and the examination, as CFP CM Exam is the most dynamic exam in the country, since lots of changes come day in day out due to changing marketing dynamics and regulatory requirement. In order to keep you abreast with these changes we have made special emphasis on online learning system also. How to read the study material: 1. Concepts Reading: Kindly make an attempt to understand the concept as such and not to read them as subjects. Concept reading will familiarize you with the required knowledge/approach to clear the exams. It also includes illustrations and concept checkers to give you the approach to solve all the practical problems 2. Check your progress: For most of the chapters Check your progress is given ,which will re-emphasize your learning. Solution of Check your progress is given at the end of every chapter. 3. Assessment test: Before you move to the next chapter you should take the assessment test and if you are scoring below 80% , then kindly again go through the concept again before moving to the next chapter. 4. Online Resources: After completing all the assessment test please go the online resources.
How to use online resources: 1. Powerpoint Presentation: Summary of all the chapters is given in PPT format. This would help you to brush up the topics before attempting the online unit test 2. Unit Test: Before taking Full length online simulated test papers, you should again take the online unit test . 3. Simulated Test paper: Before you take the date of the exam, it is advisable to take the simulated test paper , if you get above 70% , then you can take the date of the exam at NSE. How to use IMS Proschool Study Program
Introduction to Financial Planning & Investment Planning 137 Limited Preview Edition This will help you to clear the exam in the first attempt. If you score below 70%, then please go through the concept book again and then take the simulated test paper 2. Other online resources: 1. News forum: Whenever you visit online please check the news forum first , this will keep you updated with all the new announcement and changes in the syllabus & examination structure etc. 2. Question & Answer Forum: If you have any doubt related to the questions given in the concept books and the questions appearing in the exam then please ask your question using this forum. You will get reply in three days from our faculty or from any other candidate who knows the answer . You can also give answer to any other questions to make the forum interactive 3. Additional Resources: You will get additional resources file with each chapter, this will provide you the content and link available on the internet. These additional resources will be helpful to you for both the exam and practical purpose. 4. Share resources: If you come across any resources or questions which can be useful for other students then you can share using Share Resources
No, all returns come with some risk and we know the axiom Higher the return, Higher the risk, and vice-versa.
For example, Capital market offers return of 18% pa (Historical return) but it comes with the huge risk of negative return at times, on the other hand, PPF offers only 8% return, but come with almost no risk.
It is the job of a Financial Planner to measure the risk and return of any of Financial Products, and then suggest products to the client according to the suitability.
Now big question is how to measure Risk.
Introduction to Financial Planning & Investment Planning 139 Limited Preview Edition Measuring Risk: One of the ways to measure risk is using the statistical tool called as Standard Deviation 1. Measuring standard deviation of Historical Returns: Lets examine two scenarios where the scores of two players are mentioned: Match Wall Prince Match 1 45 12 Match 2 34 45 Match 3 54 60 Match 4 12 42 Match 5 17 54 Match 6 87 54 Match 7 45 45 Match 8 26 23 Match 9 16 10 Match 10 26 17 Total Runs 362 362
We are calculating the Standard Deviation (In order to find out who is more consistent) Step 1: Calculate the average score Total score / no. of matches 362/10=36.2
Introduction to Financial Planning & Investment Planning 140 Limited Preview Edition Step 2: Calculate the deviation of individual score from the average score, square it & then calculate the sum of Squares Match Wall Score Average run Deviation (Wall score Average Score) Square Match 1 45 36.2 8.8 77.44 Match 2 34 36.2 -2.2 4.84 Match 3 54 36.2 17.8 316.84 Match 4 12 36.2 -24.2 585.64 Match 5 17 36.2 -19.2 368.64 Match 6 87 36.2 50.8 2580.64 Match 7 45 36.2 8.8 77.44 Match 8 26 36.2 -10.2 104.04 Match 9 16 36.2 -20.2 408.04 Match 10 26 36.2 -10.2 104.04 Total Runs 362 4627.6
Step 3: Divide the total by total number of matches less one =4627/ (10-1) Variance = 514.17 Standard Deviation = 514.17^ (1/2) or square root of 514.17 = 22.67
Introduction to Financial Planning & Investment Planning 141 Limited Preview Edition Now thankfully we have excel also Standard Deviation on Excel Function: Select the STDEV from Statistical Functions: =
= 22.67 In the same way, for Prince Standard Deviation is: =18.866 Therefore, we can observe that Standard Deviation of Wall is more than Prince , it means that Prince is more consistent than Wall.
Introduction to Financial Planning & Investment Planning 143 Limited Preview Edition In the case of investments where the returns are market dependant, for example a stock, one will have to estimate the possible returns and the probability of getting the same, as given here below: Returns Probability of getting the returns 4% 0.1 8% 0.2 12% 0.4 16% 0.2 20% 0.1
In this case, the expected return is calculated as under: Expected return = Sum (returns*probability) = (0.04*0.1+0.08*0.2+0.12*0.4+0.16*0.2+0.2*0.1) = .004+.016+.048+.032+.02 = 0.12 or 12%
It is a normal distribution curve as pictorially depicted below:
Introduction to Financial Planning & Investment Planning 145 Limited Preview Edition Variance= Probability * (actual return expected return) 2
So, based on the figures in the table we can work out the variance as under; Expected return already calculated to be 12% Actual return Expected return minus actual return Difference squared Probability Square of difference * probability 4 -8 64 0.1 6.4 8 -4 16 0.2 3.2 12 0 0 0.4 0 16 4 16 0.2 3.2 20 8 64 0.1 6.4
Variance = sum of last column = (6.4+3.2+0+3.2+6.4) = 19.2 Standard deviation = Square root of variance = 4.3817 (Please note here we cannot use the STDEV function as there are probabilities attached to each event)
Introduction to Financial Planning & Investment Planning 147 Limited Preview Edition Calculating a standard deviation using probability distributions involves making subjective estimates of the probabilities and the likely returns. However, we cannot avoid such estimates because future returns are uncertain. The prices of securities are based on investors' expectations about the future. The relevant standard deviation in this situation is the ex ante (estimated before the event) standard deviation and not the ex post (calculated after the events/historic) based on realized returns. Although standard deviations based on realized returns are often used as proxies for projecting standard deviations, investors should be careful to remember that the past cannot always be extrapolated into the future without modifications. Historic (ex post) standard deviations may be convenient, but they are subject to errors. One important point about the estimation of standard deviation is the distinction between individual securities and portfolios. Standard deviations for well- diversified portfolios are reasonably steady across time, and therefore historical calculations may be fairly reliable in projecting the future. Moving from well- diversified portfolios to individual securities, however, makes historical calculations much less reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolio of securities, and the standard deviations of well-diversified portfolios may be more stable. Something very important to remember about standard deviation is that it is a measure of the total risk of an asset or a portfolio, including therefore both systematic and unsystematic risk. It captures the total variability in the assets or portfolios return whatever the sources of that variability. I n summary, the standard deviation of return measures the total risk of one security or the total risk of a portfolio of securities. The historical standard deviation can be calculated for individual securities or portfolios of securities using total returns for some specified period of time. This ex post value is useful in evaluating the total risk for a particular historical period and in estimating the total risk that is expected to prevail over some future period. The standard deviation, combined with the normal distribution, can provide some useful information about the dispersion or variation in returns. In a normal distribution, the probability that a particular outcome will be above (or below) a specified value can be determined. With one standard deviation on either side of the arithmetic mean of the distribution, 68.3 percent of the outcomes will be encompassed; that is, there is a 68.3 percent probability that the actual outcome
Introduction to Financial Planning & Investment Planning 148 Limited Preview Edition will be within one (plus or minus) standard deviation of the arithmetic mean. The probabilities are 95 and 99 percent that the actual outcome will be within two or three standard deviations, respectively, of the arithmetic mean.
In a bell shaped normal distribution the probabilities for values lying within certain bands are as follows: + 1 S.D. 68.3 % + 2 S.D. 95.4 % + 3 S.D. 99.7 %
Introduction to Financial Planning & Investment Planning 150 Limited Preview Edition Sum of Product of Deviation of Individual Security and Market / (n-1)
How to calculate Beta Case 1 when Probabilities are not given Here we use a Statistical concept called as Co-Variance this talks about what is called as Co-Movement between the individual stock and its benchmark.(More on Co-variance in the coming chapter)
Beta =Covariance between Stock and Market / Variance of Market.
And Covariance between Stock and Market is given by
Introduction to Financial Planning & Investment Planning 151 Limited Preview Edition 10 6 8 Solution: Now lets first calculate the Covariance between the Security and the Benchmark. Recall- when probabilities are not given, Co-Variance is Sum of Product of Deviation of Individual Security and Market / (n-1) Step 1- Calculate the Average Return of Individual Security and also that of Market.
Step 2- Calculate the Product of the deviation
Step 3 Calculate the Sum of the above product.
Step 4 Divide the above value (as obtained above) by number of observations less 1 (this is called as Loss of Degrees of Freedom). So the result that is obtained is known as the Co-Variance (this is an absolute value)
Calculation of Variance of the market. Return of Benchmark (%) Deviation of Benchmark from its Average Square of Deviations 12 3.9 15.21 15 6.9 47.61 18 9.9 98.01 4 -4.1 16.81 18 9.9 98.01 20 11.9 141.61 -12 -20.1 404.01 -18 -26.1 681.21 16 7.9 62.41 8 -0.1 0.01 Total 1564.9 Variance (Total/(10-1) 173.877
So Beta = Covariance / Variance of Market = 158.95/173.87 = .914 You can also use the Excel function Slope to determine the value of Beta, where the Y axis represents the Returns from Security and X axis represents the Returns from the market. (Kindly use the excel function Slope on the above values and check t he value of Beta)
Introduction to Financial Planning & Investment Planning 155 Limited Preview Edition Now we calculate the Covariance Probability (A) Deviation of Security (B) Deviation of Benchmark (C) Product of Deviation times probability (A*B*C) 0.05 -3.25 -7.9 1.28375 0.5 1.75 0.1 0.0875 0.3 6.75 10.1 20.4525 0.15 -18.25 -17.9 49.00125
Total 70.825 (this is Covariance)
Then we calculate the Variance of the market Probability (A) Deviation of Benchmark Square of Deviation (B) Product of Deviation times probability (A*B) 0.05 -7.9 62.41 3.1205 0.5 0.1 0.01 0.005 0.3 10.1 102.01 30.603 0.15 -17.9 320.41 48.0615
Total 81.79 (this is Variance)
So Beta = Covariance between Security and Market / Variance of Market =70.825 / 81.79 = 0.865
Introduction to Financial Planning & Investment Planning 156 Limited Preview Edition How to interpret Beta As said earlier Beta represents what is called as systematic risk, Beta values can be more than or less than 1. Suppose we have a security whose Beta say is 1.2 , then we say that the security is aggressive i.e. if the benchmark moves up or down by 10% , then this security will move up or down by 12%. Suppose the security has a Beta of less than 1 (say .8), then say that the security is defensive ,i.e. if the benchmark moves up or down by 10%, then this security will only move by 8%. Suppose the Beta is equal to 1, then we say that the security is Neutral. Market will have a Beta of 1.
Introduction to Financial Planning & Investment Planning 159 Limited Preview Edition Understanding Beta through Graph Securities with different slopes have different sensitivities to the returns of the market index. If the slope of this relationship for a particular security is a 45-degree angle, the beta is I. This means that for every one percent change in the market's return, on average this security's returns change I percent. The market portfolio has a beta of I. A security with a beta of 1.5 indicates that, on average, security returns are 1.5 times as volatile as market returns, both up and down. This would be considered an aggressive security because when the overall market return rises or falls 10 percent, this security, on average, would rise or fall 15 percent. Stocks having a beta of less than 1.0 would be considered more conservative investments than the overall market. Betas can be negative or positive. But generally betas have been found to be positive: which means that the direction of the movement of individual stock generally tends to be in line with the market; falling when the market is falling and rising when the market is rising; the rates are different. Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is used by investors to judge a stocks riskiness. Stocks can be ranked by their betas. Because the variance of the market is a constant across all securities for a particular period, ranking stocks by beta is the same as ranking them by their absolute systematic risk. Stocks with high betas are said to be high-risk securities. Given below are different scenario how the portfolio return moves relative to market for Beta equal to 1, 0.5 and 2
Beta = 1.0 -15 -10 -5 0 5 10 15 -15 -10 -5 0 5 10 15 Market P o r t f o l i o Beta = 0.5 -8 -6 -4 -2 0 2 4 6 8 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 Market P o r t f o l i o
The beta of a security is a historical measure and it is arrived at by plotting the actual returns on the security over long periods of time with market returns as shown in the above the above charts. A line is drawn which depicts beta of the security. To determine the beta of any security, you'll need to know the returns of the security and those of the benchmark index you are using for the same period. Using a graph, plot market returns on the X-axis and the returns for the stock over the same period on the Y-axis. Upon plotting all of the monthly returns for the selected time period (usually one year), we draw a best-fit line that comes the closest to all of the points. This line is called the regression line. Beta = 2.0 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 Market P o r t f o l i o
Solutions of Check Your Progress 1 1) State of the economy Probability Returns Deviations Deviations^2 Sum of Product of Deviations and Probability Boom 0.5 18% 10.0% 1.00% 0.50% Gloom 0.2 10% 2.0% 0.04% 0.01% Doom 0.3 -10% -18.0% 3.24% 0.97%
Expected Returns 8.0% Variance 1.48% Standard Deviations 12.17%
1. The Risk Free rate of return of security A is 8% and you expect that the market will give you a return of 14%. What will be the expected return of the security if the Beta is 0.7 2. Will your values change if the risk free rate of return goes to 6% and the market return remains at 14% and Beta also the same? Check Your Progress I I I
Introduction to Financial Planning & Investment Planning 164 Limited Preview Edition 2) State of the economy Probability Returns Deviations Deviations^2 Sum of Product of Deviations and Probability Boom 0.4 18% 6.8% 0.46% 0.18% Gloom 0.5 10% -1.2% 0.01% 0.01% Doom 0.1 -10% -21.2% 4.49% 0.45% Expected Returns 11.2% Variance 0.64% Standard Deviations 8.01%
3) S.No Probability Returns Deviations Deviations^2 Sum of Product of Deviations and Probability 1 0.05 16% 13.9% 1.92% 0.10% 2 0.1 12% 9.9% 0.97% 0.10% 3 0.08 6% 3.9% 0.15% 0.01% 4 0.11 -10% -12.1% 1.47% 0.16% 5 0.15 5% 2.9% 0.08% 0.01% Expected Returns 2.1% Variance 0.38% Standard Deviations 6.16%
Probability Returns of ITC (%) Returns of Sensex (%) Deviation of ITC from its Average Deviation of Sensex from its average Sum of Product of Deviation times Probability Variance of Market (Deviation of Market square times probability 0.2 30 20 11 6.1 13.42 7.442 0.5 20 15 1 1.1 0.55 0.605 0.3 10 8 -9 -5.9 15.93 10.443
Average of Security 19 Covariance 29.9 Average of Sensex 13.9 Variance of Market 18.49
3) Probability Returns of Rohini Enterprises (%) Returns of Sensex (%) Deviation of Security from its Average Deviation of Sensex from its average Sum of Product of Deviation times Probability Variance of Market (Deviation of Market square times probability 0.15 30 20 13.25 7.1 14.11125 7.5615 0.5 20 15 3.25 2.1 3.4125 2.205 0.3 10 8 -6.75 -4.9 9.9225 7.203 0.05 -15 -18 -31.75 -30.9 49.05375 47.7405 Average of Security 16.75 Covariance 76.5 Average of Sensex 12.9 Variance of Market 64.71
Assessment Test: 1. Mr. Joshi has analysed a stock for a one-year holding period. The stock is currently quoting at Rs 100/- and is paying no dividends. There is a 50-50 chance that the stock may quote Rs100 or Rs 120 by year-end. What is the expected return on the stock? 1. 12% 2. 10% 3. 15% 4. 20%
2. A stock is quoting at Rs 100 and is paying no dividends. The possible year end price and the probabilities are given below: Year end price Probability 110 0.1 115 0.2 120 0.3 125 0.2 130 0.1 What is the expected return on the stock? a. 10% b. 15% c. 18% d. 20%
3. What is the standard deviation of the stock based on the above figures in problem 2? a. 14.45 b. 5.79 c. 16.30 d. 33.60
4. Stocks A and B are not paying any dividends. Stock A is quoting at Rs 100 while B is quoting at Rs 50. There is a 50-50 chance that stock A will quote at Rs 120 and Rs 140 while there is a 50-50 chance that the stock B will quote at Rs 60 and Rs 70 at the end of the year. Which stock will you buy considering the return and the risk? a. I shall buy B because it is cheaper b. I will buy Stock B because the risk is less c. I will buy Stock A because the risk is less d. The risk and the return in both are same; I shall buy any one
5. Compute the expected return for the stock when the risk free return is 8% and the expected return from the market is 12% for a stock with Beta of 1.2. a. 15.6% b. 12.8% c. 16.4% d. 22.2%
6. Beta of stock A is 1.5 while that of stock B is 1. If the market is expected to rise then an aggressive investor would buy: a. Either A or B; because in a rising market all stocks will rise
Introduction to Financial Planning & Investment Planning 170 Limited Preview Edition b. Stock A because it may deliver superior returns compared to B c. Stock B because the risk will be less compared to A while the returns would be the same d. Stock B because it may deliver superior returns compared to A
7. The following are the assessment of the probabilities of each of the five economic scenarios:
i) What is the expected return on shares? a) 20% b) 25% c) 15.8% d) 13.2%
ii) What is the expected return on bonds? a) 9% b) 10% c) 1.9% d) 3.0%
iii) What is the standard deviation of stocks? a) 29.44% b) 28.34% c) 25.44% d) 17.95%
Growth with low inflation 0.05 6 Growth with high inflation 0.2 6 Normal growth 0.5 6 Recession with low 0.2 6 Recession with high 0.05 6 Cash Economic scenario Probability Holding period Shares Bonds 4 -10 9 35 0 74 20 14 0 -30
iv) What is the standard deviation of bonds? a) 17.96% b) 14.56% c) 9.7% d) 15.71%
8. Modern "asset allocation" is based upon the model developed by Harry Markowitz. Which of the following statements is/are correctly identified with this model? 1. The risk, return and covariance of assets are important input variables in creating portfolios. 2. Negatively correlated assets are necessary to reduce the risk of portfolios. 3. In creating a portfolio, diversifying across asset types (e.g., stocks and bonds) is less effective than diversifying within an asset type. 4. The efficient frontier is relatively insensitive to the input variable.
a) 1 and 2 only. b) 1, 2, and 3 only. c) 1 only. d) 2 and 4 only. e) 1, 2, and 4 only.
9. KM, Inc. has a beta of 1.5. The risk-free rate is 5%, and the market risk premium is 8%. a) KM has a required return of 6.5% and an expected return of 8%. b) KM has a required return of 15.5%. c) KM has a required return of 17%
10. Mahesh is keen to invest in any of the four securities A, B, C or D whose betas are 0.70, 1.00, 1.15 and -0.30 respectively. The risk free rate of return being 8% and expected rate of return on market being 14%, which security would you recommend to Mahesh? (4) a. Security C, as expected return is highest. b. Security D, as expected return is least. c. Either Security A or Security B as their return is moderate. d. More data as to the time horizon is required before passing advise to Mahesh.
Chapter - 5 Income from house property
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It gives us lots of pleasure to bring 3 rd edition of the CFP CM books. Its an earnest attempt done to simplified all topics keeping in mind the understanding and the examination, as CFP CM Exam is the most dynamic exam in the country, since lots of changes come day in day out due to changing marketing dynamics and regulatory requirement. In order to keep you abreast with these changes we have made special emphasis on online learning system also. How to read the study material: 1. Concepts Reading: Kindly make an attempt to understand the concept as such and not to read them as subjects. Concept reading will familiarize you with the required knowledge/approach to clear the exams. It also includes illustrations and concept checkers to give you the approach to solve all the practical problems 2. Check your progress: For most of the chapters Check your progress is given ,which will re-emphasize your learning. Solution of Check your progress is given at the end of every chapter. 3. Assessment test: Before you move to the next chapter you should take the assessment test and if you are scoring below 80% , then kindly again go through the concept again before moving to the next chapter. 4. Online Resources: After completing all the assessment test please go the online resources. 5. Estate Planning: All the content related to Estate Planning available online. It carries the weightage of 10- 15% in the Tax & Estate Planning Exam How to use online resources: 1. Powerpoint Presentation: Summary of all the chapters is given in PPT format. This would help you to brush up the topics before attempting the online unit test 2. Unit Test: Before taking Full length online simulated test papers, you should again take the online unit test . 3. Simulated Test paper: Before you take the date of the exam, it is advisable to take the simulated test paper , if you get above 70% , then you can take the date of the exam at NSE. This will help you to clear the exam in the first attempt. If you score below 70%, then please go through the concept book again and then take the simulated test paper 2.
How to use IMS Proschool Study Program
Tax Planning 109 Tax Planning Other online resources: 1. News forum: Whenever you visit online please check the news forum first , this will keep you updated with all the new announcement and changes in the syllabus & examination structure etc. 2. Question & Answer Forum: If you have any doubt related to the questions given in the concept books and the questions appearing in the exam then please ask your question using this forum. You will get reply in three days from our faculty or from any other candidate who knows the answer . You can also give answer to any other questions to make the forum interactive 3. Additional Resources: You will get additional resources file with each chapter, this will provide you the content and link available on the internet. These additional resources will be helpful to you for both the exam and practical purpose. 4. Share resources: If you come across any resources or questions which can be useful for other students then you can share using Share Resources
Tax Planning 110 Tax Planning I ntroduction
This lesson deals with income, which falls under the head 'Income from house property'. The scope of income charged under this head is defined by section 22 of the Income Tax Act and the computation of income falling under this head is governed by sections 23 to 27. All the provisions relating to tax treatment of income from house property are explained in this lesson.
Objectives
After going through this lesson, you will be able to understand: o The meaning of house property o Who is treated as owner of house property o The treatment of rental income from properties under different o circumstances o Determination of the annual value of a house property o The expenses deductible from rental/notional income from house property o Special treatment given to self-occupied house property o Treatment of income/loss from house property.
Basis Of Charge (Section 22)
The annual value of a property, consisting of any buildings or lands appurtenant thereto, of which the assessee is the owner, is chargeable to tax under the head 'Income from house property'. However, if a house property, or any portion thereof, is occupied by the assessee, for the purpose of any business or profession, carried on by him, the profits of which are chargeable to income- tax, the value of such property is not chargeable to tax under this head.
Thus, three conditions are to be satisfied for property income to be taxable under this head. 1. The property should consist of buildings or lands appurtenant thereto. 2. The assessee should be the owner of the property. 3. The property should not be used by the owner for the purpose of any business or profession carried on by him, the profits of which are chargeable to income-tax.
Applicability Of Section 22
Buildings or lands appurtenant thereto
The term 'building' includes residential houses, bungalows, office buildings, warehouses, docks, factory buildings, music halls, lecture halls, auditorium etc. The appurtenant lands in respect of a residential building may be in the form of approach roads to and from public streets, compounds,
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1. A member of a co-operative society, company or association of persons, to whom a property (or a part thereof) is allotted or leased under a house- building scheme of the society, company or association, is deemed to be the owner of such property.
2. A person who has acquired a property under a power of attorney transaction, by satisfying the conditions of section 53A of the Transfer of Property Act, that is under a written agreement, the purchaser has paid the consideration or is ready to pay the consideration and has taken the possession of the property, is the deemed owner of the property, although he may not be the registered owner.
3. A person who has acquired a right in a building (under clause (f) of section 269UA), by way of a lease for a term of not less than 12 years (whether fixed originally or extended through a provision in the agreement), is the deemed owner of the property. This provision does not cover any right by way of a lease renewable from month to month or for a period not exceeding one year.
Ownership must be of the superstructure. It is not necessary that the assessee is also the owner of the land. Thus, when a person obtains a piece of land on lease and constructs a building on it, the income from such building will be taxed in his hands as income from house property.
Property used for own business or profession
The owner of a house property is not liable to tax under this head if the property is used by him for his own business or profession. But the business or profession should be such whose income is chargeable to tax. Chargeability to tax does not mean that the income is actually taxed. It is possible that in a particular year the profits are not sufficient enough to attract tax liability. What it means is that the income from such business or profession is not exempt from tax.
If an employer builds quarters for residential use by his employees and the letting out of these quarters is considered as incidental to his business, the income from such property is not taxable under this head, because the property in this case is considered to be used by the owner for his own business. It shall, therefore, be taxed as business income.
The above position will not change even if the buildings are let out to government authorities for locating their undertakings like Banks, Post Office, Police Station, Central Excise Office, etc., provided the dominant purpose of letting out the accommodation is to enable the assessee to carry on his business more efficiently and smoothly. Also, income from paying-guest accommodation is taxable as income from business.
Where house property owned by a partner is used by the firm (neither it is let out to the firm nor any rent is obtained for it) for its business purposes, the partner is entitled to the exemption.
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Tax Planning 114 Tax Planning House property in a foreign country
A resident assessee is taxable under section 22 in respect of annual value of a property in a foreign country. A resident but not ordinarily resident or a non- resident is, however, chargeable under section 22 in respect of income of a house property situated aboard, provided income is received in India during the previous year. If tax incidence is attracted under section 22 in respect of a house property situated abroad, its annual value will be computed as if the property is situated in India.
Property I ncomes Exempt From Tax
Some incomes from house property are exempt from tax. They are neither taxable nor included in the total income of the assessee for the rate purposes. These are: 1. Income from a farm house [section 2(1A) (c) and section 10(1)]. 2. Annual value of one palace in the occupation of an ex-ruler [section 10(19A)]. 3. Property income of a local authority [section 10(20)]. Explain whether the income from house property will be taxable or not u/s 22 in the hands of X in the following circumstances: 1. X owns a building. It is given on rent to Y, who uses it as his office. 2. X owns a house property. He uses it as the godown for the goods produced by his factory. 3. X rents out his property as residential quarters to the workers in his factory at a nominal rent of 500 p.m. 4. X enters into a written agreement to purchase a property from Y for 25, 00,000. He has paid the consideration and taken the possession of the property but the property is yet to be registered in the name of X. 5. X owns a property, which is given on lease to Y for a period of 6 years, lease rent being 10, 000 per month. Y has a right to get the lease renewed for a further period of 6 years. 6. X owns a property, which is given on lease to Y for a period of one month, rent being 5, 000. Y has a right to get the lease renewed for a period of one month, in each subsequent month, and such renewal is possible with mutual consent till 2020. 7. X owns a property, which is given on rent to Y. Y annually pays 1,50,000 as rent of the building as well as the charges for different services (like lift, security, etc.) provided by X. 8. X owns an air-conditioned furnished lecture hall. It is let out, annual rent being 5, 00,000, which includes rent of building as well as rent of air- conditioner and furniture.
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Tax Planning 115 Tax Planning 4. Property income of an approved scientific research association [section 10(21)]. 5. Property income of an educational institution and hospital [section 10(23C)]. 6. Property income of a registered trade union [section 10(24)]. 7. Income from property held for charitable purposes [section 11]. 8. Property income of a political party [section 13A]. 9. Income from property used for own business or profession [section 22]. 10. Annual value of one self occupied property [section 23(2)]
Computation Of I ncome From Let Out House Property
Income from house property is determined as under: xxxxxxx Gross Annual Value xxxxxxx Less: Municipal Taxes xxxxxxx Net Annual Value xxxxxxx Less: Deductions under Section 24 xxxxxxx Statutory Deduction (30% of NAV) xxxxxxx Interest on Borrowed Capital xxxxxxx Income from House Property xxxxxxx
Determination Of Annual Value
The basis of calculating Income from House property is the 'annual value'. This is the inherent capacity of the property to earn income and it has been defined as the amount for which the property may reasonably be expected to be let out from year to year. It is not necessary that the property should actually be let out. It is also not necessary that the reasonable return from property should be equal to the actual rent realized when the property is, in fact, let out. Where the actual rent received is more than the reasonable return, it has been specifically provided that the actual rent will be the annual value. Where, however, the actual rent is less than the reasonable rent (e.g., in case where the tenancy is affected by fraud, emergency, close relationship or such other consideration), the latter will be the annual value. The municipal value of the property, the cost of construction, the standard rent, if any, under the Rent Control Act, the rent of similar properties in the same locality, are all pointers to the determination of annual value.
Gross Annual Value [Section 23(1)]
The following four factors have to be taken into consideration while determining the Gross Annual Value of the property:
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(a) The defaulting tenant is not in occupation of any other property of the assessee; (b) The assessee has taken all reasonable steps to institute legal proceedings for the recovery of the unpaid rent or satisfied the Assessing Officer that legal proceedings would be useless. (We will discuss about it later in the topic of Unrealised rent)
So in a nut shell there are four parameters namely 1) Municipal Value 2) Fair Rental Value (FRV) 3) Standard Rent 4) Rent Received
Please note that we need to follow the principal of High, Low, and High to determine the FRV So its Higher of 1 and 2 , say that is A and then Lower of A and 3, say that is B and then Higher of B and 4, that will be the Gross Annual Value of the House Property. Say for example the following is given Municipal Value = 25,000, Fair Rent Value = 30,000 , Standard Rent = 27,000 and Actual Rent = 32,000, Then the Gross Annual value will be Remember the steps High, Low, High Step 1 Higher of Muncipal Value and Fair Rent in this case it will be Higher of 25,000 or 30,000, so it will be 30,000, (lets call it as A) Step 2 Lower of A and Standard Rent so it will be Lower of A (i.e. 30,000) and 27,000 (Standard Rent) so will be 27,000 (lets call it B) Step 3 Higher of B and Actual Rent, so it will be Higher of B (i.e. 27,000) and 32,000 (Actual Rent) so the GAV will be 32,000.
Concept Question 1) Find the Gross Annual Value in the case of the following properties: Particulars 1 2 3 4 5 6 Municipal Value 20000 24000 36000 42000 48000 45000 Fair Rental Value 24000 24000 40000 42000 50000 50000 Standard Rent N.A 24000 50000 30000 N.A 48000 Actual Rent/Annual Rent 18000 36000 48000 36000 54000 42000
Answer : Kindly recall the rule of High, Low, High GAV 24000 36000 48000 36000 54000 48000
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Now lets talk about the situation where the House Property was part let out and part vacant.
In accordance to section 23(1), the annual value of such property shall be deemed to be (a) The sum for which the property might reasonably be expected to let from year to year (i.e. what could possibly be the expected rental income if the property was let out throughout the year). Now here two different SITUATIONS can emerge 1. Where the property or any part of the property is let out and the actual rent received is MORE than clause (a) above 2. Where the property or any part of the property is let out and the actual rent received is LESS than clause (a) above.
Lets see how the evaluation will happen in both the cases
Situation 1 where the property was let out and the rental received was more than the expected rent, then in that case the Gross Annual Value will be Higher of the two i.e. the actual rent received
Concept Question Suppose the municipal value of a house is 1, 00,000. Fair Rent is 1, 50,000. Standard Rent is 1, 30,000. The house property was let out for 13,000 per month and the house was vacant for one month. What will be the GAV in this case?
Answer : Once again lets list down all the values Particulars Amount ( ) Municipal Value 100000 Fair Rental Value 150000 Standard Rent 130000 Actual Rent/Annual Rent (13000*11) 143000 GAV 143000 (We will once again apply the High, Low, High principle till the Standard Rent and then compare it with the Actual Rent (considering that fact that its situation 1 of above) 1) What will be the GAV in the following cases Particulars 1 2 3 4 5 Municipal Value 52000 100000 60000 75000 180000 Fair Rental Value 60000 102000 68000 70000 185000 Standard Rent N.A 90000 70000 60000 175000 Actual Rent/Annual Rent 55000 95000 72000 72000 168000
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Tax Planning 119 Tax Planning Situation 2 where the property was let out and was vacant partially and the actual rent received is less than the expected annual rent then in this case the GAV of the property will be the actual rent that is received
Concept Question Continuing with the above example, what if the property was vacant for 3 months, and then the GAV will be Particulars Amount ( ) Municipal Value 100000 Fair Rental Value 150000 Standard Rent 130000 Actual Rent/Annual Rent (13000*9) 117000 GAV 117000
Recap- In the Story so far we have seen the following cases and have calculated the GAV. 1) Where the House Property was Completely Let out for the entire year. 2) Part Let out and Part Vacant. (Here we had examined two scenarios) (a) Where the rental income was more than the expected rent (b) Where the rental income was lesser than the expected rent.
Another Twist in the Tale What if the house property is let out part of the year and part Self Occupied?
Here the story line changes a bit. In such cases the period of self occupancy is ignored and it will be assumed as Part Let out property.
Concept Question: Navjot Singh Bidhu has a house property in Chandigarh whose Municipal Value is 10, 00,000 (Chandigarh hai bhai, mehenga hai) and the Fair Rental Value is 12,00,000. It was Self occupied by Bidhu from 1 st April 2009 till 31 st July 2009 and then from 1 st August 2009 was let out at 90,000 per month. Compute the annual value of the house property for the assessment year 2010-11
Answer: Lets take down all the values again Particulars Amount ( ) Municipal Value 1000000 Fair Rental Value 1200000 Standard Rent NA Actual Rent/Annual Rent (90000*8) 720000 GAV 1200000
Tax Planning 120 Tax Planning Here the Fair Rent will become the Gross Annual Value so in a snapshot to calculate the Gross Annual Value, follow the diagram given below : Step 1- Compare M.V with F.R Whichever is higher is considered as F.R. Step 2-Compare F.R. of Step 1 with S.R.Which ever is lower is considered as F.R Step 3-Compare F.R. determined above with A. A.R > F.R. When A.R < F.R When A.R < F. R (due to vacancy) A.R < F.R (other factors) A.R. is the annual Value F. R is the annual value
Deduction of Municipal Taxes
From the annual value as determined above municipal taxes are to be deducted if the following conditions are fulfilled: o The property is let out during the whole or any part of the previous year o The Municipal taxes must be borne by the landlord (If the Municipal taxes or any part thereof are borne by the tenant, it will not be allowed). o The Municipal taxes m us t be paid during t he year (Where the municipal taxes become due but have not been actually paid, it will not be allowed. Similarly, the year to which the taxes relate to, is also immaterial).
Concept Question Suppose you own the following three houses the details of which are Bungalow 1 Bungalow 2 Bungalow 3 No of Residential Units 2 1 3 Municipal Value 150000 72000 70000 Fair Rental value 170000 75000 85000 Standard Rent 160000 80000 82000 Rent Per Unit Per Annum 50000 84000 84000 Municipal Taxes 15000 (due but not paid) 8000 for last year paid this year and 9000 of current year due but not paid 90000 (it includes 84000 paid as advance for the next 9 years) What are the GAV and the Net Annual value in each case?
Answer: Gross Annual Value (80000*2) (84000*1) (84000*3) Gross Annual Value 160000 84000 252000 Municipal Taxes 0 8000 90000 Net Annual Value ( ) 160000 76000 162000
Tax Planning 121 Tax Planning Treatment of Unrealised Rent: As per the explanation, the actual rent received or receivable mentioned in section 23 (1)(b) and (c ) , shall not include the amount of rent which the owner cannot realize subject to the rules made in this behalf. Rules of Unrealised rent a. The tenancy is bona fide; b. The defaulting tenant has vacated, or steps have been taken to compel him to vacate the property. c. The defaulting tenant is not in occupation of any other property of the assessee; d. The assessee has taken all reasonable steps to institute legal proceedings for the recovery of the unpaid rent or satisfied the Assessing Officer that legal proceedings would be useless So the amount of unrealised rent is shown as deduction after computation of the gross annual value.
Concept Question: P. K Manmani submits the following details about his house property owned by him in Sangli Municipal Value 300000 Fair Rental value 340000 Rent Per Month 31000 Municipal Taxes 30000 (paid)
The tenant vacated the property on the 31 st of October and thereafter the property was let out at 35,000 per month as rent.P.K could no realize the rent for the months of September and October 2009 due to the death of his tenant.What will be the annual value of the property?
Answer: Amount ( ) Step 1 (Determine the value of the property) Higher of M.V or F.R.V ( 3,00,000 or 3,40,000) 340000
Step 2 Actual Rent Receivable (31000*7+35000*5) 392000
So GAV 392000 Less Un Realised Rent (31000*2) 62000 Less Municipal Taxes Paid 30000
Net Annual Value 300000
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Computation Of I ncome From Self - Occupied House Property
The annual value of one self-occupied house property, which has not been actually let out at any time during the previous year, is taken as 'Nil' [Section 23(2) (a)]. From the annual value, only the interest on borrowed capital is allowed as a deduction under section 24. The amount of deduction will be: o Either the actual amount accrued or 30,000/- whichever is less o When borrowal of money or acquisition of the property is after 31.3.1999 - deduction is 1, 50,000/- applicable to A.Y 2002-03 and onwards. o However, if the borrowal is for repairs, renewals or reconstruction, the deduction is restricted to 30, 000. If the borrowal is for construction/ acquisition, higher deduction as noted above is available.
1) Ms Manpreet constructed a house property for which she took a home loan of 2 Lacs at 12% per annum on the 1 st Oct 2006. The construction of the home was completed by the end of January 2008.The house property has been let out for 6000 per month from September 2008.Muncipal taxes paid during the previous year 2009-10 is 7500.Repairs incurred was 12,500. Insurance Premium due for the year but outstanding is 1500.Collection charges incurred is 100 per month. Current year interest on the loan is outstanding.
Compute the Income from House Property for the assessment year 2010-11
2) Mr. Ekagra owns a building which has 3 apartments, construction of which was completed on December 2005. The apartment was let out on rent of 1500 each per month. The annual municipal valuation of the house is 50,000. Annual municipal tax is 10,000.However in the previous year 2009-2010 he paid 15,000 which included the municipal taxes of 5,000 in respect of the previous year 2008-09.Ground rent of 1800 and Insurance premium of 1100 was paid. Ekaga had to pledge his jewellery in order to repair the property. Interest of 3000 is payable for the current year on the said loan. He has appointed Munnabhai (a local goon) to collect the rent on a monthly salary of 50.One of the apartment was vacant for 6 months during the year. Compute the income from House Property for the AY 2010-11. (lamba sawal hai, happy solving!!)
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Tax Planning 124 Tax Planning If a person owns more than one house property, using all of them for self- occupation, he is entitled to exercise an option in terms of which, the annual value of one house property as specified by him will be taken at Nil. The other self occupied house property/is will be deemed to be let out and their annual value will be determined on notional basis as if they had been let out.
Annual Value of one house away from work place [Section 23(2) (b)]
A person may own a house property, for example, in Bangalore, which he normally uses for his residence. He is transferred to Chennai, where he does not own any house property and stays in a rental accommodation. In such a case, the house property in Bangalore cannot be used for self- occupation and notional income, therefore, would normally have been chargeable although he derives no benefit from the property. To save the tax payer from hardship in such situations, it has been specifically provided that the annual value of such a property would be taken to be nil subject to the following conditions:
o The assessee must be the owner of only one house property. o He is not able to occupy the house property because of his employment, business etc., away from the place where the property is situated. o The property should not have been actually let or any benefit is derived therefrom. o He has to reside at the place of employment in a building not belonging to him .
Annual Value of a house property which is partly self - occupied and partly let out
If a house property consists of two or more independent residential units, one of which is self - occupied and the other unit(s) is let out, the income from the different units is to be calculated separately. The income from the unit which is self - occupied for residential purposes is to be calculated as per the provisions of Section 23(2)(a) i.e. the annual value will be taken as nil and only interest on borrowed capital will be deductible upto the maximum limit of 1,50,000 or 30,000, as the case may be. The income from the let out unit(s) will be calculated in the same manner as the income from any let out house property. 6.5 SOME SPECIAL PROVISIONS Taxability of Unrealized Rent recovered later (Section 25A) Where any rent cannot be realized, and subsequently if such amount is realized, such an amount will be deemed to be the income from house property of that year in which it is received. We have seen earlier that the basic requirement for assessment of this income is the ownership of the property. However, in the cases where unrealized rent is subsequently realized, it is not necessary that the assessee continues to be the owner of the property in the year of receipt also.
House Property
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1) GAV will be Particulars 1 2 3 4 5 GAV 60000 95000 48000 72000 175000
1. Yes, Income from House Property. 2. No 3. Income from Business and Profession 4. Yes it will be treated as Income from House Property (A person who has acquired a property under a power of attorney transaction, by satisfying the conditions of section 53A of the Transfer of Property Act, that is under a written agreement, the purchaser has paid the consideration or is ready to pay the consideration and has taken the possession of the property, is the deemed owner of the property, although he may not be the registered owner.) 5. Yes , Income from House Property 6. Yes, Income from House Property 7. If, it can be bifurcated (rental and other services) then rent will be taxed as Income from House Property and others as Profit and Gains from Business and Profession or Income from other sources. If it cannot be bifurcated then it will be treated as Income from Business and Profession or Income from other sources. 8. Since nothing is mentioned we will treat that as Income from Business and Profession.
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Tax Planning 126 Tax Planning 1) Income from House Property of Ms Manpreet. Particulars Amount Gross Value ( 6000*12) 72000 Less Municipal Taxes paid 7500 Net Annual Value 64500 Less Deductions u/s 24 30% of Net Annual Value 19350 1/5th of Interest (preconstruction period) 2400 Interest on Loan 24000 Income from House Property 18750
2) Computing the income from House Property of Mr. Ekagra The crucial part of this question is to compute the GAV of the property and the same is Amount Municipal Valuation 50000 Rent Received (1500*2*12)+(1500*6) 45000
Due to the vacancy the GAV will be 45,000.(Remember the chart) Particulars Amount Gross Value 45000 Less Municipal Taxes paid 15000 Net Annual Value 30000 Less Deductions u/s 24 30% of Net Annual Value 9000 Interest on Loan 3000
Income from House Property 18000
Assessment of arrears of rent received (Section 25B)
When the owner of a property receives arrears of rent from such a property, the same shall be deemed to be the income from house property in the year of receipt. 30% of the receipt shall be allowed as deduction towards repairs, collection charges etc. No other deduction will be allowed. As in the case of unrealized rent, the assessee need not be the owner of the property in the year of receipt.
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As per Section 23(2) of the Income Tax Act, the annual value of one self- occupied house property is taken to be nil. No deductions are permissible from the annual value of such property, except the interest on borrowed capital, subject to the maximum limit of 1, 50,000 or 30, 000 as the case may be.
The above provisions may result in loss from house property, which may be set off against income from another house property or against incomes under the other heads. The balance loss may be carried forward, to be set off against the income from house property, upto a maximum of eight assessment years.
Please note that this is the only head (as of now since DTC has not come into play, where the I ncome from Salary can be adjusted against Loss from House Property)
Assessment Test:
1. Mr. Arun gifted his house property to his wife in 2007 which she let out on a monthly rent of 5,000/- The income from such house property will be taxable in the hands of: a. Mrs.Arun b. Mr. Arun. However, income will be first computed as his wifes income and thereafter clubbed in his income. c. Mr.Arun as he will be treated as deemed owner of the house property and liable to tax.
2. Mr. Raj gifted house property to his minor son which was let out @ 5,000/- p.m. Income from such house property shall be taxable in the hands of: a. His minor son; b. Mr.Raj however, it will be computed as minors income and thereafter clubbed in Rajs income; c. Mr.Raj as he will be deemed owner of such property and liable to tax.
3. Mr. X transferred his house property to his wife under an agreement to live apart. Income from such house property shall be taxable in the hands of: a. Mr. X as deemed owner ; b. Mr. X however, it will be computed as Mrs. Xs income and thereafter clubbed in the hands of Mr. X provided the income of the father is higher than the income of her mother. c. Mrs. X
4. A has taken a house property on lease for 15 years from B and let out the same to C. Income from such house to A shall be taxable as: a. income under the head other sources b. income from house property as A is the deemed owner.
Tax Planning 129 Tax Planning 5. Ram gifted his house property to his married minor daughter. The income from such house property shall be taxable in the hands of: a. Ram, as deemed owner. b. Ram. However, it will be first computed as minor daughters income and clubbed the income of Ram provided the income of the father is higher than the income of her mother. c. income of married minor daughter.
6. Govind is a member of house building Cooperative Society who is the owner of flats constructed by it. One of the flats is allotted to him. The income from such house property shall be taxable in the hands of: a. The Cooperative Society b. Govind, as deemed owner.
7. X is the owner of superstructure although the land was taken by him on lease. The income of such property shall be taxable under the head: a. income from other sources b. income from house property.
8. A has taken a house on rent and sublets the same to C. Income from such house property shall be taxable under the head: a. income from house property b. income from other sources.
9. Municipal valuation of the house is 1,00,000/- whereas the fair rent of house property is 1,20,000/- and standard rent is 1,10,000/-; actual rent received or receivable is 1,40,000/- ; municipal tax paid 10%. The annual value in this case shall be: a. 90,000/- b. 1,00,000/- c. 1,30,000/-
10. Municipal valuation of the house is 1,20,000/-, fair rent is 1,40,000/-; standard rent is 1,30,000/- whereas actual rent received or receivable is 1,25,000; municipal taxes paid are 40,000/- The annual value in this case shall be: a. 1,00,000/- b. 85,000/- c. 90,000/-
11. Fair rental value of a house is 1,50,000/-, standard rent 1,20,000/-, actual rent 1,30,000/-. Municipal tax paid during the previous year for the past 7 years is 1,40,000/-. The annual value shall be: a. 20,000/- b. Nil c. (-)10,000/-