Introduction to Financial planning

By Jai Adiani

Time Value of Money

Why does Money have Time Value?
Prefer Consuming today than in future
E.g. I will prefer to spend Rs. 25000/- on the latest mobile phone than wait for a few months and buy it at a reduced price.

Money can be utilized to generate positive returns

E.g. Rs. 100/- Invested today @ 8% will grow to 108 a year later

Inflation e.g. Rs 10/- is more valuable today than a year later

E.g. Inflation today is 6.38% so a year later Rs. 10 is Rs 9.40

Time Value of Money

Cash Flows Represented by using a Timeline
Money is received or is due(to be paid/invested) All Expenses are in Begin Mode All Savings are in End Mode Inflow of money represented by +ve sign Outflow of money represented by -ve sign Annuity Due is Begin Mode Annuity Deferred, Certain is End Mode

Time Value of Money

Cash Flows Timeline: END MODE
0 9% 1 9% 2 9% 3 9% 4 9% 5
20000

20000

20000

20000

20000

Position 0 is Todays Position 9% Interest rate per period 20000/- Cash Flow Invested per period End of period 1 is Also Beginning of year 2

Time Value of Money

Cash Flows Timeline: BEGIN MODE
0 7% 1 7% 2 7% 3 7% 4 7% 5

10000

10000

10000

10000

10000

Position 0 is Todays Position 7% Interest rate per period 10000/- Cash Flow Spent per period Beginning of Period 3 is Also End of year 2

Time Value of Money

Select ON to Turn on Calculator Calculator Reset Procedure:
1. Shift 9 2. Scroll Down to All (using Replay down arrow) 3. Select EXE 4. Select EXE 5. AC

Time Value of Money

Select Desired Mode of Operation In order to Enter a Value: Enter desired value, Next Select EXE Repeat the same above to enter values in required fields In order to Calculate the Answer Select SOLVE

Time Value of Money

Calculator Modes
COMP CMPD CNVR CASH DAYS STAT (To be done in Investment Planning)

COMP Mode
Operates like a Regular Calculator Add, Subtract, Multiply, Divide, Square Root, Exponential, Power etc

CMPD Mode
Set: END(2)/BEGIN(1) N = NUMBER OF PERIODS I % = COMPOUND RATE/ DISCOUNT RATE PER PERIOD PV = PRESENT VALUE PMT = PAYMENT PER PERIOD FV = FUTURE VALUE

CNVR Mode
N = NUMBER OF COMPOUNDINGS IN A YEAR I% = INTEREST RATE EFF = EFFECTIVE RATE APR = ANNUAL RATE

CASH Mode
I% = COMPOUND RATE/DISCOUNT RATE Csh = D.Editor x (EXE to Enter Values) NPV = NET PRESENT VALUE IRR = INTERNAL RATE OF RETURN NFV = NET FUTURE VALUE

DAYS Mode
Set: 365/360 D1 = 01012004 = monthdateyear D2 = 01012004 = monthdateyear Dys = Calculates number of days

Financial Ratios
Help in Analyzing 6 Important Aspects of a Clients Financial Situation
Liquidity Debt Risk Exposure Tax Burden Inflation Protection Net Worth

Financial Ratios
Liquidity Ratio
Basic liquidity Ratio = Liquid Assets / Monthly Expenses where Liquid Assets: Cash, Near Cash Expanded Liquidity Ratio = [Liquid Assets + 50% (Other Financial Assets)] / Monthly Expenses where Other Financial Assets: Certificates of deposit, Cash value of life insurance, bonds, marketable stocks, mutual funds

Debt
Liquid Asset Coverage Ratio = Liquid Assets / Total Debt Solvency Ratio = Liquid and Other Financial Assets / Total Debt

Financial Ratios
Risk Exposure
Life Insurance Coverage Ratio = (Net Worth + Death Benefits of Principal Wage Earner) / Annual Salary of Principal Wage Earner

Tax Burden (net profit/pretax profit: NI/EBT) Inflation Protection Net Worth
Net Worth = Total Assets Total Liabilities

Code of Ethics
IOCFCPDC Integrity Objectivity Competence Fairness Confidentiality Professionalism Diligence Compliance

Code of Ethics
Code Of Ethic 1 - Integrity:
Members shall observe high standards of honesty in conducting their FP business and shall offer and provide FP services with integrity.

Rule Of Professional Conduct:

False statements, misrepresentation, misleading advertisements, promotional activities, member be responsible for clients funds, take care required of a fiduciary.

Code of Ethics
Code Of Ethic 2 - Objectivity:
Members shall disclose to client limitation on ability to provide objective FP services.

Rule Of Professional Conduct:

Reasonable & Professional judgment in professional services, interest of client, limitation on ability in products. Disclose ability to earn interest, fees, commissions, potential conflicts of interest. Annual disclosure every year to client. Oral against Oral.

Code of Ethics
Code Of Ethic 3 - Competence:
Members shall provide competent FP services and maintain the necessary knowledge and skill to continue to do so in those areas in which member is engaged.

Rule Of Professional Conduct:

Update on developments in Financial field (30C points in 2 years). Advice only in areas of competence. Have reasonable and appropriate standards for appointment of your representatives.

Code of Ethics
Code Of Ethic 4 - Fairness:
Members shall provide FP services in a fair and reasonable manner.

Rule Of Professional Conduct:

Prospective clients informed in writing about company responsible for advice, nature of service, material information, access to internal & external compliant mechanism. Members compensation be fair and reasonable. Member can provide references, disclose to prospective clients capacity to provide FP services. Provide relevant information to employer company, copartners while in business together.

Code of Ethics
Code Of Ethic 5 - Confidentiality:
Members shall not disclose any confidential client information without specific authorization of client unless compelled by law to do so.

Rule Of Professional Conduct:

Not reveal any personal info of client unless opening brokerage a/c, advisory, effect a transaction, or authorized for clients work; legal requirements, civil disputes, defend the client. Same standards to employers as to clients. Confidentiality applicable while in business together and thereafter. Disclose any original document related to FP advice to client or to his authorized representative (if he has paid for it or will pay for it).

Code of Ethics
Code Of Ethic 6 - Professionalism:
Members shall ensure their conduct does not bring discredit to the FP profession.

Rule Of Professional Conduct:

Show respect for other FP professionals, engage in fair and honorable non competitive practices. Not practice any other profession unless qualified to practice in those fields. Maintain professional indemnity insurance within requirements of FPSB. Not misrepresent status of membership, authority of FPSB.

Code of Ethics
Code Of Ethic 7 - Diligence:
Members shall act with due skill, care and diligence in providing FP services.

Rule Of Professional Conduct:

Individual capacity ability to provide required services, collect sufficient information, services provide diligently & timely basis Implementation and review

Code of Ethics
Code Of Ethic 8 - Compliance:
Members shall maintain knowledge of and comply with Constitution of FPSB, India, comply with their rules and of other government regulatory authority, licensing agency or professional organizations.

Rule Of Professional Conduct:

Comply with all rules of AFP, government agencies etc. Cooperate with AFP in all aspects of investigation, Fulfill all post certification requirements. Conduct of representatives considered conduct of members. Records to be securely stored and available for inspection, retained for 7 years from date of document was last acted upon.

Return
What is Return?
Profit per rupee of Cost E.g. if you invest Rs. 1000/- and gain a profit of Rs. 50/- in one year, then your return is Rs 50/1000 or 5%

Returns are 2 types:

1. Ex-post (Historical): Returns already generated by the investment 2. Ex-Ante (Expected): Returns not yet generated, but expected to be generated by the investment

Ex-post (Historical)
Single Period Returns
Total Return = (P1 P0) + D1 , where P0 P1 = Price per share at end of period P0 = Price per share at beginning of period D1 = Dividend/Cash flow received during the period Total Return equals Price change + Current yield Return Relative = 1 + Total Return = P1 + D1 P0 Total Return may be negative, Return relative cannot be negative (at worst it is 0)

Ex-post (Historical)
Multi Period Returns
Arithmetic Mean = [i=1 to N] Rn, where N Rn = ith Value of the total return (I = 1, n) N = Number of total returns Geometric Mean = [(1+R1)(1+R2)(1+Rn)]^(1/n)] 1 Arithmetic Mean is more appropriate measure of average performance over single period Geometric Mean is a better measure of growth over time GM is always less than AM (1 + GM)2 ~ (1 + AM)2 (Standard Deviation)2

Ex-post (Historical)
Cumulative Wealth Index (CWIn) = WI0 x [(1+R1)(1+R2)(1+Rn)], where CWIn = cumulative index at the end of n years where WI0 = the beginning index value which is typically 1 Ri = total return for year I (I = 1, .. N)

Ex-ante (Expected)

Expected rate of return of a security = Ri Pi where Ri = Return in the ith scenario Pi = Probability of the ith scenario Expected rate of return of Portfolio of Securities = Wn Rn where Wn = Weight of nth security Rn = Return of nth security

Risk
Is a chance that one does not get what is expected I.e. Variability from the expected returns Total Investment Risk is Classified as Systematic Risk and Unsystematic Risk Systematic Risk is inherent in the system and cannot be diversified:
Foreign Exchange Risk
E.g. if indian currency appreciates against foreign currencies, investors will experience currency loss on their foreign securities Conversely when rupee depreciates against foreign currency, investors will experience currency gain on their foreign securities

Risk
Inflation Risk
Systematic risk form the decline in purchasing power of the currency during periods of inflation. Real adjusted rate of return on investment r, Real Rate of Return = [(1+Nominal rate)/(1+Inflation rate)] - 1

Interest Rate Risk

Systematic risk due to uncertainty of the future value of securities because of possible variations in interest rates. E.g. owner of fixed-income security will see market prices of his or her bonds decline when the market rate of interest increase and vice versa.
Systematic risk results from day-to-day fluctuations in the prices of stocks, options caused by change in investor psychology

Market Risk

Risk
Unsystematic Risk arises from factors that are unique or typical to the individual firm and it can be reduced through diversification
Business Risk Country Risk Financial Risk Liquidity Risk

Risk
Most common measures of Risk are:
Standard Deviation ( = Variance) OR Variance of Returns (also = 2) Beta Using Formula: S.D2 (2) = [Ri R]2
N-1

When Historical Return is given:

Using Calculator: In Setup STAT: OFF, Enter data in STAT mode, Shift STAT, Select 5, Select 4

When Expected Return is given:

Using Formula: S.D2 (2) = Pi [Ri R]2

N

Using Calculator : In Setup STAT: ON, Enter data in STAT mode, Shift STAT, Select 5, Select 3