NISM INVESTMENT ADVISOR LEVEL1-XA.pdf

1  Workbook for NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination National Institute of Securities Markets www.nism.ac.in 2  This workbook has been developed to assi...

1  Workbook for NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination National Institute of Securities Markets www.nism.ac.in 2  This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets Series-X-A: Investment Adviser (Level 1) Certification Examination. Workbook Version: August 2023 Published by: National Institute of Securities Markets NISM Bhawan, Plot No 82, Sector-17 Vashi, Navi Mumbai – 400703 National Institute of Securities Markets Patalganga Campus, Plot IS-1 & IS-2, Patalganga Industrial Area Village Mohopada (Wasambe) Taluka-Khalapur District Raigad-410222 Website: www.nism.ac.in © National Institute of Securities Markets, 2023 All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 3  Foreword NISM is a leading provider of high end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the Securities markets. Till March 2023, NISM has issued more than 14 lakh certificates through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. The book covers all important topics to enhance the quality of investment advisory and related services in the financial services industry. It covers topics related to the basics of investment advisory and time value of money. This course teaches about different kinds of investment products—equity, debt, derivatives and managed portfolios such as mutual funds, portfolio management services and alternative investment funds. The book covers about portfolio construction, monitoring and evaluation. The book also discusses about operational aspects of investment management, key regulations, ethical issues for investment advisers and grievance redress system. It will be immensely useful to all those who want to learn about the various aspects of investment advisory domain. Dr. CKG Nair Director 4  Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Market (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/ need/ circumstances of individual user/ reader/ organization/ institute. Thus NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore, before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability what so ever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. Acknowledgement This workbook has been developed and reviewed by the Certification team of NISM in coordination with its subject matter experts—Arnav Pandya, Pratap Giri, Rachana Baid, Rama Iyer, Sunita Abraham, Sundar Sankaran and Uma Shashikant. NISM gratefully acknowledges the contribution of the Examination Committee of NISM Series X-A Investment Advisers (Level 1) Certification Examination consisting of representatives from the Indian Securities Market and Industry Experts. 5  About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives Securities Operations, Compliance, Research Analysis, Investment Advice and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. 6 About the Level 1 Certification Examination for Investment Adviser The examination seeks to create a common minimum knowledge benchmark for individual investment adviser or principal officer of a non-individual investment adviser and persons associated with investment advice under SEBI (Investment Advisers) Regulations, 2013. An individual investment adviser or principal officer of a non-individual investment adviser, registered under SEBI (Investment Advisers) Regulations, 2013 is required to pass both the levels (i.e. NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination and NISM- Series-X-B: Investment Adviser (Level 2) Certification Examination to fulfill the requirements under SEBI (Investment Advisers) Regulations, 2013. The certification aims to enhance the quality of investment advisory and related services in the financial services industry. Examination Objectives On successful completion of the examination, the candidate should:  Know the basics of personal financial planning, time value of money, evaluating the financial position of clients, debt management and loans.  Understand about the Indian Financial Markets and Indian Securities market segments  Get oriented to different kinds of investment products— equity, debt, derivatives and managed portfolios such as mutual funds, portfolio management services and alternative investment funds.  Know about portfolio construction, performance monitoring and evaluation.  Understand about operational aspects of investment management, key regulations, ethical issues for investment advisers and grievance redress system. 7 Assessment Structure The examination consists of 90 multiple choice questions and 9 caselets/case-based questions. The assessment structure is as follows: Multiple Choice Questions 90 [90 questions of 1 mark each] 9 Case-based Questions [6 cases (each case with 5 questions of 1 mark 6*5*1 = 30 marks each)] [3 cases (with 5 questions of 2 marks each] 3*5*2= 30 marks 150 marks The examination should be completed in 3 hours. The passing score for the examination is 60 percent which is 90 marks out of total 150 marks. There shall be negative marking of 25 percent of the marks assigned to a question. How to register and take the examination To find out more and register for the examination please visit www.nism.ac.in Important  Please note that the Test Centre workstations are equipped with either Microsoft Excel or OpenOffice Calc. Therefore, candidates are advised to be well versed with both of these softwares for computation of numericals.  The sample caselets and multiple choice questions illustrated in the book are for reference purposes only. The level of difficulty may vary in the actual examination. 8 Table of Contents MODULE 1: PERSONAL FINANCIAL PLANNING................................................................. 17 CHAPTER 1: INTRODUCTION TO PERSONAL FINANCIAL PLANNING.................................. 18 1.1 Understand the concept of Financial Planning.................................................................. 18 1.2 Understand the need for financial planning...................................................................... 19 1.3 Scope of financial planning................................................................................................ 21 1.4 Concept of asset, liabilities and net worth........................................................................ 26 1.5 Financial Planning process................................................................................................. 27 1.6 Financial advisory and execution....................................................................................... 28 CHAPTER 2: TIME VALUE OF MONEY............................................................................... 31 2.1 Time Value of Money......................................................................................................... 31 2.2 Calculate the following...................................................................................................... 33 CHAPTER 3: EVALUATING THE FINANCIAL POSITION OF CLIENTS..................................... 44 3.1 Importance of cash flow management in personal finance.............................................. 44 3.2 Preparing Household Budget............................................................................................. 45 3.3 Cash inflows and outflows................................................................................................. 47 3.4 Budgeting and forecasting................................................................................................. 48 3.5 Monitoring budgets and provision for savings.................................................................. 50 3.6 Creating a personal Balance Sheet and net-worth............................................................ 51 3.7 Creating a budget and savings plan................................................................................... 54 3.8 Contingency Planning........................................................................................................ 55 3.9 Evaluation of financial position of clients.......................................................................... 56 CHAPTER 4: DEBT MANAGEMENT AND LOANS................................................................ 64 4.1 The purpose or need of debt............................................................................................. 64 4.2 Role and impact of debt in cash flow management.......................................................... 65 4.3 Leverage and Debt Counselling......................................................................................... 67 4.4 Calculate the debt servicing requirements........................................................................ 69 4.5 Responsible Borrowing...................................................................................................... 71 4.6 Secured and Unsecured loans............................................................................................ 71 4.7 Terms related to loans....................................................................................................... 72 4.8 Types of borrowing............................................................................................................ 75 9 4.9 Understand loan calculations............................................................................................ 78 4.10 Loan restructuring............................................................................................................ 80 4.11 Repayment schedules with varying interest rates.......................................................... 81 4.12 Criteria to evaluate loans................................................................................................. 82 4.13 Opting for change in EMI or change in tenure for interest rate changes....................... 83 4.14 Invest the money or pay off outstanding loan................................................................ 84 4.15 Strategies to reduce debt faster...................................................................................... 85 MODULE 2: INDIAN FINANCIAL MARKETS....................................................................... 89 CHAPTER 5: INTRODUCTION TO THE INDIAN FINANCIAL MARKETS.................................. 90 5.1 The Indian Economy........................................................................................................... 90 5.2 The Indian Financial Markets............................................................................................. 91 5.3 Regulators of Financial Markets........................................................................................ 92 5.4 Structure of Financial Markets in India.............................................................................. 96 CHAPTER 6: SECURITIES MARKET SEGMENTS................................................................ 106 6.1 Nature and Definition of Primary Markets...................................................................... 106 6.2 Role and Function of the Secondary Market................................................................... 117 6.3 Corporate Actions............................................................................................................ 124 MODULE 3: INVESTMENT PRODUCTS............................................................................ 130 CHAPTER 7: INTRODUCTION TO INVESTMENT............................................................... 131 7.1 Types of investment......................................................................................................... 131 7.2 Equity............................................................................................................................... 131 7.3 Fixed Income.................................................................................................................... 132 7.4 Commodities.................................................................................................................... 134 7.5 Real Estate........................................................................................................................ 135 7.6 Structured products......................................................................................................... 135 7.7 Distressed Securities........................................................................................................ 136 7.8 Other investment opportunities...................................................................................... 136 7.9 Channels for making investments.................................................................................... 136 CHAPTER 8: INVESTING IN STOCKS................................................................................ 140 8.1 Equity as an investment................................................................................................... 140 8.2 Diversification of risk through equity instruments - Cross sectional versus time series. 141 10 8.3 Risks of equity investments............................................................................................. 141 8.4 Overview of Equity Market.............................................................................................. 143 8.5 Equity research and stock selection................................................................................ 143 8.6 Combining Relative Valuation And Discounted Cash Flow Models................................. 161 8.7 Technical Analysis............................................................................................................ 162 8.8 Qualitative evaluation of stocks...................................................................................... 165 CHAPTER 9: INVESTING IN FIXED INCOME SECURITIES................................................... 167 9.1 Debt market and its need in financing structure of Corporates and Government......... 167 9.2 Bond market ecosystem.................................................................................................. 169 9.3 Risks associated with fixed income securities................................................................. 171 9.4 Pricing of Bond................................................................................................................. 175 9.5 Traditional Yield Measures.............................................................................................. 183 9.6 Concept of Yield Curve..................................................................................................... 187 9.7 Concept of Duration......................................................................................................... 188 9.8 Introduction to Money Market........................................................................................ 189 9.9 Introduction to Government Debt Market...................................................................... 192 9.10 Introduction to Corporate Debt Market........................................................................ 196 9.11 Small Saving Instruments............................................................................................... 199 CHAPTER 10: UNDERSTANDING DERIVATIVES............................................................... 205 10.1 Basics of Derivatives...................................................................................................... 205 10.2 Underlying concepts in derivatives................................................................................ 206 10.3 Types of derivative products......................................................................................... 207 10.4 Structure of derivative markets..................................................................................... 212 10.5 Purpose of Derivatives................................................................................................... 212 10.6 Benefits, Costs and risks of Derivatives......................................................................... 213 10.7 Equity, Currency and Commodity derivatives............................................................... 214 10.8 Derivative markets, products and strategies................................................................. 216 MODULE 4: INVESTMENT THROUGH MANAGED PORTFOLIO......................................... 224 CHAPTER 11: MUTUAL FUNDS...................................................................................... 225 11.1 Meaning and features of Mutual Fund.......................................................................... 225 11.2 Concepts and Terms Related to Mutual Funds............................................................. 226 11 11.3 Features of and differences between Open-ended schemes, Close-ended schemes, Interval schemes and Exchange Traded Funds (ETFs)........................................................... 229 11.4 Regulatory Framework of Mutual Funds....................................................................... 230 11.5 Mutual Fund Products................................................................................................... 230 11.6 Mutual Fund Investment Options.................................................................................. 241 11.7 Triggers in Mutual Fund Investment.............................................................................. 242 11.8 Process associated with Investment in Mutual Funds.................................................. 242 11.9 Systematic Transactions................................................................................................ 245 11.10 Investment Modes....................................................................................................... 250 CHAPTER 12: PORTFOLIO MANAGER............................................................................. 253 12.1 Overview of portfolio managers in India....................................................................... 253 12.2 Types of portfolio management services...................................................................... 253 12.3 Structure of PMS in India............................................................................................... 254 12.4 Registration requirements of a Portfolio Manager....................................................... 255 12.5 Responsibilities of a Portfolio Manager......................................................................... 257 12.6 Cost, expenses and fees of investing in PMS................................................................. 258 12.7 Direct access facility offered by PMS............................................................................. 259 12.8 SEBI requirements on performance disclosure............................................................. 260 CHAPTER 13: OVERVIEW OF ALTERNATIVE INVESTMENT FUNDS (AIFs).......................... 261 13.1 Introduction to Alternative Investments....................................................................... 261 13.2 Evolution and Growth of AIFs in India........................................................................... 262 13.3 SEBI requirements on AIF............................................................................................. 263 13.4 Categories of AIFs and their comparison....................................................................... 265 13.4 Types of AIFs.................................................................................................................. 265 13.5 Role of Alternative Investments in Portfolio Management.......................................... 268 13.6 Suitability and Enablers for AIF Products in India.......................................................... 269 13.7 Current AIF Market Status............................................................................................. 270 MODULE 5: PORTFOLIO CONSTRUCTION, PERFORMANCE MONITORING AND EVALUATION.................................................................................................................................... 273 CHAPTER 14: INTRODUCTION TO MODERN PORTFOLIO THEORY................................... 274 14.1 Framework for constructing portfolios - modern portfolio theory............................... 274 14.2 Assumptions of the theory............................................................................................ 274 12 14.3 Definition of risk averse, risk seeking and risk neutral investor.................................... 275 14.4 Calculation of expected rate of return for individual security...................................... 276 14.5 Graphical presentation of portfolio risk/return of two securities................................ 280 14.6 The concept of Efficient Frontier................................................................................... 281 14.7 Portfolio Optimization process...................................................................................... 282 14.8 Estimation issues............................................................................................................ 283 CHAPTER 15: PORTFOLIO CONSTRUCTION PROCESS...................................................... 284 15.1 Importance of Asset Allocation Decision....................................................................... 284 15.2 Understanding correlation across asset classes and securities..................................... 284 15.3 Steps in Portfolio Construction Process......................................................................... 285 15.4 Investment Objectives................................................................................................... 287 15.5 Investment Constraints.................................................................................................. 287 15.6 Exposures limits to different Sectors, Entities and Asset Classes.................................. 288 15.7 Unique needs and preferences...................................................................................... 289 15.8 Assessments of needs and requirements of investor.................................................... 290 15.9 Analysing the financial position of the investor............................................................ 290 15.10 Psychographic analysis of investor.............................................................................. 291 15.11 Life cycle analysis of investor....................................................................................... 292 15.12 Forecasting risk and return of various asset classes.................................................... 294 15.13 Benchmarking the client’s portfolio............................................................................ 294 15.14 Asset allocation decision.............................................................................................. 295 15.15 Portfolio Construction Principles................................................................................. 295 15.16 Strategic versus Tactical Asset Allocation.................................................................... 296 15.17 Rebalancing of Portfolio.............................................................................................. 297 CHAPTER 16: PORTFOLIO PERFORMANCE MEASUREMENT AND EVALUATION............... 298 16.1 Parameters to define performance – risk and return................................................... 298 16.2 Rate of return measures................................................................................................ 298 16.3 Risk measures................................................................................................................ 311 16.4 Risk-adjusted return measures...................................................................................... 314 16.5 Performance Evaluation: Benchmarking and peer group analysis................................ 317 16.6 Performance attribution analysis.................................................................................. 319 13 MODULE 6: OPERATIONS, REGULATORY ENVIRONMENT, COMPLIANCE AND ETHICS..... 324 CHAPTER 17: OPERATIONAL ASPECTS OF INVESTMENT MANAGEMENT......................... 325 17.1 Investors and the investing process.............................................................................. 325 17.2 PAN and KYC Process..................................................................................................... 331 17.3 Dematerialisation and Re-materialisation of Securities................................................ 337 17.4 Power of Attorney.......................................................................................................... 340 17.5 Account Opening Process for Non-Residents................................................................ 342 17.6 Process of Consolidating, reorganising and folio keeping/Maintenance of Investments................................................................................................................................................ 346 17.7 Change in Status of Special Investor Categories............................................................ 352 17.8. Payment Instruments................................................................................................... 358 17.9 Documentation for Financial Advice.............................................................................. 361 17.10 Investing in mutual funds through the stock exchange platform............................... 363 CHAPTER 18: KEY REGULATIONS................................................................................... 366 18.1 Securities Contracts Regulation Act (SCRA 1956).......................................................... 366 18.2 SEBI Act 1992................................................................................................................. 366 18.3 SEBI Prevention of Fraudulent and Unfair Trade Practices Regulations, 2003............. 367 18.4 Securities and Exchange Board of India (Intermediaries) Regulations, 2008................ 368 18.5 SEBI (Prohibition of Insider Trading) Regulations, 2015................................................ 369 18.6 SEBI Investment Advisers Regulations, 2013................................................................. 369 18.7 Prevention of Money-Laundering Act, 2002................................................................. 384 18.8 Key provisions of various other acts, as applicable to investment advisory profession................................................................................................................................................ 387 18.9 Violation of Regulations by Registered Investment Advisers and their consequences— Some Case Studies................................................................................................................. 394 CHAPTER 19: ETHICAL ISSUES........................................................................................ 396 19.1 Ethical issues.................................................................................................................. 396 19.2 Importance of ethical conduct of business.................................................................... 397 19.3 Ethical issues for an Investment Adviser....................................................................... 398 19.4 Ethical Dilemma............................................................................................................. 400 19.5 Fiduciary responsibility of Investment Advisers............................................................ 401 19.6 Do’s and Don’ts for investors issued by SEBI................................................................. 402 14 19.7 Learn about addressing annual audit observations...................................................... 403 19.8 Global Best Practices...................................................................................................... 403 CHAPTER 20: GRIEVANCE REDRESS MECHANISM.......................................................... 406 20.1 Consumer Protection Act............................................................................................... 406 20.2 Investor Grievance Redressal Mechanism..................................................................... 407 20.3 Grievance Redress System............................................................................................. 407 20.4 Grievance Redress System of an Investment Adviser................................................... 408 20.5 Grievance Redress System in Capital Market................................................................ 408 20.6 Grievance Redress System in Banking........................................................................... 410 20.7 Grievance Redressal in Insurance.................................................................................. 411 20.8 Redress in Pension Sector.............................................................................................. 413 20.9 Securities Appellate Tribunal......................................................................................... 414 20.10 Other Redressal Fora................................................................................................... 415 15  Syllabus Outline and Weightages Module Module No. Module /Chapter Names Marks Module 1 Personal Financial Planning Chapter 1 Introduction to Personal Financial Planning Chapter 2 Time Value of Money 37 Chapter 3 Cash Flow Management and Budgeting Chapter 4 Debt Management and Loans Module 2 Indian Financial Markets Chapter 5 Introduction to Indian Financial Markets Chapter 6 Securities Market Segments 10 Module 3 Investment Products Chapter 7 Introduction to Investments Chapter 8 Investing in Stocks Chapter 9 Investing in Fixed Income Securities Chapter 10 Understanding Derivatives 30 Module 4 Investment Through Managed Portfolio Chapter 11 Mutual Fund Chapter 12 Portfolio Manager Chapter 13 Overview of Alternative Investment Funds (AIFs) 23 Portfolio Construction, Performance Monitoring and Module 5 Evaluation Chapter 14 Introduction to Modern Portfolio Theory Chapter 15 Portfolio Construction Process Chapter 16 Portfolio Performance measurement and evaluation 20 Operations, Regulatory Environment, Compliance And Module 6 Ethics Chapter 17 Operational Aspects of Investment Management Chapter 18 Key Regulations Chapter 19 Ethical Issues Chapter 20 Grievance Redress Mechanism 30 TOTAL MARKS 150 16 MODULE 1: PERSONAL FINANCIAL PLANNING Chapter 1: Introduction to Personal Financial Planning Chapter 2: Time Value of Money Chapter 3: Cash Flow Management and Budgeting Chapter 4: Debt Management and Loans 17 CHAPTER 1: INTRODUCTION TO PERSONAL FINANCIAL PLANNING LEARNING OBJECTIVES: After studying this chapter, you should know about:  Concept of Financial Planning  Need for financial planning  Scope of financial planning  Concept of asset, liabilities and net worth  Financial Planning process  Financial advisory and execution 1.1 Understand the concept of Financial Planning Financial planning aims at ensuring that a household or individual has adequate income or resources to meet current and future expenses and needs. The regular income for a household or individual may come from sources such as profession, salary, business or even investments. The normal activities of a household or individual and the routine expenses are woven around the regular income and the time when this is received. However, there are other expenses that may also have to be met out of the available income. The current income that is received must also provide for a time when there will be no or low income being generated, such as in the retirement period. There may be unexpected expenses which are not budgeted, such as a large medical expense, or there may be needs in the future that require a large sum of money, such as education of children or buying a home, all of which require adequate funds to be made available at the right time. A portion of the current income is therefore saved and applied to creating assets that will meet these requirements. Financial planning refers to the process of streamlining the income, expenses, assets and liabilities of the household or individual to take care of both current and future need for funds. Example Vinod is 40 years old and earns Rs.2 lakhs a month. He is able to save about Rs.40,000 a month after meeting all the routine expenses of his family, paying the loans for his house, car and other needs. His investments include those for tax savings, bank deposits, bonds and some mutual funds. He pays premiums on life insurance for himself and his wife. Vinod is the sole earning member of his family and he believes he takes care of his finances adequately to take care of his current and future needs. How would financial planning help him? The following are a set of indicative issues that financial planning will help Vinod resolve: 18 a) As the sole earning member has he made provisions for taking care of his expenses by creating an emergency fund if his current income is interrupted for any reason? b) Does he have adequate insurance cover which will take care of his family’s requirements in the event of his untimely demise? c) Does the family have adequate health insurance cover so that any medical emergency does not use up all the accumulated savings? d) What are his specific future expenses and how will he fund them? e) If Vinod has to create a corpus to fund large expenses in the future, what is the size of the investment corpus he should build? f) Given his current income and expenses is he saving enough to create the corpus required? g) Will he have to cut back on his current expense or can he increase his current income so that his expenses in the present and the savings for the future are met? h) What is the wealth Vinod has so far built from his savings and how can he best use it to meet his needs? i) How should his saving be deployed? What kinds of investments are suitable for Vinod to build the required corpus? j) How much of risk is Vinod willing and able to take with his investments? How would those risks be managed? k) How should Vinod ensure that his savings and investments are aligned to changes in his income, expenses, future needs? A formal treatment of the issues that Vinod faces will require a financial planning process to assess the current situation; identify the current and future needs; determine the savings required to meet those needs and put the savings to work so that the required funds are available to meet each need as planned. Financial planning is thus a process that enables better management of the personal financial situation of a household or individual. It works primarily through the identification of key goals and putting in place an action plan to realign the finances to meet those goals. It is a holistic approach that considers the existing financial position, evaluates the future needs, puts a process to fund the needs and reviews the progress. 1.2 Understand the need for financial planning There is a large range of financial products and services that are available for investors today and these need to be linked to the specific needs and situations of the client. Not every product may be suitable to every client; nor would a client be able to identify how to choose and use products and services from the choices that are available in the market. Financial planning bridges this gap as the Investment Adviser possesses the expertise to understand the dynamics of the products on the one hand and the needs of the client on the other. This makes them best suited to use such products and services in the interest of the client. 19 1.2.1 Role of the Financial Planner The Financial Planner has a significant role to play when it comes to advising clients because the needs of each person is different front that of the other. a) The financial planner has to recognise the exact needs and goals of an individual and a household or family and then make efforts to ensure that these needs or goals are achieved. b) Personal financial management requires time and attention to recognize income and expense patterns, estimates of future goals, management of assets and liabilities, and review of the finances. c) Individuals do not have time to undertake all these detailed financial activities in a busy world and they need someone like a financial planner to focus on this area and help them in their efforts. d) It is not easy to set financial goals and this requires specific expertise and skill which may not be present with most individuals. e) Every financial goals requires finding a suitable product and a proper asset allocation to different asset classes so that this can be achieved, which is where the financial planner steps in. f) Selecting the right investment products, choosing the right service providers and managers, selecting insurance products, evaluating borrowing options and such other financial decisions may require extensive research. A financial planner has capabilities to compare, evaluate and analyse various products which enables making efficient choices from competing products. g) Asset allocation is a technical approach to managing money that requires evaluating asset classes and products for their risk and return features, aligning them to the investor’s financial goals, monitoring the current and expected performance of asset classes and modifying the weights to each asset in the investor’s portfolio periodically to reflect this. Financial planners with technical expertise enable professional management of assets. h) Financial planning is a dynamic process that requires attention to the constantly changing market and product performances and matching these with the dynamic changes in the needs and status of the client. This kind of attention can be provided by a financial planner. 1.2.2 How is financial planning different from a typical financial advisory services? Financial planning requires following of a specific process wherein the client along with their overall needs and goals are at the core of everything being done. Other financial advisory services would normally look at meeting just a specific need like advising on stocks or debt but the relation with other aspects might be missing. 20 The financial planning effort is a comprehensive process as it covers all aspects of a client’s personal financial requirements including retirement, insurance, investment, estate and others. A typical financial advisory service is more likely to look at just a small part of the total financial requirements. Goal setting becomes the central part of the financial planning process and all efforts are then directed towards meeting the goals. Overall goals might not be given too much importance in a normal financial advisory activity, where some specific target is sought to be achieved. Financial planning looks to ensure that all the financial activities are not at cross purposes with each other. As against this, a typical financial advisory service might not even realise that some steps suggested would be working against some other goal or requirement. For example, financial planning would ensure that the asset allocation for an older individual meets their risk taking ability and that their equity exposure across asset classes is kept in check. This might not happen when normal advise is taken just for say equity mutual funds investment without knowing the equity exposure elsewhere. Monitoring the situation and then taking action to ensure that things remain on track is a key part of the financial planning process. It is inbuilt to the entire effort, so this becomes a natural part of the activity. This might not happen with respect to a normal financial advisory where the individual might have to take the initiative themselves and see that things are going according to plan. Financial planning looks to select what is right for an individual and this would differ from person to person. This takes into account both the returns as well as the risk which is vital. This might not happen for a normal financial advise, where the goal might be completely different like earning higher return and where risk might be ignored. There has to be continuity in financial planning efforts which sets it apart from other financial advisory wherein this could be a short one time exercise or even piecemeal efforts at different periods of time. 1.3 Scope of financial planning Financial planning enables a household or individual to manage its personal finances efficiently in line with their short and long-term objectives. The following are elements of financial advisory and planning services: 21 1.3.1 Personal financial analysis:  Goal setting with prioritizing of goals The financial planning process starts with the goal setting process. Goals refer to what has to be achieved. This gives a clear target that has to be reached. There are several features that are important when the goals are set. There should be some specific detail with respect to the goal. For example, saying that I want to be rich is a vague term because it can mean different things to different people. Saying that I want to earn an income of Rs. 50 lakh a year is specific. The goals have to be measurable, so that a person knows the exact amount that will help them reach the goal. At the same time the goals have to be realistic. If an individual is able to save around Rs 20,000 a month, then a goal which requires an investment of Rs 50,000 a month is not realistic. Finally, goals also have to be time bound so the individual has a clear idea of when they need to be reached. A goal of wanting to retire in 20 years with Rs 5 crore as corpus is clear because there is a time period attached to it which will help in planning to reach the goal. Once all these features are considered in the goal setting process there will be a list of goals that will be available. However, every individual has restrictions in terms of the income earned and amount saved. This will require that the goals be ranked in order of priority. Important goals need to be put first. So, things like children’s education and retirement should come in front of something like spending on a luxury car or other expense that does not create an asset. It is easy to look at short term needs but this can come at the cost of long term disruption of the goals. This is why there has to be priority to goals that improve the financial health of the individual. For example, there might be a large credit card outstanding and some extra income is earned by the individual. In such a situation, instead of spending the amount, it should be used to pay off the credit card debt. This might not add to an asset but it still improves the financial condition of the individual.  Focus on important goals Goals such as retirement and education of children are important financial goals for which adequate provision of funds have to be made. Long-term goals such as retirement often get lower priority for allocation of savings because it has time on its side. The urgent, shorter- term goals often get higher claim on the available savings. While this may be acceptable for shorter-term goals that are also important, such as accumulating funds for down payment on a home, it may not be right to prioritize consumption goals, such as holidays and large purchases, over long-term important goals. The delay in saving for such goals will affect the final corpus, since it loses the longer saving and earning benefits including that of compounding. 22 Clients often believe that the provident fund, superannuation and gratuity corpus they will receive on retirement will be adequate to ensure a comfortable living during the retirement years. In many cases, it turns out to be inadequate. Therefore, every client needs a retirement plan. The Investment Adviser needs to go through the numbers and demonstrate the inadequacy. The objective is to ensure that the client saves enough during the earning years for a comfortable retired life.  Staggering the timing of certain goals The financial situation of an individual may not allow all the financial goals to be provided for. Some financial goals may have to be deferred to ensure that the critical financial goals are not compromised. There are situations when it is not possible to achieve a financial goal in a specific time period. An example could be a person wanting to buy a house within the next year, which would require a down payment of Rs 20 lakh plus an Equated Monthly Instalment (EMI) of Rs 30,000 a month. It could be that the current income situation is not able to support such a situation. Instead of cancelling the goal there is another route available. This is to push back the goal by some time, which will enable the individual to get the required finances in order. Instead of 1 year, if the goal is sought to be achieved after 3 years, then there is a good chance that the desired financial position will be achieved by then. For instance, around the time that the family proposes to buy a house, the annual holiday may need to be reviewed. The holiday may be shorter or planned at a less expensive location. Some financial goals need to be fulfilled within a specified time frame. For instance, education of the child has to happen as per the normal age and progression. Prudent use of debt in the form of loans can be used to tide over any shortage of funds. 1.3.2 Cash flow management and budgeting There is a certain income that is earned by an individual along with the expenses made. Having a plan to ensure that there are savings and these are invested is one part of the process. It is also vital that there is a cash flow match so that the household or the individual does not run into any cash flow problems. This happens when the inflows and outflows of cash do not match. There can be a situation wherein a person spends less than what they earn but still run into cash flow problems. For example, if there is a large expense made at the start of a month it can lead to a cash crunch if there is a delay in the receipt of income unless there is a reserve present. In fact, it could lead to short term borrowings which are extremely costly in terms of interest rates. This could lead to a part of the amount that is being finally saved to be directed towards paying off the debt incurred due to the cash flow mismatch. 23 One of the ways to ensure that there is no cash flow problem is to have a budget. A budget is nothing but a list of the inflows and outflows that an individual will witness along with the time period when this will take place. A monthly budget will help a person to know whether they are managing their income properly. A budget has a list of all the items of income and expenses along with their amounts. This ensures that with a single look it is possible to know what the exact financial position is and whether there is adequate savings taking place. Every person should make their own personal budget. A lot of people pay attention to the Union Budget but fail to do budgeting for their ownselves. 1.3.3 Insurance Planning Several unexpected expenses that can cause an imbalance in the income and expenses of a household can be managed with insurance. Insurance is a risk transfer mechanism where a small premium payment can result in payments from the insurance company to tide over risks from unexpected events. The temporary loss of income from disabilities and permanent loss of income from death can be covered with life insurance products. Health and accident insurance covers help in dealing with unexpected events that can impair the income of a household, while increasing its expenses on health care and recuperation. General insurance can provide covers for loss and damage to property and other valuables from fire, theft and such events. Insurance planning involves estimating the losses to the household from unexpected events and choosing the right products and amounts to cover such losses. 1.3.4 Debt management and counselling Investment Advisers help households plan their liabilities efficiently. It is common for households to borrow in order to fund their homes, cars and durables. Several households also use credit cards extensively. To borrow is to use tomorrow’s income today. A portion of the future income has to be apportioned to repay the borrowings. This impacts the ability to save in future and in extreme cases can stress the ability to spend on essentials too. The asset being funded by borrowing may be an appreciating asset such as property, which is also capable of generating rental income. Or the loan could be funding a depreciating asset such as a car, which may require additional expenses on fuel and maintenance, but provide better lifestyle and commuting conveniences. Evaluating which assets or expenses can be funded by borrowings is a function Investment Advisers can perform. They can advise households about how to finance their assets, how much to borrow, how to provide for repayment, how to ensure that credit scores are not unfavourably impacted. Sometimes, excessive borrowings may lead a household into a debt trap. Such borrowers need counselling and handholding to be able to get out of debt. Sometimes assets may have to be liquidated to pay off debts. Advisers help households to deal with their borrowings taking into account their need and ability to repay debt. 24 1.3.5 Investment Planning and Asset Allocation A crucial component in financial planning and advisory is the funding of financial goals of a household. Investment planning involves estimating the ability of the household to save and choosing the right assets in which such saving should be invested. Investment planning considers the purpose, or financial goals for which money is being put aside. These goals can be short-term such as buying a car, taking a holiday, buying a gift, or funding a family ceremony or can be long-term such as education for the children, retirement for the income earners, or high-expense goals such as marriage of children. An Investment Adviser helps with a plan to save for these goals, and suggests an appropriate asset allocation to pursue. The Investment Adviser does not focus on the selection of stocks or bonds, but instead takes a top down approach of asset allocation. The focus is on how much money is invested in which particular asset class in order to deliver the expected return within the risk preference of the investor. The adviser’s job is to construct a portfolio of asset classes, taking into account the goals, the savings, the required return, and the risk taking ability of the investor. This is one of the core functions of the adviser and many specialise in asset allocation and investment planning. 1.3.6 Tax Planning Income is subject to tax and the amount an individual can save, the return they earn on their investment and therefore the corpus they are able to build for their future goals, are all impacted by the tax regime they fall under. An investment adviser should be able to assess the impact of taxes on the finances of the individual and advice appropriate saving and investment options. The post-tax return of financial products will have to be considered while choosing products and estimating holding periods. The taxability of various types of investment income such as dividends, rents and interest differ. The treatment of return if accumulated, rather than paid out periodically, varies. The taxability of gains differs based on the holding period. An investment adviser should bring in these aspects while constructing a plan for the household. 1.3.7 Retirement Planning Providing for retirement is one of the primary financial goals that all people have to plan for. Given its complexity and nature of well-being in the future, many people tend to ignore it until it may be too late thereby compromising the quality of their retirement. To be able to plan for retirement it is important to understand the concept of time value of money and inflation and how it would impact the cost of meeting expenses in the future. Saving and investing for retirement requires understanding of how compounding benefits investors saving for long-term goals. It is important to select the right financial products that are best suited to the long-term nature of the retirement goal as well as to the ability of the individual 25 to take risks. In the pre-retirement stage, rebalancing the portfolio to less volatile assets is an important activity. As retirement approaches, the process of planning should shift focus to the expenses in retirement, the adequacy of the income from investments and pension benefits to meet these expenses and strategies to meet the shortfall, if any. While investing the retirement corpus for income, the taxability of different sources should be considered. The retirement portfolio has to be monitored and rebalanced through the term of retirement too since the needs do not remain the same. Investment Advisers bring the skills required to design and execute a retirement plan. 1.3.8 Estate Planning Wealth is passed on across generations. This process of inter-generational transfer not only involves legal aspects with respect to entitlements under personal law, but also documentation and processes that will enable a smooth transition of wealth in a tax-efficient way. Estate planning refers to all those activities that are focused on transfer of wealth to heirs, charity, and other identified beneficiaries. There are several tools and structures to choose from, in estate planning. Some choices such as gifts can be exercised during one’s lifetime, while choices such as wills come into play after death. Investment Advisers help households make these choices after considering all the implications, and help them complete the legal and documentation processes efficiently. 1.4 Concept of asset, liabilities and net worth The income of a household or individual is at the base of all financial activities that are undertaken. The income is used to meet current expenses and a portion is set aside to meet expenses in the future. The portion of current income earmarked for future needs is called savings. The adequacy of the income of a household or individual is always relative to its expenses. If the expenses are managed within the income and there is surplus to save, then the household’s or individual’s finances are seen as stable. Short-term imbalances in income and expenses can be managed by loans and advances. The loans are a liability and come at a cost which may further strain the future income. The option of loans to fund expenses must be used with discretion since it weakens the financial situation of the household. The savings of a household or individual are put to work by investing them in assets. Assets are broadly classified as physical assets and financial assets. Assets may be appreciating in value or depreciating. All assets have a resale value. Investors hold assets for the returns they provide. The nature of return that an asset provides classifies them as growth-oriented, income-oriented or a combination of the two. Physical assets are tangible assets and include real estate, gold and other precious metals. Physical assets have an intrinsic value though the actual price at which they trade is impacted by demand and supply. They are usually seen as natural hedges against inflation since their 26 price show a positive correlation with inflation. Physical assets are more growth investments that are bought for the appreciation in value rather than the income they generate. Some such as real estate provide both income and growth while others such as gold are pure growth-oriented assets. The primary drawbacks of physical assets are illiquidity, lack of regulation/limited regulation and the need for specific skills to identify investment opportunities, assess the merits of the investment, arrange for the purchase of the asset and its management and sale of the asset when required. The other limitation of physical assets as an investment is that they are typically large ticket investments and require substantial savings or a combination of savings and loan to acquire. Financial assets represent a claim that the investor has on benefits represented by the asset. For example, a bank deposit gives the benefit of periodic interest and repayment of principal amount to the holder of the asset, an equity share provides periodic dividend paid, if any, and the appreciation or depreciation in its value is also to the account of the holder. These assets may be structured as growth-oriented assets, such as equity investments, or as income- oriented, such as deposits, or a combination of the two, such as all listed securities. Financial assets are typically standardized products and controlled by the regulations in force at the point in time. They may differ on liquidity features, with some such as listed securities enjoying high liquidity, while others such as privately placed instruments featuring low liquidity. The standardization of financial assets and the mandatory information made available makes evaluation and comparisons more efficient. These assets lend themselves to investment in small amounts and units. Together, the physical and financial assets represent the investments made by the investor. While these assets represent financial benefits and returns to the holder, the financial strength of the household depends upon how the assets are acquired. Loans and borrowings used to buy assets create a liability and impose a repayment obligation on the buyer and a charge on the future income of the household. Loans taken to buy appreciating assets add to the long-term wealth. Loans taken to buy financial assets, also called leveraging, is risky because of the higher volatility in the price of such assets. Assets acquired with savings and without taking on a liability add to the financial strength of the household. An assessment of the financial well-being of the household can be made by calculating the Networth. The networth is calculated as Assets – Liabilities. Higher this number better is the financial position of the household. Networth should be calculated periodically, and the progress tracked to bring the financial situation to the desired stage. 1.5 Financial Planning process Financial planning requires Investment Advisers to follow a process that enables acquiring client data and working with the client to arrive at appropriate financial decisions and plans, 27 within the context of the defined relationship between the planner and the client. The following is the six-step process that is used in the practice of financial planning. a. Establish and define the client-planner relationship: The planning process begins when the client engages an Investment Adviser and describes the scope of work to be done and the terms on which it would be done. b. Gather client data, including goals: The future needs of a client require clear definition in terms of how much money will be needed and when. This is the process of defining a financial goal. c. Analyse and evaluate financial status: The current financial position of a client needs to be understood to make an assessment of income, expenses, assets and liabilities. The ability to save for a goal and choose appropriate investment vehicles depends on the current financial status. d. Develop and present financial planning recommendations: The adviser makes an assessment of what is already there, and what is needed in the future and recommends a plan of action. This may include augmenting income, controlling expenses, reallocating assets, managing liabilities and following a saving and investment plan for the future. e. Implement the financial planning recommendations: This involves executing the plan and completing the necessary procedure and paperwork for implementing the decisions taken with the client. f. Monitor the financial planning recommendations: The financial situation of a client can change over time and the performance of the chosen investments may require review. An adviser monitors the plan to ensure it remains aligned to the goals and is working as planned and makes revisions as may be required. 1.6 Financial advisory and execution Investment Advisers may engage with their clients at various levels and the scope of services they offer may vary depending on their skills, capabilities and business model. In several countries, including India, there has been regulatory action in defining the role of various intermediaries that deal with investors. When a relationship manager, financial adviser, wealth manager or other entity, irrespective of the nomenclature used, sells financial products to a client as part of his defined role or business, and earns a commission from the producer of the financial product, there is a potential conflict of interest. The seller of the product may not act in the interest of the client, but may push products that earn a higher commission. This may lead to mis-selling, where a product not suitable to the client’s needs, or not in line with the client’s risk preference may be sold in a manner harmful to the customer’s interest. One of the regulatory initiatives to prevent such mis-selling is to differentiate between providers of advice and distributors of financial products, and to ask advisers to earn their 28 revenue from the client, and not from the producer. The distributor who executes the transactions in financial products may earn a commission from the producer. The current regulatory regime for financial advisers in India requires that anyone offering financial advice for a consideration should be registered with SEBI, and should not earn any income from the producer. There are specific exemptions provided for those that offer advice incidental to a product they may sell. The following are the various business models in the delivery of financial advice to clients: a. Fee-only financial planners and advisers: Some Investment Advisers choose to earn a primary component of their income from enabling clients to plan their finances in a comprehensive manner. They engage closely with the client, offer advice on most if not all aspects of their personal finance, and charge a fee for their services. The fee may be of various types and a combination of the following:  One-time fee for a financial plan  Fee for on-going review and periodic revisions  Asset-based fee charged as a percentage of assets being advised  Referral fee for engaging experts to take care of specific aspects of the plan  Referral fee for execution of plan through other agencies  Selection and portfolio construction fees  Fees for assessment and analysis of financial position Fee only Investment Advisers usually do not take on the execution of the plan or advice. They refer the client to other agencies who may enable execution of the recommended investment transactions. This is to ensure that the commissions earned on selling financial products, does not influence their advice to their clients. Under the amendments to the Investment Adviser Regulations, SEBI has said that individual Investment advisers cannot undertake both advisory and distribution. They have the choice to register as either of the two. A non-individual investment adviser will have client level segregation at the group level for these services. It also has to maintain an arm’s length relationship by providing the advisory services through a separate division or department. Individual Investment advisers are allowed to provide execution services but through direct schemes or products in the securities market. However, no consideration can be received at the investment advisers group or family level for these services. b. Execution only services: Some Investment Advisers do not charge their clients for advice as their core function is distributing financial products. Their income comes from the commissions from selling the product. They may also execute transactions advised by 29  another financial adviser. Such advisers may also distribute a range of products including investment products, insurance products, banking and loan products, which are subject to regulations by multiple regulators apart from SEBI. Some firms may organise the execution only services into an aggregation model. The aggregating entity has several distributors associated with it, who take a range of financial products to clients. In this case, the company shortlists the products it would offer, based on its selection criteria. It may also have a central advisory team that selects products after research and data analysis. Those that like to offer these products to their clients, may associate with such company, and share their revenue with the company for using their research services, or execution platforms. Many aggregators offer a range of support services to their associates, including training, development, customer relationship management software, execution platforms and facilities that may be expensive to set up on a standalone basis. The shared facility helps the distributors to scale up their business, and pay the aggregator a share of revenue for the benefits offered. c. Wraps and Platforms: Wraps and platforms are technology-based advisory solutions that are standardised for execution. A client or an adviser associates with the platform, and can offer its financial products as model portfolios that investors can buy. Investment Advisers may also choose these platforms to execute transactions in standardised model portfolios. Clients can view how their portfolios are performing. Advisers can monitor and review the portfolios and holistically manage the money of clients across multiple products. Wraps and platforms may charge the client a fee and share this fee with the adviser who executes the transactions using it. They may also enable the adviser to access clients using their platforms, to sell financial advice to such clients, and charge a fee and share it with the platform provider. 30 CHAPTER 2: TIME VALUE OF MONEY LEARNING OBJECTIVES: After studying this chapter, you should know about:  Time Value of Money  Concept of Annuity  Concept of Perpetuity 2.1 Time Value of Money The value of money does not remain the same at all points of time. The money available at the present time is worth more than the same amount in the future since it has the potential to earn returns (or interest as the case may be). Consider the following options, assuming there is no uncertainty associated with the cash flow:  Receiving Rs.100 now  Receiving Rs.100 after one month All investors would prefer to receive the cash flow now, rather than wait for a month, though the amount to be received has the same value. This preference is attributed to the following reasons:  Instinctive preference for current consumption over future consumption.  Ability to invest the Rs.100 for a month like a bank account or deposit and earn a return so that it grows in value to more than Rs. 100 after one month. Clearly, Rs.100 available now is not equivalent to Rs.100 received after a month. The value associated with the same sum of money received at various points on the timeline is called the time value of money (popularly known as TVM). The time value of money received in earlier periods as compared to that received in later time periods will be higher. Since most decisions in finance involve cash flows spread over more than one period (monthly, quarterly, yearly etc.) the time value of money is a key principle in financial decision-making. 31 Box 1.1 DID YOU Know - DYK or Historical Perspective Records dating as far back as 5000 BC indicate that the Mesopotamians, Hittites, Phoenicians, and Egyptians charged interest when they loaned such items as olives, dates, seeds, and animals. The time value of any loaned item was perhaps easiest to see with the loaning of seeds because any successfully planted seed would yield a plant that would produce more additional seeds. Thus, it was wise to get seeds in the ground, both to yield a healthy crop and to have more seeds for future plantings.* Since money has time value, it is not possible to compare cash flows received in different time periods. Consider the above example: suppose the Rs.100 received now is placed in a one-month bank deposit yielding 6 % p.a. After a month, the value would grow to Rs.100.50. If an investor has to opt for receiving Rs.100 after a month, then he needs to be compensated by Rs.0.50, the amount that has been foregone by waiting for a month. The two options will be equivalent from the investor’s point of view if the option is to receive Rs.100 now or Rs.100.50 after one month. When time values are taken into account, the following points need to be noted: Future inflows are discounted by a relevant rate to reach their present value; this rate is known as the discount rate or return rate or interest rate. Present inflows are increased at a relevant rate to reach their future values: this rate is known as the compound interest rate. The later in the future a cash flow is likely to be received, the lower its value at the current time. Rs.100 available after one month is more valuable today than Rs.100 available after one year, which has a better value today than Rs.100 available after 5 years. The higher the discount rate, the lower the present value of future cash flows. A higher rate means that investors have to forego more returns by opting to receive the money today instead of future cash flows. For example, Rs 1,000 received after 3 years when discounted at 5 per cent is worth Rs 864 today but the same amount discount at 8 per cent is worth only Rs 794. In any time, value situation, the important parameters are: a. Cash inflows or outflows: These could be either in the form of single period cash flow or in the form of an annuity or a stream of uneven or even cash flows. b. Rate of interest: Also known as compounding rate or discount rate or reinvestment rate. c. Time Period: This may be annual or any other fraction thereof like monthly, quarterly etc. d. Frequency of cash flows, which may or may not be fixed. Financial problems involving time value of money are usually concerned with calculating one of the above parameters. * (https://www.encyclopedia.com/finance/encyclopedias-almanacs-transcripts-and-maps/time-value- money) 32 2.2 Calculate the following 2.2.1 Present value Present value is the amount that you would pay today for a cash flow that comes in the future. It brings the future value down to today’s price. It is based on the basic principle of time value of money that value of money keeps reducing as time passes. There are two ways in which the present value can be calculated. If there is a future value that has been given then this can be brought to the present by discounting it by the rate of return. This will give an idea of what the value of the future amount is worth today. PV = FV/(1+r)^n Where FV= Future Value PV= Present Value r = rate of return for each compounding period n = number of compounding periods For a one time receipt, PV is calculated as per the following formulae: PV = C/(1+r)^n In case of a regular cash flow the present value can be calculated by the following formula PV = C * ((1-(1/(1+r)^n))/r) Where C is the regular cash flow For example, Shyam is going to receive a sum of Rs 6,500 a year for the next 8 years at an interest rate of 7 percent. He would like to know whether he should take the cash flow or a lump sum now and what this would be worth In this case using the formula or the excel function the Present value would come to PV = 6500/(1.07)^1 + 6500 /(1.07)^2 + 6500 / (1.07)^3 + 6500 /(1.07)^4 + 6500 / (1.07)^5 + 6500/( 1.07)^6 + 6500 / (1.07) ^7 + 6500 / (1.07)^8=38813.44 The present value can also be arrived at using the formula for a regular receipt 33  PV = 6500*((1-(1/(1.07)^8))/0.07) In the excel function the rate of return has be put in as 0.07, the nper as 8 and the payment figure (pmt) as -6500 to arrive at the answer. For E.g. - The Excel PV function calculates the Present Value of an investment, based on a series of future payments. The syntax of the function is: PV( rate, nper, [pmt], [fv], [type] ) On the other hand, there can be a future payment of Rs 50,000 that might be received after a period of 5 year earning 6 per cent but this need to be evaluated in light of how much an investor should have in hand today. This can be calculated as PV = 50000/(1.06)^5 PV = 37362.91 2.2.2 Future value Future value represents what something is worth at some point in the future. There can be various amounts for which such a future value might need to be calculated and this will give an idea of the erosion in value from the current period. FV = PV (1+r)^n 34 Where FV= Future Value PV= Present Value r = rate of return for each compounding period n = number of compounding periods Note that the rate of return for each compounding period has to be adjusted for the frequency of compounding. For example, if an investment pays 8% interest p.a. compounded quarterly, then the applicable rate of return for each compounding period is 8%/4, or 2%. Or it can be different for different periods in future. The number of compounding periods (n) refers to the periodicity with which interest is paid on the investment during the year. For example, the Post Office Monthly Income Scheme (MIS) pays interest every month, while the Senior Citizens Scheme pays every quarter. The greater the frequency of compounding, the more often interest is paid on interest, and the greater are returns earned through compounding. Consider the following example. Krishna invests Rs.5 lakhs in a 5 year bank deposit that pays 8% interest compounded annually. What is the interest he earns from the investment in the following three scenarios? Scenario: 1 The interest is used to pay the college fees of his daughter and there is no compounding. Scenario: 2 The cumulative option is chosen and the interest is paid at maturity i.e. interest is compounded yearly. Scenario: 3 If the interest is instead compounded quarterly and he chooses the cumulative option. Under Scenario 1 The interest income earned is: Rs.5 lakhs x 8% x 5=Rs.200,000 There is no compounding benefit since the interest is taken out and used and not re-invested. This is also known the simple interest. Under scenario 2 The maturity value will be= 500,000 x (1+8%)^5= Rs.734,664 Interest income earned over 5 years = Rs.734,664- Rs.500,000= Rs.234,664 35 The interest income is higher because the interest earned each year is re-invested and earns interest too. This is the compounding benefit. Under scenario 3 Here the interest is compounded quarterly so this requires the rate to be divided by 4 while the total quarterly period are 20 during the 5 years The maturity value will be= 500,000 x (1+(8%/4)^20) = 500,000 x (1+2%)^20= Rs.742,974 Interest income earned over 5 years = Rs.742,974- Rs.500,000= Rs.242,974 The interest income is higher than scenario 2 because the frequency of compounding is higher. The interest is paid each quarter and this earns interest for the remaining period. The future value of an investment can be easily computed in EXCEL using the FV function which prompts the user to input the interest rate, the number of total periods in the investment, the payment made each period, and whether payment is made at the beginning or end of the period. FV( rate, nper, [pmt], [pv], [type] ) For example, a sum of Rs 5,000 growing at 8 per cent per annum will become Rs 7346.64 in 5 years FV (0.06,5,,-5000,,0) FV = 7346.64 2.2.3 Rate of return The rate of return is the percentage rate that is earned on a particular investment. There are times when the investor has just the amount that has been earned but this needs to be converted into a rate of return. This will enable proper comparison with other instrument and options that are present in the market and will aid in proper decision making too. In financial markets, the time value of money is always taken into account. It is assumed that if an investment provides a series of cash inflows, they can be re-invested to earn a positive return. Alternatively, an investment that does not have intermediate cash flows, is assumed to grow at an annual rate each year, to be compounded every year to reach the final value. The compounded annual growth rate (CAGR) of an investment is the underlying compound interest rate that equates the end value of the investment with its beginning value. Consider the following formula for FV: 36 PV (1+r)^n = FV A sum of money at the current point in time (PV) grows at a rate of r over a period n to become a future value (FV). CAGR is the rate r, which can be solved as: CAGR is computed using the above formula, given a beginning and end value for an investment and the investment period in years. Since FV and PV represent end and beginning values of the investment for which CAGR is to be computed, the formula for CAGR (in decimals, not %) can be written as: CAGR = ((End Value/Beginning Value) ^ (1/n)) - 1 The resulting CAGR has to be multiplied by 100 to be expressed in percent terms. For example, consider an investment of Rs.100 that grows to Rs.120 in 2 years. In this case: End Value (or FV) = 120 Beginning Value (or PV) = 100 No. of years ‘n’ = 2 Substituting in the formula for CAGR we have: 120 = 100*(1+r/100) ^ 2 We consider that Rs.100 has grown to Rs.120 over a 2 year period at CAGR of r. Rearranging the terms and writing CAGR instead of r we get: 120/100 = (1+CAGR) ^ 2 CAGR = ((120/100) ^ (1/2)) - 1 CAGR = ((1.2) ^ (1/2)) - 1 = 1.095 – 1 = 0.095 = 9.5% In Excel the CAGR can be found out by the Rate Formula 37 CAGR = RATE(Years,,-PV,FV) In the above example NPER or years =2 PV = -100 FV = 120 =RATE(2,,-100,120) =0.095 CAGR is the accepted standard measure of return on investment in financial markets, except in case of returns that involve periods of less than one year. The following example shows how CAGR is computed for a mutual fund investment. Assume that Rs. 10.50 was invested in a mutual fund and redeemed for Rs. 12.25 at the end of 3 years. What is the compounded rate of return? In this problem, Rs.10.50 grew at some compounded rate to become Rs.12.25 at the end of 3 years. To solve for the CAGR, we use the formula: CAGR = ((12.25/10.5) ^ (1/3)) – 1 = 5.27% The same formula may be applied for fractional compounding periods. Consider this example: An investor purchased mutual fund units at an NAV of Rs.11. After 450 days, she redeemed it at Rs.13.50. What is her compounded rate of return, assume that it’s a non-leap year? In order to use the CAGR formula, period of 450 days has to be converted into years or 450/365 years. CAGR = ((13.5/11) ^ (365/450)) – 1 = 0.1807 = 18.07% 2.2.4 Periodic investments or pay-outs There are a lot of areas where the investor will be making a regular or a periodic payment. The most common example is that of a loan, where there is a regular Equated Monthly Instalment (EMI) being paid out to the lender each month. It is essential to know the amount that would be paid, so that there can be a proper planning made of how the amount should be accumulated. 38 This can be obtained using Excel using the PMT formula where the inputs will be the following r = the rate of interest on the loan Nper = the number of periods for which the loan has to be repaid PV = the value of the loan that has to be repaid The figure that emerges will be the EMI that will have to be paid. For example, Satish is thinking of taking a loan of Rs 30 lakh for the purchase of a house property in his hometown. The current rate of interest is 6.5 per cent with a monthly reset and he is looking for a 20 year loan. What would be his monthly EMI? In this case, all the relevant details are available. One thing to take care of is that the interest rate would have to be divided by 12 because the period for this is monthly. At the same time the period of payment is monthly so this would become 240 months. Entering the figures into the formula it will be PMT =(0.065/12,240,-3000000) PMT = 22367.19 The final EMI figure that would have to be paid comes to around Rs 22,367. This kind of calculation can be done, so that the client is able to know whether the amount is affordable for them. Also, any change in the interest rate can also be applied to witness the kind of impact that is seen in the monthly payments and the change therein. For example, in the above case if the interest rate falls to 6.25 per cent then what will be the EMI for the 20 year loan. In this case PMT= (0.0625/12,240.-3000000) PMT =21927.85 This shows that the EMI will fall to around Rs 21,928 when the interest rate falls by 0.25 per cent from the earlier case. Changes at any point of time during the loan period can be seen through this calculation. 2.2.5 Period of the loan (NPER) There are times when a person would like to know the time period within which they would be able to pay off an amount. Given the fact that there is a capital amount that is present 39 along with the loan interest and a fixed amount repaid each month the amount in which the loan can be repaid can be known. This is also known by its Excel term NPER. The details that are vital here is the r = rate of interest on the loan PMT = the equal payment on the loan PV = The present value of all the future payments For example, a person wants to know the NPER of a loan that is worth Rs 5 lakh now and where the EMI is Rs 12,000 per month. The rate of interest on the loan is 8 per cent. In this case too since this is a monthly payment the interest rate would have to be divided by 12 and putting this into the Excel formula we get =NPER(0.08/12,-12000,500000). = 48.97 The result is 48.97 months. This gives a clear idea about the time period in which the payment would be complete. The NPER is useful to calculate the time period of repayment and this is then matched with the EMI payable, so that it can be affordable for the individual. 2.2.6 Annuity An annuity is a sum of money paid at regular periods, such as monthly, quarterly, annually. A common example of an annuity is pension. Annuities can be of two types (1) Fixed annuity and (2) Flexible annuity. Fixed Annuity means that fixed returns are received at regular periods. For instance, a fixed deposit with a bank paying 5.5 % p.a. on the investment for a predetermined term assured (for example, for the next 5 years). Floating annuities are those in which the returns are benchmarked to inflation or index returns or any other return as specified in the indenture agreement at the time of buying. So, the annuities paid are not fixed, but change in line with the chosen benchmark. Annuities are used extensively during retirement wherein there is the need for a regular cash flow and this is generated by several investment instruments. There are various terms by which an annuity is referred to but the key point is that the feature of all these are that there is a regular sum of money being received. There are two types of annuities that can be received on an investment: 40 Ordinary Annuity An annuity is differentiated based on the time period when the payment on it is made. In case of an ordinary annuity the payment is made at the end of the relevant time period. Most of the annuities are of this type as the payment comes at the end of the period. Consider for example a bond, which pays out a sum of money. This is received at the end of the year if the payment is made annually and this becomes an ordinary annuity. The way to calculate an annuity is to look at the present value of such a cash flow. This will tell you what the future payments are worth at the present time. This can also be used to make various calculations in terms of how much is required in order to ensure a certain payment in the future. The calculation for an ordinary annuity can be done as a normal present value formula. For example, consider an annuity that is paid out each year of Rs 5,000 and this is at a rate of return of 10 per cent for a period of 4 years. In this case the present value of the annuity would come out to PV = PV(0.1,4,-5000) PV = 15849.33 When the PV calculation is made in excel there is a row for details to be entered called type present in the formula. This is usually left blank and it takes the default position of the payment coming at the end of the period. There can also be the use of an annuity table for the purpose of the calculation. An annuity table gives a multiple for different rates of interest and varying time periods. One can just look up the annuity table figure and then use this in the calculation. For example, consider a person who wants to value an annuity of Rs 12,000 a year for 10 years at 5 per cent per annum. The normal PV calculation will give the answer as: PV =PV(0.05,10,-12000) PV = 92,660 Looking at the annuity table the annuity factor for 10 years at 5 per cent is 7.7217 So, PV = 12000 X 7.7217 PV = 92,660 41 Annuity Due There is a change that occurs in an annuity due as compared to an ordinary annuity and this is with respect to the time period when the payment is made. Here the payment is made at the start of the period instead of at the end of the period. This will impact the value of the annuity because if you are a person receiving the payment then you are getting it at the start of the year which gives the chance for this to be deployed during the year. In order to get the value of such an annuity the present value of the cash flow would need to be calculated. As compared to an ordinary annuity there is an additional figure that will come in the calculation. The calculation for an ordinary annuity can be done using the PV function but here in the type column instead of leaving it blank or 0, the number 1 is entered. For example, consider an annuity that is paid out each year of Rs 5,000 and this is at a rate of return of 10 per cent for a period of 4 years. This is the same case that was considered in the ordinary annuity working but here if the payment is made at the start of the year as is the case with an annuity due then the calculation will become PV =PV(0.1,4,-5000,,1) PV = 17434.26 As can be seen from above, the payment at the start of the period raises the value of the annuity. One has to consider this from various angles. It is more valuable for a person to receive an annuity due because they get the money earlier which can be invested to earn further return. For someone who has to make payments for any purpose at the start of the period then this is more costly because they are losing the opportunity of earning on that particular capital for the duration of the year for which the amount would have otherwise remained with them. 2.2.7 Perpetuity Perpetuity is a cash flow from an investment that goes on forever. A normal instrument would have a specific time period for which the cash flow might be received but in case of perpetuity there is no finite period for which the cash flow is received. There are perpetual bonds that are issued by entities and these are the best example of real life perpetuity. In these bonds the cash flow keeps coming year after year. The other common life example would be pensions that are payable to pensioner till their life term. The perpetuity provides a constant cash flow for an unlimited time period. In order to calculate the value of perpetuity one has to find its present value. This is given by 42 PV = C/ (1+r)^1 + C/(1+r)^2 + C/(1+r)^3 +..... PV = C/r Where PV = Present Value C = Cash flow r = discount rate The constant stream of a similar cash flow will ultimately lead to the calculation being made as the cash flow divided by the discount rate. Example A bond pays out Rs 10,000 as interest on an annual basis and this is a perpetual bond. If the discount rate or the interest rate is 8 per cent then the valuation of the perpetuity would be as under: PV = C/r PV = 10,000/0.08 PV = 125,000 43 CHAPTER 3: EVALUATING THE FINANCIAL POSITION OF CLIENTS LEARNING OBJECTIVES: After studying this chapter, you should know about:  Cash flow management in personal finance  Know about preparation of household budget  Cash inflows and outflows  Know about budgeting and forecasting  Importance of monitoring budgets and provision for savings  Creating personal balance sheet and net-worth  Creating a budget and savings plan  Understand contingency planning  Evaluating the financial position of clients  3.1 Importance of cash flow management in personal finance Personal finance involves looking at the various sources of income and expenses and ensuring that there is some surplus savings which is allocated to various investments to meet the different goals in the future. One of the key aspects of the entire process is to look at the cash flow that is generated by the individual or household and how this is handled. There are several factors that make the entire process of managing the cash flow very significant in the personal finance management process. The cash flow is the starting point of the whole personal finance process. The time and the amount of income that is generated and the time and the amount when this is spent as expense is critical to ensure that there is a proper balance maintained between the two. The time of the cash flow becomes critical because the income has to be available when expenses crop up. A very good example of a balance between income and expense is that of a salaried individual who gets a monthly income in the form of salary and whose expenses are also due monthly like payment of electricity, telephone bill, salary to household staff etc.. Even a slight mismatch between the cash flow can lead to the need for debt which is costly for the individual. If there is a situation wherein the income comes in at unspecified time intervals, but the expenses are evenly spread out then this can lead to a short term mismatch. This has to be met through debt, which comes at a cost in the form of interest. The interest becomes an extra outgo, which reduces the savings further. There has to be adequate income coming in at all points of time so that a surplus is generated. This surplus called savings is essential because this is necessary for difficult times. Cash flow 44 mismanagement can become a source of tension for the individual and family. This can disrupt normal life and peace in the family which becomes a crucial factor to consider. This can further lead to health problems if the tension persist over a period of time. Cash flow management ensures that there is a control over the finances in a family and for an individual. There is a sense of empowerment that this gives, because there is confidence that things are being handled in a proper manner. It also makes for smooth running of the household as funds are available as and when required. 3.2 Preparing Household Budget The investment adviser performs an important role in helping the household or an individual understand a household budget. Preparing a household budget entails an understanding of the sources from which the household or individual receives income, and the application of these funds in a typical month. A sample household budget is shown in Table 3.1. The way to go about preparing a household budget is to first start with the various heads of income. All the amount that is received from various sources has to be listed out and this will become the income. Some of it might be regular in nature while there might be heads like investment income that is not regular and which comes infrequently. On the expense side there are some amounts that have to be compulsorily spent and these are called mandatory expenses. Others are essential living expenses, which are necessary for daily use. Finally comes the discretionary expenses and these are the expenses that can be cut in case there is need for a control on the total amount spent. The total expenses when reduced from the total income would give the savings that are managed by the household. In some cases there could be just a single family member who is earning while in other families there could be more than one earning family member. The difference between monthly surplus in hand and savings is to be noted. The monthly surplus in hand is calculated after mandatory deductions, such as, contributions made to provident fund and National Pension System. These are added back to the monthly surplus in hand to arrive at the savings. Let us assume that 6 months expenses need to be covered. Monthly expenses to consider are Rs.79,000(regular expenses) and Rs.12,000 (loan servicing) i.e. Rs.91,000. 45 Table 3.1 Month