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7Financial Planning HandbookPDP
Chapter 1

8 Financial Planning Handbook PDP
Introduction to Financial Planning
The Indian youth never had it so good. On the consumption side, the choice of goods and services
available is unprecedented. And, as far as income is concerned, given the booming economy and its
ever improving prospects, opportunities have never been better! So the youth are earning a lot and
spending a lot as well. It is definitely a happy situation to be in.
In times like these, when everything seems to be going right for so many people, there is a tendency to
ignore that one great habit –saving money. The rationale is simple-since the future looks great from here,
why set aside money for the future needs and contingencies. But in our view, this is an ideal time to save
money as surplus monies are high. Rather than spending this money on a product that you don’t really
need, you would do well to invest in the future for some later date critical need.
In this book of financial planning, we discuss this and a lot more, including investment avenues available.
We also discuss the concept of spending wisely and creating wealth in a systematic way.
Happy Investing!
Financial decisions are critical decisions, which decide how comfortably we end up monetarily in life.
Poorly planned financial decisions can cause, at best, great anxiety and at worst lead to bankruptcy,
whereas well thought-out decisions can lead to a prosperous lifestyle.
The complexities of our financial circumstances are many and we need to take a careful well thought-out
solution to such problems. The concerns could be many. Some of them are:
How can I grow and protect my financial wealth?
How can I pay and manage my debt?
How much should I save to be able to pay for my children’s education?
How can I maximize the tax benefits which can be availed of?
How can I save enough to be able to retire comfortably and maintain the current lifestyle?
How can I maximize what my heirs will inherit?
Definition:
Financial Planning is the process of identifying a person’s financial goals, evaluating existing resources
and designing the financial strategies that help the person to achieve those goals.
The key basic steps toward reaching this end as a financial advisor are:
Organizing your client’s financial data.
Assisting your client in goal setting.
Financial Analysis for the client.
Developing appropriate strategies.
Evaluating and choosing the best option amongst the various strategies.
Coordinating and implementation of the planned decisions.

What is Financial Planning?
Financial planning is the process of meeting your life goals through the proper management of your
finances. Life goals can include buying a home, savings for your child’s education, planning for your
retirement or estate planning.
This process consists of six basic steps. Using these broad six steps, you can work out where you are
now, what you may need in the future and what you must do to reach your goal.
The process involves gathering relevant financial information, setting life goals, examining your current
financial status and coming up with a strategy for a plan on how you can meet with your goals, and map
the gap.
The Benefits of Financial Planning
Financial Planning helps you give direction and meaning to your client’s financial decisions. It allows him to
understand how each financial decision affects other areas of finance. For example, buying a particular
investment product may help your client to pay off his mortgage faster or may delay his retirement significantly.
By viewing each financial decision as a part of a whole, you may help your client consider the long term and
the short term effects on his life goals. You will help them feel more secure and more adaptable to life
changes, once they can measure that they are moving closer to the realization of their goals.
Best Practices When Approaching Financial Planning
Set measurable goals.
Understand the effect your financial decisions have on other financial issues.
Revaluate your financial plan periodically.
Start now. Do not assume that financial planning is for when you are older.
Start with what you have got. Do not assume that financial planning is for the wealthy.
Take charge. You are in control of the financial planning process.
Look at the bigger picture. Financial planning is more than retirement planning or tax planning.
Do not confuse financial planning with investing.
Do not expect unrealistic returns on the investments.
Do not wait for a money crisis to begin financial planning.
How Do You Make Financial Planning Work For Your Clients.
To achieve your goals of making a complete financial plan for your client, you have to be completely in
sync with his financial needs and his responsibilities. This can be best achieved by following the processes:
Set measurable goals.
Set specific targets of what your client wants to achieve with a specific time line. For example, instead of
saying that he wants to be comfortable when he retires, or that he wants to send his children to good schools,
he should be able to quantify what “comfortable” and “good” means. He will have to as specific as “I need
Rs.100000pm income post retirement for 25 years from the age of 60, considering the anticipated inflation
rate at 5%. These plans may have to be changed keeping in view the market scenario or a changed need.
Understand the effect of each financial decision.
Make the client realize that each financial decision that he takes will affect several other areas of his life.
For example, an investment decision may have tax consequences that are harmful to his estate plans or
a decision on the retirement plans may affect his retirement goals. If he has invested in real estate and

would like this investment to provide for his retirement income that he has to realize that real estate
investment would invite long term capital gains tax which can reduce the post tax returns and keep
margins for this deduction.
Re-evaluate the financial situation periodically.
Financial planning is a dynamic process. These goals may change over the years due to changes in
lifestyle or circumstances such as an inheritance, marriage, birth, house purchase or change in job
status. Revisiting these goals periodically is very important to keep track of how much our client is on
course, both from a long term perspective and a short term perspective.
Start planning soon.
Explain to the client consequences of waiting and how any delay in financial planning affects the whole
big picture that he has in mind for himself and his family. Developing good habits like saving, budgeting,
investing and regularly reviewing one’s finances early in life, makes one better prepared to meet changes
and handle emergencies. If one starts investing Rs. 500, one can expect to have Rs.58 Lakhs at age 60.
Remember that every Rs.500 that you can save from the age of 21 can get you Rs. 58 Lakhs towards
your retirement, but if you start at age 41, you will get only Rs.5 Lakh.
Be realistic in terms of expectations.
Financial planning is a commonsensical approach to managing one’s finances to reach one’s life goals.
It is a life long process. There are certain extraneous factors like inflation, changes in macro economic
policies or interest rates that may affect one’s financial results.

Chapter Review

Chapter 2

Assessing your current wealth
Taking Stock
The first step in assessing your current wealth is determining your net worth. It is the starting point for
financial planning. It provides an indication of your capacity to achieve your financial goals. Your net
worth can be ascertained by drawing up a personal balance sheet, as shown in
Worksheet 2. 1. The process consists of three steps:
1. List the items of value that you own. These are your assets.
2. List the amounts that you owe to others. These form your liabilities.
3. Subtract your liabilities from your assets; the difference is your net worth.
This relationship is shown below:
Items of Value - Amounts Owed = Net Worth
Definition:
Your assets are the things that you own. You probably own assets that have many different forms,
including cash, investments, personal property, real estate etc.
Assets possess value. Value can be of different types. The most basic measure of value is cost i.e. the
amount of money you spent in acquiring the asset. However, usually cost is not a very accurate meaure
of value. This is because, over time, the market value of an asset changes significantly from its original
cost. For example, your house may have cost Rs. 10 Lakhs ten years back. But today it is likely to sell for
much more. In case of such assets, market value or the amount someone would be reasonably willing to
pay for it in today’s marketplace is a much more accurate estimate of the value. However, collector’s
items like art pieces and antiques have an emotional value which may be significantly different from their
market value or cost.
In the Balance Sheet or the Statement of Net Worth, the assets are arranged in order of liquidity. The
most liquid assets are listed at the top of the list and include cash, bank accounts, and money market
mutual funds.
Definition:
Liquidity is a measure of the ease with which an asset can be converted into cash or cash equivalents.
The easier an asset is to convert into cash, the more liquid it is. Cash is the most liquid asset.
The cash surrender values of your whole life insurance policies and annuities can be determined by
contacting your insurance company.
The value of cars can be obtained from agencies which buy and sell used cars.
Household furniture, clothing, and personal effects should be more conservatively valued so as not to
overstate their value. It should be remembered that in an actual sale of these items, you are likely to get
far less than the estimated values.

Your home is likely to be your largest asset, so its value should not be over- or under-stated. The figure
that you should use is the current market value; that is, the amount that someone would be willing to pay
for your house. Do remember that the cost of the property is not an accurate indicator of its value if you
have owned your house for a long period of time. The most recent selling prices of houses similar to
yours in your area are a good indicator of the likely market value of your house. Real estate brokers can
also provide you with an estimate of the value of your house.
Note
There is another school of thought, which proposes that the value of a self-occupied house should not be
considered in the net worth statement because one cannot really sell the house to raise resources. This
approach is also worthy because it is the more conservative of the two.
Liabilities
Definition:
Your liabilities are amounts that you currently owe (i.e., your financial obligations). The sum of your
liabilities is what you must pay today to overcome debt.
Begin by listing your most current debts, such as utility bills, telephone bills, and others.
Next, list the balances outstanding on your credit card debts and loans. For most people, a home loan is
their largest single debt outstanding. The amount to include is not the original amount of the loan but the
current outstanding balance. The current outstanding balance of the loan can be obtained directly from
the lender.
Add up all the amounts owed to others and to get the total of your liabilities.
Net Worth
Definition:
Your net worth is the difference between the totals of your assets and liabilities. In other words, if you
sold all your assets for the values stated and paid off all your debts, the amount left over would be
your net worth. The net worth of a person is a measure of a person’s financial position as of the date
of the personal balance sheet.

Steps:
List all items of value starting with cash, investment assets, the current value of your house, and
possessions.
List and total all liabilities.
Subtract total liabilities from total assets.
Notes:
Assets
Determining the value of your stocks, bonds, and mutual funds is easy. The prices can be found in
newspapers or on financial websites.
WORKSHEET 2.1 How to determine your net worth
A. Assets Amount (in Rupees)
Cash
Bank Accounts
Fixed Deposits
Cash surrender value of life insurance
Cash surrender value of annuities
Market value of investments
Mutual funds
Stocks
Bonds
Others
Market value of house/real estate
Investment property
Vehicle(s)
Household furniture/appliances
Jewelry/precious metals
Collectibles
Loan receivables
Others
Total Assets
B. Liabilities
Credit card balances
Bills outstanding
Outstanding loan balances
Taxes due
Others
Total liabilities
Net worth [assets minus liabilities (A-B)]

Why Is Determining Net Worth Important?
Determining your net worth is the first step in financial planning and assessing your financial wealth. Net
worth is a tool for comparing the changes in your financial position over a period of time. An increase in
net worth over a period of time is a favorable trend, and a decrease in net worth is a reduction in wealth.
There are a number of ways to increase net worth:
Appreciation of assets (for example, a rise in the value of stocks, bonds, mutual funds, and real
estate).
Reducing liabilities.
Increasing income, such as through salary and wage increases as well as growth in investment
income.
Reducing the amount spent on living expenses.
The importance of increasing net worth is obvious. It is important to remember that addition of assets
may not always increase your net worth. This is especially true for depreciating assets, such as cars,
computers, electronic equipments etc.
Investment assets like shares could also lose substantial part of their value.
Creating a personal balance sheet will assist you in tracking your personal wealth over time and enable
you to see relationships among the balance sheet items. The relationship between liquid current assets
and current liabilities indicates the relative ease or difficulty in paying upcoming debts. This evaluation
ratio is the current ratio and is determined as follows:
Current Ratio = Current Assets ÷ Current Liabilities
For example, if a person has Rs. 10 Lakhs in liquid current assets and Rs. 5 Lakhs in current liabilities,
the current ratio is 2. This means that for every Rs. 1 in current debts, there is Rs. 2 in liquid assets.
Generally, most current debts are repaid from liquid current assets such as cash, savings accounts etc.
In the event of unemployment or insufficient liquid current assets to cover current debt, longer-term
investment assets would need to be liquidated to pay off the debt.
The other significant relationship between balance sheet items is the debt ratio, which is total liabilities
divided by net worth:
Debt Ratio = Total Liabilities ÷ Net Worth
For example, if a person has Rs. 1 Lakh as total liabilities and a net worth of Rs. 2,00,000, the debt ratio
is 0.5.
We need to make the Cashflow statement and the Income and Expenditure Statement, to assess changes
in networth.

Chapter Review
Exercise
1. Mukesh bought a flat for 12 Lakhs, worth 20 Lakhs today. He has no loan repayments i.e. EMIs due
on his flat. He has FDs worth Rs. 2 Lakhs and cash of 30,000 in his account, jointly held with his
wife. He has mutual funds worth 1.5 Lakhs and stocks worth 1.5 Lakhs. Ritesh, an old colleague of
his, has taken a loan from him for Rs. 50,000, for which he pays him 10,000 every month. His wife,
Geeta is fond of diamond jewellery and owns up to 3 Lakhs of diamond jewels.
Mukesh bought a car for 4 Lakhs, 3 years ago. He has a tax liability of Rs. 35k per year. He has no
other outstanding bills pending, except for telephone and electricity bills to the tune of Rs. 5,000 .
A] What is his net worth?
B] Can you think of ways of increasing his net worth?
C] What is his current ratio and debt ratio?

Chapter 3

The Income and Expense Statement and
the Cashflow Statement
Your Income and Expense Statement reports income earned and spent during a specified period,
while the Cashflow Statement presents a record of all the cash inflows and outflows during a particular
time period.
The difference between the two is that the cashflow statement records only the actual cash inflows and
outflows. It does not include amounts spent or earned on credit. On the other hand the income and
expense statement records all types of income and expenses.
These statements make it easy to see where your money is being spent. Many people complain that
they earn large sums of money, but they never have anything left over. Recording their expenditures is
a first step to taking control of their financial affairs. Because earnings and living expenses also influence
net worth, these statements also show that change.
The income statement shows actual income and expenditures over a period of time, whereas a balance
sheet or Statement of Net Worth shows financial position at a single point in time.
There are three steps to creating an income statement, as shown in Worksheet 3.1.
List all income received during the time period.
List all expenditures made during the time period.
Determine the surplus/deficit of income over expenditures.
Step 1: List All Sources of Income
List all sources of income for the period of the income statement. Income from salary is generally
received after deducting tax at source (TDS).
The main source of income for most people comes in the form of salaries, wages, self-employment
income, and commissions. Other sources of income include bonuses, interest, dividends, rent, gain on
the sale of assets, and gifts and inheritances. All sources of income should be included in order to make
the income statement complete and accurate.
Step 2: List All Expenditures
Expenditures show where cash flows have been spent. Major categories of expenditures should be listed. It
isnotnecessarytoaccountforeverypennyspent.Byreviewingcheque-bookrecordsandcreditcardstatements
and recording the cash payments, you can easily develop categories of expenditures. By adding the payments
made in each category, you will have a fairly accurate account of where your money has gone.
Certain expenditures are fixed; that is, they remain the same each month or year. Examples of such
expenses are rent, mortgage payments, life insurance premiums, and equated monthly instalments of
loans. These are called Fixed expenditures.

Certain expenses change from month to month, such as food, clothing, medical expenses; telephone
and utility payments; household operating expenses; contributions; and recreational expenses. These
are called Variable expenditures.
Both Fixed and Variable expenses can be either Discretionary or Non-Discretionary Expenses.
Discretionary Expenses: Eating outside, Excess Consumarisation, Changing models of mobile every 3
months etc.
Non-Discretionary Expenses: House Maintenance Charges, Grocery Expenses, Medical Expenses,
Electricity Charges where you cannot really do any curtailments.
Step 3: Determine whether there is a Surplus or Deficit of Net Cash Flow
When income exceeds expenditures, there is a surplus. When expenditures exceed income, there is a
deficit. Funds to cover a deficit can come from withdrawal from savings or by taking a loan, both of which
decrease net worth.
A surplus represents an increase to net worth if the amount is used to increase savings, invest it wisely
to acquire additional assets, and/or pay off debt.
Note:
Cash surplus increases net worth while a deficit decreases it.

What can the Income and Expense Statement/Cashflow Statement tell you?
The income and expense statement is an important tool which helps in understanding current spending
patterns and formulating a budget.
If your expenses exceed your income, you have a negative bottom line or a "net loss." That is, you are
depleting your net worth, a situation that sometimes requires prompt attention. If you have a substantial
surplus, it means that your net worth is growing.
You can divide total expenses by total income to learn what percent of income you are spending into
Discretionary and Non Discretionary Expenses. This shall give the indication of what amount is utilized
and what amount is being wasted. Compare this to previous periods to learn if your ability to grow your net
worth is improving.
Income is difficult to increase in the short term. Longer-term income can be increased by establishing
yourself in your profession, finding a better-paying job, or changing careers. The latter alternative should
be deliberated carefully before any moves are made.
Expenditures are also difficult to reduce, but variable (Discretionary) expenditures are easier to cut than
(Non Discretionary)fixed expenditures. For example, it may be easier to reduce recreation, summer
vacation, and/or entertainment expenses than necessary living expenses, such as food, loan payments
and utility expenses.
By going through the process of compiling an income statement, you can see where money has been
spent and where you need to reduce expenditures, if necessary. The income statement is not only an
important tool in helping to understand current spending patterns, it also assists in formulating a budget.

Chapter Review
Exercise
1. Anil lives in a flat, which he purchased 10 years ago for Rs. 10 Lakhs. There is a loan outstanding
for Rs. 3 Lakhs left. The monthly EMIs, which Anil pays towards the loan, is Rs. 4000 pm. His wife
has jewellery worth Rs. 2 Lakhs.He has a car, which he purchased for 3 Lakhs, four years ago. He
pays a monthly EMI of Rs. 2000 for his car loan. His life insurance and pension funds cost him Rs.
4000 pm. He earns Rs. 40000 pm. His car requires petrol worth Rs. 3000 pm. The grocery bill adds
up to Rs. 8000 pm. His wife, Mina likes to eat out. They spend Rs. 2000 on entertainment every
month. His mobile bill and utilities come to Rs. 6000 pm. His credit card bill is Rs. 2000 pm.Anil
earns interest income up to Rs. 400 pm.He has no other source of income.
Prepare his income and expense statement. Is there a surplus or a deficit? State the discretionary
and non-discretionary income. What is the percentage of discretionary and non-discretionary expenses
to the income?
2. Mukesh, a student had withdrawn Rs.3000 on 1st
May’07. By the 10th
of May, he had only Rs. 100
in his wallet. Intrigued as to where he spent all his money, he decided that for the following month,
he would maintain a note of all his cash outflows and inflows.
One June 1’07, Mukesh withdrew Rs. 3000 from ICICI Bank. On the 1st
, he had travel and eating
expenses of Rs. 150. On the 2nd
, he bought some fruits worth Rs. 45 and had conveyance of Rs.
50. On the 4th
and the 5th
, he had miscellaneous expenses of Rs. 500. On the 7th
of June, he realized
that the rains will start soon and that he needed both a pair of rainy shoe and a bag. He purchased
the office bag at Rs. 700 and the shoes cost him Rs.900. He hunted out his old umbrella that had
served him well for the last 2 rainy seasons.
How does Mukesh’s cash inflow-outflow statement look like? Does Mukesh have a surplus or a
deficit? Is he better off in June than in May?

Chapter 4

Budgeting
What is budgeting?
Budgeting is a process for tracking, planning, and controlling the inflow and outflow of income.
How does the budgeting process work?
The budgeting process begins with gathering the data that makes up your financial history. Next, you use
this information to do a cash flow analysis. You will calculate your net cash flow, which tells you whether
cash is coming in faster than it’s going out, or vice versa. Then you will determine your net worth. Having
a snapshot of your present financial situation, you’ll then define your financial objectives and create a
spending plan to achieve them. Finally, you will periodically check your progress against the plan and
make adjustments as needed.
How to Formulate a Budget?
A budget is a plan for how you intend to spend your money during the coming month or year. It is an
integrated statement based on details of your income statement and balance sheet for the past month or
year. The budget expresses what you would like to achieve in terms of spending and savings in the future.
A budget can assist you in determining whether:
You are living within your income limits
Your current spending patterns are satisfactory
You are saving and investing sufficient amounts to satisfy your financial goals
You need to make changes in order to satisfy your financial goals
A suggested budget format is shown in Worksheet 4.1. You can also make budgets using personal
finance software programs.
More specifically, a budget can be drawn up in six steps:
Estimate your future net income for the period of the budget.
Determine your expected expenditures during the period of the budget.

Determine what you expect to spend to fund your personal goals.
Determine whether there is a surplus or a deficit.
Record your actual income and expenditures.
Evaluate whether changes in spending and saving are necessary.
Step 1: Estimate Your Future Income
Estimating income is self-explanatory but seldom easy to implement. It is the process of combining
everything you know or sense what is likely to affect your income for a specific future period, then using
it to forecast income. Some sources of income are naturally much more difficult to forecast than others.
One way to arive at an estimate is to combine prior period income with anticipated changes to estimate
your future income.
When there are multiple income sources, it is necessary to first estimate each one, and then add the
individual estimates to derive total estimated income for the period being considered. Common income
sources include all anticipated receipts of money, such as future salary, estimated profits (or losses,
which are deductions from income) from a business, bonuses, commissions, interest, dividends, rent,
gains, tax refunds, loans, and other sources of income.
Some of the factors that can increase (or decrease) future levels of income are:
Bonuses
Business upturn/downturn
Commissions and royalties
Cost-of-living adjustments
Disability
Dividends
Gifts
Health condition
Inheritance
Interest rate changes
Investment gains/losses
Job promotion
Personal property sale
Salary increase/decrease
Change in tax bracket
Tax refunds
Remember
When estimating income that is highly variable, the estimate should be conservative. Being surprised by
an income surplus is far more pleasant than having an unexpected income shortfall. In fact, the latter can
cost even more if you need to rely on credit to cover the shortage. Being conservative by underestimating
budgeted income is prudent so as to avoid overspending.Use the reasonableness test to avoid unrealistic
estimates.

Step 2: Determine Your Expected Expenditures
The second step is to estimate all expenditures during the period of the budget. Estimating expenses is
similar to estimating income. Both are equally important and use a prior period’s information as their
starting point. Naturally, some expenses are more difficult than others to predict and therefore require
estimation. Unlike income, expenses can arise from tremendously diverse sources, estimating expenses
is more complex and requires greater effort to do well.
Estimating expenses is central to the budgeting process, because it is the first step in controlling the
outflow of household income. Forecasting expenses is also directly related to achieving financial goals.
Only by knowing what your expenses are likely to be, can you plan for meeting financial goals.
The following steps are involved in estimating expenses for a future period:
Review prior period expenses and determine which will recur in the forthcoming period
Determine what new expense items are anticipated
Estimate the amount of each expense for the period
Add individual estimated expenses to obtain total estimated expenses
Whether estimating expenses or income, you should always estimate conservatively. Being surprised by
lower than expected expenses is far more pleasant than experiencing a spending deficit. If you need to
borrow funds to cover a spending deficit, you’ll be spending even more. Use the reasonableness test to
avoid unrealistic estimates.
Expenses can come from many directions, so be careful not to overlook any that could be significant.
Expenses that are uncommon and nonrecurring are the most difficult to predict, yet are frequently the
cause of budget chaos.
Certain expenditures such as rent, mortgage, and car loan payments are fixed in amount and do not vary
from month to month, whereas other expenditures such as food, clothing, and utilities vary in amount
from month to month. Anticipating these variable expenditures with accuracy may be difficult. The purpose
of budgeting is not to bind you so much that you cannot maneuver. On the contrary, its purpose is to
provide you with flexibility in your financial planning so you can achieve your financial goals.
Step 3: Determine Your Financial Goals
In order to set aside money for your financial future, you need to estimate the expenditures that go
toward your savings and investments. Financial goals vary from person to person over time. Some
sample financial goals maybe:
Saving for an emergency fund
Increasing savings and investments
Buying a new car
Paying off a loan
Buying a house
Saving to fund children’s education
Providing retirement income
Some of these are short-term goals while others are longer term. It is often easier to concentrate on the
short-term goals and neglect longer-term goals. By assigning priorities to each of the goals and quantifying
their cost, you can determine the amount of savings needed to fund them.

The table below shows an example of prioritizing of goals:
1. Column 2 shows the estimated amount of money needed to fund each goal.
2. Column 3 lists each goal’s priority. For example, buying new furniture is the lowest of the family’s
priorities.
3. Column 4 shows when the expenditures will be needed. For example, a new car to be purchased in
12 months; fund children’s education in 15 years (180 months); retirement in 24 years (288 months);
and new furniture to be bought in six months.
4. Column 5 shows the amount that will be needed every month to finance each goal. It is calculated as
follows:
Monthly Amount = Estimated Cost ÷ Time Needed
For example: Monthly amount required for a new car = 600000 ÷÷÷÷÷12 = 50000
Since setting appropriate financial goals forms the foundation of any budget, we will look at the process
of setting budget goals in detail in the next chapter.
Step 4: Determine whether there is a Surplus or a Deficit
If budgeted amounts for income exceed expenditures, there is a surplus. Expenditures and the amounts
needed to fund personal goals added together equal the total expected expenditures. It is a good idea to
incorporate goals into a budget so that monthly or periodic income is set aside to address them.
When projected income exceeds projected expenditures, there will be additional amounts of cash, which
can then be added to savings/investment plans or used to pay down liabilities.
When projected expenditures exceed projected income, there is a deficit. This means additional amounts
will have to be withdrawn from savings/investment plans to pay for these additional expenditures. In
such a case, it may be necessary to review projected expenditures and reduce some of them, or look for
ways to increase projected income.
Step 5: Record Actual Income and Expenditures for the Period Budgeted
Actual amounts earned and spent are not always the same as those projected. By recording the actual
amounts and comparing them with the budgeted amounts, you can immediately see the differences,
called variances. Spending more than a budgeted amount for one item can be offset by spending less
than the budgeted amount for another item.
Similarly, if actual income exceeds actual expenditures, there is a surplus, which means additional cash.
The opposite is a deficit, which means that cash will have to be withdrawn from cash savings or other
assets in order to pay for the deficit spending.
Step 6: Evaluate Whether Changes in the Budget Are Necessary
If there are large variances, or your surplus/deficit is not what you would like, you need to analyze your
budget. Examine the variances and study where the amounts spent are greater than the budgeted amounts.

For example, if your actual phone bills are consistently greater than the amounts budgeted, then you
need to either reduce your phone usage, if possible, or increase the amount budgeted for this item. When
you increase planned spending, you will need to find items where you can make corresponding cuts to
compensate for the increases. If you don’t, the amounts set aside for personal goals or savings will be
reduced.
There are certain expenditures over which you have some degree of control. These are your discretionary
or variable expenditures, such as entertainment and miscellaneous expenses. Entertainment and food
are the most common areas of overspending, particularly when they involve eating out at restaurants.
By contrast, non-discretionary fixed expenditures such as rent, loan payments, taxes, and insurance
premiums cannot be easily trimmed without consequences. You may need to prioritize your expenditures
to see which are necessary and which can wait.
The purpose of a budget is to help you plan the use of your resources so that you can fund your goals and
set aside more of your money to savings. Following your budget will help you achieve what you want
most from your resources.
Establishing appropriate financial goals is the foundation on which a budget is built. We will look at the
process of setting goals in more detail in the next chapter.

Exercise
1. Priti is a 30-year-old young professional. Her net salary is Rs. 50,000 pm. She is expecting a bonus
of Rs. 30,000 in the next 6 months. Her car loan outflow is Rs. 6,000 pm. The rent is Rs.15,000 pm.
She spends on food and clothing Rs. 9,000 pm.She invests all her surplus funds in retirement
schemes, so far. She invests Rs.10,000 pm on pension annuity fund. She wants to save money to
enjoy a holiday with her parents and take them on a world tour. She will have to have Rs. 6 Lakhs
for this trip. She has monthly medical and miscellaneous expenses for her parents to the tune of
Rs. 5,000 pm. Her salary is expected to go up by Rs. 5,000 net of tax, in 2 months time.
Prepare a budget for Priti.
Should she invest in any other instruments as well? What could they be? Discuss.
2. Nitish is a 40year old, working with Elder Pharma Ltd. He lives with his wife, child and elderly
parent. In the year 2007-2008, he expects interest from his Fixed Deposits to amount to Rs. 20,000.
He has invested in mutual funds to the tune of Rs. 2 Lakhs, the value of which all together is Rs. 2.5
Lakhs. He has received tax-free dividends of Rs. 10,000, in the year. His agricultural income
comes from the land in his village. He received Rs. 1 Lakh this year as agricultural income. He is
quite generous with the people who look after his farm, and they are faithful farmers who have been
associated with his family for more than 40 years, now.
He lives in a self-occupied house, where the EMIs are Rs. 15,000 pm. His salary is Rs. 8 Lakh pa.
His monthly expenses to look after the house inclusive of groceries, utility bills, car maintenance,
and children’s education comes to Rs. 30,000 pm. Medicines and miscellaneous purchases come
to approximately Rs. 10,000 pm. His insurance payment is Rs. 5,000 pm. He wants to set up an
emergency corpus of Rs. 2 Lakhs and set aside Rs. 10,000 pm as retirement funds. There is an
anticipated expense to cover the leakage in the house to the tune of Rs. 50,000. This leak has to be
fixed before the monsoon begins, which is in another 2 months time.
Prepare a worksheet and analyze his expenditure pattern to determine if his future goals can be
achieved.
3. Naik, who is living in Mumbai decided to look into his finances one saturday afternoon. He had not
had a look at them in a long time for now. It was decided that it was high time that he took out some
time for stocktaking regularly. He and his wife Renu, sat down to discuss and enumerate all their
respective responsibilities and priorities. Renu said that she had a family wedding coming up and
there were some gifts to be purchased on an immediate basis. Her brother’s wedding was fixed up
and she wanted to buy a gift worth Rs. 8,000 for him.
Their son would require tuition fees to be paid to Aggrawal classes. Aggrawal Classes charged Rs.
20,000, a year which was due to be paid in 2 months time. Mr. Naik had a commitment to pay EMIs
for his home loan for which the monthly outflow was to the tune of Rs. 12,000 pm. Looking at their
long-term plan, they wanted to save Rs. 5 Lakhs for their child’s education, Rs.8 Lakhs for his
wedding and Rs. 50 Lakhs as a corpus for their retirement. Mr. Naik is due to retire in 5 years time.
He earns Rs. 60,000 pm, after taxes.
Identify the short term and the long-term goals, their priority and the time needed to fulfill the goals
and their monthly cost. Determine if there is a surplus or a deficit to fulfill these goals.

Chapter Review

Chapter 5

Setting Budget Goals
What are budget goals?
Think of your budget goals as your financial wish list and your spending plan as a way to make those
wishes a reality. Without clear budget goals, your financial life may remain in disarray. Like any other
goals in life, your budget goals help you turn your wish list into an action plan.
Your budget goals also help you take the drudgery out of following the budget because now, when you
give up any immediate desire, you know that you are one step closer to something you really want. For
example, when you give up having dinner in a nice restaurant, you know that you are closer to being able
to buy a dream car next year. With clear goals in sight, you can chart your course of action and change
your direction when needed.
Step 1 : Start by listing your goals
Setting your budget goals requires forecasting your future needs and dreams. Involve every member of
your family and discuss each possible goal with them. Have a brainstorming session with your entire
family and ask each member to make a list of three to five of their possible needs and dreams as
individuals and as a family. At this stage, keep in mind that you want to list all of your goals and dreams.
Examining them and prioritizing them will come later. Strive to be as specific and unambiguous as
possible so that they become easier to plan. For example, instead of listing a goal of “taking a family
vacation somewhere within next five years,” list “taking a vacation in the Himalayas next summer.” Once
each member has made the list, go over all the goals and see if you want to make any changes before
you incorporate them into your budget.
Step 2 : Categorize your goals
Divide up your goals, according to how long it will take to meet each goal, into three categories:
Short-term goals (less than a year)
Medium-term goals (one to five years)
Long-term goals (more than five years)

Short-term goals are your immediate needs and wants, such as buying a music system next month or
buying a new car next year. Since these goals are, by definition, less than a year from being realized,
they are relatively easy to estimate and plan.
Medium-term goals are things that you and your family want to achieve during the next five years, such
as taking a vacation or renovating your home. These goals require more planning and careful estimation
of their costs.
Long-term goals extend well into the future, such as planning for your retirement or for your child’s
education. These goals require the most planning, including estimating the cost, forecasting your income,
and estimating the growth of your investments. You may need expert help to plan for these goals.
Step 3 : Estimate the cost of each goal
Find out how much it costs today. Before you assign priority to your goals, it is important to determine
the cost of each goal. The greater the cost of a goal, the more alternative goals must be sacrificed in
order to achieve that goal.
Step 4 : Project the future cost
For your short-term goals, inflation is not a big factor, but for your medium- and long-term goals, you need
to factor in the inflation so that you have a more accurate estimate of their costs. Inflation can be a very
tricky issue in dealing with long-term goals. Even a relatively modest inflation rate can increase the cost
of your goal by 2 to 3 times over a 20-year period. However, there is no need to panic, since time is also
your ally. If invested properly, the money you will be saving toward that goal can also grow at a rate that
will outpace inflation.
To calculate the future cost of your goals, you need to determine the rate of inflation that will apply to
each particular goal. Often, prices change in different industries at different rates. For example, the real
estate prices in your area may rise at a different rate than college education costs.
There are two ways to estimate the rate of inflation for your goal. You may observe current and past
inflation rates and make some assumptions as to the rate of inflation for the period of your goal. Or you
may find out what experts are predicting in the industry in which you are interested. For example, if your
goal is to buy a new car, find out the rate of inflation for the auto industry by reading the financial
newspapers. By finding out what it costs today and factoring in the rate of inflation, you can now project
the cost of all of your goals in the future. It is crucial that your estimate be as accurate as possible,
especially for your long-term goals.
Step 5 : Calculate how much you need to set aside each period
Once you have some idea about the future cost of your goals, your next step is to determine how much
you should put aside each period to meet all your goals. Keep in mind that you may not need to assign
a separate savings or investment account for each goal as long as you have a method to keep a record
of your goals. You may want to have a separate investment strategy, however, for your short- and long-
term goals.
For your short-term goals, it is easy to estimate the cost, the amount you will need to set aside each
month, and your projected income during that time. Divide the cost by the number of months until you
need to meet your goal. You then know the amount of money you need to put aside each month for your
goal. For example, if you want to buy a music system in six months and it costs Rs. 30,000, you need to
put aside Rs. 5,000 a month for the next six months.

For your medium- and long-term goals, the process can get complicated, since you also need to take into
account the interest you will earn on your savings. Computer programs are available to calculate your
monthly requirement for your future goals, taking into account interest earnings. You may also project
the amount of interest your money will earn at a specific rate of return. Subtract this amount from the
future cost of your goal to find out how much more you need to save to meet your long-term goals.
Example
If you are saving for your child’s college education and you will need that money in 10 years, you first find
out the amount of money you will need, taking into account the rate of inflation. Say, for example, you will
need Rs. 6,00,000 for the first year of college. Now, calculate the amount of money you will need to save
each month, taking into account the estimated rate of return on your savings or investments.
Once you have calculated this number for all of your goals, you get an amount that you will need to save
every month. Then you need to evaluate your goals in order of their priority so that you can channel your
savings in the right direction.
Step 6 : Prioritize your goals
Once you have a list of all your goals and the estimated amount needed for each goal, prioritize those
dreams. Unfortunately, for most families and individuals, it is not possible to realize all goals, which is
why setting priorities is essential.
Review your goals and give each a number that reflects its priority. For instance, a number one would
mean the goal is extremely important to you. Like shown in the table below saving for your retirement,
saving for your child’s education, or saving for a down payment of a house could be priority one for you.
Goals with a number two are somewhat important to you, such as taking a vacation or replacing your car.
A number three reflects any goal that is more of a wish than a need, such as buying a vacation home.
After assigning priorities your list might look like as shown below:
Your first focus will be on the goals marked with a number one. Calculate the amount of money you will
need to put aside each month to meet these goals. Do the same for goals with priority number two,
followed by those for number three. You can then write your goal schedule.
Goal Priority
Saving for Retirement 1
New Car 2
Saving for child’s education 1
Taking a vacation 2
Buying a music system 3
Buying a vacation home 3

Step 7 : Create a schedule for meeting your goals
List all your goals according to their priority. Then write down the amount of money needed, when you will
need it, and how many installments you will need to meet your goals. Here is what your goal schedule
might look like:
This table will give you a picture of how much money you need to save every month to achieve all your
goals. The table will also give you an idea of your investment options, since your personal time line
affects your choice.
With the clear picture of your goals, their priority, the amount of money you need, and the amount of monthly
savings to attain those goals, you can move to the next step - developing a spending plan for your budget.

Chapter Review
Exercise
Sayantani had the following goals that she wanted to fulfill.
She wanted to take up higher education in a city which is full of growth prospects, ie Mumbai.
She is already a graduate, but she wanted to pursue a career in mass media for two years.
She wanted to learn music, side by side, with a famous music teacher who is renowned for his
tutelage and his performances. This has been a dream for her since a long time. It was one of
the factors which made her consider Mumbai as the first choice. This teacher was expensive
and charged Rs. 500 per hour. She had to take atleast ten classes in a month.
She had to throw a party for her friends since she was soon leaving town. This would cost her
Rs. 500.
She wanted to own a scooty for ease in commute. This would cost her Rs. 30000 upfront.
Sayantani, was to go and stay with her uncle while she was studying, but she would have to
allocate some funds for renting a place, because she knew that it was a burden on him as well.
So after two years, she would have to spend Rs. 3000 pm on her rent.
She had to repay her educational loan, which she had taken to complete her education. This
loan was repayable six months after she graduated. She had taken a Rs. 1lakh loan.
She had to send back Rs. 1000 pm to her parents for the education of her siblings. Though her
parents were not asking her for it, she knew that it was her duty to support them financially.
She had an expense of Rs. 1000 immediately for clothes and other necessities since she was
leaving out of town.
She was hoping that she could start out as a media reporter for a TV channel since this was something
which she thought she was good at. The pay currently for any of these jobs as a media reporter was
about Rs. 10000 pm, and in the next two years would be Rs.12000 - 13000.
Prioritize, prepare a goal schedule and write down a plan as to how she should allocate her funds after
she starts working.
Start with yourself. Create a goal-list, Cost attached to it, prioritise it as make a schedule. For each of
you this will be the start of dealing with your own Financial planning.

Chapter 6

Developing a Spending Plan
What is a spending plan?
Your spending plan is your active strategy for getting where you want to go. Think of your spending
plan as a road map that helps you reach your goals. Your spending plan provides a sense of
direction and puts you in charge of how your money is spent on a weekly, monthly, and yearly basis.
What are the steps to develop a spending plan?
It takes significant time and commitment to develop a spending plan that is right for you and your family.
The steps are:
Step 1 : Record all your expenses
In order to develop a spending plan that is appropriate for your lifestyle, you need to understand your own
spending habits. First, start recording all your expenses – every single rupee that you spend - for at least
a month. You may record all your expenses in a notebook or use your computer. However you do it, it is
important to remember that you include all expenses, no matter how trivial. You will find that just recording
all your expenses may allow you to focus your attention on how, where, and how much money you are
spending. Categorize it into heads like rent, food, clothing, transportation, any other expenses. These
will include phone, mobile phones, unexpected household purchases, utilities maintainance, memberships,
life and other insurances, entertainment, travel etc.
After recording and prioritizing, take the following steps.
Step 2 : Identify out-of-pattern expenses
Once you have created categories and listed all your expenses for a month, your next step is to identify
your out-of-pattern expenses. There are many expenses such as insurance payments, festival gifts, or
taxes that occur annually, semiannually, or quarterly. Identify all of your out-of-pattern expenses. Add all
your out-of-pattern expenses on a yearly basis and divide them into 12 so that you have a clear idea of
how much you need on a monthly basis for your spending plan.

Step 3 : Estimate your income
If you are getting a regular salary, estimating your income is easy. Write down your monthly income
minus income tax and any other automatic deductions. Add other income such as dividends, interest,
and rent. Make sure you include all types of income.
If your income is irregular, you will have to start with the premise that your total income is somewhat
predictable, but your payments come at uneven intervals. Look at your income over the last two years
and project your income for the next 12 months. Divide that number by 12 and consider that to be your
monthly income. Plan your spending with that income in mind. During months that you earn more than
average, save the extra earnings for the months when you earn less.
Step 4 : Develop your plan
Now you are ready to create a spending plan based on your income and your expenses. Here are some
guidelines that experts suggest.
Suggested spending plan percentages of your gross income:
Look at your records and see how your spending is distributed in terms of percentage of your income.
You can see how your own spending habits compare with the guidelines above. You may choose to
follow these guidelines closely, or you may decide to make changes so that the overall spending plan
reflects your lifestyle. For example, if you love to travel, your transportation budget may be larger than
the suggested average. To compensate for that extra spending, you will have to reduce some of your
other expense categories. Also, keep your goals and priorities in mind and adjust your spending plan
accordingly. For instance, if you are not saving any money right now but you want to save 10 percent of
your income for retirement, find out from which categories the money will come.
Implementing and Monitoring Your Spending Plan:
Once you have identified your budget goals and created a spending plan to meet them, you are ready to
put your plan into action. Before you begin, though, here are some tips to avoid common mistakes.
Tips to Implement and Monitor your Spending Plan
Involve the entire family.
Implementing and monitoring your budget plan requires commitment as well as discipline from the entire
family. Make sure that they are all in agreement and understand your plan. The better you all work as a
team, the greater the chances for success.
Be disciplined.
To get long-term benefits, your budget should become a way of life. Jot down all the expenses, item by
item, day by day, in your diary. If you are using your computer, make sure you enter all the expenses at

the end of the day or at the end of the week. Don’t wait until the end of the month because, by then, you
will have so many entries that you are likely to give up.
Keep it simple.
Keep monitoring simple. Divide your expenses into fixed, variable, and discretionary categories. Monitor
your variable and discretionary expenses, such as clothing money or eating out, once you have assigned
your fixed expenses.
Use different credit cards.
Track different categories by using different credit cards. Dedicate one credit card for clothing purchases
so that you don’t need to write down your expenses every time you buy any clothes. Instead, your credit
card statements will itemize your clothing expenses for you. Use an oil company card when you fill up
your car’s fuel tank.
Caution
If you’re going to use multiple credit cards to help track your expenses, make sure that you aren’t
paying high annual fees for each of these cards.
Be careful not to fall into the trap of using credit to pay for everyday expenses and not paying off your
outstanding balance each month. If you do this, it will seem like you are spending less, but your debt
will continue to increase.
Fine tune as you go.
Keep in mind that implementing a spending plan requires fine tuning of your estimates and your expenses
as you go along. You will get better as time progresses. Don’t give up too quickly if you feel it is not
working.

Chapter Review
Exercise
1. Nishant had joined TCS on the 1st
of July’07. He had come to Bombay from Nagpur. In the first
month, he took a vehicle loan, so that his commute is faster and convenient. He had to allocate Rs.
6000pm for this outflow. Initially, during the first few days, he had to spend Rs. 15000 from his
pocket for stay and food expenses until he rented a place and made arrangements for food. He
made clothing purchases for Rs. 6000, just before he joined his organization. The petrol costs were
amounting to Rs.1000pm. His mobile monthly expense came to Rs.2000pm. He spent Rs. 2000
initially on gifts and entertainment. His monthly expenses for food and rent were up to Rs.12000pm.
He wanted to plan to save money for his sister’s college education, as soon as possible. His
monthly salary was Rs. 25000pm. The corpus required for education was Rs. 2 Lakhs.
Record Nishant’s expenses and develop a plan to save money for his goals.

Chapter 7

Time Value of Money
The time value of money is one of the most important concepts in personal finance decision-making.
Money does not have the same value over time due to the fact that it earns interest. Consequently,
a rupee today is not the same as a rupee in the future.
Investing that rupee today yields an amount greater than the rupee in the future because of the interest or
return that the investment generates. The interest rate or the rate of return is the link between the present
and future value of money.
The impact of the time value of money is dependent on the following three factors:
The amount of money
The annual rate of interest
The length of time
Another way to look at the time value of money is to view it as an opportunity cost. Spending rather than
saving means lost interest. What you could have earned on that money has been lost. It therefore
becomes important to know the interest rate on all your savings and investments to determine whether
you should be saving or spending your money.
Simple Interest
The most basic method of calculating interest is the simple interest method. The other, more common
method, of calculating interest is the compound interest method.
Definition:
Interest is the cost charged or payment made for the use of money.
The simple interest method calculates interest on the principal only, without any compounding. In other
words, the interest earned is not used to earn further interest.
The elements used to determine simple interest are the principal, the rate of interest, and the length of
time that the principal is invested or borrowed. The formula for simple interest is as follows:
Interest = Principal Amount ×Annual Interest Rate ×Time Period
or
I =P × R × T

For example, Rs. 2,000 deposited for two years at an interest rate of 5 percent per annum would earn
Rs. 200 in simple interest (Rs. 2,000 x 0.05 x 2). The total amount received at the end of two years would
be the principal amount plus the interest, or Rs. 2,200.
If the amount is deposited for less than one year, then the time period is divided accordingly. For
example if Rs. 2,000 is deposited for a period of 9 months at an interest rate of 5%, then the amount of
interest is calculated as below:
Interest = Rs. 2,000 x 0.05 x (9/12)
= Rs. 75
Compound Interest
Compound interest differs from simple interest in that interest is paid not only on the principal but also on
the accumulated interest, assuming that the interest is left to accumulate. The greater the number of
periods for which interest is calculated, the greater is the accumulation of interest earned on interest plus
interest earned on the principal.
The formula for compound interest is expressed as follows:
Future Value = Principal (1 + Interest Rate)n
or
FV = P (1 + i)n
where
FV = Total future value (principal plus total compound interest)
P = Principal (amount invested)
i = Interest rate per year or annual percentage rate
n = The number of periods at the interest rate
Example:
To illustrate the difference between simple and compound interest, assume that Rs. 100 is invested at
an interest rate of 5 percent per year for five years and the interest is not withdrawn. If compounded
annually, the compound interest earned would be Rs. 27.63, while the simple interest earned would be
Rs. 25, as shown in the figure.

The principal amount of Rs. 100 is used to determine the interest in the simple interest method, whereas
compound interest uses the principal plus the accumulated interest from the previous year to calculate
the interest for the next year. Thus, when given a choice between investing in a simple interest or
compound interest account, you should choose compound interest, assuming risk and all other factors
are the same.
You can see that the difference between the compound interest and simple interest figures is quite
significant if the amount is invested for a period of only five years. This difference grows quite rapidly as
rate of interest increases. Consider this example:
Compounding Effect as ROI increases:
Impact of Inflation
Definition
Inflation is the tendency of prices to rise over time.
Learnings
Through this example, you will see that as time goes by, the expenses will only increase, by the order of
inflation. It is safer to ensure that you are geared up for it today.
Inflation erodes the value of your financial assets. For example, suppose you are able to fulfil all your
household needs for Rs. 10,000 currently. If the rate inflation is 4% p.a., it means that the same household
goods will cost Rs. 10,400 next year. As we have seen the impact of compound interest, this would
mean that in about 18 years the cost of all goods will be twice their current cost.
What this means is that a rupee today is more valuable than a rupee in the future. Also it implies that all
investments that you make should earn you a return that is in excess of the rate of inflation.

The concept of time value of money is therefore important to understand for making the apprpriate
investment choices. For instance, investment products that offer payments spread over many years are
often far less attractive than they seem at first glance. Likewise, investment products that return money
to you sooner offer better returns than those that defer payments till late.
The time value of money is a double-edged sword. It benefits you by increasing the size of your savings
but at the same time inflation will decrease the value of your holdings.
Chapter Review

Chapter 8

The Financial Planner's Toolkit
As a financial planner, you will be doing a lot of mathematical calculations for your clients. Doing
these calculations for a large number of years is very tricky and difficult if you do not use the correct
tools. It is recommended that you use either computer spreadsheet software like MS Excel or a financial
calculator to do these calculations.
Basic Concepts of Time Value of Money
Money today is more valuable than money in future. This is because when you forego spending money
at present, you can earn interest on it. Interest can be considered to be the rent for money. When you
give your house to somebody to live in, you get some money as rent. Similarly, when you deposit your
money with somebody, you get interest as rent.
Interest is expressed as a rate or percentage. The amount of interest that you receive is determined by
multiplying the time for which you deposit the money with the rate of interest and with the amount of
money that you deposit. So the future value of your money is calculated as below:
Future Value = Original Amount Deposited + Interest on the original amount
The original amount that you deposit is referred to as the Principal. Since it is the amount that you have
at present, it is also known as the Present Value.
Therfore the generalized formula for calculating interest is:
FV = PV + PV x R x T
Or FV = PV(1+R)T
Where,
FV = Future Value
PV = Present Value
R = Rate of Interest
T = Time period
Interest can be calculated in two ways:
Simple Interest
This is when interest is calculated on the principal amount only.
SI = PV x R x T
Where,
SI = Simple Interest
R = Rate of Interest
T = Time period

Compound Interest
This is when the earned interest is also deposited alongwith the principal and you also receive interest on
interest. To illustrate, 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
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 Rs. 8 i.e. 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
Let us now look at various scenarios where you may be required to calculate present value and future value.
A Single Cash Flow
Future Value of a Single Cash Flow
The future value of a single cash flow with simple interest is given by:
FV = PV(1+r)t
Where,
FV = Future Value
PV = Present Value
r = Rate of Interest
t = Time period
The future value of a single cash flow with compound interest is given by:
FV =PV (1+r)t
Where,
FV = Future Value
PV = Present Value
t = Time period
MS Excel
The Excel FV function can be used to find out the future value of a single cash flow. The FV function is:
= FV(RATE,NPER,PMT,PV,TYPE)
Where,
RATE is the interest rate for the period;
NPER is the number of periods;
PMT is the equal payment or annuity each period;
PV is the present value of the initial payment; and
TYPE indicates the timing of the cash flow, occuring either in the beginning or at the end of the period.

The PMT and TYPE parameters are used while dealing with annuities.
Note:
The initial payment is a cash outflow, while the future value is a cash inflow for the investors. Accordingly,
we need to treat the initial payment as ‘negative’ in value.
Financial Calculator
Use [ ] [ ] to select “Set:”, and then press [EXE]
Press [2] to select “End”
Use [ ] [ ] to select “n”, input 8, and then press [EXE]
Use [ ] [ ] to select “I%”, input 12, and then press [EXE]
Use [ ] [ ] to select “P/Y”, input 1, and then press [EXE]
Use [ ] [ ] to select “PV”, input –22,000, and then press [EXE]
Use [ ] [ ] to select “FV”
Press [SOLVE] to perform the calculation
Present Value of a Single Cash Flow
The present value of a single cash flow is given by:
PV = FV / (1+r)t
Where,
FV = Future Value
PV = Present Value
t = Time period
MS Excel
We can find the present value of a single cash flow in Excel by using the built-in PV function:
= PV (RATE, NPER, PMT, FV, TYPE)
Suppose that a firm deposits Rs. 22,000 for eight
years at 12 per cent rate of interest. How much would
this sum accumulate to at the end of the eight year?
F8
= PV x (1+i)n
= 22,000 x (1+0.12)8
= Rs. 54,471.19
In column B7 we write the formula:
=FV (B4,B3,0,-B2,0). FV of Rs. 54,471.19 is the same
as calculated above.

Suppose that an investor wants to find out the
present value of Rs. 25,000 to be received after
13 years. Her interest rate is 9 per cent.
We enter in column B5 the formula:
= PV (B4,B3,0,-B2,0).
We enter negative sign for FV; that is –B2. This
is done to avoid getting the negative value for
PV.
You can also find the present value by directly
using the formula
PV = FV x
l
(l + i)n
The function is similar to FV function except the change in places for PV and FV. We use the values of
parameters as given in the following illustration:
Use [ ] [ ] to select (1) “Set:”, and then press [EXE]
Use [ ] [ ] to select (2) “n”, input 13, and then press [EXE]
Use [ ] [ ] to select (3) “I%”, input 9, and then press [EXE]
Use [ ] [ ] to select (6) “FV”, input 25,000, and then press [EXE]
Use [ ] [ ] to select “PV”
Future Value of an Annuity
An Annuity represents a series of equal payments (or receipts) occurring over a specified number of
equidistant periods.
Ordinary Annuity
Payments or receipts occur at the end of each period.

Annuity Due
Payments or receipts occur at the beginning of each period.
The future value of an ordinary annuity is given by:
Where
FVA = Future Value of Annuity
A = Annual Payment Amount
i = interest
n = number of years
The future value of an annuity due is given by:
FVADn = FVAn (1+i)
Where
FVADn = Future Value of Annuity Due
FVAn = Future Value of Annuity
i = interest
n = number of years

MS Excel
The Excel FV function for an annuity is the same as for a single cash flow. Here, we are given value for
PMT instead of PV. We will set a value with negative sign for PMT (annuity) and a zero value for PV. We
use the values for the parameters as given in the following illustration:
Suppose that a firm deposits Rs. 3,000 at the
end of each year for six years at 3 per cent rate
of interest. How much would this annuity
accumulate at the end of the sixth year?
F6
= 3,000 (FVA6, 0.03
) = 3,000 x 6.4684 = Rs.
19,405.23
In column C6 we write the formula:
= FV (B5,B4,-B3, 0, 0). FV of Rs. 19,405.23 is
the same as in the illustration.
Instead of the built-in Excel function, we can
also directly use the formula below to find the
future value:
We can enter the formula and find the future
value. We will get the same result.

Use [ ] [ ] to select (4) “PV”, input 0, and then press [EXE]
Use [ ] [ ] to select (5) “PMT”, input –3,000, and then press [EXE]
Use [ ] [ ] to select “FV”
Annuity of a Future Value (Sinking Fund)
In the previous example, we had seen that Rs. 3,000 deposited for a period of 6 years at 3% accumulates
to Rs. 19,405. However, if we wish to calculate the opposite – that is the value of annual payments that
will accumulate to Rs. 19,405 in 6 years at 3%, then the formula is given by:
Where
FVA = Future Value of Annuity
i = interest
n = number of years
MS Excel
The Excel function for finding an annuity for a given future amount is as follows:
= PMT (RATE, NPER, PV, FV, TYPE)
We use the values for the parameters as given in the following illustration:
Suppose that a firm earns Rs. 19,405 at the end
of for five years at 6 per cent rate of interest.
What is the annuity (PMT) of this value?
In column B6 we write the formula:
= FV (B5,B4,B2,-B3,0).
Note that we input both FV and PV and enter
negative sign for PMT. The value of PMT is Rs.
3,442.38.
Instead of the built-in Excel function, we can enter
formula:
and find the value of the sinking fund (annuity).
We will get the same result.

Use [ ] [ ] to select (4) “PV”, input 0, and then press [EXE]
Use [ ] [ ] to select (6) “FV”, input –19,405, and then press [EXE]
Use [ ] [ ] to select “PMT”
Shridhar invests Rs. 1 Lakh at the end of each year, in the retirement fund corpus. LICL has promised a
return of 10% pa. How much has his retirement corpus grown to in 20 years time.
Present Value of an Annuity
The present value of an ordinary annuity is given by:
Where
PVA = Present Value of Annuity
i = interest

The present value of an annuity due is given by:
PVADn
= PVAn
(1+i)
Where
PVADn
= Present Value of an Annuity Due
PVAn
= Present Value of Annuity
I = interest
n = number of years
MS Excel
The Excel PV function for an annuity is the same as for a single cash flow. Here we have to put in the
value for PMT instead of FV:
Suppose that an investor wants to find out
the present value of an annuity of Rs. 10,000
to be received for 5 years. The interest rate
is 9 per cent.
We enter in column B5 the formula:
= PV (B4,B3,-B2,0,0).
We enter negative sign for FV; that is –B2.
This is done to avoid getting the negative
value for PV.
You can also find the present value by
directly using the formula:

Use [ ] [ ] to select (5) “PMT”, input –10,000, and then press [EXE]
Use [ ] [ ] to select “PV”
Perpetuity
A perpetuity is an infinite annuity. In a perpetuity, the annual cash flows continue forever. The present
value of a perpetuity is given by:
PV = a/r
Where
PV = Present Value
a = Annual Payment Amount
r = interest rate
The concept of perpetuity finds application in case of stock valuation. Stocks are valued at present value
of their expected earnings. For example, suppose a company is expected to earn Rs. 5 every year. If the
discount rate is 10% then the value of the stock would be:
Price of Stock = PV of earnings = 5/0.10 = Rs. 50
Growing Perpetuity
The present value of a perpetuity that grows at a constant rate of g% is given by:
PV = a/(r-g)

Where
PV = Present Value
a = Annual Payment Amount
r = interest rate
g = growth rate of annual payments
To illustrate, a company expects to earn Rs. 5 per share in this year and expects its earnings per share (eps)
to grow at a rate of 6% every year. If the discount rate is 10%, then the current price of the share would be:
Price = 5 / (10-6) = 5/0.04 = Rs. 125
This formula also enables us to understand the PE Ratio in terms of the growth rate of earnings.
PE Ratio = Price per share / Earnings per share
Or
Where
P0
= Current Stock Price
e0
= Current Earnings per share
g = earnings growth rate
r = discount rate
Different Periods of Compounding
The future value depends a lot on the way the interest is compounded. Interest may be compounded
once a year or more frequently like semi-annually, quarterly, monthly or even daily. In such cases, the
future value is given by:

Where
FVn
= Future Value after n periods
r = rate of interest per period
n = number of periods
m = number of times of compounding per period
PV0
= Present Value at start of period 0
Exercise:
Let us see the effect of compounding at different periodicity:
Comparison of different compounding periods for Rs. 1000 invested for 2 Years at an annual interest rate
of 12%.
Annual FV2
= 1,000(1+ [.12/1])(1)(2
= 1,254.40
Semi FV2
= 1,000(1+ [.12/2])(2)(2)
= 1,262.48
Qrtly FV2
= 1,000(1+ [.12/4])(4)(2)
= 1,266.77
Monthly FV2
= 1,000(1+ [.12/12])(12)(2)
= 1,269.73
Daily FV2
= 1,000(1+[.12/365])(365)(2)
= 1,271.20
Therefore, you can see that although the stated rate of interest is 12% in each case, the results are
significantly different. The stated rate is also known as Annual Percentage Rate, APR. The Effective
Annual Rate, EAR, is the rate if there was compounding only once per period; it is true effective rate.
The relation between APR and EAR is given by:
If the compounding period is made infinitely small, it is known as continuous compounding. The EAR for
continuous compounding is given by:
Yield or IRR Calculation
MS Excel
Excel has built-in functions for calculating the yield or IRR of an annuity and uneven cash flows. The
Excel function to find the yield or IRR of an annuity is:
= RATE (NPER, PMT, PV, FV, TYPE, GUESS)
GUESS is a first guess rate. It is optional; you can specify your formula without it.

The Excel built-in function IRR calculates the yield or IRR of uneven cash flows:
IRR (VALUES, GUESS)
The values for the cash flows should be in a sequence, starting from the cash outflow.
GUESS is a first guess rate (arbitrary) and it is optional. In the worksheet, we have entered the cash
flows of an investment project. In column B4 we enter the formula: = IRR (B3:G3) to find yield (IRR).
Note that all cash flows in year 0 to year 5 have been created in that sequence. The yield (IRR) is
27.43 per cent.
You can also use the built-in function, NPV, in Excel to calculate the net present value of an investment
with uneven cash flows. Assume in the present example that the discount rate is 20
per cent. You can enter in column B5 the NPV formula: = NPV (0.20, C3:G3) +B3. The net present
value is Rs. 21,850. If you do not enter +B3 for the value of the initial cash outflow, you will get the
present value of cash inflows (from year 1 through year 5), and not the net present value.
In column C6 we enter the formula: = RATE (C5,
C4, C2, 0, 0, 0.10). The last value 0.10 is the
guess rate, which you may omit to specify. For
investment with an outlay of Rs. 20,000 and
earning an annuity of Rs. 5,000 for 8 years, the
yield is 18.62 per cent.
Use [ ] [ ] to select (3) “I%”, input 20, and then press [EXE].
Use [ ] [ ] to select “Csh=D.Editor x”, and then press [EXE].
This displays the DataEditor. Only the x-column is used for calculation. Any values in the y-column and
FREQ-column are not used.
-40,000 [EXE] (CF0).
15,000 [EXE] (CF0).
25,000 [EXE] (CF0).
30,000 [EXE] (CF0).
17,000 [EXE] (CF0).
16,000 [EXE] (CF0).
Press [ESC] to return to the value input screen.
Use [á] [â] to select “NPV: Solve”.
Press [SOLVE] to perform the calculation.
Use [á] [â] to select “IRR: Solve”.
Press [SOLVE] to perform the calculation.
Impact of Tax and Inflation
In the previous examples, we have considered the rate of interest without adjusting for tax or inflation. In
real life both of these factors reduce the real rate of return that an investor gets.

Exercise
1. Naina is 22 years old. She has recently started her work. Naina is working with an educational
institute and she has been trained to counsel students. Day in and day out, she talks to young
people about the careers and goals and where they want to be in life. This set her thinking in terms
of her future.
Her aspiration levels increased and she herself wanted to study further. She knew her potential and she
was getting educated on the job market and her areas of interest. After doing the initial research, she
concluded that she wanted to study abroad. However, as is well known, a 22 year old doesn’t have a
lot of money in her kitty. Also she knew that her parents could not take the burden of such a loan. She
decided that she would need to plan for fulfilling this dream of hers. She calculated the amount to be
Rs. 15 Lakhs. She wanted to have saved up Rs. 15 Lakhs in 8 years time. The average market return
is about 10%pa. How much would she need to invest to get Rs. 15 Lakhs in 8 years?
Also, if Naina invests in yearly installments rather than a one time proposition, how much will she
have to invest each year, so that she will have Rs. 15 Lakhs corpus at the end of 8 years at a 10%
rate of return.
2. Let us assume that an investor invests Rs. 1000 at 12% for a period of one year. Let us assume
inflation to be 6% and the tax rate to be 30%. The real return that the investor gets is calculated as
below:
Therefore the formula for finding the real rate of return is:
Real Rate = I(1-T) – R
Where
I = interest rate received
T = tax rate
R = rate of inflation
Amount Invested Rs. 1000
Rate of Interest 12%
Time Period 1 year
Interest received Rs. 120
Tax Rate 30%
Amount payable as tax Rs. 36
Amount after tax Rs. 84
Inflation Rate 6%
Amount Lost due to Inflation Rs. 60
Interest after tax adjusted for inflation Rs. 24
Effective Rate 2.4%

Chapter 9

Protecting your wealth
Once you have made an assessment of your current financial situation and decided on your financial
goals, it is time to develop and deploy strategies to achieve them.
Risk Mitigation
A business / financial proposition becomes risky, when one cannot predict the outcome of a decision.
However, by careful analysis and preparation the risk can be mitigated.
Protection
Asset protection or wealth protection essentially means safeguarding its financial value.
Let us see a corporate example to understand both sides of a coin :
Example
An IT company, primarily in software development has been affected by the strengthening of the rupee.
The earnings of the company has dipped. To protect itself from future fluctuations in exchange rate, it
quickly decides to diversify to closely related areas of business that it is already into. Besides doing
software development initiative, they have quickly spread their boundaries with a view to reducing their
risk and protecting their incomes.
Decrease outflow
This is a more passive conservative way by which wealth could be protected. Suppose you have Rs.
10,000 as your budget for the month. You can blow it up in a party by spending it once or twice or you
decide to spend not more than Rs. 300 a day and more importantly on the essentials first and
luxurious later.
Increase inflows
This is a more aggressive approach to wealth protection. A good example would be a B.Com student,
simultaneously studying for CA. During the student days, they build on their experience and earn minimally
to support their pocket money.
This way, they armor themselves with a thorough preparation for higher education and have learnt to
manage personal finances.
In the context of financial planning, we are concerned only with pure risks.

Types of Pure Risks
Pure risks that can cause financial insecurity can be categorized as below:
Let us look at these in more detail.
Personal Risks
Personal risks are those risks that directly affect an individual. They cause financial insecurity because
they usually result in reduction or stoppage of income, increase in expenses and depletion of financial
resources. Some of the major personal risks are:
Risk of premature death
Risk of poor health
Risk of temporary or permanent disability
Risk of insufficient income during retirement
Property Risks
Persons owning property face the risk of having that property damaged or destroyed or lost due to
different causes. They cause financial insecurity because they affect the income streams being produced
from usage of the property. They also increase expenses because the damaged/destroyed/lost assets
need to be repaired/replaced. Property risks can cause loss in two major ways:
Direct Loss
Indirect or Consequential Loss
Direct Loss
A direct loss results from physical damage, destruction or theft of property. For example, if your house
is damaged due to earthquake, the amount of loss is known as direct loss.
Indirect or Consequential Loss
An indirect loss results from the consequences of a direct loss. For example, if your house is destroyed
in an earthquake, you may have to live in a rented house till your house is repaired. The rent that you pay
is the indirect loss.
Liability Risks
Liability risks arise from the possibility of being held legally liable for the loss to another person. If a person
commits a mistake or because of negligence, causes bodily harm or injury to another person, a court of law
can order that individual to pay damages to the injured party. Liability risks can be categorized into:

Statutory Liability eg. Third Party Liability in M.V. Act, I.D. Act, W.C.Act, P.I.
Under Common Law eg. Libel and Slander
Under Contract eg. Contractual Obligations
These liabilities may arise in personal or professional capacity.
Personal Liability
Personal liability arises when a person acts negligently or carelessly during the course of his personal life
and causes harm to another. For example, if you hit a pedestrian with your car due to jumping traffic
lights, you may be asked to bear the treatment expenses and pay damages to the victim.
Professional Liability
Professional liability arises when a person harms another while performing as a professional. For example,
a doctor who causes harm due to a wrong diagnosis can be held professionally liable to pay damages to
the patient.
Liability risks cause financial insecurity because they result in depletion of existing financial resources.
Let us consider, Keshav who is running an industrial unit at Vapi, near Surat. His company manufactures
heavy machinery to handle equipments that are used in construction activities. He has employed a full
time work force of 10 workers and part time contractual workers, another 10 in number. Contractual
workers balance out the cost as well as the requirement needs during peak season.
His work force risks the possibility of permanent or temporary disability while at work. What category of
risk does this fall under?
Solution : This is a professional liability.
Some of the equipment is old and doesn’t function properly. During peak season, to make up for the
capacity, Keshav has to hire additional machinery to cover for the productivity loss due to his old
equipment.
What kind of loss is this?
Solution : This is an Indirect loss.
Chapter Review

Chapter 10

How can we manage risk?
While risks cannot be eliminated, measures can be taken to reduce the probability and size of loss
caused by risks. This process is known as risk management.
Response to risk
The different methods used for management of risk can be broadly categorized into two categories:
Risk Control
Risk Financing
Risk Control
Risk Control methods are those that try to minimize the losses from risks. These can be of two types:
1. Risk Avoidance
Risk avoidance is accomplished by not engaging in the action that gives rise to risk. Avoiding risk is an
appropriate strategy for high frequency and high severity risks.
While the avoidance of risk is one method of dealing with risk, it has many negative consequences. for
example, you can avoid dying in an air crash by giving up air travel, but it also means giving up the huge
time savings and convenience that air travel offers.
2. Risk Reduction
Risk reduction is achieved through loss prevention and control. For example, the risk of fire can be
reduced by measures like installing fire extinguishing systems and sprinklers, using fire retardant materials
in construction. It is an appropriate strategy for high frequency and low severity risks.
Risk Financing
Risk financing methods are those that pay for losses that actually happen. These can be of two types:
1. Risk Retention
Risk retention is used when the risk is retained. The retention may be voluntary or involuntary. This is an
appropriate strategy for low frequency and low severity risks. For example, the risk of suffering from
common cold can be retained. As a general rule, risks that should be retained are those that lead to
relatively small certain losses. The reason for retention is because there is a cost attached to transfering,
reducing or avoiding risk. It may be more cost effective to retain the risk since its frequency as well as
impact is low.
2. Risk Transfer
Risk transfer is the transfer of risk from one individual to another who is more willing to bear the risk.
Insurance is the most widely used means for reducing risk by transfer. Risk transfer is appropriate for low
frequency and high severity risks.

Risk Management
Let us try to understand these for concepts better through some examples.
Examples
1] Vikram had a run of 7kms from home to his office. There are two routes he can take. One route is
faster, but highly dangerous. It is a main highway and has a record number of accidents. In other words,
the area is accident-prone. The second route typically takes him 15-20 mins more. Since it is an inner
city road, it has less of heavy traffic and this route is considerably safer. Which kind of risk would you
classify this as? What is the best way to deal with it?
Since his travel frequency in that route was twice a day, back and forth from home to office, in case of
any accident, the impact would be fatal, hence it can be classified as high frequency, high severity risk
and best way to deal with it is Risk avoidance.
2] Anand was earning well in his company. His friendliness was unfortunately taken as his vulnerability.
Whenever, any of his friends needed some money, they would invariably ask Anand. Anand could never
say no, and always felt that he should help someone in need. The loan was always given on a returnable
basis, but that never happened. What kind of a financial risk does it entail? How should it be handled?
This can be classified as high frequency, low severity risk hence best way to handle it would be Risk
reduction.
C] Prem was to take an official trip to USA. His wife also wanted to join him, as a personal holiday trip. His
company gave Prem an insurace cover. Should his wife also take an insurance cover? What are the risks that
could arise incase the risk cover is not taken? What is the category of risk and how should it be handled?

The chance of his wife meeting with an accident is low, however if she does, the severity would be high
hence best way to deal with this is Risk transfer.
D] Laxman and Preet used to go and play together everyday with the other boys of the building. All of
them got together and played cricket in the nearby playground.It is quite possible that one of them gets
hurt while playing.
What is the probability and the risk of such an injury? How should such a risk be handled?
It is a case of low frequency and low severity, hence Risk retention is the best way to deal with it.
Personal Risk Management
The methods discussed above can also be applied to the financial risks to which an individual is exposed.
List of some of these events that have the potential to cause financial loss (whether through increase in
expenses or through decrease in earning potential) are given below:
Death
Disability
Major surgery or hospitalization
Illness
Liability for injuries to others
Burglary of home
Destruction of house and contents
Car accident – major or minor damage to car
Professional Liability, etc.
Steps to handle Personal Management Risk:
Step 1 : List down all the risks.
Step 2 : Rate each event for severity of financial loss. Severity of financial loss can be categorized into:
a. Extremely Severe – an event that is financially devastating, possibly resulting in bankruptcy.
b. Very Severe – an event that has a huge financial impact that can radically change lifestyle of the
affected person.
c. Moderately Severe – an event that has an uncomfortable but manageable financial impact.
d. Not Severe – an event that has very little financial impact, that can be covered by emergency cash
reserves held in liquid form.
Step 3 : Rate each event for probability or frequency of occurrence. Frequency of occurrence can be
categorized into:
a. Extremely Probable/Frequent – an event that is almost certain to happen, or that happens very
frequently.
b. Very Probable/Frequent – an event that is quite likely to happen, or that happens often.
c. Moderately Probable/Frequent – an event that could happen, or that happens infrequently.
d. Not Probable/Infrequent – an event that is unlikely to happen, or that almost never happens.

Step 4 : Plot all events into the four quadrants as per the following rules:
High frequency and High severity Risk Avoidance Quadrant
High frequency and Low severity Risk Reduction Quadrant
Low frequency and High severity Risk Transfer Quadrant
Low frequency and Low severity Risk Retention Quadrant
Step 5 : Compare the recommended methods of handling risks with the ways they are currently handled,
to identify gaps or mismatches in the current risk management strategies.
Create an action plan to plug the identified gaps. Keep in mind that:
Step 6 : The topmost priority must be given to risks that should be avoided or transferred but are being
borne. These risks can completely wreck the financial affairs of a person. Accordingly, they need to be
handled foremost. Next priority should be given to risks that should be reduced but are being currently
borne. These risks should be immediately managed by making lifestyle changes and by putting appropriate
loss control mechanisms in place. If risks that should be borne have been transferred through insurance,
the amount of insurance may be reduced or completely eliminated. The resultant cost savings should be
employed into addressing the other gaps. The most common method of risk transfer is insurance. In the
next chapter, we will discuss the relationship between risk and insurance.
Chapter Review

Chapter 11

Insurance is the most common method used for transferring risks. It transfers the risk from an individual
to a group. It also provides a means for paying for losses. Insurance provides an important means of
preventing risk from interfering with a client’s achieving financial objectives.
How Insurance works?
To understand the concept of insurance, let us imagine a small town with 100 houses. The town is
located in an area where storms of great severity occur frequently.
Each family in the town faces the risk that a storm will destroy their house completely. If the house is
destroyed, the family will have to spend Rs. 50,000 to reconstruct the house. However, at the same
time, it is unlikely that a storm will destroy all the 100 houses simultaneously.
Let’s suppose all the citizens of the town agree to share the losses (if and when they occur) equally, so
that no single family will be forced to bear the entire loss of Rs. 50,000. This means that whenever any
house is destroyed, every family will pay a sum of Rs. 500 to the affected family to rebuild their house.
While the cost of Rs. 50,000 would have been crippling for a single family, the expense of Rs. 500 is
easily affordable.
Thus, the risk is transferred from a single family to the entire village and the loss (when it occurs) is
shared.
In our example, the risk sharing and risk transfer is dependent upon the town people successfully agreeing
to bear the expenses of reconstruction of houses. In the real world, it would be very difficult to reach at
such an agreement and even more difficult to enforce it, because:
Some people might not agree to be part of such an agreement, making it difficult to reach the large
numbers of participants necessary for the scheme to work.
Some people might not pay their share, even though they were part of the agreement.
Someone would need to perform the task of collecting money from the people and providing it to the
affected family.
In the real world, insurance companies act as facilitators and remove the obstacles to risk transfer and
risk sharing. They perform the functions of making agreements, collecting money, calculating losses
and providing payments to affected persons.
Risk and Insurance

Definition:
Insurance is defined as an economic device whereby the individual can substitute a small definite
cost (the premium) for a large uncertain financial loss (the risk).
In the larger perspective, let us hear what an insider has to say from an expert view point.
Expert View
In an interview Mr.K R Subramanian, COO, ING Vysya Life mentions that in a fiercely competitive
market like life insurance, all players deal in similar products. They use the same Indian mortality
assumptions and pricing. “The only differentiating factor is cost leadership and efficient service. We
have to issue policies faster and make sure that normal insurance applications are processed quickly.”
Subramanian feels that there is a need to build awareness about risk management so that people adopt
good risk minimisation methodology. Insurance is a crucial element of transferring risk. Today’s well-
informed customers want to spend an allotted amount intelligently.
“Insurance has developed to such an extent that it can shift risk from insurance to the capital market by
means of a methodology called alternate risk transfer (ART). This includes catastrophe bonds, for instance
you get a particular return if earthquake hits Japan or you get another value as return if an earthquake
does not hit Japan,” says Subramanian. These are high end investment instruments targeted at very
specific well informed clientele.
Pooling of Risks
To perform the function of insurance and to carry out their own activities, insurance companies need to
collect contributions from individuals. But since losses are unpredictable, how does the insurance company
decide how much to collect from each individual?
The theory of probability deals with random events and postulates that while some events appear to be
a matter of chance, they actually occur with regularity over a large number of trials revealing a measurable
pattern.
To draw an analogy – it is difficult to state with confidence whether the daytime temperature will cross 40° C
on a particular day in Delhi, but if data for the past 15 years is collected, it can be seen that in Delhi, the
daytime temperature exceeds 40° C on most days in May and June. Study of historical data is an important
means to understand probability of occurance. Statistical tools are also employed to this effect.

This phenomenon is known as the Law of Large Numbers.
Definition:
The law of large Numbers implies that the frequency with which an event happens, reflects the actual
probability of the event occurring more closely if the number of cases involved is larger.
The law of large numbers finds many applications in the field of insurance. The most important of them
is that if the risks faced by a large number of individuals are pooled together, then the probability of the
adverse events actually occurring can be predicted quite accurately. This enables the insurance companies
to predict the losses that will actually occur over a period of time and thereby fix the contributions
payable by each individual.
Insurance companies also employ other statistical techniques like regression analysis, loss distributions,
mortality tables to arrive at the probability of occurrence of a particular event which, in turn, is used to fix
the level of premium contributions.
Characteristics of Insurable Risks
Insurance thus appears to be an elegant solution for transfer of all risks. With relative ease, an individual
can be free of all risks that can cause financial insecurity. However, not all risks are insurable. Insurance
companies do not cover speculative risks. They cannot be expected to absorb risk that a person creates
wilfully in expectation of a profit. The essential characteristics of insurable risks are:
The risk must be a part of a large number of homogeneous units; otherwise the law of large
numbers will not apply – making it difficult to estimate the probability of losses.
The loss due to the risk must be definite and measurable. The insurer must be able to determine
that a loss has occurred and to accurately measure the economic impact of the loss. This is because
insurers can only provide re-imbursement of the financial loss occurred. They cannot always undo
the damage done. For example, a rare painting of say, Picasso, if destroyed, can’t be reconstructed.
The damage or loss due to the risk must be fortuitous or accidental. Insurers cannot be held
responsible to pay for certain (intentionally caused) losses.

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