YTM method to calculate pre-tax return on deposit

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SummaryRecently, a public sector bank came out with a five-year fixed deposit scheme where it promises to pay an annual pre-tax yield of 17.39% for senior citizens.

Recently, a public sector bank came out with a five-year fixed deposit (FD) scheme where it promises to pay an annual pre-tax yield of 17.39% for senior citizens. This has raised eyebrows as the annual pre-tax yield of 17.39% is somewhat better than what the present market conditions offer.

This opinion holds greater significance when one looks at the pessimistic macroeconomic environment scenario for the forthcoming financial years.

Scheme details: The initial amount required to be deposited is R10,000. The FD offers an annual interest rate of 9% for five years for senior citizens with a maturity period of five years. The interest rate for non-senior citizens is 8.5% per annum, while other features of the FD are the same for them. The bank will return Rs 10,000 at the end of the fifth year to the investor, along with the interest proceeds. The scheme also offers income-tax deduction for the amount of deposit, subject to a total ceiling for deduction of R1 lakh. This deduction brings down the initial deposit amount of R10,000 by 30% to R6,910, assuming the investor is in the 30% tax slab. The investment cannot be pre-closed before the expiry of the maturity period.

The big question: At the outset, it is not believable to earn 17.39% annual return from a FD as it is something historic and even if one assumes an annual inflation rate of 8%, this investment vehicle offers 9.39% real rate of return, which is on par with the returns offered by equity investments in our country.

Yield to maturity: The calculation of 17.39% is arrived by using the YTM concept.

According to this method, the market values an investment based on the present value of all the return streams and the redemption of the principal amount, i.e., the maturity amount at the expiry of the investment horizon.

In other words, the concept states that an investment is exactly worth the present value of its returns (i.e., the annual interest payments and the amount of maturity to be paid by the bank at the end of the maturity period).

In simple words, to draw an analogy with capital expenditure investment decisions, YTM is nothing else but the internal rate of return (IRR) of the fixed income security. YTM is normally computed on a trial and error basis. (Our calculations shows that at an YTM of 19%, the amount comes equal to the initial investment of R6,910. The number

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