2013 AM Mock Institutional IPS

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luftwaffle

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This is question #6 on 2013 AM Mock.
Some details provided are as follows:
  • New university foundation created with initial value of 100 million
  • 3 million is given out at the start of year 1 from the foundation
  • starting in year 2, the foundation will recieve 2 million at the start of the year
  • Starting in year 2, the spending requirement will be 6% of the preceding year portfolio value.
  • Inflation rate is 3.5% for the university
  • Investment advisor is hired with management fees of 0.4% per year based on the year end value of the portfolio, paid on first day of the following year
What is the return requirement for year 2?
The CFA answer: 6% + 0.4% + 3.5% (or multiplicative works as well)
Can someone explain why you wouldn’t calculate an exact return requirement? Do you always just add up the spending rate and fees and inflation?
For example what I did:
100 milion - 3 million given out = 97 million left at the end of the year 1
Required distribution = .06(97 million) = 5.82 million - 2million (recieved at start of year 2)Total = 3.82 million
Required return = (distribution/year 2 starting value) + inflation + management fee = (3.82/97) + 0.035 + 0.004 = 7.83%
Although in the question, the return earned during the first year wasn’t specified, so the starting year 2 value is probably not accurate. I was kinda confused about this one.
 
all 3 components of the return are based on the value of the portfolio at T=1, you should be getting the same total return calculating it using $ or just simply percentages. This is how I think the math is supposed to work out
97 * .06
97 * .035
97 * .004
——————–
9.6m / 97 = 9.9% (same as CFAI answer)
 
Ah I see the mistake. But do we not reduce the required distribution by the incoming cash? That’s what I’m kinda confused about. Your spending dollar amount should then be lower?
 
I did the same mistake. I thought that the yearly donation would obviously reduce the return requirement. Connects to the last part of the excercise where it asks how it influences return requirements when donations end. CFAI says that it has no effect.
Why is a yearly, predetermined inflow of cash not relevant for the return requirement?
 
The foundation would still have to maintain its real purchasing power regardless of the yearly annual contribution…the annual contribution does not affect the return requirement in anyway
 
luftwaffle wrote:
Ah I see the mistake. But do we not reduce the required distribution by the incoming cash? That’s what I’m kinda confused about. Your spending dollar amount should then be lower?
Click to expand...
Ya I consider this one of the “tricks” to the test where the wording is sneaky. Technically the objective is to maintain it’s base value regardless if it has income or not. The whole 6% thing was never mandated.
 
I still don’t get it. If they know that they’ll have an inflow of 2mln each year, doesn’t this lower the return requirement? I don’t get why they completely ignore it in the answer.
 
Ah ok, reading helps “The Foundation’s goal is to preserve the real value of its investment portfolio and any future contributions”.That’s why the contributions are not subtracted
 
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