Financial Planning PDF

M.Com. (Previous) Semester-I Paper - MCCC 104 Financial Planning Study Material SCHOOL OF OPEN LEARNING University of Delhi Department of Commerce Editor : Dr. K.L. Dah...

M.Com. (Previous) Semester-I Paper - MCCC 104 Financial Planning Study Material SCHOOL OF OPEN LEARNING University of Delhi Department of Commerce Editor : Dr. K.L. Dahiya  Unit I Lesson 1 INTRODUCTION TO FINANCIAL PLANNING 1 STRUCTURE 1.1 Background/Introduction 1.2 Benefits of Financial Planning 1.3 What Are You Planning For 1.4 Components of a Financial Plan 1.5 Globally Accepted Steps in Developing Financial Planning Process 1.6 General Principles of Cash Flow Planning 1.7 How Components Relate to Cash Flows 1.8 General Principles of Budgeting 1.9 Sources of Information 1.10 Overview of Risk Management 1.11 Risk management Process 1.12 Legal Aspects of Financial Planning 1.13 Self-Assessment Questions 1.1 BACKGROUND / INTRODUCTION (Eliud Bundi Ondara, 2016) “Financial Planning” is essential for each and every person, for almost every decision involving finance or money. The decision could be related to organizing an event, party or any celebration, planning for further higher studies, for buying house or land, for managing daily household expenditures etc. There are number of uncertainties in a person’s life. Thus, to achieve financial goals, one must possess a good understanding of financial planning & management. So, it is advisable to start as early as possible. Only the one can get what he or she wanted in life. Every individual is required to understand the need & importance to manage his or her finances. First step should understand financial needs or objectives of an individual, and then the person could plan how to achieve these goals. 1 For example-if we are planning a trip, we should find out the available transportation options with approximate fare details, and then we can evaluate the various options according to our suitability & select the one which matches our requirements & is within our budget too. After that we can decide about the accommodation, food & guide charges etc., in a similar manner, this is how we can plan a trip. Just like that people might want to earn money, in the form of interest or dividend, capital appreciation etc. For this many investment plans are available in the market to suit the risk preferences of varied investors. If a person has knowledge about the financial planning then he could build his portfolio on his own, otherwise if he can opt for the expert guidance of a financial advisor but for that he needs to pay the fee to the advisor. When you make your own financial decisions you need to be more concerned about the each and everything related to spending, financing and investing. An understanding of finance will help in many ways, a person can judge the advice given by the financial advisor whether it is useful or not, a person can guide someone in investing or financing, he can pursue a career in the same field as financial advisors, because many people lack an understanding of personal finance. The idea of personal financial planning is very much similar to the idea of planning for almost anything. You figure out where you are (your current financial position), where you would like to be (your desired financial position), and planning is required when there is any difference between the two positions. The process is difficult due to number of factors that needs to be considered, by their complex relationships with each other, and by the profound nature of these decisions, because how you finance your life, will to a large extent determine the life that you live. One of the factors which make the process difficult is risk. In that case one has to take decision after collecting information so that risk can be minimised. Personal financial planning is a continuous process. A financial plan has to be revised time to time. It has to be flexible enough to be responsive to unanticipated needs and desires, robust enough to advance toward goals, and all the while be able to protect from unimagined risks. One of the most critical resources in the planning process is information. But to use that information you have to understand what it is telling, why it matters, where it comes from, and how to use it in the planning process. You need to be able to put that information in context, before you can use it wisely. That context includes factors in your individual situation that affect your financial thinking, and factors in the wider economy that affects your financial decision making. 2 1.2 BENEFITS OF FINANCIAL PLANNING (Jeff Madura, 2007) If you have knowledge related to personal finance, this can help you accomplish your goals. In fact, it can help you define your goals. Questions like- Should you go to college? Should you buy a car? Should you work part-time or focus only on school and try to get a scholarship? Should you apply for credit card? What are the pros and cons of that decision? Will get the answer. If you have good understanding of personal finance, this will help you make informed decisions about your personal situation. In case if a person has better knowledge of financial planning so he could have used the money to buy a household necessity item, rather than buying the ticket for amusement park. He could have also put the money in savings account. Learning about financial decision making may help an individual to begin thinking in these terms. We all know money can’t buy happiness, but financial security certainly makes life easier. Good financial decisions lead to flexibility and allow an individual to achieve true desires in due time without fear of not being able to make the payments. Thus, we can say that the understanding of financial planning provides the following benefits:  You can make your own financial decisions  You are able to judge the advice of financial advisers  You can also become a financial adviser 1.3 WHAT ARE YOU PLANNING FOR? (Jeff Madura, 2007 & SEBI) Every person has his or her own personal goals which are different for each individual. These can range from starting a business to taking a dream vacation. Some of your goals are short- term in nature, and others may require years to accomplish. When you are thinking of buying a cycle is a short-term goal whereas saving enough money to buy a house is obviously a long-term goal. With good financial planning, you can identify your goals and begin working toward short-term, intermediate-term, and long-term goals—all at the same time. Some areas in which planning & decision making are required are as follows:  Education One of the major decisions that you will be required to make is whether to pursue a college degree or some other type of high school education. There is a significant relationship between your educational qualification and your earnings potential. At this point in your life, you should start exploring various career options 3  and determine the education required to pursue each option. Education is costly and needs time to complete any course. One should always focus on a career that holds your interest, and it is also important to investigate the expected payoffs. You should spend some time planning your career choice and then engage in financial planning to determine how to pay for that education.  Emergencies Fund Emergencies can occur to any person at any point of time, such as car breakdowns may occur. Good financial planning will help you establish an emergency fund to deal with any future financial crisis. Financial planning guides you to think about and plan for those unexpected expenses or the possibility of an interruption in earnings as the result of illness or job loss. If a person starts planning for any unexpected emergency before time, he can have enough money to cover those expenses.  Buying a Car whenever you want to buy a new car, what sources you can avail. Will your parents help in buying? Or will you have to pay for it with your own money? When do you want to buy it? At age 25? At age 30? A good financial planning can help you determine whether you can eventually afford the car. It can also help you identify the steps you need to take to buy & own such assets.  Buying a House every person has this dream in mind to buy his own house. Some of you might want to travel the world. One can begin saving now for the down payment of home. What better time to accumulate wealth than when you are young & not financially burdened? It gets increasingly more difficult to save money when you have to pay rent and buy groceries. The earlier you begin the less money you have to set aside on a regular basis. If you plan carefully, you can set aside money for long- term goals without making any compromises on your short term needs.  Retirement Financial planning can give you the option of retirement planning as well. You can begin to build your wealth at an early age. This may allow you to retire without any worries for post retirement expenses.  Charity A number of people want to donate some of their money to worthy causes, and charitable giving is an important component of many financial plans. Some people may prefer to accumulate wealth and provide a large sum to a specific charity. Others may donate in smaller amounts on a regular basis. Knowledge of financial planning can help you achieve whatever goals you may have in this area. 4 1.4 COMPONENTS OF A FINANCIAL PLAN (Jeff Madura, 2007) A complete financial plan contains your personal finance decisions related to six key components: 1. Budgeting and tax planning 2. Managing your liquidity 3. Financing your large purchases 4. Protecting your assets and income (insurance) 5. Investing your money 6. Planning your retirement and estate All these components are different. For making an overall financial plan we need to concentrate on each component separately. 1. Budgeting and Tax Planning Budgeting is the process of forecasting future expenses and savings. The decision of savings and expenditure is different for each individual. It depends on the preference & requirement of each person. If a person has received Rs.10,000 in a month, and might have spent Rs.7,000, so the amount which he has not spent on anything i.e., Rs.3,000 is the amount which will be treated as his saving. Some individuals are big spenders and some are big savers. The big spenders have lesser of saving and the big savers will definitely have more of the savings. Budgeting may help a person in estimating how much of the income will be required to cover monthly expenses so that an individual can save some portion of his income every month. Thus the first step talks about the evaluation of income, expenses, assets and liabilities. Where assets are what you own and liabilities are what you owe, so when we subtract liabilities from the assets we will get net worth. By calculating the net worth a person could have the idea about how much saving he has with him, and he can also invest the saved amount in other investment opportunities. Many financial decisions are affected by tax laws, as some forms of income are taxed at a higher rate than others. By understanding how your alternative financial choices would be affected by taxes, you can make financial decisions that have the most favourable effect on your cash flows. Budgeting & tax planning decisions are the main component in the decision process as they affect decisions in the all other parts of your financial plan. In other words, it involves asking how much you plan to spend next week or next month, and what is the expected source of that money. The purpose of a budget is to plan your spending and saving, given your income level, so that you can meet your needs and wants. 5 Creating a Budget Involves Four Steps Step 1: Determining Your Net Worth The first step in budget planning is to determine your current financial position. Do you have money in the bank? Do you owe people money? Do you have a job? What are your total expenses? Answering these questions can help you to get an accurate picture of your current financial position. This will help you recognize how far—or near—you are from your goals and help you set budget priorities. The formula for determining your net worth is as follows: Net Worth = Assets - liabilities Step 2: Establishing Your Income A key factor in shaping a budget is to know your income. Income is the money coming in through wages earned, allowances received, or other sources. Having an income is the major means by which a person saves money, builds wealth, acquires assets, and fulfills wants and needs. Your income will determine many of the details in your budget. A person’s income is often positively correlated to his education and career choice. In general, more education or specialized training translates into more income. Think about the people you know who are making good money. What jobs do they do? You will probably list a number of professions, some that require a college degree, such as medical professionals and teachers. Others, such as electricians, mechanics, and plumbers require specialized training. In almost every case, you will find that higher income comes with higher levels of education and/or training. Step 3: Identifying Your Expenses Your expenses are also important in your budget. When you create your budget, you will estimate how much money you are spending every month. Typical expenses might be on food, clothing and entertainment. Some of you might even have a car payment and related expenses. Note that your consumption patterns are highly dependent on your life stages & thus will change over time accordingly. You will need to have accurate estimates of your expenses to determine how much you can save. Remember that saving for the future requires you to cut down on expenses today. Step 4: Considering the Impact of Taxes Income taxes—money owed to government on earned income may also impact your budget. In general, more the money you make, the higher the taxes you pay. As your income level increases, you might want to begin to include tax planning in your financial plan. For example, you may want to save some of your income in ways that help you put off or avoid taxes. Examples include certain retirement or college savings plans. Tax laws change constantly, and many of your financial decisions will have tax impacts that you will want to consider. 6 2. Manage Liquidity liquidity means access to funds to cover any short-term cash deficiencies. A person should always have certain amount of cash with him for the short term cash needs because you unexpected expenses which may arise in near future. A person can enhance his/her liquidity by using money management and credit management. Money Management is the decision to decide how much should be retained by the person in liquid form and how much should be invested in the short term investment plans. If a person has access to money to cover cash needs, it means he has sufficient liquidity and vice versa. So a person should decide how much to invest and where to invest for receiving some amount of return. Even the decision regarding liquidity should also be taken into consideration. Thus if any unexpected expenditure arises in the near future, he/she has sufficient cash for the same. Money management involves making decisions about how much cash to keep in reserve and how much to invest in less liquid assets, such as real estate (land & buildings). If a person finds out that he doesn’t have enough money to cover his immediate needs, then you need more liquidity. Sometimes you may have the money invested but that is not easily and quickly accessible. In that situation you should think wisely. Money management helps you determine how much money to keep liquid to avoid cash shortfalls. Credit Management is the use of borrowed funds, while investing or utilizing it for the daily expenditure. So here the person should do the research on- from where to borrow and how much to borrow. Credit, however should be used only when necessary, it can be very costly, as you will need to pay back borrowed funds with interest (and the interest expenses may be very high). For example- credit cards can be very costly. When you use credit (borrow money), the lender charges interest on the money you borrow. Think of the interest rates, some lenders charge higher interest than others. In general, it is not wise to rely on credit cards if you will not be able to pay back the borrowed money quickly. Whenever a person doesn’t have sufficient cash, credit management helps in that situation and also enhances the liquidity. Credit is commonly used to cover immediate cash shortfalls, so it increases liquidity. A financial plan should contain a credit management plan. This might involve details such as limiting the number of credit cards you have and the amount of credit you can use at any one time. Thus, liquid assets include cash and assets that can be quickly and easily turned into cash. Your level of liquidity, then, refers to how much readily available cash you have in hand for meeting immediate wants and needs. Note that your liquidity is very different from your net worth. You may have a number of valuable assets, but if they are not liquid, they will be of little use to you when facing a short-term financial need. For example, what if your car 7 breaks down or you need new tires? Or, what if, you need Rs 2000 to pay for a field trip? The fact that you own a car worth 500,000 will do little to help you solve such problems. 3. Planning for Financing loans are needed to finance large expenditures or capital expenditures, such as the purchase of a car or a home, payment of the college fees etc. The amount of financing needed is the difference between the amount of the purchase and the amount of money you have available with you. So the choice of loan will depend on the ability to pay the loan back, maturity of the loan and one with the least interest rate. Major purchases such as cars, houses etc. typically require borrowing money for long periods of time as people don’t have enough cash to pay for such huge expenses. However, it is common to pay a portion of the cost of a house or car and to take a loan for—or finance—the remaining amount. 4. Planning for Protection of Assets and Income To protect your assets, you can go for the insurance planning. For the protection of vehicles there is an automobile insurance and even there is facility to protect your home and factory. For the medical expenses we have health insurance by different companies. And for protecting the income we have life insurance. As you accumulate assets, you need to devise a plan to protect those assets. For example, if you buy a car, what happens if that car is stolen or rammed in a parking lot by another car? Unless you have insurance on that car you will suffer the loss of that asset yourself. You are assuming all the risk—the possibility of a financial loss. Risk is related to the likelihood of loss. If there is a greater chance of your suffering a financial loss, then the risk is higher. For that reason many people purchase insurance. Insurance planning is a component of your financial plan that determines the types and amounts of insurance you need. What other assets should you have insured? People typically insure houses, boats, cars etc. However, you also need insurance to cover you in case of other unexpected events, such as an illness or injury. Your parents also have life insurance that will provide a cash amount in the event of their death which provides financial safeguard to the loved ones left behind. 5. Planning for Investing The meaning of investments is that a person will sacrifice some amount of income at present in expectation of future returns. The return will be varying due to the investment proposals available to the investor. Thus any funds that a person has beyond what is needed to maintain liquidity should be invested. Investment opportunities available to the investors are equity shares, mutual funds, bonds, stocks and real estate etc. All these investments have certain level of risk. The variation in the return is called risk. Hence this needs to be managed so that the risk is limited to a tolerable level. You know you need to accumulate some funds for liquidity to meet day-to-day expenses and to pay for 8 sudden unexpected events. Any other funds that you do not spend should be invested with the expectation of earning even more money. 6. Planning for Retirement and Estate One should think about the source of income after retirement. So he should invest in some retirement plans well before the retirement and could get the sufficient amount of money after the retirement. The money which is invested in retirement plans is also protected from the tax until it is withdrawn from the retirement account. How many of you know people who are retired? Have you noticed that some people retire earlier than others? People who retire early are often people who began planning for retirement while they were young. Retirement planning involves determining how much to save for retirement every year and how to invest that money. The government provides several ways to save for retirement that allow you to accumulate wealth without paying taxes until you retire. By putting off paying taxes until later, you increase the amount invested. This, in turn, may increase the amount of money the investment earns. Whereas estate planning is the act of planning how the wealth will be distributed before or upon your death. Effective estate planning protects the wealth against unnecessary taxes, and ensures that the wealth is distributed in the manner that a person desire. 1.5 GLOBALLY ACCEPTED SIX STEPS IN DEVELOPING FINANCIAL PLANNING PROCESS (Jeff Madura, 2007) Step 1: Establish Financial Goals A person should specify his/her goals in the form of purchases that he/she wishes to make someday, or his goals may simply be to get out of debt or improve the credit history. If an individual simply wants to accumulate a specific amount of savings over time so that he can afford to do whatever he wants in the future, help other family members, or contribute to a worthy cause. An individual should also have this in mind that the goal needs to be realistic. You have read several times that planning can help you achieve your goals. But what are your goals? What do you want to accomplish in the future? Needless to say, you cannot reach a goal if you do not know what it is. Establishing clear goals is essential to any successful plan. You can categorize your financial goals in terms of when you hope to accomplish them as follows: 9   Short-term goals are those you plan to accomplish within the next year. For example- To save enough money to buy an MP3 player in a few weeks.  Intermediate-term goals are those you aim to meet within the next one to five years. For example- To save enough to buy a nice car next year.  Long-term goals will take more than five years to accomplish. For example-To save enough money for the down payment on a house in the next 10 years. As your goals become more involved, you will need a more specific and ambitious financial plan. It is essential that you set realistic goals. Goals must be achievable. It does not do any good to set a goal that you can never reach. If you focus on unrealistic goals, you will likely become discouraged when you do not achieve them. On the other hand, establishing an achievable goal encourages you when you accomplish it or as you see that you are making progress toward it. Remember you will set a number of goals for your financial life. In particular, you will want to set goals for each of the components of your financial plan. Step 2: Consider the Current Financial Position Second step in the financial planning process is concern about considering the current financial position. Even in the day to day life activities or events people consider their current situation. Let’s take a case of planning for a trip. And if you are new to the place and don’t know how to reach the destination. Then before starting your journey, you need to make a plan and your current position, because your selection of transport is based on your current financial position. The same principle is true for your personal finances. You need an accurate picture of your current personal and financial situation. Only then you can plan effectively. Your decisions about how much money to spend next month, how much to save, and how often to use your credit card depend to a large extent on your current situation. A person with a lot of debt and no assets will make different decisions about spending and saving than a person with low debt and a lot of assets. People with no dependents make different decisions than married people with children. People make different decisions at age 18 than at age 50. So we can say that different people see things differently. Since financial goals depend on your income, you can see that they are based on your level of education and your choice of career. Simply saying, having a good, solid income allows you to set more and loftier goals. You may know where you are and where you want to be, but you also need to know what roads to take to get there. A forecast is a projection about what will happen in the future. For business and personal finance, forecasts typically involve making projections about cash flows money you have coming in (inflow) and going out (outflow). Obviously, when we are evaluating our financial position, it is helpful to make projections about the future. For individuals, cash inflow is referred to as income. You can 10 get income from some external source, such as a job, allowance from your parents, or a scholarship. You may also get income from savings or investments—for example, interest earned on a savings account. Most people also have cash outflows to consider. We refer to these as expenses. An expense is anything on which we spend money. Examples include the phone bill and car payments. Some expenses we are obligated to pay every month and may be fixed. For example, rent of Rs 6000 a month would be a fixed expense. Fixed expenses, by definition, remain the same from period to period. Other expenses may be variable, or change from one period to the next. Your phone bill is an example of a variable expense. Each bill differs depending on how many minutes you use in the billing period. Step 3: Identify and Evaluate Alternative Plans that Could Achieve Your Goals Individual must identify and evaluate the alternative financial plans that could achieve his or her goals, given the financial position. For example, to accumulate a substantial amount of money in 10 years, you could decide either to save a large portion of your income over those years or to invest your initial savings in an investment that may grow in value over time. The first plan is a more conservative approach, but requires you to save money consistently over time. The second plan does not require as much planning, because it relies on the initial investment to grow substantially over time. However, the second plan is more likely to fail because there is risk related to whether the value of the initial investment will increase as expected. Step 4: Select and Implement the Best Plan for Achieving Your Goals After you develop multiple ways to achieve a goal, you need to decide which option is most realistic and suitable for you. Two people who seem to be in identical situations may still opt for two different plans. Your tolerance for risk and your self-discipline often determine which particular plan offers the best option for achieving a specific goal. Risk is often defined as the likelihood of loss. Think about different tolerances for risk in terms of a game. Your school may be playing last year’s state championship in the opening game. Some of your team members are dreading the game because they realize the risk that they will lose is very high. These players have a low risk tolerance. However, some other team members welcome the risk. They are excited about the game because even though the risk is high, the potential reward is huge. They realize that if they are able to beat the state champs, they will achieve much recognition. Neither of these two attitudes is right or wrong. Each indicates different tolerances for risk. You can apply the same thought process to your financial decision making and financial plan. Some of you will choose plans that have a higher level of risk of loss but also have a higher potential payoff. Others will pick plans with lower risk that are more certain to accomplish the ultimate goal. 11 Step 5: Periodically Evaluate Your Financial Plan After selecting a plan, you need to monitor the progress because sometimes plans may falter or get off track. Unless you are monitoring your progress toward your goals, it is likely that you will not notice a problem and make any needed adjustments. So the question which arises are- is your financial plan working properly? That is, will it enable you to achieve your financial goals or not? Step 6: Revise Your Financial Plan What will happen if you find out that your plan is unachievable? If you find that it is difficult to follow the financial plan that you developed, you need to revise it. But keep in mind, any revision to one part of your financial plan may impact other aspects of your plan. By the time, your financial position will change, especially upon specific events such as graduating from colleges, marriage, a career change, or any big event. As your financial position changes, your financial goals may change as well. You need to revise your financial plan to reflect such changes in your means and priorities. For example- Arjun’s original financial plan required that he should save Rs.5000 a month for 2 years in order to have Rs.120000 for the down payment of a car. However, after one year he has managed to save only Rs50000. What will Arjun need to do in order to accomplish his original goal? Solution: In this case Arjun needs to save another Rs 70000 to reach his original goal (i.e. 120000-50000=70000). To accomplish that goal he needs to save rs70000/12 = Rs 5833.33 per month. Hence he will have to increase his savings to Rs 5833 approx. per month to accumulate Rs 120000 by the end of next year. So whatever the plan is, this needs to be monitored periodically. And revise the plan whenever it is necessary. 1.6 GENERAL PRINCIPLES OF CASH FLOW PLANNING (Jeff Madura, 2007) Just like business plan, a set of financial statements providing information related to cash- flow is essential. This will provide details of actual cash required by your business on timely basis may be day-to-day, month-to-month and year-to-year basis. The needs of a business entity constantly changes and cash flow will highlight any shortfalls in cash. And it is required at that time to think for those shortfalls. Even there should be some measures to overcome these deficiencies. Many established and even profitable businesses fail due to cash not being available when they need it most. Good cash flow management is critical to run a successful business. You must have certain amount as reserve so that you are able to 12 pay your bills while you await payment from your customers. There are many well- documented cases of businesses failing not because they were not profitable but because of poor cash flow management. It is said that you're in business to make a profit. You won't be able to stay in business, however, unless you have cash, hence the famous adage 'cash is king'. There will probably be a time lag between your business providing its goods or services and getting paid. This means you have to make sure that there is sufficient cash in your company's bank account for the payment of all its bills in the meantime. Whether these are related to invoices from suppliers, employees' wages, rent, taxes or anything else. Even if the business is profitable, there may be times when you are short of cash because may be you are awaiting payment for a large order. This is likely to be a particular problem during your first year when you are building up your business and don't have regular cash inflows. The General Principle of Cash Flow Management is that  You should speed up your cash inflows (customer payments, interest from bank accounts etc.) and  Slow down your cash outflows (purchase of stock and equipment, loan repayments and tax charges etc.) as much as possible. It can be difficult to affect your outflows other than extending your credit terms with your suppliers, which will often occur on fixed dates in the month and your employees and suppliers might also not take too kindly to you delaying payment to them. But there is more scope for you to improve your cash inflows. This could mean billing regularly, chasing bad debt, selling your debt to a third party (factoring), negotiating extended credit terms with suppliers, managing your stock effectively (which could entail ordering little and often) and giving your customers 30-day payment terms. Also, as businesses naturally have peaks and troughs, it is important that you put money away during the peaks so that you can dip into it during the troughs. It is a good idea to think about investing in some accounting software to help you manage your cash flow. There are many software providers: an internet search should reveal the most common. Most provide software that can help you with cash flow analysis and forecasting, so that your business is never caught short of cash in the bank. Your accountant should be able to help advice you on which software package to buy. 13 1.7 HOW THE COMPONENTS RELATE TO YOUR CASH FLOWS (William J. Hass and Shepherd G. Pryor IV, 2006) A person receives cash inflows in the form of income from the employer and uses some of that cash to spend on products and services. Income focuses on the relationship between the income and the spending. The budgeting decisions determine how much of the income to spend on products and services. The residual funs can be allocated for the personal finance needs. Liquidity management focuses on depositing excess cash or obtaining credit if the person is short on cash. Financing focuses on obtaining cash to support the large purchases. Protecting your assets and income focuses on determining your insurance needs and spending money on insurance premiums. Investing focuses on using some of the cash to build the wealth. Planning for the retirement focuses on periodically investing cash in the retirement account. In case if you need more cash, you should invest the money which is left after using for day to day expenses. For that you should invest your savings in some of the investment plans (as per the risk preference of the investor). Basic Principles to Consider When Preparing Cash Flow Forecasts and Plans 1. Understand cash flow contributions of different product lines and/or business units and overall strategies and risk involved. 2. Involve those who will be accountable. 3. Identify and communicate key performance measures. 4. Adapt the cash flow planning and update processes to the organisational capability. 5. Encourage open debate and fact-finding on the cash flow plan. 6. Quantify the magnitudes and likelihood of risks and opportunities to the base plan. 7. Monitor execution weekly or daily. 8. Update assumptions and renew outlook weekly. 9. Communicate thoroughly. 10. Recognize owner and stakeholder priorities. 11. Focus on significant improvements and strategic initiatives. 12. Measure and monitor the results. 14 1.8 GENERAL PRINCIPLES OF BUDGETING (Jeff Madura, 2007) Creating a budget is a key part of your financial plan. A budget is a forecast of future cash inflows and outflows. Once you have identified your personal goals, you need some specific plans about how to reach those goals. Your household budget provides that guidance. It gives you a detailed road-map to your financial future. He wants to pay off his credit cards, save some money for a rainy day, and treat himself to a few things he wants. Can he accomplish all those goals? If he plans well and doesn’t attempt to do all of them at once, he can achieve his goals. A budget will be a detailed plan of action for the next several years. Step 1: Create a Personal Cash Flow Statement The first step in the budgeting process is to identify your current cash inflows and outflows. Any money that is coming is a cash inflow. The primary cash inflow for most people is their salary, hourly wages, or any money they earn. However, some people may have income from savings accounts or other similar sources. Others may receive an allowance and perquisites of some type. In addition, if you receive money from a scholarship, that is income, too. Any money that is going out is a cash outflow. Expenses such as car payments or insurance premiums are cash outflows. At some point you may begin paying rent and utilities or your cell phone bill. These are all cash outflows. Typically, family size, age, and your personal spending habits have an impact on cash outflows. Your personal cash flow statement records both cash inflows and outflows. This allows a person to easily track where your money comes from and where it goes. Step 2: Turn Your Cash Flow Statement into a Budget The next step is to turn your personal cash flow statement into a budget. To do this, you must forecast your net cash flows for a period of time into the future. A good budget should cover anticipated cash inflows and outflows for several months to a year or more. As you work on this step, it’s important to think about how your cash flows might change from month to month. Will you spend more money at certain times of the year, or are your cash flows similar from month to month? What about the holiday seasons? Be sure that you consider expected but irregular expenses. Examples include activity fees for school functions or money for your summer break activities. A yearly vacation is another example of an expense that will not show up in the typical month. Indeed, many people find that expenses occur unexpectedly. Accidents or medical emergencies are unpredictable. What happens when you are at college and you unexpectedly 15 need to return home for a weekend? Who will pay for the gas? A good budget will force you to set aside money to take care of unexpected expenses and to take advantage of unexpected opportunities. Taking your personal cash flow statement and turning it into a budget for an entire year involves some guesswork and estimating. Obviously, you cannot plan the exact cost of events or expenses that have not occurred yet. You can always go back and adjust the budget as you get more information. This annual budget can help you identify times when you can save money and times when you will have more outflows than inflows. Step 3: Working with and Improving Your Budget We know that a budget is a great planning tool. A budget can help you save money for major purchases, unexpected expenses, and unexpected opportunities. One of the primary benefits of a budget is that it will help you anticipate future cash shortfalls. This may be tempting for individuals to satisfy all their desires at once, perhaps by continuing to overuse their credit card. However, this is a risky path that leads many people into financial disaster. With a good budget, people can meet their wants and needs without a costly and unwise dependence on credit. Step 4: Assessing the Accuracy of the Budget One of the things you need to do is periodically evaluate your forecasts and compare these with the actual cash flows. It’s a good idea to look at last month’s forecasts or the last three months’ forecasts and compare those with actual numbers. The best way to know exactly how you spend your money is to keep an expense details. Write down every rupee you spend during a week or a month. It might really surprise you where your money is going. Sometimes you will find that you underestimated your cash outflows or were too optimistic regarding your cash inflows. The difference between what you forecast and what actually happens is known as forecast error. After knowing the forecast error, you may find that you need to adjust your spending. If you continue to come up short of money at the end of each month, you need to increase your income or decrease your outflow. It is important to have a good knowledge of budgeting principles that can make the difference in the financial health of the organisation. Failure to engage in sound budgeting processes would be the main reasons why companies and organisations fail. Even for personal financial planning these steps should be followed. An individual should always keep in mind that panning at each level is required. And comparison of forecasts and actual budget will tell the position of an individual. And that person can work on that difference to make his position better. 16 1.9 SOURCES OF INFORMATION (M. Ranganathan and R. Madhumathi and Vikaspedia) It may seem difficult to think about some aspects of financial planning right now. Goals may seem too numerous or out of reach. The stakes of good and bad decisions may seem high. Fortunately, there are many resources available to help you make good choices. The 4 main areas are: 1. Print and media Books, periodicals, newsletters, television and radio programs 2. Digital sources websites, blogs, phone apps, online videos, social media 3. Financial experts seminars courses with financial planners, bankers, accountants, insurance agents, credit counsellors, tax preparers 4. Financial institutions materials from credit unions, banks, investment, insurance, real estate companies The Internet can be a wonderful source of information about a number of financial aspects of your life. You can use the Internet to research prices of major purchases or look up investment performance data. There are a number of Websites that provide payment calculators, benefits or information on wealth building. However, the Internet also poses some dangers. You need skill and care to evaluate the quality of information you find there. And you must always be cautious about advice from sources that are selling a service. The Internet has its share of unethical people trying to defraud you and increase their wealth at your expense. Understanding personal financial planning will help you make good decisions about how to spend money, finance purchases such as cars and houses, and save and invest your money. However, many of you may want to turn some of these decisions over to professionals who understand all the tax laws and can monitor your investments more closely. Many people spend more time picking out music to download than they spend choosing a financial advisor. Understanding financial planning will help you determine whether an advisor is giving you advice that is in your best interest. Again, the Internet is a good source of information about financial planners. Stick with planners who have reputable credentials such as a Certified Financial Planner (CFP) or Certified Public Accountant (CPA), since credentials indicate a certain level of knowledge about financial planning. Remember that no matter who you hire to help you with your finances, you are responsible for monitoring your own investments. Be cautious. Never rush into a financial decision. If someone tries to rush a decision, it is rarely good for you. There 17 are many resources available to help you make your financial decisions. One resource is the Internet. Other resources include financial planners or advisors. Financial planners or advisors can help you with all aspects of your financial decisions including monitoring your investments and keeping you posted on tax law. 1.10 OVERVIEW OF RISK MANAGEMENT (Prasanna Chandra, 2012) Every organization, no matter how large or small, inherently possesses exposures to risk. They change constantly and are rarely stationary. Employees come and go, new services and programs are provided, outdated services and programs are eliminated, equipment wears out and must be replaced, facilities are built, renovated, demolished, laws change, the state’s business marches on. Thus, management of these risks requires a coordinated, disciplined managerial approach to eliminate or control the risks. This managerial approach is called ―risk management.‖ A Risk Exposure is the possibility of loss or injury because of some peril or cause of a loss. Management is the process of planning, organizing, staffing, leading, and controlling human and physical resources in order to achieve the organization’s objectives and goals. Therefore, Risk Management, by definition of its component terms, is the management process of planning, organizing, staffing, leading, and controlling an organization’s resources to minimize the possibility of loss or injury from various causes of loss. Simply stated, risk management is the process of identifying and controlling an organization’s losses. Quite often, risk management is too narrowly defined. The term is often thought to simply mean a safety program. Or, it is thought of as being the arm of the organization that deals only with insurance matters. Safety and insurance are both components of a risk management program. However, because risk exposures exist in all areas of the organization, a comprehensive risk management program involves the risk management staff in accounting and finance, law, human resources, and all operations of the organization. Benefits of Risk Management A well-conceived, comprehensive risk management program requires a significant commitment of time and resources by the organization. However, the cost of this organizational commitment is fully mitigated by the realization of the following benefits to the organization that are the direct result of the risk management program: 18   Reductions in misuse, theft, and/or losses to equipment and property  Reductions in the frequency and severity of accidents  Reductions in the expenditures of claims  Reductions in legal expenditures  Increased productivity  Improved employee morale. Objective and Goals of Risk Management Reducing the cost of risk is the primary objective of a risk management program. The cost of risk for a specified loss is the total value of all related costs and resources, both direct and indirect. The total cost of risk to an organization is the sum of the following:  The replacement value of all equipment and property damaged or lost Total claims expenditures, including legal expenditures.  The costs of insurance premiums, lost productivity, Administrative and overhead costs. Since reduction of the cost of risk is the primary objective of a risk management program, specific goals that support this primary objective are to minimize exposures to financial losses- Protect physical assets, Reduce the frequency and severity of accidents. Provide a reasonably safe environment for employees and the public Minimize interruptions of services provided to the public. 1.11 RISK MANAGEMENT PROCESS (Stephanie Ray, Oct 2017) The steps of the risk management process 1. Identification of Risk It allows operations staff to become aware of potential problems. Not only should risk identification be undertaken as early as possible, but it also should be repeated frequently. 2. Analyze and Prioritize Risk analysis transforms the estimates or data about specific risks that developed during risk identification into a consistent form that can be used to make decisions around prioritization. Risk prioritization enables operations to commit resources to manage the most important risks. 19  3. Plan and Schedule Risk planning takes the information obtained from risk analysis and uses it to formulate strategies, plans, change requests, and actions. Risk scheduling ensures that these plans are approved and then incorporated into the standard day-to-day processes and infrastructure. 4. Track and Report Risk tracking monitors the status of specific risks and the progress in their respective action plans. Risk tracking also includes monitoring the probability, impact, exposure, and other measures of risk for changes that could alter priority or risk plans and ultimately the availability of the service. Risk reporting ensures that the operations staff, service manager, and other stakeholders are aware of the status of top risks and the plans to manage them. 5. Control & Learn Risk control is the process of executing risk action plans and their associated status reporting. Risk control also includes initiating change control requests when changes in risk status or risk plans could affect the availability of the service or service level agreement (SLA). Risk learning formalizes the lessons learned and uses tools to capture, categorize, and index that knowledge in a reusable form that can be shared with others. Management of Risk with the Help of Following Measures (a) Investment, (c) Retirement solutions, (b) Insurance, (d) Tax and estate planning. (a) Investment Investment planning is an essential part of the financial planning process. Without a proper investment plan, the client is unlikely to reach the set target in funding his/her retirement and educational needs. In investment planning, some of the important factors that need to be considered are as follows:  What is the person's risk profile - How averse is he to investment risk? This will help determine proper asset allocation and selection of investment vehicles. A more conservative investor should opt for an asset allocation that takes into account his aversion to high investment risk taking.  What is his time horizon - How much time does the person have to achieve his financial objectives? If the time horizon is long, investments having a higher risk and potential returns may be resorted to or may be to produce a better yield. 20   What are the person's financial objectives? To accomplish anything, it is necessary to set targets. This is especially so in the realm of investments. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or will be sold at a higher price for a profit. The term "investment" can be used to refer to any mechanism used for the purpose of generating future income. In the financial sense, this includes the purchase of bonds, stocks or real estate property. Additionally, the constructed building or other facility used to produce goods can be seen as an investment. The production of goods required to produce other goods may also be seen as investing. Taking an action in the hopes of raising future revenue can also be an investment. Choosing to pursue additional education can be considered an investment, as the goal is to increase knowledge and improve skills in the hopes of producing more income. Investment products are available for individual and institutional investors, and are purchased in an attempt to generate a profit. Some investment products, such as certain types of bonds, provide a fixed interest payment in addition to a return of the initial investment at the time of maturity. Other types of investment products, such as stocks, which have greater risk and on the other hand earnings are not guaranteed. Thus, Investment means to purchase various financial instruments which will pay you a return on some future date. The difference between savings and investment is that savings is simply idle cash while investments help your funds to grow over a period of time. We can meet our short-term needs with our savings but to meet our long term goals we need to make investments. Savings help to protect our principal while investments help us earn returns over our investments. (b) Insurance Insurance is a means of protection from financial loss. It is a form of risk management primarily used to hedge against the risk of an uncertain loss. An entity which provides insurance is known as an insurer, insurance company, or insurance carrier. A person or entity who buys insurance is known as an insured or policyholder. The insurance transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to compensate the insured in the event of a covered loss. The loss may or may not be financial, but it must be reducible to financial terms, and must involve something in which the insured has an insurable interest established by ownership, possession, or pre-existing relationship. 21 The insurer receives a contract, called the insurance policy, which provide details related to the conditions and circumstances under which the insured will be financially compensated. The premium is the amount of money charged by the insurer to the insured for the coverage set forth in the insurance policy. If the insured experiences a loss which is potentially covered by the insurance policy, the insured submits a claim to the insurer for processing by a claims adjuster. Methods of Insurance In accordance with study books of The Chartered Insurance Institute, there are the following types of insurance:  Co-insurance risks shared between insurers  Dual insurance risks having two or more policies with same coverage  Self-insurance situations where risk is not transferred to insurance companies and solely retained by the entities or individuals themselves  Reinsurance situations when Insurer passes some part of or all risks to another Insurer called Reinsurer (c) Tax and Estate Planning While tax evasion is illegal and punishable under the law, it is lawful to minimise one's tax obligations if done legally. The financial planner will normally work in hand with a tax adviser to help the client derive and implement a tax plan that will minimise the tax outlay of the client. In estate planning, the financial planner helps the client to develop and implement an estate plan that will enhance and preserve the client's assets during his lifetime, minimise his estate duty liabilities upon his death and ensure that the estate is managed and distributed to beneficiaries in accordance with the client's wishes. Such recommendations may involve the drawing of wills and trust instruments. Nominated executors and guardians will have to be thoroughly briefed and conveyances may have to be effected to achieve the desired objectives. Estate planning is even farther into the future than retirement but is something you should be aware of. Estate planning is the process of determining how your wealth will be allocated on or before your death. In other words, what happens to your assets when you die? Do you want them to go to the state, to a particular charity, or to your children and grandchildren? If 22 you resolve these questions prior to your death, you are more likely to have your wishes honoured. It will also make it easier on your loved ones. (d) Retirement Planning India and other countries too currently face a problem of an aging population. The future increase in the elderly population will pose questions such as:  How will their medical needs be taken care of?  How can they remain useful and productive?  How will their financial needs be met? One of the government's answers to these questions is to increase public awareness of financial planning and to encourage people to obtain proper financial planning advice so that their retirement needs will be taken care of during their golden years. The financial planner assists their clients by deriving and implementing a suitable retirement plan to realise their retirement objectives. He helps the clients calculate their retirement funding needs and comes up with a savings and investment plan for them. 1.12 LEGAL ASPECTS OF FINANCIAL PLANNING (Jeff Madura, 2007) In the area of legal practice, financial planning can play a useful role in helping the lawyer give more holistic and complete legal advice to their clients. This is particularly so in areas that impinges on the personal financial affairs of the client. Apart from knowing the technicalities of the law, an understanding by the lawyer of the financial aspects of a legal problem can help address the more fundamental needs of the client. Some examples can be found in the areas of: (a) Family law; (b) Wills and estate matters; and (c) Bankruptcy matters. (a) Family Law Financial planning is particularly useful in the area of family law practice. Under most divorce matters, maintenance and division of matrimonial property are important matters that have to be addressed by the courts. 23 The courts, in deciding on maintenance issues, will have to look into the financial needs of the family and how the spouse should contribute, particularly in meeting the financial needs of the children. In many cases, however, the party that needs the support may not be knowledgeable enough to determine exactly what his/her needs or the dependants' needs should be. More often than not, they end up giving estimates which may not be accurate. Should there subsequently be a shortfall, a further application to the court may be necessary to seek redress. This often results in additional legal costs and time spent. However, if the lawyer is armed with relevant financial planning knowledge, he can advise his clients and guide them in a manner where accurate computation of maintenance needs can be derived. Sometimes a party may agree to pay a lump sum to the other spouse as provision of maintenance, and then the financial needs of that spouse throughout her entire life would be a relevant consideration. In such cases, financial planning advice will be useful in determining the global amount. An important factor for the courts to consider in deciding on maintenance is what amounts the payer can afford. The courts in making a decision will, among other things, need to balance the interest of all parties concerned. The application of the financial planning process will enable the payer to determine his own personal needs and, if they are properly derived, the courts will be better persuaded to accept his position and submissions when allocating maintenance. (b) Wills and Estate Matters Financial planning can be very useful to the lawyer in estate matters, such as the drafting of wills. Under most circumstances, a lawyer normally takes instructions from the client and drafts a will in accordance with such instructions. The lawyer is mainly concerned with ensuring that the will is technically and legally valid and in accordance with the instructions. However, the lawyer is often unable to advice as to whether the instructions are suitable to the client's real needs. The lawyer can add further value to his legal advice by addressing these concerns, some of which are:  How can the will and other legal instruments, like trust and insurance policies, be utilised so as to minimise the estate duty in the event of death?  How should the estate be distributed to the desired beneficiaries? For example, if a client is afraid that the beneficiary may fritter away the assets, the lawyer may give advice on the suitability of using instruments like trust and annuities. 24   What sort of powers should be allocated to the executor? For example, if the client's main asset is his business, the lawyer could advise the client about extending the executor's authority and allowing him to continue the business before selling it at a desired price, thus preventing the business assets from being forcefully sold at unattractive prices.  Who should be appointed as the children's guardian in the event of death of both parents?  How should the estate be managed by the executor in the event of the testator's death and pending distribution? In using financial planning knowledge to advise the client, not only can the lawyer advise on whether the instructions of the client are legal, but also whether these instructions can achieve the client's needs and desires. (c) Bankruptcy Matters In bankruptcy matters, a client will be faced with severe financial and maybe legal constraints should be adjudicated a bankrupt? The lawyer can assist the client in the legalities of the bankruptcy and if he has financial planning knowledge, such knowledge can be used to help the client assess the financial impact of the bankruptcy on him and his family so that he can make the most suitable decision under the given circumstances. The simple objective of financial planning is to make the best use of your resources to achieve your financial goals. The sooner you develop your goals and a financial plan to achieve those goals, the easier it will be to achieve your objectives. Your financial planning decisions allow you to develop a financial plan, which involves a set of decisions on how you plan to manage your spending, financing, and investments. We can say that all components of financial plan are related. In the planning process, budget determines how much money you can set aside to maintain liquidity or to invest in long-term investments. Also the way you obtain funds to finance large purchases such as a car or a home is dependent on whether you sell any of your existing investments to obtain all or a portion of funds needed. Your need for insurance is dependent on the types of assets you own. Your ability to save for retirement each month is dependent on the amount of funds you need to pay off any existing credit balance or loans. The cash flow statement measures your cash inflows, cash outflows and their difference over a period of time. Cash inflows generally result from your salary or from income generated by your investments. And cash outflows result from your spending. Budget can help you in 25 forecasting net cash flows, which is based on forecasted cash inflows and outflows for an upcoming period. The budget process allows you to control your spending. And by comparing the forecasted and actual income and expenses conclusion can be drawn whether you were able to stay within the budget or not. This will help in modifying the spending in the future or perhaps adjust the future budgets. Your budget decisions dictate your level of spending and saving and therefore affect the other parts of the financial plan. The amount you save affects your liquidity, the amount of financing necessary, the amount of insurance that you can afford and need, the amount of funds that you can invest, and the level of wealth that you will need for retirement. 1.13 SELF-ASSESSMENT QUESTIONS 1. Fill in The Blanks (a) _____________ is the process of planning your spending, financing, and investing to optimize your financial situation. (Financial planning) (b) The financial planning process involves ______ steps. (Six) (c) You can forecast net cash flows by creating a __________. (Budget) (d) The ______________ process allows you to control spending. (Budgeting) (e) The personal balance sheet measures the value of your assets, your liabilities, and your ____________ (net worth) (f) The difference between total assets and total liabilities is net worth, which is a measure of your __________ (wealth) (g) Your budget decision dictates your level of spending and saving and therefore affects the other parts of the __________________. (Financial plan) (h) Your budget determines how much money you can set aside to maintain __________or to invest in long-term investments. (liquidity) 2. Long Answer Questions Q1. Define financial planning. What types of decisions are involved in a financial plan? Q2. What are the benefits associated with understanding of financial plan? Q3. What are the six key components of a financial plan? Why there is a need to revise your financial plan? 26 Q4. Define budget planning. What elements must be assessed in budget planning? Q5. What is the meaning of liquidity? What two factors are considered in managing liquidity? Q6. What is the primary objective of investing? What else must be considered? Q7. How does each element of financial planning affect your cash flows? Q8. Once your financial plan has been implemented, what is the next step? Why is it important? Q9. Why there is a need to revise your financial plan? Q10. Define cash inflows and cash outflows and identify some sources of each. How can you modify your cash flows to enhance your wealth? Q11. What is budget? What is the purpose of a budget? How can a budget help when you are anticipating cash shortages or a cash surplus? Q12. How do you think people who do not create a budget deal with cash deficiencies? How can this affect their personal relationships? SUGGESTED READINGS 1. Madura, Jeff. (2007). Personal Finance. (ed. 3rd). Florida Atlantic University, Pearson. 2. Madura, Jeff, Mike Casey, Sherry J. Roberts. (2010) personal financial literacy. Retrieved from http://textarchive.ru/c-2512111-pall.html 3. Eliud Bundi Ondara. (2016). Financial Planning. Retrieved from https://www.slideshare.net/ebondara/financial-planning-57558492 4. Sullivan University Library. Retrieved from https://libguides.sullivan.edu/finance/personalfinance 5. Madura, Jeff. Personal finance, (6th ed.). Retrieved from http://cbafaculty.org/personal%20Finance/LN01_Madura_3001_PF_06_LN01.pptx 27 6. M. Ranganathan and R. Madhumathi. Investment Analysis and Portfolio Management. Pearson Education, New Delhi. 7. Donald E. Fischer and Ronald J. Jordon. Security Analysis and Portfolio Management, PHI. 8. Chandra, Prasanna. (28th june 2012). Investment Analysis and Portfolio Management. (4th ed). McGraw-Hill, Delhi. 9. Lawrence J. Gitman, Michael D. Joehnk, Randy Billingsley. (2010). Personal financial planning. (12th ed.). Cengage Learning 10. MCX Stock Exchange and Ft Knowledge Management Company. (July2010). Retrieved from https://www.sebi.gov.in/sebi_data/investors/financial_literacy/College%20Students.p df. Published by SEBI. 11. Ray, Stephanie. (Oct19th2017). Risk Management. Retrieved from https://www.projectmanager.com/blog/risk-management-process-steps 12. William J. Hass and Shepherd G. Pryor IV. (2006). Building Value through Strategy, Risk Assessment and Renewal. Chicago. Retrieved from http://board- resources.com/articles/Hass-Pryor-CashFlowPrinciples-reprint.pdf 13. R. P. Rustagi. (2008). Investment analysis and portfolio management. (2nd ed.). Sultan Chand & Sons. 14. Vikaspedia. A knowledge portal. Common information sources for financial planning. Retrieved from http://vikaspedia.in/social-welfare/financial-inclusion/financial- literacy/seeking-advice-and-help/sources-of-advice 15. Lessons on financial planning for young investors, publication securities Exchange Board of India. 28  Unit II Lesson 2 INVESTMENT ENVIRONMENT 2 STRUCTURE 2.1 Investment 2.2 Speculation 2.3 Factors of Sound Investment 2.4 Investment Process 2.5 Portfolio Management 2.6 Types of Investment 2.7 Equity Shares 2.8 Bonds 2.9 Mutual Funds 2.10 Fixed Deposits 2.11 PPF 2.12 Financial Derivatives 2.13 Commodity Derivatives 2.14 Gold and Bullion 2.15 ETFs 2.16 REITs 2.17 Certificate of Deposits 2.18 Real Estate 2.19 Objectives & Rewards of Investing 2.20 Self-Assessment Questions 2.1 INVESTMENT (Prasanna Chandra, 2012 and V K Bhalla, 2009) An investment is an asset or an Item which is acquired with the objective of income generation and value appreciation. Investment is a commitment of funds made in the expectation of some positive return. For the investment one needs to sacrifice some portion of his/her present funds for a specified time period for uncertain future rewards, where some 29 risk is also involved. There are risk-free investments or investments having minimal risk available for an investor. These are government bonds and certificate of deposit which are considered as risk free investments. Some investors are willing to take high risk because of the expectation that the high risk will be rewarded with high returns. We know that there are many ways to invest money. Of course, to decide which investment option is suitable for an investor, we need to know their characteristics and why they may be suitable for a particular investing objective. So we can say that it also depends on the objective of the investor. If the investor is risk lover, he would like to invest in most risky securities. And if the investor is risk averse then he will go for less risky or risk-free investment options. In case of short term gain, investor would prefer to invest in shares and in case of long term gain the choice will be PPF, mutual funds, real estate and post office saving scheme. Capital Market A market where buying and selling of equity and debt instruments takes place. Capital markets channel savings and investment between suppliers of capital such as retail investors and institutional investors, and users of capital like businesses, government and individuals. Capital markets are vital to the functioning of an economy, since capital is a critical component for generating economic output. Capital markets include primary markets which is a new issue market, and secondary markets which trade existing securities. There are numerous participants in the capital market. The participants are individual investors, institutional investors such as pension funds and mutual funds, governments, corporate and organisations, banks and financial institutions. Money Market The money market is where financial instruments those having high liquidity and short maturities are traded. It is used by investors as a means for borrowing and lending in the short term, with maturities that usually range from overnight to just under a year. Among the most common money market instruments are euro dollar deposits, certificate of deposits (CDs), banker’s cheque, Treasury bills, commercial paper, etc. 2.2 SPECULATION (M. Ranganathan and R. Madhumathi) Speculation is a process includes buying and selling of securities with a view to earn profits due to price fluctuations. High risk is involved with speculation. Points of Investment Speculation Gambling Difference Planning Longer planning Short planning horizon Short planning horizon horizon horizon 30 Basis for Scientific analysis of Inside information, Based on tips and decision Intrinsic worth of the hearsays, markets rumours security psychology Return Moderate rate of return High rate of return Negative returns are expectation expected Risk Moderate risk High risk Artificial risk Funds Use of own funds Use of borrowed funds Unplanned activity Motive Reasonable return on a One time, large return Entertainment while consistent basis rather quickly earning 2.3 FACTORS WHICH INFLUENCE THE DECISION OF AN INVESTOR (V K Bhalla, 2009)  Stability of Return This factor is the important factor as mostly every investor wants to have a stable return. Life insurance is considered as the best investment option. As a primary benefit, it offers financial protection to the policyholder and his/her nominee or family. For example, fixed deposits A/c, bonds and debentures, interest from savings account in a bank, etc.  Risk Investors has a concern for risk associated with the investment. Because more the risk more the return will be. That’s why people with risk appetite will invest in more risky securities.  Liquidity liquidity of any investment plan will also have an impact on the decision of the investor. As it gives a benefit of easy convertibility into cash. Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price.  Tax Shelter A tax shelter is a vehicle used by taxpayers to minimize their tax liabilities. Tax shelters can range from investments or investment accounts that provide favourable tax treatment, to activities or transactions that lower taxable income. The most common type of tax shelter is an employer-sponsored 401(k) plan. Investment in PPF has tax benefits too.  Safety of Principal some investors will invest in those securities which will give assurance related to safety of principal amount. People who want safety of principal 31  will invest in PPF, national saving certificates etc. As they give assurance of safety of principal and also provide tax shelter.  Hedge Against Inflation An inflation hedge is considered to provide protection against the decreased purchasing power which results from the loss of its value because of rise in prices (inflation). It typically involves investing in an asset that is expected to maintain or increase its value over a specified period of time. Alternatively, the hedge could involve taking a higher position in assets, which may decrease in value less rapidly than the value of the currency. 2.4 THE INVESTMENT PROCESS (Bodie, Kane and Marcus, 2013) Investment decision process is a dynamic and continuous process. The investment decision process starts with designing an investment policy. After that E-I-C analysis takes place (where E is economy, I is Industry and C is company). Next step is the valuation of investment opportunities available to an investor. Diversification and allocation is the next step in the process. Where diversification is the risk management process, which includes wide variety of investments within a portfolio. Last step is the most important step as it includes appraisal and revision of investment. In this an investor will do the evaluation and if necessary revise the portfolio. Revision may include deletion of previous security or may be an inclusion of new profitable security. The Investment Process Includes Two Steps Step 1: Asset Allocation Decision the investor has to decide about the broad classes of investments. These classes may be shares, bonds, gold, real estate, commodities, etc. Asset allocation is to identify and select the assets classes appropriate for a specific investment portfolio, and determining the proportions of these assets within the given portfolio. Some factors which needs to be considered are objective of the investment, risk associated with the investment, and the time horizon of the investment. Step 2: Security Analysis the investor has to select a specific security. It involves analysis of available securities that currently appear to be worth buying or worth selling. Security analysis includes fundamental analysis and technical analysis.  Fundamental Analysis follows the EIC approach. This approach attempts to study the economic scenario, industry position and company expectations. 32  o Economic Analysis business cycles, monetary policy, fiscal policy, inflation, interest rate structure, GDP growth, unemployment, foreign trade, etc. o Industry Analysis demand-supply relationship, industry structure and competition, cost structure, quality control standards, responsiveness to income, etc. o Company Analysis expected earnings, dividends, funds position, accounting policies, risk-returns, quality of management, etc.  Whereas, Technical Analysis is based on the proposition that the securities prices and volume in past suggest their future price behaviour. Technical analysis may also be called the market analysis because it uses the market record and market information to predict the volume and prices. It is based on the principle that let the market narrates its own story. 2.5 PORTFOLIO MANAGEMENT (Prasanna Chandra, 2012) Portfolio is a combination of securities with their own risk and return characteristics. Portfolio management is the dynamic function of analysing, selecting, evaluating and revising the portfolio in terms of stated investor objectives. The two approaches to portfolio management are traditional portfolio management which includes selection of those securities that best fit the personal needs and desires of the investor. It may yield less than optimum results and the second is modern portfolio management which is a scientific approach i.e., based on estimates of risk and return of the portfolio. Investment Categories  Real Assets tangible, material things like, automobiles, real estate (land & building), plant & machinery, furniture, gold, silver, etc. Real assets are heterogeneous, thus less liquid.  Financial Assets paper claims that represent an indirect claim on the real assets of an entity. E.g.,: debt or equity instruments like equity shares, mutual funds, preference shares, commercial papers, savings account, loans and deposits, etc. Financial assets offer the benefit of liquidity to the investor. 33 2.6 TYPES OF INVESTMENT OPPORTUNITIES AVAILABLE TO AN INVESTOR There are many types of investments and styles of investment available to an investor. Shares (equity or preference), mutual funds, ETFs, bonds or fixed income securities, financial derivatives, real estate etc. are few examples. The first priority of any investor will always be liquidity. And liquidity needs can be fulfilled by investing in certificate of deposit (CD). But where an investor is willing to take risk, there are wide variety of investments available. There are several different money market securities like certificate of deposit, money market deposit account, and money market funds. Most money market securities provide interest income. Even if your liquidity needs are considered, you may invest in these securities to maintain a low level of risk. 2.7 EQUITY SHARES (V K Bhalla, 2009 and R. P. Rustagi, 2008) An equity share, commonly referred to as ordinary share also represents the form of fractional or part ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a business venture. The holders of such shares are members of the company and have voting rights. A first thing that comes to investors mind while talking about equity is a risk. A risk is the probability of permanent loss of capital. If risk is reduced or eliminated, equity will become the first choice for the investors. Motives for investing in equity can be broadly explained as ownership & control and Periodic gain & appreciation. Benefits of Equity Share Investment  Dividend An investor is entitled to receive a dividend from the company. It is one of the two main sources of return on his investment.  Capital Gain The other source of return on investment apart from dividend is the capital gains. Gains which arise due to rise in market price of the share.  Limited Liability Liability of shareholder or investor is limited to the extent of the investment made. If the company goes into losses, the share of loss over and above the capital investment would not be borne by the investor. 34   Exercise Control By investing in the company, the shareholder gets ownership in the company and thereby he can exercise control. In official terms, he gets voting rights in the company.  Claim over Assets and Income An investor of equity share is the owner of the company and so is the owner of the assets of that company. He enjoys a share of the incomes of the company. He will receive some part of that income in cash in the form of dividend and remaining capital is reinvested in the company.  Bonus Shares At times, companies decide to issue bonus shares to its shareholders. It is also a type of dividend. Bonus shares are free shares given to existing shareholders and many times they are given in lieu of dividends.  Liquidity The shares of the company which is listed on stock exchanges have the benefit of any time liquidity. The shares can very easily transfer ownership. Disadvantages of Equity Share Investment  Dividend The dividend which a shareholder receives is neither fixed nor controllable by him. The management of the company decides how much dividend should be given.  High Risk Equity share investment is risky as compared to any other investment like debts etc. The money is invested based on the hope an investor has in the company. There is no collateral security attached with it.  Fluctuation in Market Price The market price of any equity share has a wide variation. It is always very difficult to book profits from the market. On the contrary, there are equal chances of losses.  Limited Control An equity investor is a small investor in the company; thus, it is hardly possible to impact the decision of the company using the voting rights.  Residual Claim An equity shareholder has a residual claim over both the assets and the income. Income which is available to equity shareholders is after the payment of all other stakeholders’ viz. debenture holders etc. 35 Classification of Equity Meaning Shares Blue Chip shares shares of well-established, financially strong companies with impressive earnings Income shares Shares of companies with stable operations, relatively limited growth opportunities and high-dividend payout ratio Growth shares Shares of companies which have an above-average rate of growth & profitability Cyclical shares Shares of companies that have a pronounced cyclicality in their operations Defensive shares Shares of companies that are relatively unaffected by ups and downs in general business conditions Speculative shares Shares that fluctuate widely. A lot of speculative trading in these shares Pricing of Equity Shares 1. Valuation based on accounting concepts 2. Valuation based on dividend (dividend discounting models) 3. Valuation based on earnings (relative methods) 1. Valuation Based on Accounting Concepts Book Value (B.V.) ͇ Equity Share Capital + Accumulated Profits - Accumulated Losses No. of Equity Shares  It ignores profitability of firm  Incorporates historical figures, most of which might have become outdated  Assumption: all assets are expected to realise an amount equal to their B/S value. Liquidation Value L.V. = amount of cash that will be received if all its assets are sold and liabilities are paid.  L.V. of shares might be zero  Based on current realisable values than historical value. 36   Limitation of L.V., it lacks consideration of profitability of firms.  Requires finding out realisable values of all assets, not an easy task. 2. Valuation Based on Dividends (Dividend Discounting Models) Zero Growth Model Po = D/Ke (same amount of dividend every year) Where, Po = value of equity shares D = annual dividend Ke = required rate of return (market capitalisation rate) Constant Growth Model Po = D1/(Ke-g) Where, Po = present value of stock D1 = dividend expected one year hence Ke = required rate of return g = rate of growth of dividend Multiple Growth Model Po = D1/(1+K)1 + D2/(1+K)2.........+ P∞/(1+K)∞ 3. Valuation of Dividend on The Basis of Earnings Gordon’s Model Po ͇ EPS (1-b) Ke-br Where, Po = price of a share EPS = earning per share at the end of year 1 b = retention ratio r = rate of return on investment Ke = required rate of return on equity 37 Walter’s Model Po ͇ DPS + r/Ke (EPS−DPS) Ke Ke 2.8 BONDS (V K Bhalla, 2009) "Bond" is a term for any type of debt investment. When you buy a bond, you loan money to an entity (a corporation or the government, for example) and they pay you back over a set period of time with a fixed interest rate. The rate of interest is also denoted as coupon rate. In some cases, however, no interest are payable to debenture holders. These are known as zero coupon bonds. The value of a bond is equal to the present value of the cash flows expected from it. Some examples are:  Junk Bonds  Floating Rate Bonds  Callable and Putable Bonds  Deep Discount Bonds  Inverse Floaters  Municipal Bonds  Indexed Bonds Bonds are basically a certificate that function-promises to repay a certain amount of money at some future time. For example, a company or government decides to issue a series of bonds valued at Rs 1,000 each. An investor agrees to buy one of these bonds by giving Rs 1,000 to the bond issuer. In return, the bond issuer agrees to pay interest to the owner of the bond, and also to repay the principal Rs 1,000 at some point in the future. So, when you buy the bond, you are essentially loaning the issuer money. The issuer will pay you interest until the maturity date and at that time they will pay back Rs 1,000. People buy bonds with the expectation of receiving interest income while they hold the bond and getting their money back when the bond matures. However, bond issuers are not always able to pay interest or even to return the principal amount. Because of this reason, investing in bonds involves some risk.  The coupon rate is fixed for the term of the bond  The coupon payments are made every year 38   The bond is redeemed at par on maturity; however, it may be different also. In some cases bond securities are redeemed by conversion into equity shares.  In case of liquidation of the company, the claim of the debt holders is settled in priority over all shareholders, and generally other unsecured creditors also.  Each coupon payment is receivable exactly a year later than the preceding payment Requisites to Determine Value of a Bond (a) Estimate of expected cash flows (b) Estimate of the required return Valuation of bonds n P ͇ ∑ C + M t-1 (1+t)t (1+r)n Where, P = value (in Rs.) n = number of years C = annual coupon payment (in Rs.) r = periodic required return M = maturity value t = time period when the payment is received 2.9 MUTUAL FUNDS (R. P. Rustagi, 2008) Mutual funds are another investment option available to an investor. A team of professional fund managers manages these investments. The shareholders see an increase or decrease in the value of their shares based on the overall performance. Investors who buy individual stocks and bonds can achieve diversification on their own, but it takes many purchases—and a considerable amount of money. So investors with limited funds who want to diversify may choose a mutual fund. It is possible to make a mutual fund investment with minimum amount of Rs 500, and this investment in a well-managed fund will be diversified. Another advantage of mutual funds is that they are managed by experienced people. Such people may be better at picking good investments than a newcomer to the game of buying 39 and selling stocks and bonds. Of course, not all mutual fund managers are successful, and some funds clearly have a better record than others. There are thousands of mutual funds that invest in stocks and bonds, with many specializing in certain types of securities. Mutual fund companies and rating services categorize their funds by level of risk or whether the fund goals are producing long-term growth in share value or providing steady income for shareholders. Investors can purchase mutual funds through a brokerage. They can also buy funds directly from the companies. One type of fund that is increasing in popularity is an exchange-traded fund (ETF). ETFs provide diversification benefits similar to mutual funds, but they are typically designed to mimic a stock index like the Standard & Poor’s 500. In addition, ETFs typically have very low management fees. Investors can buy and sell ETFs in the same way they buy and sell stocks. This ease of buying and selling makes ETFs more accessible to small investors and has attracted billions to ETF investments in the past decade. There are different ways in which various mutual fund schemes can be classified. Classification on the Basis of Types 1. Life span close-ended scheme, open-ended scheme 2. Income mode income scheme, growth scheme 3. Portfolio Equity schemes, debt schemes, balanced schemes 4. Maturity of securities Capital market schemes, money market schemes 5. Sectors Different sectoral schemes 6. Load basis Load schemes, no load schemes 7. Special schemes Index schemes, offshore schemes, gilt securities schemes, exchange traded funds, funds of funds Benefits of Mutual Funds Mutual funds are attractive to some investors for several reasons. Few reasons are listed below  The mutual fund professionals will devote time for analysis so the investor’s time will be saved.  An investor is able to get the services of professionals and experts at a nominal cost.  He gets an ownership of a diversified portfolio. 40   MFs have large funds to invest. So, economies of scale are available to them and also available to the unit holders.  Different types of mutual fund schemes are available to an investor.  Mutual fund investment is risk-hedging mechanism. 2.10 FIXED DEPOSITS (D. Muraleedharan, 2014) A fixed deposit (FD) is a financial instrument provided by banks which provides investors with a higher rate of interest than a regular savings account, until the given maturity date. It may or may not require the creation of a separate account. It is known as a term deposit or time deposit in Canada, Australia, New Zealand, and the US, and as a bond in the United Kingdom and India. They are considered to be very safe investments. Term deposits in India are used to denote a larger class of investments with varying levels of liquidity. The defining criterion for a fixed deposit is that the money cannot be withdrawn from the FD as compared to a recurring deposit or a demand deposit before maturity. Some banks may offer additional services to FD holders such as loans against FD certificates at competitive interest rates. It's important to note that banks may offer lesser interest rates under uncertain economic conditions. The interest rate varies between 5.75 and 6.85 percent (SBI rates). The tenure of an FD can vary from 7 or 45 days to 10 years. These investments are safer than Post Office Schemes as they are covered by the Deposit Insurance and Credit Guarantee Corporation (DICGC). Fixed deposits are a high-interest -yielding Term deposit and offered by banks in India. The most popular form of Term deposits are Fixed Deposits, while other forms of term Deposits are Recurring Deposit and Flexi Fixed Deposits (the latter is actually a combination of Demand deposit and Fixed deposit). To compensate for the low liquidity, FDs offer higher rates of interest than saving accounts. The longest permissible term for fixed deposits is 10 years. Generally, the longer the term of deposit, higher is the rate of interest. But a bank may offer lower rate of interest for a longer period if it expects interest rates, at which the Central Bank of a nation lends to banks ("repo rates"), will dip in the future. Usually in India the interest on FDs is paid every three months from the date of the deposit. (E.g. if FD a/c was opened on 15th jan, first interest instalment would be paid on 15 april). The interest is credited to the customers' Savings bank account or sent to them by cheque. This is a Simple FD. The customer may choose to have the interest reinvested in the FD 41 account. In this case, the deposit is called the Cumulative FD or compound interest FD. For such deposits, the interest is paid with the invested amount on maturity of the deposit at the end of the term. Although banks can refuse to repay FDs before the expiry of the deposit, they generally don't. This is known as a premature withdrawal. In such cases, interest is paid at the rate applicable at the time of withdrawal. For example, a deposit is made for 5 years at 8%, but is withdrawn after 2 years. If the rate applicable on the date of deposit for 2 years is 5 per cent, the interest will be paid at 5 per cent. Banks can charge a penalty for premature withdrawal. Banks issue a separate receipt for every FD because each deposit is treated as a distinct contract. This receipt is also known as the Fixed Deposit Receipt (FDR) that has to be surrendered to the bank at the time of renewal or encashment of fixed deposit. Many banks offer the facility of automatic renewal of FDs where the customers do give new instructions for the matured deposit. On the date of maturity, such deposits are renewed for a similar term as that of the original deposit at the rate prevailing on the date of renewal. Nowadays, banks give the facility of Flexi or sweep in FD, where in an investor can withdraw his money through ATM, through cheque or through funds transfer from your FD account. In such case, whatever interest is accrued on the amount withdrawn will be credited to the savings account (the account that has been linked to your FD) and the balance amount will automatically be converted in new FD. This system helps an investor in getting his funds from the FD account at the times of emergency without wasting time. Benefits Associated With FDs Customers can avail loans against FDs up to 80 to 90% of the value of deposits. The rate of interest on the loan could be 1 to 2 percent over the rate offered on the deposit. Residents of India can open these accounts for a minimum of 3 months. Tax is deducted by the banks on FDs if interest paid to a customer at any bank exceeds Rs. 10,000 in a financial year. This is applicable to both interests payable or reinvested per customer. This is called Tax deducted at Source and is presently fixed at 10% of the interest. Banks issue Form 16A every quarter to their customers, as a receipt for Tax Deducted at Source. However, tax on interest from fixed deposits is not 10%; it is applicable at the rate of tax slab of the deposit holder. If any tax on Fixed Deposit interest is due after TDS, the holder is expected to declare it in Income Tax returns and pay it by himself. 42 If the total income for a year does not fall within the overall taxable limits, customers can submit a Form 15 G (below 60 years of age) or Form 15 H (above 60 years of age) to the bank when starting the FD and at the start of every financial year to avoid TDS. 2.11 PUBLIC PROVIDENT FUND (The Public Provident Fund Scheme, 1968) The Public Provident Fund is a savings-cum-tax-saving instrument in India, introduced by the National Savings Institute of the Ministry of Finance in 1968. The aim of the scheme is to mobilize small savings by offering an investment with reasonable returns combined with income tax benefits. The scheme is fully guaranteed by the Central Government. Balance in PPF account is not subject to attachment under any order or decree of court. However, Income Tax & other Government authorities can attach the account for recovering tax dues. A minimum yearly deposit of Rs. 500 is required to open and maintain a PPF acc