Inflation rate - tax rate adjustment

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oz001

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CFAI Vol 2 Reading 10, PG. 177
after-tax nominal return objective = 1.17% + 3% (expected inflation) = 4.17%
“Note: strictly speaking the inflation rate should be adjusted upward by the portfolio’s average tax rate. For ease of presentation we have simply added 3% inflation”
could someone please clarify the note above, why would the inflation rate need to be adjusted upward by the tax rate if calculating after-tax required return?
 
If inflation is 3%, you will need to take out an extra 3% from your portfolio to cover the same expenses as last year. If you take out an extra 3% you will need to pay taxes on the gains. So in order to have the 3% extra you actually need to adjust upward by the tax rate to end up with 3% in your pocket.
if your tax rate on your portfolio is 15% you would need to return:
3%/(1-.15) = 3.53%
in order to be able to cover inflation after taxes.
 
Thank you FinNinja. I agree with your calculation, that 3.53% would be the “pre-tax” inflation return required to yield 3% after taxes with a 15% tax rate.
However the way the note is worded (at least my interpretation of it), it appears to suggest an upward adjustment to the 3% inflation rate in order to compute the required “after-tax”return. note that 1.17% in the above example is the after tax real return, which would also have to be adjusted upward for taxes. but the note mentions an upward adjustment to the inflation rate only. thats what i dont get.
 
isn’t that what was just done. 3/(0.85) is higher than 3
original calculation = 1.17 + 3 = 4.17%
new one: 1.17 + 3.53 (upward adjustment) = 4.70%
 
thanks cpk. so per your calculation 4.7% is pre-tax? but i think if its the pre-tax return requirement then it should be computed as (1.17/0.85) + 3.53 i.e. upward adjustment to the 1.17% component also since 1.17 is after tax. why is the upward adjustment only to the 3% component?
 
why would the 1.17 change ever? it is after tax… and if the cash flows (inflows / outflows) remained the same, it would still be 1.17.
If the cash flow numbers have changed due to inflation …. then that number would be recalculated.
Here we are talking only about the inflation effect (and any adjustment to that part) on the pre vs. post tax.
(And I am sure I missed this on my first pass through, must be a pretty small foot note on the book).
 
yes cpk, it’s a minor note in the book and actually not critical. was just curious.
required after tax = 1.17 + 3
required pre tax = 1.17/.85 + 3/0.85 = 4.91 (assuming 15% tax)
hence i thought the 1.17 should change to 1.38.
still not clear why the note mentions an adjustment to the 3% only i.e. after tax = 1.17 + 3.53.
guess its not worth spending much time on anyways. thanks for the response though.
 
I didn’t remember this until I went over that section again last night. I see what they are saying, but I am fairly confident that you will not be docked in the essay for not doing this… it’s kind of along the same lines as adding inflation rather than multiplying, they will take either one so long as you are consistent. Don’t sweat this detail IMO, other’s feel free to correct me.
oz001 wrote:
yes cpk, it’s a minor note in the book and actually not critical. was just curious.
required after tax = 1.17 + 3
required pre tax = 1.17/.85 + 3/0.85 = 4.91 (assuming 15% tax)
hence i thought the 1.17 should change to 1.38.
still not clear why the note mentions an adjustment to the 3% only i.e. after tax = 1.17 + 3.53.
guess its not worth spending much time on anyways. thanks for the response though.
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