2009 Ips - Return Requirement (Q1 Aii)
Couple sources confusion, but first the story:
Next year at 60 this couple will have 1.1m in assets. They will also pay off mortgage of 100k.
Asset base therefore = 1m.
Now their Cashflows:
They have POST TAX next year a total of 80k from the pension and annual expenses next year of 125k. The Inflation rate is 4%. Tax is 20%.
What is their PRE TAX NOMINAL return?
OK - I am wondering why this solution is not correct:
1. They make 80k post tax, so pre tax its 80k/0.8 = 100K.
2. Therefore pre tax CF = 100k-125k = -25k
3. -25K/1m = 2.5%
4. Plus inflation 4% = 6.5%
Correct = Take the 80k POST TAX -125k = net POST TAX CF = -45k
THEN, we do -45k/0.8 to gross up pre tax = 56,250
THEN we do 56,250/1m = 5.625% + 4% = 9.625%
What gives? Isn’t my method doing the same calculation but I am grossing it up first then calcluating the shortfall return, then adding inflation. I.E I am taking their combined salaries and working out what it is on a pre tax basis, then using that as a return.
Why are these different and why am i wrong?
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