Re: 2008 AM Q1 A i, calculating the after-tax nominal rate of return that is required for the next year. In the guidance answer, you can see the “real” return is calcualted as: (1) Outflows required next year 55,000 (2) Divided by investable assets 995,000 (3) Result: 5.53% Then, the guidance answer added inflation adjustment to this 5.53% return, and got a 9.75% after-tax nominal rate of return. But seriously, isn’t the 5.53% already nominal rate of return? The mortage payment is already a nomial amount, because it doens’t inflation adjust each year. If the required return is 9.75%, what do you do with the 41,989 (9.75%-5.53%) return? I don’t get it why CFAI calculates this way… Any insights?
The problem states that salaries and expenses are expected to increase with inflation. I agree that normally a mortgage doesn’t increase, but you take what they give you. It makes the problem easier if you assume all expenses increase with inflation. The difference between 9.75% and 5.53% is to adjust for inflation, or in other words, the additional return required to maintain the inflation-adjusted value of the portfolio.
Think of it this way Let’s say in Year 0, your portfolio is $100, your required return is 5% and inflation is 4%. So your real required return is 5% (to cover expenses) but your nominal required return is 5%+4%=9%. That means that in order to preserve the inflation-adjusted value of your portfolio, you must have a portfolio value of $109 in Year 1. Then you take out $5 for expenses and you left with $104. That $104 in Year 1 is equivalent to $100 in Year 0 since inflation is 4%. So you actually need to earn 4% just to maintain your portfolio’s real (i.e. inflation-adjusted) value.
Hezagenius, Thanks for the explanation!