Advanced Financial Planning Case Studies for   CFP

Posted by Prashant Shah on April 4, 2012

Following are the case studies which are reasonably tough but good to solve. Please note that FPSB India is the sole owner of the case studies.

Every paper has two cases:

Click to Download

1. 010JAN   Vijay Case 2. 011FEB-09   SOPORI CASE

3. 012MAR-09   ARKA   ROY CASE

4. 013APR-09   ANAMIKA

5. 014MAY-09   SAUMYA

6. 015 JUNE-09 RAHUL

Solution:

1. 010JAN   Vijay Ans 2. 011FEB-09   SOPORI ANS

3. 012MAR-09   ARKA   ROY ANS

4. 013APR-09   ANAMIKA

5. 014MAY-09   SAUMYA

6. 015 JUNE-09 RAHUL

Estate Planning for CFP –   2

Posted by Prashant Shah on October 22, 2012

Intestate Succession:

A person who dies without making a Will is known as intestate A heir is a person entitled to inherit property after death of the intestate

Succession Acts:

For Hindus, Buddhists, Jains and Sikhs the laws of inheritance have been codified in the Hindu Succession Act, 1956

For Christians the Indian Succession Act, 1925 will be applicable

Parsis and Muslims have a different law of inheritance

It extends to the whole of India except the State of Jammu and Kashmir

The law of intestate succession is concerned with matters as to who are the heirs, what are the rules of preference among the various relations, in what manner is the property distributed in case where there is more than one heir and so on.

Heirs of a Hindu Male:

1. Class I heirs2. Class II heirs

3. Agnates

4. Cognates, and

5. Government

General rules of succession in the case of males

(a) firstly, upon the heirs, being the relatives specified in class I of the Schedule; (b) secondly, if there is no heir of class I, then upon the heirs, being the relatives specified

in class II of the Schedule;

(c) thirdly, if there is no heir of any of the two classes, then upon the agnates of the deceased; and

(d) lastly, if there is no agnate, then upon the cognates of the deceased.

Distribution of property among heirs in class I of the Schedule

Rule 1-The intestate’s widow, or if there are more widows than one, all the widows together, shall take one share.

Rule 2-The surviving sons and daughters and the mother of the intestate shall each take one share.

Rule 3-The heirs in the branch of each pre-deceased son or each pre-deceased daughter of the intestate shall take between them one share.

Rule 4-The distribution of the share referred to in Rule 3:

o (i) among the heirs in the branch of the pre-deceased son shall be so made that his widow (or widows together) and the surviving sons and daughters get equal portions; and the branch of his predeceased sons gets the same portion;

o (ii) among the heirs in the branch of the pre-deceased daughter shall be so made that the surviving sons and daughters get equal portions.

Distribution of property among heirs in class II of the Schedule

The property of an intestate shall be divided between the heirs specified in any one entry in class II of the Schedule so that they share equally.

Agnates and Cognates:

Next heir of Hindu male is ‘Agnates and Cognates’. In it first preference is given to ‘Agnates’ & then ‘Cognates’. The rules for determining who areagnates & cognates are the same; so are the rules relating to distribution of property among them.

Agnates mean when a person traces his relationship with another through males.

Cognates means whenever in the relationship of a person with another, a female (or more than one female).

List of Class I Heirs

i. Mother ii. Widow

iii. Daughter

iv. Son

v. Widow of a predeceased son

vi. Son of a predeceased son

vii. Daughter of a predeceased son

viii. Widow of a predeceased son of a predeceased son

ix. Daughter of a predeceased son of a predeceased son

x. Son of a predeceased son of a predeceased son

xi. Daughter of a predeceased daughter,

xii. Son of a predeceased daughter.

New heirs are added by Hindu Succession (Amendment) Act, 2005.

i. Son of a predeceased daughter of a predeceased daughter ii. Daughter of a predeceased daughter of a predeceased daughter

iii. Daughter of a predeceased son of a predeceased daughter

iv. Daughter of a predeceased daughter of a predeceased son

Class II Heirs

Category – I

Father

Category – II

(1)Son’s daughter’s son, (2)Son’s daughter’s daughter,

(3) brother,

(4) sister.

Category – III

(1) Daughter’s son’s son, (2) daughter’s son’s daughter,

(3) daughter’s daughter’s son,

(4) daughter’s daughter’s daughter.

Category -IV

(1) Brother’s son, (2) sister’s son,

(3) brother’s daughter,

(4) sister’s daughter.

Category -V

Father’s father; father’s mother.

Category -VI

Father’s widow; brother’s widow.

Category -VII

Father’s brother; father’s sister.

Category -VIII

Mother’s father; mother’s mother

Category -IX

Mother’s brother; mother’s sister.

Posted in CFP, Estate Planning | Leave a Comment »

Estate Planning for CFP –   1

Posted by Prashant Shah on October 15, 2012

What is Estate Planning?

Estate Planning is a process of arranging and planning a person’s succession and financial affairs. The primary goal of estate planning is ensuring that the estate of the individual passes to the estate owner’s intended beneficiaries.Importance of Estate Planning:

1. Harmonious and planned succession and disposition of the estate which helps ensure that your money and other assets go to the people you choose

2. Efficient management and accumulation during and after life

3. To take care of unforeseen eventualities by providing for who will care for your minor children if you become unable to

4. Defusing potential conflicts over the distribution of your assets

In the real world you may seldom find the families those who have no issues related to the estate. Estate planning is indeed a need of the day. It is the core responsibility of the planner to make the client aware about the importance and ease of process for estate planning. You may also observe that people talk a lot about estate, think even more for the ways of disposing it but do nothing to avoid probable conflicts among the loved family members.

Means of Estate Planning – Will

A will is a legal document that states how your assets will be distributed after your death as per your wishes. There Often arises problems and complications when a person dies without a Will. A Will  is defined as “the legal declaration of the intention of the testator, with respect to his property, which he desires to be carried into effect after his death.”Characteristics of  Will:

1. Legal Declaration: The documents intending to be a Will or a testament must be legal, i.e. in conformity with the law and must be executed by a person legally competent to make it

2. Disposition of Property: The declaration should relate to disposition of the property of the person making the Will

3. Death of the Testator: The declaration as regards the disposal of the property must be intended to take effect after his death

4. Revocability:The essence of every Will is that it is revocable during the lifetime of the testator. People capable of making Wills are, Every person who is:

1. not a minor

2. of sound mind

3. free from fraud, coercion or undue influence

Types of Will

Important terms:

Testator: A person who makes the will

Testament: A legal document declaring a person’s wishes regarding the disposal of their property when they die

Codicil: According to Indian Succession Act, Section 2(b) Codicil is an instrument made in relation to a Will and explaining, altering or adding to its dispositions and shall be deemed to form part of the will

Probate: A probate means a copy of the will, given to the executor, certified under the seal of the competent court and signed by one of the registrar, certifying that the Will has been proved

Life Insurence Policy   Selection

Posted by Prashant Shah on September 25, 2010

Before choosing any life insurance product one must consider the following:

1. Adequacy of coverage2. Cash outflow/ amount of premium

3. Duration of need

4. Expenses of the policy

5. Surrender charges

However there are several methods to evaluate the various life insurance policies.

Belth Method

The Belth yearly price of protection method enables to determine whether a given life insurance policy is competitively priced based on the annual cost per Rs. 1,000 of protection.

Simply put, it weighs costs against coverage.

The Belth yearly rate of return method allows to determine whether the rate of return on the investment component of a given policy is good, fair, or poor.

Try to solve above equation with following:

Post Tax Interest Rate   = 12%

Annual Premium  = Rs. 10000

Bonus   = Rs. 15000

Death Benefit   = Rs. 10 lacs

CSV   = Rs. 5,00,000

CVP   = Rs. 4,60,000

Internal Rate of Return

Commonly used for policy evaluation purposes in business purchases of life insurance 

Surrender-Based IRR

Solves for the IRR/interest rate/yield that causes accumulated premiums (less any bonus paid)to equal the policy CV at one or more pre-selected policy durations

Typically, highly negative (with a limit of a negative 100 percent) in early years (short durations) and becomes less negative, and increasingly positive, with longer durations

Death-Based IRR

Solves for the IRR/interest rate/yield that causes accumulated “net” premiums to equal the Face Amount at one or more selected policy durations

In early years (short durations), this IRR will be very large but declines with longer durations (i.e., the longer the insured lives).

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Linked Life   Insurance

Posted by Prashant Shah on September 23, 2010

These plans have been of great success in recent years. It is a hybrid plan which gives an option of choosing the investment portion to the insured. It combines the benefit of life insurance as well as giving various options of participating in the growth of the capital market. The traditional plan of insurance companies never disclose to insured where his money is invested. This non transparency part is eliminated by the linked plans. The SA or death cover, payable in the event of death during the term, is related to the premium usually as multiple like 5 times the annual premium. IRDA guideline: SA has to be 1.25 times for single premium or 5 times in case of annual premium.

When we talk about transparency and facilities we should also consider the charges of linked plans. They are as follows:

1. Premium Allocation Charge2. Mortality Charges

3. Fund Management Fees

4. Policy/ Administration Charges

5. Surrender Charges Service Tax Deductions

Investors may note, that the portion of the premium after deducting for all charges and premium for risk cover is utilized for purchasing units.

Lets also understand the difference between the traditional plans and the linked plans

Financial Planning Practice   Standards

Posted by Prashant Shah on September 8, 2012

FPSB’S FINANCIAL PLANNING PRACTICE STANDARDS

FPSB has defined standards of performance that:

1. Establish the level of practice expected of a financial planning professional engaged in the delivery of financial planning to a client;

2. Establish norms of professional practice and allow for consistent delivery of financial planning by financial planning professionals;

3. Clarify the respective roles and responsibilities of financial planning professionals and their clients in financial planning engagements; and

4. Enhance the value of the financial planning process.

A financial planning professional should always consider all aspects of the client’s financial situation in formulating strategies and making recommendations, and should follow these Practice Standards to the extent that they apply to any given situation. At least some of these Practice Standards apply both to comprehensive financial planning and to the provision of services that only represent one of the components of financial planning (i.e., Financial Management, Asset Management, Risk Management, Tax Planning, Retirement Planning and Estate Planning).

As these standards are extremely important for FPP, same has been reflected in the CFP exams, especially in Exam 5. You can expect at least one question from the practice standards.

Time Value of   Money,   Part-9

Posted by Prashant Shah on September 6, 2010

If Mr. A is earning 12% rate of return and inflation for the same period happened to be 8%. The real rate of return earned by him is..

Let’s first of all understand the concept of real rate.

Real rate is the adjusted rate. This adjustment can done with any rate say for example an automobile company’s sales has grown by 10% and the price rise during the year is 5%. The real growth in the sales of the company is

Real growth is [(1+0.10)/(1+0.05)]-1 = 4.76%

The equation above which we have used is Fisher’s equation.

In the case of Mr. A the answer is

[(1.12)/(1.08)] – 1 = 3.70%.

Hence we can say that Mr. A has earned 3.70% in terms of purchasing power even though the total rate of 12%.

 The concept of real rate is useful for financial planning while doing the retirement planning especially at the withdrawal stage.

Now let’s take up some of the miscellaneous approaches for time value

First is rule of 72

If Mr. earns 12% rate of return, within how many years his money will get doubles

Equation: 72/r

Where r= rate of interest

Answer: 72/0.12 = 6 years

 Second is rule of 69

Equation: 0.35 + (69/r)

If we find the doubling period using previous question, the same will be

Answer: 0.35 + (69/.12) = 6.1 years.

Rule of 72 and 69 both are the approximation methods however rule of 69 gives better approximation.

Important: Both the methods assume compound interest.

Posted in TVM | 2 Comments »

Time Value of   Money,   Part-8

Posted by Prashant Shah on September 4, 2010

Let say Mr. A wants to arrange money for his children forever. Will time value of money be useful to understand such arrangement?

Yes definitely. The concept which we are talking about is ‘Perpetuity’. Let’s understand with an example.

Mr. A has Rs.10 lakh with him and wants to give some money to his children every year at the end of year. If rate of return which he can earn is 10%, what amount of money he can give to his children?

1000000 × 0.10 = Rs.1,00,000 forever, if rate of return is constant at 10%.

 Mr. A wants Rs.1 lakh forever. Rate of return is 12%, what amount of money he is required to invest now?

 This is the question of present value of perpetuity.

PV = 100000/0.12

Answer: Rs.8,33,333

 Mr. A wants Rs.1 lakh forever from today. Rate of return is 12%, what amount of money he is required to invest now?

This is the question of present value of perpetuity due.

PV = (100000/0.12) × 1.12

Answer: Rs.9,33,333

Alternatively you can find the PV of perpetuity in normal way and can add up the required money today. Say 8,33,333+1,00,000 = Rs.9,33,333.

 Mr. A wants Rs.1 lakh forever at an interval of every two years. Rate of return is 12%, what amount of money he is required to invest now?

We require the compound rate for two years. i.e. (1.12)2 – 1 = 25.44%

PV = 100000/0.2544

Answer: Rs.3,93,082

Now let’s take up a challenge question

Mr. A requires Rs.2 lakh forever at an interval of every three years. First withdrawal is after 1 year from today. Rate of return is 9% per annum. The amount of money to be invested today for the same is…..

Answer: Keep trying… All the best!

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Risk and Return for   CFP-6

Posted by Prashant Shah on March 25, 2013

Risk Adjusted Performance Measurement (Important for Examination)

The Sharpe measure

Sharpe (1966) defined this ratio as the reward-to-variability ratio, but it was soon called the Sharpe ratio in articles that mentioned it. It is defined by

This ratio measures the excess return, or risk premium, of a portfolio compared with the risk-free rate, compared, this time, with the total risk of the portfolio, measured by its standard deviation.

If the portfolio is well diversified, then its Sharpe ratio will be close to that of the market. With this ratio the manager can check whether the expected return on the portfolio is sufficient to compensate for the additional share of total risk that he is taking. Since this measure is based on the total risk, it enables the relative performance of portfolios that are not very diversified to be evaluated, because the unsystematic risk taken by the manager is included in this measure.

The Treynor measure

The Treynor (1965) ratio is defined by

The term on the left is the Treynor ratio for the portfolio, and the term on the right can be seen as the Treynor ratio for the market portfolio, since the beta of the market portfolio is 1 by definition. Comparing the Treynor ratio for the portfolio with the Treynor ratio for the market portfolio enables us to check whether the portfolio risk is sufficiently rewarded.

The Treynor ratio is particularly appropriate for appreciating the performance of a well diversified portfolio, since it only takes the systematic risk of the portfolio into account.

The Jensen measure

Jensen’s alpha (Jensen, 1968) is defined as the differential between the return on the portfolio in excess of the risk-free rate and the return explained by the market model, or

Illustration:

You are evaluating the rankings based on Sharpe and Treynor Ratio of three funds A, B and C . The average returns obtained from funds A, B and C have been 16%, 19% and 14%, respectively against the market return of 13%. The standard deviations of fund returns have been 17, 22 and 16, respectively versus the market return standard deviation of 15. If the beta reported of these

funds is 1.2, 1.4 and 1.1, respectively and the risk-free rate of return is 5.5%, what are your rankings in the order of best to worst?

Posted in CFP, Investment Planning, Risk And Return | Leave a Comment »

Risk and Return for   CFP-5

Posted by Prashant Shah on March 19, 2013

Modern Portfolio Theory and Asset Pricing

The relation between portfolio returns and portfolio risk was recognized by two Nobel Laureates in Economics, Harry Markowitz and William Sharpe. Harry Markowitz tuned us into the idea that investors hold portfolios of assets and therefore their concern is focused upon the portfolio return and the portfolio risk, not on the return and risk of individual assets.

The relevant risk to an investor is the portfolio’s risk, not the risk of an individual asset. If an investor considers buying an additional asset or selling an asset from the portfolio, what must be considered is how this change will affect the risk of the portfolio.

Possible Portfolio

 The Efficient Frontier: the best combinations of expected return and standard deviation.

All the assets in each portfolio, even on the frontier, have some risk. Now let’s see what happens when we add an asset with no risk—referred to as the risk-free asset.

If we look at all possible combinations of portfolios along the efficient frontier and the risk-free asset, we see that the best portfolios are no longer those along the entire length of the efficient frontier; rather, the best portfolios are now the combinations of the risk-free asset and one and only one portfolio of risky assets on the frontier.

Sharpe demonstrates that this one and only one portfolio of risky assets is the market portfolio—a portfolio that consists of all assets, with the weights of these assets being the ratio of their market value to the total market value of all assets.

If investors are all risk averse—they only take on risk if there is adequate compensation—and if they are free to invest in the risky assets as well as the risk-free asset, the best deals lie along the line that is tangent to the efficient frontier. This line is referred to as the capital market line (CML). If the portfolios along the capital market line are the best deals

and are available to all investors, it follows that the returns of these risky assets will be priced to compensate investors for the risk they bear relative to that of the market portfolio.

The CML specifies the returns an investor can expect for a given level of risk. The CAPM uses this relationship between expected return and risk to describe how assets are priced.

The CAPM specifies that the return on any asset is a function of the return on a risk-free asset plus a risk premium. The return on the riskfree asset is compensation for the time value of money. The risk premium is the compensation for bearing risk. Putting these components of return together, the CAPM says:

Expected return on an asset = Expected return on a risk-free asset + Risk premium

Hence, Required rate or return = Rf + (Rm – Rf) β

Where,  (Rm – Rf) is Market Risk Premium

For each asset there is a beta. If we represent the expected return on each asset and its beta as a point on a graph and connect all the points, the result is the security market line (SML) 

Security Market Line:

Illustrations:

Find Beta of security X if expected market premium is 15%, risk free return is 7% and expected return of security X is 20%?

(a)   0.834 (b)   0.900

(c)    0.700

D)    0.867

Risk free rate of return is 8%, expected market premium is 15% and Beta of security is 0.80. What is the expected rate of return of the security?

(a)   13.6% (b)   15.00%

(c)    12.00%

(d)   20.00%

Assume Rf  is 7%, Km  is 16% for a security X and has a beta factor of 1.4, the required return of the security is_______.

21.6% 20.0%

17.4%

19.6%

23.2%

 Source: Financial Management and Analysis by FRANK J. FABOZZI.