Real Returns Calculator

/ M. Pattabiraman / 18 Comments

Published: December 23, 2013 at 6:42 pm

Last Updated on

Photo of M Pattabiraman, founder, editor and primary author of freefincal.com By M. Pattabiraman   

Use this real returns calculator to check how effective a  financial instruments is in protecting the purchasing power of a lumpsum from inflation.

The reserve bank of India has announced the issue of inflation linked bonds in which a lumpsum  invested for 10 years will receive an interest equal to 1.5% + ‘change’ in the consumer priced index (CPI).

This change in the CPI is explained quite well here: Inflation Indexed Securities: Buy if at Lower Tax Slabs

Unfortunately, income from these bonds will be taxed as per income slab on maturity. So if you think the buying power of your lump sum will be protected from inflation, think again.

You will need to calculate the  real return after taking taxes into account to check if the buying power has been protected from inflation.

What is a real return? A real return is the return from a financial instrument after accounting for inflation and taxes. Most discussions of real return ignore taxes and simply account for inflation.

A real return gives an idea of how much the purchasing power of a lump real-returnsum has changed upon maturity of a financial instrument.

The post-tax real return is calculated as shown in the picture

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real-return

If the real return is 1%(-1%)  then the purchasing power of the lump sum has enhanced (diminished) by 1%  (-1%).

  • If the real return is zero, the purchasing power of the lump sum is unchanged. That is inflation and taxes have exactly nullified the return from the financial instrument.
  • Intuitively, it is clear that because of the nature of taxation (as per slab), the real post-tax return from these inflation indexed bonds will be quite low.
  • The above post-tax return is valid if tax is paid as per slab each financial year.
  • If tax is paid as per slab upon maturity, the formula is (thanks to Ronnie Joshua Reuben for pointing out an error)

post-tax-return =[(1+return)^duration x (1-tax)]^(1/duration) -1

Here is a real returns calculator with which you can access the effectiveness of these RBI inflation indexed bonds or any other financial instrument in protecting the purchasing power of a lumpsum from inflation. Both types of post-tax return computation are included.

Download the Real Returns Calculator – RBI Inflation Linked Bonds

 Notes:

  • The calculator can be used for any financial instrument. Set the base interest rate (1.5% for inflation indexed bonds) to zero for other financial instruments.
  • The calculator gives you only estimate. For inflation indexed bonds, the net pre-tax return will be known only on maturity and will be determined by the course of inflation.
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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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18 Comments

  1. Dear Pattu, an important post just in time. Not many people give a thought to real return after Inflation and taxation.

    thanks

    Ashal

    Reply

  2. Dear Pattu, an important post just in time. Not many people give a thought to real return after Inflation and taxation.

    thanks

    Ashal

    Reply

  9. Sir can you help me understand the POST TAX RETURN on MATURITY FORMULA, i see that it is some what similar to the effective rate of interest formula but (+ tax term) I fail to understand. If you can hint me towards the source then i will surely look into that. Thanks!!

    Reply

    1. Hi Ronnie, you are correct about the + tax term. It is wrong. I have corrected the equation and the excel file. Thank you so much. Here is the math for those interested.

      maturity =investment x (1+return)^duration
      maturity(post-tax) = (investment x (1+return)^duration) x (1-tax)
      maturity(post-tax)= investment x (1+post-tax-return)^duration
      So
      investment x (1+post-tax-return)^duration =(investment x (1+return)^duration) x (1-tax)
      (1+post-tax-return)^duration =(1+return)^duration x (1-tax)
      post-tax-return =[(1+return)^duration x (1-tax)]^(1/duration) -1

      Reply

  10. Sir can you help me understand the POST TAX RETURN on MATURITY FORMULA, i see that it is some what similar to the effective rate of interest formula but (+ tax term) I fail to understand. If you can hint me towards the source then i will surely look into that. Thanks!!

    Reply

    1. Hi Ronnie, you are correct about the + tax term. It is wrong. I have corrected the equation and the excel file. Thank you so much. Here is the math for those interested.

      maturity =investment x (1+return)^duration
      maturity(post-tax) = (investment x (1+return)^duration) x (1-tax)
      maturity(post-tax)= investment x (1+post-tax-return)^duration
      So
      investment x (1+post-tax-return)^duration =(investment x (1+return)^duration) x (1-tax)
      (1+post-tax-return)^duration =(1+return)^duration x (1-tax)
      post-tax-return =[(1+return)^duration x (1-tax)]^(1/duration) -1

      Reply

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