The World of Investments and Money

Friday, May 18, 2007

How double indexation works for FMPs

My last post discussed FMPs and why they are better than FDs because of Double indexation benefits. I'll discuss how double indexation works for FMPs against FDs, for the same amount of investment:

Let's say you invest Rs 1000 in FDs and Rs 1000 in an FMP in March this year.
The maturity value in May next year for both FD and FMP = Rs 1100 approx.
Assuming inflation of 6%, the cost price of your investment after March this year = 1000 + 1000*6/100 = Rs 1060
Cost price of Rs 1060 after March next year = 1060+ 1060*6/100 = Rs 1123.6
For FMPs the maturity value of Rs 1100 is less than the cost price of Rs 1123.6, that is you are at a loss in paper. This happen because the effect of inflation in case of FMPs is calculated twice, at the end of March this year (that is the financial year end) and also at the end of March next year. This results in capital gains tax = 0. This is double indexation benefit.

For FDs, the cost price = Rs 1060 ( it is calculated only once ).
Maturity value of Rs 1100 is more than cost price, so you have to pay capital gains tax on the interest earned.

This results in FMPs giving a post tax return of about 8.5%, where as FDs give about 5.5%. This is for a period of about 13 months of investment that started in March and ended in May.
FMPs don't work for you in case you want to withdraw the money invested before the maturity period. Then FDs might be a better choice.
If one is sure they can remain invested for the period, then FMPs are a good choice over FDs.


Raj Gopal Vuppala said...

Nice explanation of double indexation benefit.

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