Limited Preview of CFP Study Material of IMS Proschool

1. How to use Proschool Study Material?
2. Financial Planning Mathematics

3. Investment Planning Risk & Return
4. Tax Planning- Income from house
property
CFP Study Material Preview

Introduction to Financial Planning & Investment Planning
136
Limited Preview Edition

It gives us lots of pleasure to bring 3
rd
edition of the CFP
CM
books. Its an earnest attempt done to
simplified all topics keeping in mind the understanding and the examination, as CFP
CM
Exam is
the most dynamic exam in the country, since lots of changes come day in day out due to changing
marketing dynamics and regulatory requirement. In order to keep you abreast with these changes
we have made special emphasis on online learning system also.
How to read the study material:
The chapter contains 1. Concept reading, 2. Check your progress 3. Assessment Test, 4. Online
resources
1. Concepts Reading: Kindly make an attempt to understand the concept as such and not to read
them as subjects. Concept reading will familiarize you with the required knowledge/approach
to clear the exams. It also includes illustrations and concept checkers to give you the
approach to solve all the practical problems
2. Check your progress: For most of the chapters Check your progress is given ,which will
re-emphasize your learning. Solution of Check your progress is given at the end of every
chapter.
3. Assessment test: Before you move to the next chapter you should take the assessment test
and if you are scoring below 80% , then kindly again go through the concept again before
moving to the next chapter.
4. Online Resources: After completing all the assessment test please go the online resources.
How to use online resources:
1. Powerpoint Presentation: Summary of all the chapters is given in PPT format. This would
help you to brush up the topics before attempting the online unit test
2. Unit Test: Before taking Full length online simulated test papers, you should again take the
online unit test .
3. Simulated Test paper: Before you take the date of the exam, it is advisable to take the
simulated test paper , if you get above 70% , then you can take the date of the exam at NSE.
How to use IMS Proschool Study Program

137
This will help you to clear the exam in the first attempt. If you score below 70%, then please
go through the concept book again and then take the simulated test paper 2.
Other online resources:
1. News forum: Whenever you visit online please check the news forum first , this will keep
you updated with all the new announcement and changes in the syllabus & examination
structure etc.
2. Question & Answer Forum: If you have any doubt related to the questions given in the
concept books and the questions appearing in the exam then please ask your question using
this forum. You will get reply in three days from our faculty or from any other candidate who
knows the answer . You can also give answer to any other questions to make the forum
interactive
3. Share resources: If you come across any resources or questions which can be useful for other
students then you can share using Share Resources
Live Virtual Classroom (LVC)
Live Virtual Classroom is one of the most advanced feature of IMS Proschool study program.
This program is ideal for those who prefer real time learning of classroom, but have constraints in
attending the classroom sessions.
How to use LVC: Students those how are enrolled for this program, can see the online schedule
on their online learning homepage. As per your suitability , you can register online for the classes.
(Note: once register for particular class then you cannot attend same class again). Recorded
sessions are also available. After registering for the class, you will get online invitation with user
id and password to attend the class.
With Best Wishes,
Ankush Bhandari
Product Manager IMS Proschool

138
1.Financial Planning Mathematics

Mr. Ravi is an investor who is going to meet his Financial Planner for advice. Before
meeting him, he has noted down few questions that he would like to ask his financial
Planner:
1. I want to go abroad for which I will need Rs.2 lacks after 5 years. How much I
need to invest every year to get the required amount after 5 years (assuming a
return of 12% p.a)?

2. How much I need to save every year to build a fund for my retirement expenses?

3. If I save Rs.5000 every month how much I will able to save in next 20 years for
my daughter marriage?

These are some of the most common questions that you face day to day life. To answer
these questions, knowing Basics of Time Value of Money or Financial Planning
Mathematics is very important.

139

Time Value of Money: Concept and Calculation
One of the most fundamental concepts in finance is that money has a time value. That is to say
that money in hand today is worth more than money that is expected to be received in the future.
This leads us to summarize the concept of time value: A Rupee today is worth more than a
Rupee tomorrow."
The purpose of this chapter is to introduce you to the concepts, terminology, and mathematics of
the time value of money. Understanding this topic is crucial in understanding and calculating all
sorts of financial questions in personal finance in general and investments in particular.

Time Value of Money for Even Cash flows
Future Value (FV)
This term refers to the value of a present cash flow (or series of cash flows) at a future
date. Any cash flow that is scheduled to occur sometime later than today is referred to as a
future value. Literally translated, future value means what would be worth of todays
Rs 1 at some future point? For example, if an investment promises to pay Rs.100 one
year from now, then the Rs.100 is the future value of the investment because that
investment will be worth Rs.100 at that point in time. Or if you deposit Rs.500 every year
for next ten years to get Rs.7000 after 10 years, then the Rs.7, 000 is the FV.

Present Value (PV)
This term refers to the current (todays) value of a single or series of future cash flows. In
other words, it is the amount that you would be willing to pay today in order to receive a
cash flow (or a series of them) in the future. For example, if you invest Rs.50,000 and get
Rs.100,000 after 5 years, then Rs.50,000 is the present value of the investment or if you
deposit Rs.10,000 to get Rs.2000 for next 7 years, then Rs.10,000 is the present value.

Number of Periods (NPER)
The total number of periods is a key variable in all time value of money questions. It is
important to distinguish between the number of periods and the number of years. For
example, when we refer to a 30-year Home Loan we are talking of 360 months or
periods of repayment and not 30 years.

Payment (PMT)
The payment is a series of cash flows. Typically, payment refers to all types of the cash
flow in an annuity. For example, if you deposit Rs.500 every year for next 10 years to get
Rs.20, 000. Then, Rs.500 is the payment (PMT). Common examples of Annuity/Payment
are EMI, Pension, and Systematic Investment Plan (SIP) etc

140

Rate
This is the rate that is used for compounding or discounting the future values or present
values. For example, if you deposit Rs.10, 000 and earn 12% pa on your deposit, then
12% pa is the Rate.

Interest can be calculated in two ways:

a. Simple I nterest
This is when interest is calculated only on the principal amount.

Where,
SI = Simple Interest
R = Rate of Interest
T = Time period

For example, if you deposit Rs. 100 for 2 years at an interest rate of 8% p.a., then after
one year, the interest you will earn would be: 100 x 8% = Rs. 8 and after 2 years : 100 x
8% x 2 =16

b. Compound Interest
This is when the earned interest is also reinvested along with the principal and one
receives interest on interest. For example, if you deposit Rs. 100 for 2 years at interest
rate of 8% p.a., then after one year, the interest you will earn would be: 100 x 8% = Rs. 8

For the next year, you will not only earn interest on Rs. 100 but also on the interest that
you earned in the first year i.e Rs. 8 and therefore you will earn interest on Rs. 108.
108 x 8% = Rs. 8.64

The generalized formula for calculating future value at compound interest can be stated as
below:

FV = PV (1 + R) T
= 100(1 + 8/100) ^2
= 108.64

SI =PV x R x T
Note:
In all the time value of money
calculation, if rate is given 8% pa
then it means 8%pa compounded
annually (Unless, Simple interest
is mentioned in the question)

141

How to Solve Time Value of Money (TMV) questions using Excel Functions:

Write the TMV terminology that you need to use to get the answer.
For Example: After how many years your deposit of Rs.12, 000 will become Rs.20,
000 @15%.
Answer: NPER
Now Solve:
1. You need Rs.5,000 after 5 years. How much you need to deposit today?
___________
2. You need Rs.500 every year for the next five years. How much you should deposit
today? ______________
3. You invest Rs.1, 000 every year for next 20 years. How much amount you will
have after 20 years? ___________________
4. How much you have to deposit every year to get Rs.5000 after 5 years @12%
pa_______________
Benefits of Excel over Financial Calculator
In the exam, you can use either Financial Calculator or Excel for solving TMV problems, but
we strongly recommend students to use Excel to solve TMV problems because
a. Easy to remember: All the formulas are given in Excel Fx
b. Faster approach:
c. Easy to verify
d. Critical problem: Problems like Loan amortization are easy to solve on Excel sheet.
e. Presentation Advantage: Financial calculations can be presented to the clients on Excel
sheet
f. Record keeping: All the calculation done on Excel sheet can be saved for future
reference. More over for similar problems you just have to change the figures.

Check Your Progress I

142

To start solving TMV problem using Excel Functions: open Excel on your Computer System

1. Click Fx on your excel sheet:

2. Select a category: Financial

Function (Fx)

143

3. Select a Function: Select a function as per the requirement of Question. For example, if you
want to find out the amount to deposit today so as to get Rs.10,000 after 5 years, then double
click on PV:

Time Value of Money Calculations:
1. How much amount you have to deposit to get Rs.10, 00,000 after 10 years @12% pa.?

Explanation:
PV =?
Rate: 12%
NPER: 10
FV: 1000000

144

Some pages are omitted from this chapter preview

145

2. How many years will it take to make Rs.20,000 if you deposit Rs.5,000 per annum @15%
pa.?
Explanation:
Nper =?
Rate: 15%
PV: -5000
FV: 20000

Ans: 9.9 years

Note:
Whenever one is depositing/investing money , an outflow of cash occurs from ones pocket,
then a negative sign precedes the amount. For example, in the above question, we have
deposited Rs.100,000, so put negative sign before it i.e. -100,000. If you will receive some
amount, then you dont have to put any sign before that, because any figure without sign is
always considers as positive. For example in the 1st Example, we have put 1000,000 in FV
rather than +1000,000.

146

3. At what rate of return will your investment of Rs.200,000 become Rs.500,000 in 12 years?
Explanation:
Rate:?
NPER: 12
PV: -200000
FV: 500000

Ans: 7.9%

5.A Calculate the amount you will get after 5 years, if you deposit Rs.100 at the end of every
year for five years at 12% pa. ?
Explanation :
FV = ?
PMT: Rs.100
Rate: 12%

147
NPER: 5

Ans: Rs.635.28

5.B Calculate the amount you will get if you deposit Rs.100 at the beginning of every year for
five years @ 12% pa.
Explanation:
Rate: 12%
NPER: 5
PMT: Rs.100
Type: 1

148

Ans: 711.52

Note:
In all Annuity/payment questions Type plays an important role.
a. In the question no 5 A, when you deposit Rs.100 at the end of every year for 5 years, then
in Type you have to put value 0 or simply omit it. This type of Annuity is called
Ordinary Annuity
b. In the question no. 5 B, when you deposit Rs.100 every year at the beginning for the next 5
years, and then in Type you have to put value 1. Type 1 means payment at the
beginning of the year. This type of Annuity is called Annuity Due

149
Type 0 or 1 on Time Line
A.

B.

When to use Type
1. Type is used only with annuity (PMT) Calculations
2. Whenever you invest regularly consider it at the end of the period and type 0 (Unless
given in the question that investment at the beginning of period or investments starts from
now/immediately)
3. Whenever you withdraw regularly , consider it at beginning of the period and use type 1
(Unless given in the question that withdrawal at the end of period is given)

5.C: How much amount you need to deposit to get Rs.20000 for ever @10% pa
=Annuity amount/rate
=20000/10% = 20000*100/10 = 200,000

Note:
This type of Annuity is called Perpetual
Annuity .This type of Annuity will provide
you regular amount forever. In the above
example, if you deposit Rs.200,000 @10% pa
then, you will get Rs.20,000 forever.

150
Faster approach of solving TMV calculations on Excel sheets
In the examination, you have to solve TMV problems frequently, that is why opening the Fx
every time becomes time consuming. Another way of solving problem is to write the formulae
Functions with in the cell of Excel :
The table below shows various Excel Functions:

Solve questions using Excel Functions:
How much amount you have to deposit today to get Rs.10,00,000 after 10 years @12% pa.?

151


152

6. . X is planning to send his daughter to college 18 years from now and will need Rs.100,000
at that time in order to pay for her tuition fee. Given annual rate of return of 8% per year, how
much money he needs to invest every year to achieve the set goal?
___________________________

7. . X is planning to send his daughter to college 18 years from now and will need Rs.100,000
at that time in order to pay for her tuition fee. Given annual rate of return of 8% per year, how
much money he needs to invest in the beginning of every year ( start now)to achieve the set
goal?_________________________

8. You want to withdraw Rs.5,000 every year for next 20 years for your retirement expenses.
Assuming an return of 10% pa , how much money you need have to achieve your goal?
____________________________

9. You require Rs.10,000 forever . How much you invest today @12% pa to get the required
annuity?__________________________

10. Suppose that you are offered an investment that will cost Rs.925 and will pay you interest
of Rs.80 per year for the next 20 years. Furthermore, at the end of the 20 years, the investment
will pay Rs.1,000. If you purchase this investment, what is your compound average annual
rate of return?_____________________________

153
TMV for Uneven cash flows
Net Present Value:
How much amount you have to deposit to get an annuity of Rs.1,000 every year for next 20 years
@ 12% pa?
To solve this question, you will use Present Value: = pv(12%, 20,1000) =
Now, suppose you want to know how much you have to deposit to get Rs.4000 at the end of first
year, 6000 at the end of second year, 8,000 at the end of third year & 10,000 at the end fourth
year @12% pa?
To solve the above problem, you cant use PV function as the cash flows are uneven. To get the
present value of uneven cash flow, you have to use Net Present Value (NPV) function

Answer: 20,404.

I nternal Rate of Return:
You are investing Rs.20,000 in a fund which will give back Rs.5000 for next five years. How
much rate of return you are deriving from this investment?
To answer this, you will use Rate =rate (5,5000,-20000)
Now, suppose you are investing Rs.20,000 and will get Rs.6,000 after one year, Rs.8,000 after
two years and Rs.10,000 after 3 years. How much rate of return you are getting in the above
investment

154
To solve the above problem, you cant use Rate function as the cash flows are uneven. To get
the rate of return of uneven cash flow, you have to use Internal Rate of Return (IRR) function

I llustrations:
What is rate of return in an investment, where you deposit Rs.10,000 in first year and get
RS.6,000 in third year,Rs.8,000 in 6 year and Rs.10,000 in seventh year.

Note:
If for any period there is no
investment/return, then put
Zero in the year when you will
not invest or get any amount.

155

1. If you make an investment of 1 lakh in a project initially and future cash flows at the end of
every year are given as :
25000
15000
18000
17000
35000
25000
What is the rate of return you earned ?___________________________
2. You have to make a following series of payments at the end of year (given rate of return 8
% pa)
12000
14000
18000
19000
29000
What amount should you deposit to take care of the payments ?______________________
3. You have the option of receiving following payments at the end of each year:

a.Given the rate of return is 9 % which option would you choose ?___________________
b.If you had to make these payments which option you would choose ?_______________
Check Your Progress II I

156


157
As a financial planner, what option would you advice him to invest?
Your decision will depend on how much annual return your client will get from the various
options and this annual return is called Effective Annual rate of Return

CASE I
Consider a stated annual rate of 10%. Compounded yearly, this rate will turn Rs.1000 into
Rs.1100. However, if compounding occurs half yearly, Rs.1000 would grow to Rs.1102.50 by the
end of the year, rendering an effective annual interest rate of 10.25%. Basically the effective
annual rate is the annual rate of interest that accounts for the effect of compounding.
Calculation:
(1+ i/n)
n
-1
i = stated annual interest rate
n = number of compounding periods
=(1+0.1/2)^2 -1=0.1025 or 10.25%
CASE I I
Now suppose you are investing Rs.1000 every month in a Mutual Fund (SIP mode) for 1 year
which gives a return12% pa. Note that the given return is annual, but you are investing monthly.
Now if you apply rate = 12%/12 or 1%, (=fv (1%,12,-1000) it would be compounded every
month and effective rates becomes = 12.68% (1 + (.12/12)) ^12 -1.Then you will get a return
higher than the actual return.
Therefore your monthly effective rate will be less than 1%, which after compounding 12 times in
a year will become 12%.
Monthly effective rate= (1 + R/100) ^ (1/npery) -1
(npery = no. of periods in a year).
For the above calculation, monthly effective rate will be:
= (1+ 12/100) ^ (1/12)-1
= (1.12)^(1/12)-1= .009489 or 0.9489%
Then, future value of above mutual fund will be
=fv (.9489%, 12,-1000) =12,646
Note:
In the above question 10% will
be nominal rate and 10.25%
will be Annual Effective rate.

158

I nflation adjusted rate /Real rate of return
How much did your investments really earn last year? You can calculate a rate of return, but if
you dont adjust it for inflation, youre not getting the real rate of return.
This is the difference between the nominal interest rate (before adjusting for inflation) and the
real interest rate. You need to know the real rate, since that is the only number that means
anything.
Think of it this way: the nominal interest rate tells you the growth rate of your money, while the
real interest rate tells you how much your purchasing power is growing.
Growing Money
For example, if you make a Rs.1,000 investment that earns 8% in one year, you end the year with
Rs.1,080. In other words, your money has grown by Rs.80. This is called nominal rate of return.
However if inflation is 3% for the year, your Rs.1,080 is only worth Rs.1,050. Inflation devalues
your returns. Your real rate of return is approximately 5%. This is your inflation adjusted rate of
return

Note:
When to use effective rate of return?
When ever annual rate is given but you are investing or withdrawing
monthly/quarterly/daily/half yearly.For example you are investing Rs.1,000 monthly in a
Mutual Fund with rate of return of 12% pa
When not to use effective rate of return ?
Whenever calculation involves products such home loan, car loan etc or any other
products where it is mentioned that interest rate will be compounded .For example in
National Saving Certificate (where 8% pa is compounded half yearly)

159
I llustration
What is the real rate of return, if inflation rate is 5% and rate of returns for investments is 12%?
= (1+.12/1+.05)-1
= .06667 or 6.6%
Alternatively, Real rate of return = (interest rate inflation rate)/ (100+ inflation rate)
Illustrations: (12-7)/(100+5) = 7/105 = .06667 or 6.6%

Bond Valuation:
Bond Valuation and TMV
A bond is a debt instrument issued with the purpose of raising capital by borrowing. Generally, a
bond is a promise to repay the principal along with interest (coupons) on a specified date
(maturity). Some bonds do not pay interest, but all bonds require a repayment of principal. A
bond may be described in terms of par value ( the value stated on the face of the bond), coupon
rate (interest rate payable to the bondholder) & maturity date ( the date when the principal amount
is payable to the bondholder). For example, an issuer may sell a bond with a par value of
Rs.1000, a coupon rate of 8% and maturity period of 5 years. The buyer of such bond would
1. You are taking a home loan of Rs.20 lac for 20 years at 12% pa. What will be your EMI?
2. You are investing in a mutual Fund Rs.1,000 monthly at 15% pa . What amount you will
get after 5 years?
3. You are investing Rs.1,00,000 in a Bank Fixed Deposit for a term of 5 years at the rate of
9% pa ( Compounded Quarterly). What will be your maturity amount?
4. Rajendra has a retirement Fund of Rs.10 lac. How much annuity(Annuity Due) he can
withdraw monthly for the next twenty years, if he is expecting the rate of return of 8% pa.
5. You are investing Rs.5,000 quarterly in a Mutual Fund SIP at the rate of return of 12% pa.
How much amount you will get after 10 years?
6. You are investing in a fund which is giving a return of 12% pa. If inflation rate is 6%, then
what would be real rate of return?
Check Your Progress I V

160


161

To calculate the present value of the bond paying coupon half yearly you have to:
1. Divide rate by 2 i.e. 10%/2 = 5%
2. Multiply NPER by 2 i.e. 5 * 2 = 10
3. Divide Coupon by Rs.2 i.e 8/2 = 4
= pv (10%/2, 5*2,4,100)= 92.28

Zero Coupon Bond:
In a Zero coupon bond, there will not be any coupon rate which means bond holder will not
receive any regular payouts like Rs.8 in earlier question, but only Rs.100 or par value on maturity
.
Valuation of Zero Coupon Bond:
A bond is available with a par value of Rs.100, maturing after 5 years. If you are expecting a
yield of 10% pa, then how much will you pay for this bond?
= PV(12%,5,,100)=56.74

Note:
No value in PMT, because you
will not get any regular amount
in Zero Coupon bond.

162

Solution of Check your Progress
1.
Sr.No Answer
1 Present value
2 Present value
3 Future value
4 PMT

2.
Sr.no Answer Formula
1 161.051 =FV(10%,5,,-100)
2 -25024.90 =PV(8%,18,,100000)
3 8.043 =NPER(9%,,-1250,2500)
4 0.093 =RATE(18,,-20000,100000)
5 -6417.65 =PV(9%,10,1000)
6 -2670.20 =PMT(8%,18,,100000)
7 -2472.41 =PMT(8%,18,,100000,1)
8 -46824.600 =PV(10%,20,5000,,1)
9 83333.33 =10000/0.12
10 0.08 =RATE(20,80,-925,1000)
1. A bond (Face value Rs.1000) with 10 % coupon paying interest on a semi annual basis,
is trading at 890 with maturity after 5 years . What is its Yield to Maturity (YTM) ?
2. You need a return of 12 % p.a. A 1000 rupee bond is trading at 925 with 3 years of
maturity pays a coupon of 7%.At what price should you buy it ?
3. A bond with face value of 1000 coupon of 7.5% paying semi annually , will mature in
17.5 yrs.Similar bond in market with yield of 8 % would be available at what price ?
4. A Zero coupon bond of Rs.100 maturing after 4 years is available, how much price you
will pay to buy the Bond , if your expected yield is 12%?
5. A Bond (face value Rs.1000), with 12% coupon paying interest on a quarterly basis, is
trading at Rs.800 with maturity after 4 years. What is its Yield to Maturity?
Check Your Progress V

163
3.1.
A B C
11
12 =IRR(F13:F19)
13 1 -100000
14 2 25000
15 3 15000
16 4 18000
17 5 17000
18 6 35000
19 7 25000
20
Ans:8.733%

2.

A B
11
12 =NPV(8%,F13:F17)
13 1 12000
14 2 14000
15 3 18000
16 4 19000
17 5 29000
18
19
20

Rs.71,105

3.

E F G H I
11 option 1 option 2 option 3 option 4
12 8845.64159205786 9289.15473757128 9364.98811428976 8175.22693569237
13 =NPV(9%,F14:F17) =NPV(9%,G14:G17) =NPV(9%,H14:H17) =NPV(9%,I14:I17)
14 1 5000 0 5000 0
15 2 2000 4000 3000 0
16 3 1500 4000 2000 6000
17 4 2000 4000 1000 5000

164


165

Assessment Test:
1. Salim expects to pay out the following in next few years: to pay out these amounts how much
should he have now, assuming an annual rate of 10%?
End of Year 1: Rs. 25,000
a) 65908
b) 66905
c) 68868
d) 74184
2. A 10 year bond pays a coupon of 10% p.a. with interest paid semiannually. The Yield on the
bond is 11%. Find its current price assuming Face Value of 1000.
a) 956.91
b) 1,050.43
c) 986.36
d) 940.25
3. If the pre tax return on a security is 10.00%, the real post-tax return would amount to
_______% if the inflation rate is 3% & income tax rate is 20%.
a) 4.85%
b) 3.51%
c) 4.30%
d) 3.12%

4. If you borrow Rs.500000 for a house @ 8.25% p.a.(compounding monthly) for 20 years, what
is your monthly payment?
a) 5,343
b) 4,260
c) 5,433
d) 3,134

166

5. In 1971, a breakfast used to cost Rs. 10. If the cost has increased to Rs. 55 now, what is the
effective annual rate of inflation over the period from 1971 to 2010?
a) 4.47%
b) 6.63%
c) 7.84%
d) 450.00%

6. At an interest rate of 8%, compounded semi-annually, how long does it take a given sum to
triple in value?
a) 14.5 years
b) 16 years
c) 28 years
d) 29 years

7. Chris wants Rs.300,000. She currently has a balance of Rs.100,000 and earns 8% per year,
compounded quarterly. How long will it take for Chris to accumulate the money
a) 13 years and 10 months
b) 18 Years and 9 months
c) 29 years
d) 19 years

8. Which of the following selections has the lowest present value if the discount rate is 5%? The
first cash flow occurs at the end of the first period, the second cash flow at the end of the
second period, and so on.
a) Rs.100; Rs.100; Rs.100; Rs.100
b) Rs.0; Rs.0; Rs.0; Rs.500
c) Rs.350; Rs.0; Rs.0; Rs.0
d) Rs.50; Rs.50; Rs.50; Rs.375

9. Arijit has taken a home loan of 30 lakhs @ 8.25% p.a. for 20 years. What is the EMI?
a) 23416
b) 25387
c) 25006
d) 25,561

167
10. A bond pays a coupon of 10% annually with interest paid semiannually. The bond has a
duration of 6 years. The Yield on the bond is 11%. Find its current price assuming Face Value
of 1000.
a) 956.91
b) 1,050.43
c) 922.83
d) 986.36

11. If the pre tax return on a security is 8.00%, the real post-tax return would amount to
_______% if the inflation rate is 3% & income tax rate is 20%.
a) 2.97%
b) 3.51%
c) 3.30%
d) 3.12%

12. If you want to spend a sum equivalent to Rs. 5000 p.a. for the next 5 years when the rate is
5% you need _________ today.

a) Rs. 22647
b) Rs. 20647
c) Rs. 21647
d) Rs. 23647

13. Raju wants to go on a foreign holiday at the end of every alternate year. It is expected to cost
him Rs. 2 Lakh per trip. How much corpus will Raju require to invest so that he can take care
of this requirement till perpetuity? Rate of return is 8%. (Round off to nearest lakh)

a) 2500000
b) 5100000
c) 1200000
d) 1000000

168


Lots of time investor would ask for an avenue having maximum returns with minimum risk. Is it
possible for a Financial Planner to provide maximum return with minimum risk? , its like asking
for S Class Mercedes with a CNG fittings!
Chapter - 3
889999
Measurement of Risk

136

rd
edition of the CFP
CM
CM
Exam is
chapter.

online unit test .

137
structure etc.
interactive
3. Additional Resources: You will get additional resources file with each chapter, this will
provide you the content and link available on the internet. These additional resources will be
helpful to you for both the exam and practical purpose.

138

No, all returns come with some risk and we know the axiom Higher the return, Higher the risk,
and vice-versa.

For example, Capital market offers return of 18% pa (Historical return) but it comes with the
huge risk of negative return at times, on the other hand, PPF offers only 8% return, but come with
almost no risk.

It is the job of a Financial Planner to measure the risk and return of any of Financial Products,
and then suggest products to the client according to the suitability.

Now big question is how to measure Risk.

139
Measuring Risk:
One of the ways to measure risk is using the statistical tool called as Standard Deviation
1. Measuring standard deviation of Historical Returns:
Lets examine two scenarios where the scores of two players are mentioned:
Match Wall Prince
Match 1 45 12
Match 2 34 45
Match 3 54 60
Match 4 12 42
Match 5 17 54
Match 6 87 54
Match 7 45 45
Match 8 26 23
Match 9 16 10
Match 10 26 17
Total Runs 362 362

We are calculating the Standard Deviation (In order to find out who is more consistent)
Step 1: Calculate the average score
Total score / no. of matches
362/10=36.2

140
Step 2: Calculate the deviation of individual score from the average score, square it & then calculate the sum of
Squares
Match Wall Score Average
run
Deviation
(Wall score Average
Score)
Square
Match 1 45 36.2 8.8 77.44
Match 2 34 36.2 -2.2 4.84
Match 3 54 36.2 17.8 316.84
Match 4 12 36.2 -24.2 585.64
Match 5 17 36.2 -19.2 368.64
Match 6 87 36.2 50.8 2580.64
Match 7 45 36.2 8.8 77.44
Match 8 26 36.2 -10.2 104.04
Match 9 16 36.2 -20.2 408.04
Match 10 26 36.2 -10.2 104.04
Total Runs 362 4627.6

Step 3: Divide the total by total number of matches less one
=4627/ (10-1)
Variance = 514.17
Standard Deviation = 514.17^
(1/2)
or square root of 514.17 = 22.67

141
Now thankfully we have excel also
Standard Deviation on Excel Function:
Select the STDEV from Statistical Functions:
=

= 22.67
In the same way, for Prince Standard Deviation is:
=18.866
Therefore, we can observe that Standard Deviation of Wall is more than Prince , it means that Prince is more
consistent than Wall.

Run

142


143
In the case of investments where the returns are market dependant, for example a stock, one will
have to estimate the possible returns and the probability of getting the same, as given here below:
Returns Probability of getting the returns
4% 0.1
8% 0.2
12% 0.4
16% 0.2
20% 0.1

In this case, the expected return is calculated as under:
Expected return = Sum (returns*probability)
= (0.04*0.1+0.08*0.2+0.12*0.4+0.16*0.2+0.2*0.1)
= .004+.016+.048+.032+.02
= 0.12 or 12%

It is a normal distribution curve as pictorially depicted below:

Normal Distribution
Returns
P
r
o
b
a
b
i
l
i
t
y

144


145
Variance= Probability * (actual return expected return)
2

So, based on the figures in the table we can work out the variance as under;
Expected return already calculated to be 12%
Actual return Expected
return minus
actual return
Difference
squared
Probability Square of
difference *
probability
4 -8 64 0.1 6.4
8 -4 16 0.2 3.2
12 0 0 0.4 0
16 4 16 0.2 3.2
20 8 64 0.1 6.4

Variance = sum of last column = (6.4+3.2+0+3.2+6.4) = 19.2
Standard deviation = Square root of variance =
4.3817
(Please note here we cannot use the STDEV function as there are probabilities attached to each
event)

146


147
Calculating a standard deviation using probability distributions involves making subjective
estimates of the probabilities and the likely returns. However, we cannot avoid such estimates
because future returns are uncertain. The prices of securities are based on investors' expectations
about the future. The relevant standard deviation in this situation is the ex ante (estimated before
the event) standard deviation and not the ex post (calculated after the events/historic) based on
realized returns.
Although standard deviations based on realized returns are often used as proxies for projecting
standard deviations, investors should be careful to remember that the past cannot always be
extrapolated into the future without modifications. Historic (ex post) standard deviations may be
convenient, but they are subject to errors. One important point about the estimation of standard
deviation is the distinction between individual securities and portfolios. Standard deviations for
well- diversified portfolios are reasonably steady across time, and therefore historical calculations
may be fairly reliable in projecting the future. Moving from well- diversified portfolios to
individual securities, however, makes historical calculations much less reliable. Fortunately, the
number one rule of portfolio management is to diversify and hold a portfolio of securities, and the
standard deviations of well-diversified portfolios may be more stable.
Something very important to remember about standard deviation is that it is a measure of the total
risk of an asset or a portfolio, including therefore both systematic and unsystematic risk. It
captures the total variability in the assets or portfolios return whatever the sources of that
variability. I n summary, the standard deviation of return measures the total risk of one security
or the total risk of a portfolio of securities. The historical standard deviation can be calculated
for individual securities or portfolios of securities using total returns for some specified period of
time. This ex post value is useful in evaluating the total risk for a particular historical period and
in estimating the total risk that is expected to prevail over some future period.
The standard deviation, combined with the normal distribution, can provide some useful
information about the dispersion or variation in returns. In a normal distribution, the probability
that a particular outcome will be above (or below) a specified value can be determined. With one
standard deviation on either side of the arithmetic mean of the distribution, 68.3 percent of the
outcomes will be encompassed; that is, there is a 68.3 percent probability that the actual outcome

148
will be within one (plus or minus) standard deviation of the arithmetic mean. The probabilities are
95 and 99 percent that the actual outcome will be within two or three standard deviations,
respectively, of the arithmetic mean.

In a bell shaped normal distribution the probabilities for values lying within certain bands are as
follows:
+ 1 S.D. 68.3 %
+ 2 S.D. 95.4 %
+ 3 S.D. 99.7 %

149


150
Sum of Product of Deviation of Individual Security and Market / (n-1)

How to calculate Beta
Case 1 when Probabilities are not given
Here we use a Statistical concept called as Co-Variance this talks about what is called as Co-Movement
between the individual stock and its benchmark.(More on Co-variance in the coming chapter)

Beta =Covariance between Stock and Market / Variance of Market.

And Covariance between Stock and Market is given by

Consider the following

Concept Question:
Year Return of Security
(%)
Return of Benchmark (%)
1 15 12
2 12 15
3 13 18
4 -6 4
5 24 18
6 22 20
7 -14 -12
8 -10 -18
9 12 16

151
10 6 8
Solution:
Now lets first calculate the Covariance between the Security and the Benchmark.
Recall- when probabilities are not given, Co-Variance is
Sum of Product of Deviation of Individual Security and Market / (n-1)
Step 1- Calculate the Average Return of Individual Security and also that of Market.

Step 2- Calculate the Product of the deviation

Step 3 Calculate the Sum of the above product.

Step 4 Divide the above value (as obtained above) by number of observations less 1 (this is called as Loss of
Degrees of Freedom). So the result that is obtained is known as the Co-Variance (this is an absolute value)

Step 5 Calculate the Variance of the Market

Step 6 - Calculation of Beta = (Step 4/Step 5)

152

Deviation of Individual Security
from its Average (A)
Deviation of
Benchmark from its
Average (B)
Product of Deviation
(AxB)
7.6 3.9 29.64
4.6 6.9 31.74
5.6 9.9 55.44
-13.4 -4.1 54.94
16.6 9.9 164.34
14.6 11.9 173.74
-21.4 -20.1 430.14
-17.4 -26.1 454.14
4.6 7.9 36.34
-1.4 -0.1 0.14

Total of Product of
Deviation
1430.6

Covariance 158.9555556
(1430.6/(10-1))

153

Calculation of Variance of the market.
Return of
Benchmark (%)
Deviation of Benchmark
from its Average
Square of Deviations
12 3.9 15.21
15 6.9 47.61
18 9.9 98.01
4 -4.1 16.81
18 9.9 98.01
20 11.9 141.61
-12 -20.1 404.01
-18 -26.1 681.21
16 7.9 62.41
8 -0.1 0.01
Total 1564.9
Variance (Total/(10-1) 173.877

So Beta = Covariance / Variance of Market = 158.95/173.87 = .914
You can also use the Excel function Slope to determine the value of Beta, where the Y axis represents the
Returns from Security and X axis represents the Returns from the market.
(Kindly use the excel function Slope on the above values and check t he value of Beta)

154


155
Now we calculate the Covariance
Probability (A) Deviation of
Security (B)
Deviation of
Benchmark (C)
Product of Deviation times
probability (A*B*C)
0.05 -3.25 -7.9 1.28375
0.5 1.75 0.1 0.0875
0.3 6.75 10.1 20.4525
0.15 -18.25 -17.9 49.00125

Total 70.825
(this is Covariance)

Then we calculate the Variance of the market
Probability
(A)
Deviation of
Benchmark
Square of
Deviation (B)
Product of Deviation times
probability (A*B)
0.05 -7.9 62.41 3.1205
0.5 0.1 0.01 0.005
0.3 10.1 102.01 30.603
0.15 -17.9 320.41 48.0615

Total 81.79
(this is Variance)

So Beta = Covariance between Security and Market / Variance of Market
=70.825 / 81.79 = 0.865

156
How to interpret Beta
As said earlier Beta represents what is called as systematic risk, Beta values can be more than or less than 1.
Suppose we have a security whose Beta say is 1.2 , then we say that the security is aggressive i.e. if the
benchmark moves up or down by 10% , then this security will move up or down by 12%.
Suppose the security has a Beta of less than 1 (say .8), then say that the security is defensive ,i.e. if the
benchmark moves up or down by 10%, then this security will only move by 8%.
Suppose the Beta is equal to 1, then we say that the security is Neutral. Market will have a Beta of 1.

157

1) Calculate the Beta in the following case

Period Return % (Security) Return % (Benchmark)
1 10 12
2 15 14
3 18 13
4 14 10
5 16 9
6 16 13
7 18 14
8 4 7
9 -9 1
10 14 12
11 15 -11
12 14 12
13 6 8
14 7 7
15 -8 10

Check Your Progress I I

158


159
Understanding Beta through Graph
Securities with different slopes have different sensitivities to the returns of the market index. If
the slope of this relationship for a particular security is a 45-degree angle, the beta is I. This
means that for every one percent change in the market's return, on average this security's returns
change I percent. The market portfolio has a beta of I. A security with a beta of 1.5 indicates that,
on average, security returns are 1.5 times as volatile as market returns, both up and down. This
would be considered an aggressive security because when the overall market return rises or falls
10 percent, this security, on average, would rise or fall 15 percent. Stocks having a beta of less
than 1.0 would be considered more conservative investments than the overall market.
Betas can be negative or positive. But generally betas have been found to be positive: which
means that the direction of the movement of individual stock generally tends to be in line with the
market; falling when the market is falling and rising when the market is rising; the rates are
different.
Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is
used by investors to judge a stocks riskiness. Stocks can be ranked by their betas. Because the
variance of the market is a constant across all securities for a particular period, ranking stocks by
beta is the same as ranking them by their absolute systematic risk. Stocks with high betas are said
to be high-risk securities.
Given below are different scenario how the portfolio return moves relative to market for Beta
equal to 1, 0.5 and 2

160

Beta = 1.0
-15
-10
-5
0
5
10
15
-15 -10 -5 0 5 10 15
Market
P
o
r
t
f
o
l
i
o
Beta = 0.5
-8
-6
-4
-2
0
2
4
6
8
-14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14
Market
P
o
r
t
f
o
l
i
o

161

The beta of a security is a historical measure and it is arrived at by plotting the actual returns on
the security over long periods of time with market returns as shown in the above the above charts.
A line is drawn which depicts beta of the security.
To determine the beta of any security, you'll need to know the returns of the security and those of
the benchmark index you are using for the same period. Using a graph, plot market returns on the
X-axis and the returns for the stock over the same period on the Y-axis.
Upon plotting all of the monthly returns for the selected time period (usually one year), we draw a
best-fit line that comes the closest to all of the points. This line is called the regression line.
Beta = 2.0
-14
-12
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
14
-14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14
Market
P
o
r
t
f
o
l
i
o

162


163

Solutions of Check Your Progress 1
1)
State of
the
economy
Probability Returns Deviations Deviations^2 Sum of Product of Deviations and
Probability
Boom 0.5 18% 10.0% 1.00% 0.50%
Gloom 0.2 10% 2.0% 0.04% 0.01%
Doom 0.3 -10% -18.0% 3.24% 0.97%

Expected
Returns
8.0% Variance 1.48%
Standard
Deviations
12.17%

1. The Risk Free rate of return of security A is 8% and you expect that the market will give you a
return of 14%. What will be the expected return of the security if the Beta is 0.7
2. Will your values change if the risk free rate of return goes to 6% and the market return remains at
14% and Beta also the same?
Check Your Progress I I I

164
2)
State of the
economy
Probability Returns Deviations Deviations^2 Sum of Product of
Deviations and
Probability
Boom 0.4 18% 6.8% 0.46% 0.18%
Gloom 0.5 10% -1.2% 0.01% 0.01%
Doom 0.1 -10% -21.2% 4.49% 0.45%
Expected
Returns
11.2% Variance 0.64%
Standard
Deviations
8.01%

3)
S.No Probability Returns Deviations Deviations^2 Sum of Product of Deviations and
Probability
1 0.05 16% 13.9% 1.92% 0.10%
2 0.1 12% 9.9% 0.97% 0.10%
3 0.08 6% 3.9% 0.15% 0.01%
4 0.11 -10% -12.1% 1.47% 0.16%
5 0.15 5% 2.9% 0.08% 0.01%
Expected
Returns
2.1% Variance 0.38%
Standard
Deviations
6.16%

165

Period Return %
(Security)
Return %
(Benchmark)
Deviation
of Security
Deviation of
Benchmark
Product of
Deviation
Variation of
Market
1 10 12 0 3 0 9
2 15 14 5 5 25 25
3 18 13 8 4 32 16
4 14 10 4 1 4 1
5 16 9 6 0 0 0
6 16 13 6 4 24 16
7 18 14 8 5 40 25
8 4 7 -6 -2 12 4
9 -9 1 -19 -8 152 64
10 14 12 4 3 12 9
11 15 -11 5 -20 -100 400
12 14 16 4 7 28 49
13 6 8 -4 -1 4 1
14 7 7 -3 -2 6 4
15 -8 10 -18 1 -18 1
Using Slope 0.3541666
67
Total 221 624
Average of
Security
10 Covariance
(total/(n-1)
15.7857142
9

Average of
Benchmark
9 Variance 44.57142857
Beta (15.785/44.
57)
0.354166667

Solutions of Check Your Progress II

166

2)

Probability Returns
of ITC
(%)
Returns
of
Sensex
(%)
Deviation
of ITC
from its
Average
Deviation of
Sensex from
its average
Sum of
Product of
Deviation
times
Probability
Variance of
Market
(Deviation
of Market
square
times
probability
0.2 30 20 11 6.1 13.42 7.442
0.5 20 15 1 1.1 0.55 0.605
0.3 10 8 -9 -5.9 15.93 10.443

Average of
Security
19 Covariance 29.9
Average of
Sensex
13.9 Variance of
Market
18.49

Beta 1.617090319

167

3)
Probability Returns of
Rohini
Enterprises
(%)
Returns
of
Sensex
(%)
Deviation
of
Security
from its
Average
Deviation of
Sensex from
its average
Sum of
Product of
Deviation
times
Probability
Variance of
Market
(Deviation
of Market
square
times
probability
0.15 30 20 13.25 7.1 14.11125 7.5615
0.5 20 15 3.25 2.1 3.4125 2.205
0.3 10 8 -6.75 -4.9 9.9225 7.203
0.05 -15 -18 -31.75 -30.9 49.05375 47.7405
Average of
Security
16.75 Covariance 76.5
Average of
Sensex
12.9 Variance of
Market
64.71

Beta 1.182197497

168

Assessment Test:
1. Mr. Joshi has analysed a stock for a one-year holding period. The stock is currently quoting
at Rs 100/- and is paying no dividends. There is a 50-50 chance that the stock may quote
Rs100 or Rs 120 by year-end. What is the expected return on the stock?
1. 12%
2. 10%
3. 15%
4. 20%

2. A stock is quoting at Rs 100 and is paying no dividends. The possible year end price and the
probabilities are given below:
Year end price Probability
110 0.1
115 0.2
120 0.3
125 0.2
130 0.1
What is the expected return on the stock?
a. 10%
b. 15%
c. 18%
d. 20%

169

3. What is the standard deviation of the stock based on the above figures in problem 2?
a. 14.45
b. 5.79
c. 16.30
d. 33.60

4. Stocks A and B are not paying any dividends. Stock A is quoting at Rs 100 while B is quoting
at Rs 50. There is a 50-50 chance that stock A will quote at Rs 120 and Rs 140 while there is a
50-50 chance that the stock B will quote at Rs 60 and Rs 70 at the end of the year. Which
stock will you buy considering the return and the risk?
a. I shall buy B because it is cheaper
b. I will buy Stock B because the risk is less
c. I will buy Stock A because the risk is less
d. The risk and the return in both are same; I shall buy any one

5. Compute the expected return for the stock when the risk free return is 8% and the expected
return from the market is 12% for a stock with Beta of 1.2.
a. 15.6%
b. 12.8%
c. 16.4%
d. 22.2%

6. Beta of stock A is 1.5 while that of stock B is 1. If the market is expected to rise then an
aggressive investor would buy:
a. Either A or B; because in a rising market all stocks will rise

170
b. Stock A because it may deliver superior returns compared to B
c. Stock B because the risk will be less compared to A while the returns would be the
same
d. Stock B because it may deliver superior returns compared to A

7. The following are the assessment of the probabilities of each of the five economic scenarios:

i) What is the expected return on shares?
a) 20%
b) 25%
c) 15.8%
d) 13.2%

ii) What is the expected return on bonds?
a) 9%
b) 10%
c) 1.9%
d) 3.0%

iii) What is the standard deviation of stocks?
a) 29.44%
b) 28.34%
c) 25.44%
d) 17.95%

Growth with
low inflation
0.05 6
Growth with
high inflation
0.2 6
Normal growth 0.5 6
Recession
with low
0.2 6
Recession
with high
0.05 6
Cash
Economic
scenario
Probability
Holding period
Shares Bonds
4
-10
9
35
0
74
20
14
0
-30

171

iv) What is the standard deviation of bonds?
a) 17.96%
b) 14.56%
c) 9.7%
d) 15.71%

8. Modern "asset allocation" is based upon the model developed by Harry Markowitz. Which of
the following statements is/are correctly identified with this model?
1. The risk, return and covariance of assets are important input variables in creating
portfolios.
2. Negatively correlated assets are necessary to reduce the risk of portfolios.
3. In creating a portfolio, diversifying across asset types (e.g., stocks and bonds) is less
effective than diversifying within an asset type.
4. The efficient frontier is relatively insensitive to the input variable.

a) 1 and 2 only.
b) 1, 2, and 3 only.
c) 1 only.
d) 2 and 4 only.
e) 1, 2, and 4 only.

9. KM, Inc. has a beta of 1.5. The risk-free rate is 5%, and the market risk premium is 8%.
a) KM has a required return of 6.5% and an expected return of 8%.
b) KM has a required return of 15.5%.
c) KM has a required return of 17%

172

10. Mahesh is keen to invest in any of the four securities A, B, C or D whose betas are 0.70, 1.00,
1.15 and -0.30 respectively. The risk free rate of return being 8% and expected rate of return
on market being 14%, which security would you recommend to Mahesh? (4)
a. Security C, as expected return is highest.
b. Security D, as expected return is least.
c. Either Security A or Security B as their return is moderate.
d. More data as to the time horizon is required before passing advise to Mahesh.

Chapter - 5
Income from house property

Tax Planning
108 Tax Planning

rd
edition of the CFP
CM
CM
Exam is
chapter.
5. Estate Planning: All the content related to Estate Planning available online. It carries the
weightage of 10- 15% in the Tax & Estate Planning Exam
online unit test .


Tax Planning
109 Tax Planning
structure etc.
interactive
3. Additional Resources: You will get additional resources file with each chapter, this will
provide you the content and link available on the internet. These additional resources will be
helpful to you for both the exam and practical purpose.

Tax Planning
110 Tax Planning
I ntroduction

This lesson deals with income, which falls under the head 'Income from house property'. The
scope of income charged under this head is defined by section 22 of the Income Tax Act and the
computation of income falling under this head is governed by sections 23 to 27. All the provisions
relating to tax treatment of income from house property are explained in this lesson.

Objectives

After going through this lesson, you will be able to understand:
o The meaning of house property
o Who is treated as owner of house property
o The treatment of rental income from properties under different
o circumstances
o Determination of the annual value of a house property
o The expenses deductible from rental/notional income from house property
o Special treatment given to self-occupied house property
o Treatment of income/loss from house property.

Basis Of Charge (Section 22)

The annual value of a property, consisting of any buildings or lands appurtenant thereto, of which
the assessee is the owner, is chargeable to tax under the head 'Income from house property'.
However, if a house property, or any portion thereof, is occupied by the assessee, for the purpose
of any business or profession, carried on by him, the profits of which are chargeable to income-
tax, the value of such property is not chargeable to tax under this head.

Thus, three conditions are to be satisfied for property income to be taxable under this head.
1. The property should consist of buildings or lands appurtenant thereto.
2. The assessee should be the owner of the property.
3. The property should not be used by the owner for the purpose of any business or profession
carried on by him, the profits of which are chargeable to income-tax.

Applicability Of Section 22

Buildings or lands appurtenant thereto

The term 'building' includes residential houses, bungalows, office buildings, warehouses, docks,
factory buildings, music halls, lecture halls, auditorium etc. The appurtenant lands in respect of a
residential building may be in the form of approach roads to and from public streets, compounds,

Tax Planning
111 Tax Planning


Tax Planning
112 Tax Planning

1. A member of a co-operative society, company or association of persons, to whom a property
(or a part thereof) is allotted or leased under a house- building scheme of the society,
company or association, is deemed to be the owner of such property.

2. A person who has acquired a property under a power of attorney transaction, by satisfying the
conditions of section 53A of the Transfer of Property Act, that is under a written agreement,
the purchaser has paid the consideration or is ready to pay the consideration and has taken the
possession of the property, is the deemed owner of the property, although he may not be the
registered owner.

3. A person who has acquired a right in a building (under clause (f) of section 269UA), by way
of a lease for a term of not less than 12 years (whether fixed originally or extended through a
provision in the agreement), is the deemed owner of the property. This provision does not
cover any right by way of a lease renewable from month to month or for a period not
exceeding one year.

Ownership must be of the superstructure. It is not necessary that the assessee is also the owner of
the land. Thus, when a person obtains a piece of land on lease and constructs a building on it, the
income from such building will be taxed in his hands as income from house property.

Property used for own business or profession

The owner of a house property is not liable to tax under this head if the property is used by him
for his own business or profession. But the business or profession should be such whose income
is chargeable to tax. Chargeability to tax does not mean that the income is actually taxed. It is
possible that in a particular year the profits are not sufficient enough to attract tax liability. What
it means is that the income from such business or profession is not exempt from tax.

If an employer builds quarters for residential use by his employees and the letting out of these
quarters is considered as incidental to his business, the income from such property is not taxable
under this head, because the property in this case is considered to be used by the owner for his
own business. It shall, therefore, be taxed as business income.

The above position will not change even if the buildings are let out to government authorities for
locating their undertakings like Banks, Post Office, Police Station, Central Excise Office, etc.,
provided the dominant purpose of letting out the accommodation is to enable the assessee to carry
on his business more efficiently and smoothly. Also, income from paying-guest accommodation
is taxable as income from business.

Where house property owned by a partner is used by the firm (neither it is let out to the firm nor
any rent is obtained for it) for its business purposes, the partner is entitled to the exemption.

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House property in a foreign country

A resident assessee is taxable under section 22 in respect of annual value of a property in a
foreign country. A resident but not ordinarily resident or a non- resident is, however, chargeable
under section 22 in respect of income of a house property situated aboard, provided income is
received in India during the previous year. If tax incidence is attracted under section 22 in respect
of a house property situated abroad, its annual value will be computed as if the property is
situated in India.

Property I ncomes Exempt From Tax

Some incomes from house property are exempt from tax. They are neither taxable nor included in
the total income of the assessee for the rate purposes.
These are:
1. Income from a farm house [section 2(1A) (c) and section 10(1)].
2. Annual value of one palace in the occupation of an ex-ruler [section 10(19A)].
3. Property income of a local authority [section 10(20)].
Explain whether the income from house property will be taxable or not u/s 22 in the hands of
X in the following circumstances:
1. X owns a building. It is given on rent to Y, who uses it as his office.
2. X owns a house property. He uses it as the godown for the goods produced by his
factory.
3. X rents out his property as residential quarters to the workers in his factory at a
nominal rent of 500 p.m.
4. X enters into a written agreement to purchase a property from Y for 25, 00,000. He
has paid the consideration and taken the possession of the property but the property is
yet to be registered in the name of X.
5. X owns a property, which is given on lease to Y for a period of 6 years, lease rent
being 10, 000 per month. Y has a right to get the lease renewed for a further period of
6 years.
6. X owns a property, which is given on lease to Y for a period of one month, rent being
5, 000. Y has a right to get the lease renewed for a period of one month, in each
subsequent month, and such renewal is possible with mutual consent till 2020.
7. X owns a property, which is given on rent to Y. Y annually pays 1,50,000 as rent of
the building as well as the charges for different services (like lift, security, etc.)
provided by X.
8. X owns an air-conditioned furnished lecture hall. It is let out, annual rent being 5,
00,000, which includes rent of building as well as rent of air- conditioner and furniture.

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115 Tax Planning
4. Property income of an approved scientific research association [section 10(21)].
5. Property income of an educational institution and hospital [section 10(23C)].
6. Property income of a registered trade union [section 10(24)].
7. Income from property held for charitable purposes [section 11].
8. Property income of a political party [section 13A].
9. Income from property used for own business or profession [section 22].
10. Annual value of one self occupied property [section 23(2)]

Computation Of I ncome From Let Out House Property

Income from house property is determined as under: xxxxxxx
Gross Annual Value xxxxxxx
Less: Municipal Taxes xxxxxxx
Net Annual Value xxxxxxx
Less: Deductions under Section 24 xxxxxxx
Statutory Deduction (30% of NAV) xxxxxxx
Interest on Borrowed Capital xxxxxxx
Income from House Property xxxxxxx

Determination Of Annual Value

The basis of calculating Income from House property is the 'annual value'. This is the inherent
capacity of the property to earn income and it has been defined as the amount for which the
property may reasonably be expected to be let out from year to year. It is not necessary that the
property should actually be let out. It is also not necessary that the reasonable return from
property should be equal to the actual rent realized when the property is, in fact, let out. Where
the actual rent received is more than the reasonable return, it has been specifically provided that
the actual rent will be the annual value. Where, however, the actual rent is less than the
reasonable rent (e.g., in case where the tenancy is affected by fraud, emergency, close relationship
or such other consideration), the latter will be the annual value. The municipal value of the
property, the cost of construction, the standard rent, if any, under the Rent Control Act, the rent of
similar properties in the same locality, are all pointers to the determination of annual value.

Gross Annual Value [Section 23(1)]

The following four factors have to be taken into consideration while determining the Gross
Annual Value of the property:

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(a) The defaulting tenant is not in occupation of any other property of the assessee;
(b) The assessee has taken all reasonable steps to institute legal proceedings for the recovery of
the unpaid rent or satisfied the Assessing Officer that legal proceedings would be useless. (We
will discuss about it later in the topic of Unrealised rent)

So in a nut shell there are four parameters namely
1) Municipal Value
2) Fair Rental Value (FRV)
3) Standard Rent
4) Rent Received

Please note that we need to follow the principal of High, Low, and High to determine the
FRV
So its Higher of 1 and 2 , say that is A and then Lower of A and 3, say that is B and
then Higher of B and 4, that will be the Gross Annual Value of the House Property.
Say for example the following is given
Municipal Value = 25,000, Fair Rent Value = 30,000 , Standard Rent = 27,000 and Actual
Rent = 32,000,
Then the Gross Annual value will be
Remember the steps High, Low, High
Step 1 Higher of Muncipal Value and Fair Rent in this case it will be Higher of 25,000 or
30,000, so it will be 30,000, (lets call it as A)
Step 2 Lower of A and Standard Rent so it will be Lower of A (i.e. 30,000) and 27,000
(Standard Rent) so will be 27,000 (lets call it B)
Step 3 Higher of B and Actual Rent, so it will be Higher of B (i.e. 27,000) and 32,000
(Actual Rent) so the GAV will be 32,000.

Concept Question
1) Find the Gross Annual Value in the case of the following properties:
Particulars 1 2 3 4 5 6
Municipal Value 20000 24000 36000 42000 48000 45000
Fair Rental Value 24000 24000 40000 42000 50000 50000
Standard Rent N.A 24000 50000 30000 N.A 48000
Actual Rent/Annual Rent 18000 36000 48000 36000 54000 42000

Answer : Kindly recall the rule of High, Low, High
GAV 24000 36000 48000 36000 54000 48000

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Now lets talk about the situation where the House Property was part let out and part vacant.

In accordance to section 23(1), the annual value of such property shall be deemed to be
(a) The sum for which the property might reasonably be expected to let from year to year (i.e.
what could possibly be the expected rental income if the property was let out throughout the
year). Now here two different SITUATIONS can emerge
1. Where the property or any part of the property is let out and the actual rent received is MORE
than clause (a) above
2. Where the property or any part of the property is let out and the actual rent received is LESS
than clause (a) above.

Lets see how the evaluation will happen in both the cases

Situation 1 where the property was let out and the rental received was more than the expected
rent, then in that case the Gross Annual Value will be Higher of the two i.e. the actual rent
received

Concept Question
Suppose the municipal value of a house is 1, 00,000. Fair Rent is 1, 50,000. Standard Rent is
1, 30,000. The house property was let out for 13,000 per month and the house was vacant for
one month. What will be the GAV in this case?

Answer : Once again lets list down all the values
Particulars Amount ( )
Municipal Value 100000
Fair Rental Value 150000
Standard Rent 130000
Actual Rent/Annual Rent (13000*11) 143000
GAV 143000
(We will once again apply the High, Low, High principle till the Standard Rent and then
compare it with the Actual Rent (considering that fact that its situation 1 of above)
1) What will be the GAV in the following cases
Particulars 1 2 3 4 5
Municipal Value 52000 100000 60000 75000 180000
Fair Rental Value 60000 102000 68000 70000 185000
Standard Rent N.A 90000 70000 60000 175000
Actual Rent/Annual Rent 55000 95000 72000 72000 168000


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Situation 2 where the property was let out and was vacant partially and the actual rent received
is less than the expected annual rent then in this case the GAV of the property will be the actual
rent that is received

Concept Question
Continuing with the above example, what if the property was vacant for 3 months, and then the
GAV will be
Standard Rent 130000
GAV 117000

Recap- In the Story so far we have seen the following cases and have calculated the GAV.
1) Where the House Property was Completely Let out for the entire year.
2) Part Let out and Part Vacant. (Here we had examined two scenarios)
(a) Where the rental income was more than the expected rent
(b) Where the rental income was lesser than the expected rent.

Another Twist in the Tale What if the house property is let out part of the year and part Self
Occupied?

Here the story line changes a bit.
In such cases the period of self occupancy is ignored and it will be assumed as Part Let out
property.

Concept Question:
Navjot Singh Bidhu has a house property in Chandigarh whose Municipal Value is 10, 00,000
(Chandigarh hai bhai, mehenga hai) and the Fair Rental Value is 12,00,000. It was Self
occupied by Bidhu from 1
st
April 2009 till 31
st
July 2009 and then from 1
st
August 2009 was let
out at 90,000 per month. Compute the annual value of the house property for the assessment
year 2010-11

Answer: Lets take down all the values again
Standard Rent NA
GAV 1200000

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Here the Fair Rent will become the Gross Annual Value so in a snapshot to calculate the
Gross Annual Value, follow the diagram given below :
Step 1- Compare M.V with F.R Whichever is higher is considered as F.R.
Step 2-Compare F.R. of Step 1 with S.R.Which ever is lower is considered as F.R
Step 3-Compare F.R. determined above with A.
A.R > F.R. When A.R < F.R
When A.R < F. R (due to vacancy) A.R < F.R (other factors)
A.R. is the annual Value F. R is the annual value

Deduction of Municipal Taxes

From the annual value as determined above municipal taxes are to be deducted if
the following conditions are fulfilled:
o The property is let out during the whole or any part of the previous year
o The Municipal taxes must be borne by the landlord (If the Municipal taxes or any part thereof
are borne by the tenant, it will not be allowed).
o The Municipal taxes m us t be paid during t he year (Where the municipal taxes become due
but have not been actually paid, it will not be allowed. Similarly, the year to which the taxes
relate to, is also immaterial).

Concept Question
Suppose you own the following three houses the details of which are
Bungalow 1 Bungalow 2 Bungalow 3
No of Residential Units 2 1 3
Municipal Value 150000 72000 70000
Fair Rental value 170000 75000 85000
Standard Rent 160000 80000 82000
Rent Per Unit Per Annum 50000 84000 84000
Municipal Taxes 15000 (due
but not paid)
8000 for last
year paid this year
and 9000 of
current year due
but not paid
90000 (it
includes
84000 paid as
advance for the
next 9 years)
What are the GAV and the Net Annual value in each case?

Answer:
Gross Annual Value (80000*2) (84000*1) (84000*3)
Gross Annual Value 160000 84000 252000
Municipal Taxes 0 8000 90000
Net Annual Value ( ) 160000 76000 162000

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Treatment of Unrealised Rent:
As per the explanation, the actual rent received or receivable mentioned in section 23 (1)(b) and
(c ) , shall not include the amount of rent which the owner cannot realize subject to the rules made
in this behalf.
Rules of Unrealised rent
a. The tenancy is bona fide;
b. The defaulting tenant has vacated, or steps have been taken to compel him to vacate the
property.
c. The defaulting tenant is not in occupation of any other property of the assessee;
d. The assessee has taken all reasonable steps to institute legal proceedings for the recovery of
the unpaid rent or satisfied the Assessing Officer that legal proceedings would be useless So
the amount of unrealised rent is shown as deduction after computation of the gross annual
value.

Concept Question:
P. K Manmani submits the following details about his house property owned by him in Sangli
Fair Rental value 340000
Rent Per Month 31000
Municipal Taxes 30000 (paid)

The tenant vacated the property on the 31
st
of October and thereafter the property was let out at
35,000 per month as rent.P.K could no realize the rent for the months of September and October
2009 due to the death of his tenant.What will be the annual value of the property?

Answer:
Amount ( )
Step 1
(Determine the value of the property)
Higher of M.V or F.R.V
( 3,00,000 or 3,40,000) 340000

Step 2
Actual Rent Receivable
(31000*7+35000*5) 392000

So GAV 392000
Less Un Realised Rent (31000*2) 62000
Less Municipal Taxes Paid 30000

Net Annual Value 300000

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Computation Of I ncome From Self - Occupied House Property

The annual value of one self-occupied house property, which has not been actually let out at any
time during the previous year, is taken as 'Nil' [Section 23(2) (a)]. From the annual value, only the
interest on borrowed capital is allowed as a deduction under section 24. The amount of deduction
will be:
o Either the actual amount accrued or 30,000/- whichever is less
o When borrowal of money or acquisition of the property is after 31.3.1999 - deduction is 1,
50,000/- applicable to A.Y 2002-03 and onwards.
o However, if the borrowal is for repairs, renewals or reconstruction, the deduction is restricted
to 30, 000. If the borrowal is for construction/ acquisition, higher deduction as noted above
is available.

1) Ms Manpreet constructed a house property for which she took a home loan of 2 Lacs at
12% per annum on the 1
st
Oct 2006. The construction of the home was completed by the
end of January 2008.The house property has been let out for 6000 per month from
September 2008.Muncipal taxes paid during the previous year 2009-10 is 7500.Repairs
incurred was 12,500. Insurance Premium due for the year but outstanding is
1500.Collection charges incurred is 100 per month. Current year interest on the loan is
outstanding.

Compute the Income from House Property for the assessment year 2010-11

2) Mr. Ekagra owns a building which has 3 apartments, construction of which was completed
on December 2005. The apartment was let out on rent of 1500 each per month. The
annual municipal valuation of the house is 50,000. Annual municipal tax is
10,000.However in the previous year 2009-2010 he paid 15,000 which included the
municipal taxes of 5,000 in respect of the previous year 2008-09.Ground rent of 1800
and Insurance premium of 1100 was paid. Ekaga had to pledge his jewellery in order to
repair the property. Interest of 3000 is payable for the current year on the said loan. He
has appointed Munnabhai (a local goon) to collect the rent on a monthly salary of
50.One of the apartment was vacant for 6 months during the year. Compute the income
from House Property for the AY 2010-11.
(lamba sawal hai, happy solving!!)

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124 Tax Planning
If a person owns more than one house property, using all of them for self- occupation, he is
entitled to exercise an option in terms of which, the annual value of one house property as
specified by him will be taken at Nil. The other self occupied house property/is will be deemed to
be let out and their annual value will be determined on notional basis as if they had been let out.

Annual Value of one house away from work place [Section 23(2) (b)]

A person may own a house property, for example, in Bangalore, which he normally uses for his
residence. He is transferred to Chennai, where he does not own any house property and stays in a
rental accommodation. In such a case, the house property in Bangalore cannot be used for self-
occupation and notional income, therefore, would normally have been chargeable although he
derives no benefit from the property. To save the tax payer from hardship in such situations, it has
been specifically provided that the annual value of such a property would be taken to be nil
subject to the following conditions:

o The assessee must be the owner of only one house property.
o He is not able to occupy the house property because of his employment, business etc., away
from the place where the property is situated.
o The property should not have been actually let or any benefit is derived therefrom.
o He has to reside at the place of employment in a building not belonging to him .

Annual Value of a house property which is partly self - occupied and partly let out

If a house property consists of two or more independent residential units, one of which is self -
occupied and the other unit(s) is let out, the income from the different units is to be calculated
separately. The income from the unit which is self - occupied for residential purposes is to be
calculated as per the provisions of Section 23(2)(a) i.e. the annual value will be taken as nil and
only interest on borrowed capital will be deductible upto the maximum limit of 1,50,000 or
30,000, as the case may be. The income from the let out unit(s) will be calculated in the same
manner as the income from any let out house property. 6.5 SOME SPECIAL PROVISIONS
Taxability of Unrealized Rent recovered later (Section 25A) Where any rent cannot be realized,
and subsequently if such amount is realized, such an amount will be deemed to be the income
from house property of that year in which it is received. We have seen earlier that the basic
requirement for assessment of this income is the ownership of the property. However, in the cases
where unrealized rent is subsequently realized, it is not necessary that the assessee continues to be
the owner of the property in the year of receipt also.

House Property

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1) GAV will be
Particulars 1 2 3 4 5
GAV 60000 95000 48000 72000 175000

1. Yes, Income from House Property.
2. No
3. Income from Business and Profession
4. Yes it will be treated as Income from House Property (A person who has acquired a
property under a power of attorney transaction, by satisfying the conditions of section
53A of the Transfer of Property Act, that is under a written agreement, the purchaser
has paid the consideration or is ready to pay the consideration and has taken the
possession of the property, is the deemed owner of the property, although he may not
be the registered owner.)
5. Yes , Income from House Property
6. Yes, Income from House Property
7. If, it can be bifurcated (rental and other services) then rent will be taxed as Income
from House Property and others as Profit and Gains from Business and Profession or
Income from other sources.
If it cannot be bifurcated then it will be treated as Income from Business and
Profession or Income from other sources.
8. Since nothing is mentioned we will treat that as Income from Business and Profession.

Answer of check Your Progress I

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126 Tax Planning
1) Income from House Property of Ms Manpreet.
Particulars Amount
Gross Value ( 6000*12) 72000
Less Municipal Taxes paid 7500
Less Deductions u/s 24
30% of Net Annual Value 19350
1/5th of Interest (preconstruction period) 2400
Interest on Loan 24000
Income from House Property 18750

2) Computing the income from House Property of Mr. Ekagra The crucial part of this
question is to compute the GAV of the property and the same is
Amount
Municipal Valuation 50000
Rent Received (1500*2*12)+(1500*6) 45000

Due to the vacancy the GAV will be 45,000.(Remember the chart)
Particulars Amount
Gross Value 45000
Less Municipal Taxes paid 15000
Less Deductions u/s 24
30% of Net Annual Value 9000
Interest on Loan 3000

Income from House Property 18000

Assessment of arrears of rent received (Section 25B)

When the owner of a property receives arrears of rent from such a property, the same shall be
deemed to be the income from house property in the year of receipt. 30% of the receipt shall be
allowed as deduction towards repairs, collection charges etc. No other deduction will be allowed.
As in the case of unrealized rent, the assessee need not be the owner of the property in the year of
receipt.

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As per Section 23(2) of the Income Tax Act, the annual value of one self- occupied house
property is taken to be nil. No deductions are permissible from the annual value of such property,
except the interest on borrowed capital, subject to the maximum limit of 1, 50,000 or 30, 000
as the case may be.

The above provisions may result in loss from house property, which may be set off against
income from another house property or against incomes under the other heads. The balance loss
may be carried forward, to be set off against the income from house property, upto a maximum of
eight assessment years.

Please note that this is the only head (as of now since DTC has not come into play, where the
I ncome from Salary can be adjusted against Loss from House Property)

Assessment Test:

1. Mr. Arun gifted his house property to his wife in 2007 which she let out on a monthly rent of
5,000/- The income from such house property will be taxable in the hands of:
a. Mrs.Arun
b. Mr. Arun. However, income will be first computed as his wifes income and thereafter
clubbed in his income.
c. Mr.Arun as he will be treated as deemed owner of the house property and liable to tax.

2. Mr. Raj gifted house property to his minor son which was let out @ 5,000/- p.m. Income
from such house property shall be taxable in the hands of:
a. His minor son;
b. Mr.Raj however, it will be computed as minors income and thereafter clubbed in Rajs
income;
c. Mr.Raj as he will be deemed owner of such property and liable to tax.

3. Mr. X transferred his house property to his wife under an agreement to live apart. Income from
such house property shall be taxable in the hands of:
a. Mr. X as deemed owner ;
b. Mr. X however, it will be computed as Mrs. Xs income and thereafter clubbed in the hands
of Mr. X provided the income of the father is higher than the income of her mother.
c. Mrs. X

4. A has taken a house property on lease for 15 years from B and let out the same to C. Income
from such house to A shall be taxable as:
a. income under the head other sources
b. income from house property as A is the deemed owner.

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5. Ram gifted his house property to his married minor daughter. The income from such house
property shall be taxable in the hands of:
a. Ram, as deemed owner.
b. Ram. However, it will be first computed as minor daughters income and clubbed the income
of Ram provided the income of the father is higher than the income of her mother.
c. income of married minor daughter.

6. Govind is a member of house building Cooperative Society who is the owner of flats
constructed by it. One of the flats is allotted to him. The income from such house property shall
be taxable in the hands of:
a. The Cooperative Society
b. Govind, as deemed owner.

7. X is the owner of superstructure although the land was taken by him on lease. The income of
such property shall be taxable under the head:
a. income from other sources
b. income from house property.

8. A has taken a house on rent and sublets the same to C. Income from such house property shall
be taxable under the head:
a. income from house property
b. income from other sources.

9. Municipal valuation of the house is 1,00,000/- whereas the fair rent of house property is
1,20,000/- and standard rent is 1,10,000/-; actual rent received or receivable is 1,40,000/- ;
municipal tax paid 10%. The annual value in this case shall be:
a. 90,000/-
b. 1,00,000/-
c. 1,30,000/-

10. Municipal valuation of the house is 1,20,000/-, fair rent is 1,40,000/-; standard rent is
1,30,000/- whereas actual rent received or receivable is 1,25,000; municipal taxes paid are
40,000/- The annual value in this case shall be:
a. 1,00,000/-
b. 85,000/-
c. 90,000/-

11. Fair rental value of a house is 1,50,000/-, standard rent 1,20,000/-, actual rent
1,30,000/-. Municipal tax paid during the previous year for the past 7 years is 1,40,000/-. The
annual value shall be:
a. 20,000/-
b. Nil
c. (-)10,000/-

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