2011 CFAI Exam, Question 1

"Michael Becker expects to receive his after-tax inheritance of 8.0 million U.S. dollars (USD) at the end of this year. The Beckers both plan to retire at that time, and are meeting with Emily Frost to help them establish an investment plan. The Beckers currently do not have an investment portfolio and they own a home valued at USD 3.7 million.At the end of this year, the Beckers’ outstanding debt will be USD 3.5 million (home mortgage) and USD 150,000 (consumer debts). The Beckers will pay off their mortgage and their consumer debts soon after the inheritance is received. The Beckers currently have a combined after-tax salary of USD 475,000, current-year living expenses of USD 250,000, plus annual mortgage payments (principal + interest) of USD 225,000. Michael’s company pension will pay him USD 48,000 after-tax next year, and then payments will grow at the rate of inflation, which is expected to be 3% annually."

"Calculate the after-tax nominal rate of return required for the Beckers’ first year of retirement."

Why don’t the current year living expenses of $250,000 get deducted from the $8,000,000 windfall inheritance Becker received? Why don’t the $475,000 in current year income get added to the investable assets? Since we are breaking up the timeline into:

  1. This year before retirement and

  2. Next year at retirement

when calculating required rate of return, shouldn’t this year’s expenses and salary increase/decrease the investable assets the way that mortgage debt and consumer debt do?

Thanks as always, gentlemen.

Because excess salary = 475,000 - 250,000 - 225,000= 0

Oh ok. Thank you Galli! Would have been nice if CFA had pointed that out in the answer.