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Investing for good post-tax returns

Last updated on: May 10, 2010 11:31 IST

Investors often get very excited when banks and companies offer returns of 8 per cent and 10 per cent because they seem extremely high.

And especially, in a volatile equity market, an assured return of 8 per cent in a bank fixed deposit (FD) seems like the best bet. However, look at absolute returns while making investment decisions.

Investors in all kinds of instruments need to pay tax on the returns. And then, there is the impact of inflation and tenure that needs to be taken into account. Let's try to understand how these impact the returns on investment.

Tax-adjusted returns

Investors are required to pay taxes on the income they earn from investments. Your tax bracket depends on your taxable income. The income liable to tax is required to be adjusted for the tax liability.

To illustrate, let's calculate the effective returns for a bank deposit at various interest rates. The table below gives the returns for an individual falling in the 10 per cent, 20 per cent and 30 per cent tax bracket:

*Calculation done with education cess and higher education cess at 2% and 1%, respectively

As can be seen, even if you invest in a bank FD at nine per cent interest, your tax-adjusted return will be only 6.22 per cent in case you fall in the 30 per cent tax bracket.

Thus, even if an FD fetches you nine per cent, if you consider the tax element, it may not be attractive. A similar method has to be adopted to evaluate investment in post office savings deposits, company fixed deposits, GOI bonds and taxable corporate bonds.

At times, some investment may not be attractive on absolute return but have a good post- tax return. We mention some:

Public Provident Fund (PPF): Public Provident Fund is one attractive investment avenue, with high post-tax yield. Currently, it gives a tax-free return of 8 per cent.

So, post-tax yield comes to around 11.55 per cent for a person at the highest tax bracket, that is, 30 per cent. In addition, investment up to Rs 70,000 per annum qualify for rebate under section 80C of the Income Tax Act.

A PPF account can be opened at any branch of State Bank of India or its subsidiaries or at post offices or at branches of nationalised banks.

The minimum and maximum amounts that can be invested in a year are Rs 500 and Rs 70,000, respectively. An account matures in 15 years; however, withdrawal is permitted after completion of the sixth financial year from the initial year of subscription.

Liquid Funds: For investors looking to park their money for the short term, liquid funds are an attractive option. At present, liquid funds are offering a pre-tax return of four to five per cent, more attractive than a bank FD for a very short to short tenure.

The added advantage in these funds is that you can redeem the units at any time, whenever you require the money. Popular liquid funds include ICICI Prudential Liquid Fund, HDFC Liquid Fund, LIC Liquid Fund and Reliance Liquid Fund. The minimum investment varies from Rs 5,000 to Rs 25,000, depending on the fund.

Good dividend-yield stocks: In India, there are stocks listed on bourses with a dividend yield of more than four to five per cent. Investors may note that the dividend received on equity shares is tax-free in the hands of the investor. Hence, a dividend yield of four to five per cent is very attractive.

In addition, if these shares are held for the long term, they can get you capital appreciation, too. Examples of high dividend stocks are Tata Investment Corporation, Merck, GNFC, Vijaya Bank, Bank of Maharashtra and Castrol.

Inflation adjustment

Tax is not the only aspect that has to be adjusted from the returns. Inflation is another aspect that needs to be considered while calculating the 'real' returns.

When an investment is made, you postpone your current consumption for future income. If during the period of investment the price of goods or services rises, you require more money to acquire these. It is, therefore, essential to adjust your total return on investment for inflation. This is known as the real rate of return.

To illustrate, let's consider Sheela's case. Interest earnings on investment of Rs 10 lakh for a year is Rs 80,000. That is a rate of return of eight per cent.

However, at an inflation rate of six per cent, the real return after adjusting for this, would be only two per cent (eight minus six). If inflation is more than eight per cent (as in India presently), the real rate of return would be negative.

Holding period return

Another aspect is the time element. The period you own an investment is known as its holding period and the return for that period is the Holding Period Return (HPR). This is the total return earned by holding an investment for a given period.

For example, you buy two stocks, say HDFC and SBI, for Rs 2,000. Let us assume you sell HDFC after a year for Rs 2,500 and SBI for Rs 2,800 after two years.

Then, the absolute return on HDFC is 25 per cent and on SBI, 40 per cent. However, considering the holding period, the return is 25 per cent and 20 per cent for HDFC and SBI, respectively.

Measuring your return on investment is critical for evaluation. It helps in building a better portfolio and taking asset allocation decisions. These examples clearly show that taxes, inflation and time are important factors to consider while evaluating investment returns.

The author is a freelance writer.

Ashish Pai
Source: source
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