A really tough question!!!

jlpalu

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Barbara Analee, a retired registered nurse and business woman, recently retired at age 50 to pursue a life as a blues singer. She had been running a successful cosmetics and aesthetics business using state-of-the-art lasers to treat wrinkles and skin blemishes. She is married to Tom, a retired scientist (age 55). They have saved $3 million in their portfolio (Barbara contributed $2.5 million to this portfolio) and now they want to travel the world. Their three children are all grown and out of college and have begun to have their own families. Barbara now has two grandchildren. Barbara and Tom feel that they have achieved a comfortable portfolio level to support their family’s needs for the foreseeable future.
In order to meet their basic living expenses, Tom and Barbara feel that they need $75,000 per year in today’s dollars before taxes to live comfortably. As a trained professional, Barbara likes to be involved in intensively researching investment opportunities. Barbara and Tom want to be able to provide $10,000 per year (pretax) indexed for inflation to each of their grandchildren over the next ten years for their college education. She believes that she can accomplish this through her portfolio. She also wants to set aside $15,000 each year (pretax) indexed for inflation for traveling for her musical performances at various dinner clubs around the U.S. They have no debt and they own their home without a mortgage. Most of their portfolio is currently in large cap U.S. stocks and U.S. Treasury notes and bills.
They have approached Pamela Jaycoo, CFA, for guidance on how they could best achieve their financial goals while also providing for their grandchildren’s college needs. Inflation is expected to increase at an annual rate of 3 percent into the foreseeable future.
For this question only, assume that Barbara has accepted an offer to work part-time as a lounge singer in Las Vegas for the next five years but still continue with her traveling as a blues singer. This position will pay her a gross income of $45,000 annually. However, the Analees annual living expenses will increase to $85,000. After five years, Barbara plans on returning to retirement at which point, the Analees living expenses will return to 75,000 per year in today’s dollars. Also assume they will live for 30 more years.
Based on this new information, what is the Analees return objective?
A) 2.39%.
B) 6.97%.
C) 6.48%
 
I dont have the calculator , but i will describe my process
1) Calculate PV of expenses for grandchild
I/Y = 3% , N= 10, FV = O, PMT = -20000, PV = ?
2) Calculate PV of extra income ( 45,000 - 10,000)
I/Y = 3%, N=5, FV=0, PMT = +35000, PV = ?
3) Add (2) , subtract (1) from 3 million
Calculate return = 75000 / (answer to 3)
Add inflation
 
how it is possible for you to use 3% as the discount rate? what’s 3%?
also how is the logical process of calculating the extra income of 45k-10k?
this question itself is somewhat flawed. 45k gross? she can’t get this after paying tax.
 
Scwheser question bank…..
CF0 = -3 mil
CF1 = 75k F0= 5 years
CF2 = 110k F0 = 5
CF3 = 90k F0 = 20
IRR = -6.01
add the inflation and you get 2.9…
didn’t strike me as odd when i did this question earlier…but now thats its posted ..is this correct..totally ?
 
Bingo!!!
quantforCFA, you’re right: it’s the correct answer to a Q-bank question….which I hope we’ll not find in the actual exam!!!
Do you think a kind of question like this may appear??
 
The return objective in an IPS should only be for the first time horizon. There are multiple time horizons in this question.
 
@mwvt9
are you sure about this ? I do recall doing IPS questions from different sources having multiple time horizons wherein you end up having to use the cash flows with their time periods….
 
I am almost 100% sure.
This looks more like a problem to calculate MWR.
 
quantforCFA Wrote:
——————————————————-
> @mwvt9
>
> are you sure about this ? I do recall doing IPS
> questions from different sources having multiple
> time horizons wherein you end up having to use the
> cash flows with their time periods….
The idea behind a time horizon is a delinination for changing needs in the IPS. Here the cash flows are changing all the time.
The only way this could be justified was if they are saying the whole time is one time horizon “retirement”. This doesn’t make sense with income through part of it, college funding through part of it…..
 
quantforCFA Wrote:
——————————————————-
> Scwheser question bank…..
>
> CF0 = -3 mil
> CF1 = 75k F0= 5 years
> CF2 = 110k F0 = 5
> CF3 = 90k F0 = 20
similar approach to what I did but CF1 = 15K+10K+85K-45K=65K
 
I was thinking the same as mw because I remember seeing return objectives where you are funding the kids college education for the next 4 years. The approach has been to just calculate next years expenses and calculate return objective.
Only time I have seen them use anything other than the next years expenses is when you are given a terminal value of the bequests or soemthing
 
I highly doubt something like this will show up on exam. Also are we making some assumptions?
1. after 30 years; nothing left in portfolio is okay
2. gross salary = gross after tax salary
3. the expense figures are for first year not right now? do we need to compound with the inflation for CF1?
4. can we separate the inflation out in the IRR calcuation? then add it back in?
Also I did this in excel; and I was not able to come up with the exact answer.
n|Living Exps |Child suppt|Pretax…..|Pretax…..|Sum
.|Before Tax |Pretax…..|Travel…..|Salary…..|
0|____________|___________|___________|___________|(3,000,000.00)
1| 85,000.00 | 20,000.00 | 15,000.00 |(45,000.00)| 75,000.00
2| 87,550.00 | 20,600.00 | 15,450.00 |(46,350.00)| 77,250.00
3| 90,176.50 | 21,218.00 | 15,913.50 |(47,740.50)| 79,567.50
4| 92,881.80 | 21,854.54 | 16,390.91 |(49,172.72)| 81,954.53
5| 95,668.25 | 22,510.18 | 16,882.63 |(50,647.90)| 84,413.16
6| 86,945.56 | 23,185.48 | 17,389.11 |___________| 127,520.15
7| 89,553.92 | 23,881.05 | 17,910.78 |___________| 131,345.75
8| 92,240.54 | 24,597.48 | 18,448.11 |___________| 135,286.13
9| 95,007.76 | 25,335.40 | 19,001.55 |___________| 139,344.71
10| 97,857.99 | 26,095.46 | 19,571.60 |___________| 143,525.05
11| 100,793.73 |___________| 20,158.75 |___________| 120,952.47
12| 103,817.54 |___________| 20,763.51 |___________| 124,581.05
13| 106,932.07 |___________| 21,386.41 |___________| 128,318.48
14| 110,140.03 |___________| 22,028.01 |___________| 132,168.03
15| 113,444.23 |___________| 22,688.85 |___________| 136,133.08
16| 116,847.56 |___________| 23,369.51 |___________| 140,217.07
17| 120,352.98 |___________| 24,070.60 |___________| 144,423.58
18| 123,963.57 |___________| 24,792.71 |___________| 148,756.29
19| 127,682.48 |___________| 25,536.50 |___________| 153,218.98
20| 131,512.95 |___________| 26,302.59 |___________| 157,815.54
21| 135,458.34 |___________| 27,091.67 |___________| 162,550.01
22| 139,522.09 |___________| 27,904.42 |___________| 167,426.51
23| 143,707.76 |___________| 28,741.55 |___________| 172,449.31
24| 148,018.99 |___________| 29,603.80 |___________| 177,622.79
25| 152,459.56 |___________| 30,491.91 |___________| 182,951.47
26| 157,033.34 |___________| 31,406.67 |___________| 188,440.01
27| 161,744.35 |___________| 32,348.87 |___________| 194,093.21
28| 166,596.68 |___________| 33,319.34 |___________| 199,916.01
29| 171,594.58 |___________| 34,318.92 |___________| 205,913.49
30| 176,742.41 |___________| 35,348.48 |___________| 212,090.90
IRR = 2.19%
 
maratikus Wrote:
——————————————————-
> quantforCFA Wrote:
> ————————————————–
> —–
> > Scwheser question bank…..
> >
> > CF0 = -3 mil
> > CF1 = 75k F0= 5 years
> > CF2 = 110k F0 = 5
> > CF3 = 90k F0 = 20
>
> similar approach to what I did but CF1 =
> 15K+10K+85K-45K=65K
maratikus, there are two grandkids so you need another 10k from the portfolio.
 
CF0 = -3M
CF1-5 = 75k = 15+10*2+85-45
CF6-10 = 110k = 15+10*2+75
CF11-30 = 90k = 15+75
IRR = -0.6071%
(1+IRR)*(1.03) - 1 = 2.374%
Thoughts ?????
———————-
Ooh good call on $10g per grandkid!!
 
mwvt9 Wrote:
> maratikus, there are two grandkids so you need
> another 10k from the portfolio.
thanks, mwvt. You are absolutely correct. Though I’m very interested in your other point too that return objective should be specified per stage. I will look into that.
 
I seem to recall a single stage RR calc on a recent past exam. I think I attempted to determine PV, FV, PMT etc. only to find that it was simply a straightforward calc based on the next years CF needs.
Given that, as I attempted this here I was simply going:
income……………………expense
45k………………………..85k
…………………………….20k
…………………………….15k
Net: 75k
real RR = 75/3,000 = 0.025
Before tax nominal RR (1.025)(1.03)-1 = 5.58%
D
 
I thought we were supposed to assume that principal should be maintained
 
I don’t think you would see something quite like this on the actual exam. CFAI will ask the return requirement in one of two ways: a) the return requirement for a specific time, usually next year such that the principal is preserved, or b) the return requirement in order to have some amount of money at some point in the future.
I see what Schweser is doing here but CFAI wouldn’t pull something like this on the exam. If they did, it would take way too much time to do this correctly. I think CFAI is more interested in testing candidates on how they identify each piece that fits into the return requirement (salary, living expenses, tuition, one-time expenditures, desire to have a certain amount of money at a certain point in time, etc.) and how to address taxes and inflation for each piece.
Unless specified, the principal should be preserved. In that case, the return requirement for the next year would be 75K/3M + 3% = 5.5%.
If you are looking at a 5-year period, I would say
PV = -3M
N = 5
PMT = +75K
FV = 3M
CPT I/Y = 2.5%
Return Requirement = 2.5 + 3 = 5.5%
If you are looking at a 30-year period, I would say
CF0 = -3M
CF1 = +75K
F1 = 5
CF2 = +110K
F2 = 5
CF3 = 90K
F3 = 19
CF4 = 3M + 90K = 3.09M (since it didn’t state the investors had no desire to leave any money, I assumed all principal was preserved and was returned in 30 years)
F4 = 1
CPT IRR = 3.02%
Return Requirement = 3.02 + 3 = 6.02%
 
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