2013 Q1 A

[whatsyourgovt]

In the answers they adjust the cash for this year for inflation (300 x 1.025), but they also tack on an inflation adjustment to the required return too (they take the required return derived from cash needed after inflation / total investable assets and multiply that figure by inflation). To me, that is double accounting for inflation.
My second problem is, to my knowledge, no adjustment for taxes. I divided my return figure by (1-t) to get what i thought was the after tax return.
Can someone break this first problem down for me please?

 

[cpk123]

next year you need 300*1.025 - inflation adjusted living expenses.
End addition of 2.5% is to maintain the spending power of the portfolio.
And this is NOT the only exam where they do this piece. It is done in EVERY IPS problem that I have seen in the CFAI land.

 

[whatsyourgovt]

Thanks cpk, ive seen this in most of them as well. Does my question not logical though? If you adjust the expenses every year for inflation and use that figure to derive your return requirement, isnt the spending power of the portfolio already maintained?
Forget the tax question, that makes sense now.

 

[cpk123]

nope it does not… you still need to increase the amount on the actual portfolio.
S2000 has a write up on this I believe and a similar question was asked a couple days ago as well.

 

[Would You Look]

whatsyourgovt wrote:
My second problem is, to my knowledge, no adjustment for taxes. I divided my return figure by (1-t) to get what i thought was the after tax return.
Can someone break this first problem down for me please?

When you divide your calculated return by (1 - tax rate), you are grossing the number up to a pretax return.
For example, in 5 months you are going to buy a bike for $1,000 dollars. You, therefore, know you need $1000 after all income taxes (the person selling you the bike does not care how much you have to pay in income taxes, he only cares about the $1,000 you owe him for the bike). You are subject to a 25% tax rate. If you need $1,000 after taxes, you actually need to earn 1000 / (1 - 0.25) $1,333.33 before you pay income taxes to wind up with the $1,000 for the bike. $1,333.33 - (0.25 x 1333.33) = $1,000.
I was only illustrating that because you seem confused on the calculation in general. The question on the 2013 exam you are referring to does not require you to calculate a PRE-Tax return. If you do, you are unnecessarily calculating it and will get it wrong since the question asked for after-tax return.

 

[dwheats]

Would You Look at That wrote:

whatsyourgovt wrote:
My second problem is, to my knowledge, no adjustment for taxes. I divided my return figure by (1-t) to get what i thought was the after tax return.
Can someone break this first problem down for me please?

When you divide your calculated return by (1 - tax rate), you are grossing the number up to a pretax return.
For example, in 5 months you are going to buy a bike for $1,000 dollars. You, therefore, know you need $1000 after all income taxes (the person selling you the bike does not care how much you have to pay in income taxes, he only cares about the $1,000 you owe him for the bike). You are subject to a 25% tax rate. If you need $1,000 after taxes, you actually need to earn 1000 / (1 - 0.25) $1,333.33 before you pay income taxes to wind up with the $1,000 for the bike. $1,333.33 - (0.25 x 1333.33) = $1,000.
I was only illustrating that because you seem confused on the calculation in general. The question on the 2013 exam you are referring to does not require you to calculate a PRE-Tax return. If you do, you are unnecessarily calculating it and will get it wrong since the question asked for after-tax return.

wow i did that same as whatsyougov and grossed up the after tax. i see im wrong in doing that now..