 # Discrepancy in CFA books return requirements

Guys, I know that this has been discussed before but I have a problem with computing return requirements. Can anybody help? What I don’t get is how to compute it, is it – (R + i)/(1 – tax) or - (R/(1 – tax)) + i?? ‘R’ being the real after-tax rate of return and ‘i’ = inflation. The problem I have is that even CFAI contradicts itself – if you look in Q9 of the 2003 exam (Bavier-Campbell), the return requirement is computed in the following way (ignoring the 1% growth requirement) - ((\$78,000 / (1 – 0.30)) / \$3,000,000) + 2% inflation = (\$111,429 / \$3,000,000) + 2% inflation = 3.71% + 2% = 5.71% So that means that CFAI used (R/(1 – tax)) + i BUT – this case is also presented as an example in CFAI book 5, Study Session 15, page 382, read both questions, they’re the same, but here the return calculation is computed in the other way, so we would have (again, without the 1% growth requirement) – (\$78,000/ \$3,000,000) = 2.6 (2.6 + 2% inflation)/(1 – 0.3) = 6.57 This gives a difference in return requirements of almost 1%, so which method is correct??! Can anybody help? I must be missing something here but I don’t know what to do!! Thanks, dalian

I would use the second one

I think this was even discussed last year, but I would actualy go with first one b/c i think i’ve seen it more often done that way.

I think that it’s situations like this that people really need to take into consideration the true value of the past exams. It would seem obvious to me that here the CFAI has changed it’s mind as to how we should be calculating the return requirement, hence the reason for including the comments in the CFAI volume question that it has been modified from the 2003 exam. This is where the practice questions from the CFAI texts contain a lot of their value. So in short, as hala said, use the second method.

Sorry Flames but you are agreeing with the OLD Method ten, from 2003… Reread.

ignore

No worries!

Wait so the CFAI is telling us to do it the First way?? B/c that’s hwo the book does it?

Once again I confused myself. The 2nd method is not the same as the 2nd method…confused… Ok when he first writes the equations down the 2nd equation he explains First, so that is why I have been soo confused. We were agreeing on the same forumula there is no difference between the two method as you seem to indicate: 78/3000 =2.6% before tax = 2.6/(1-0.3) = 3.71 +infllation = 5.71 inflation should be added at the end. same as 78/(1-0.3) = 111.43 111.43/3000=3.71 +2 =5.71%

krishna1, there’s a difference between adding inflation first and getting the pre-tax return AND getting the pre-tax return and adding inflation. The numbers will vary. The consensus seems to be to FIRST add the inflation and then get the pre-tax number.

yes, first add inflation and then pre-tax. That is how i saw it on all CFAI exams (2005,6,7)

I am also in agreemnt that adding inflation first and then adjusting for taxes is the way to go. The difference between the two methods is the treatment of inflation with taxes, r/(1-t)+i ignores adjusting inflation for taxes and the more correct way (r+i)/(1-t) addjust for it, also in this method you would add any other expenses in the numerator, if applicable (i.e., investment management fee) Lets say you earn 10% return, tax is 30%, and inflation is 2%. You pay taxes first, then remove inflation, and end up with your “real” return .1 * (1 - .3) - .02 = .05 or 5% to reverse engineer 10% we would do (.05 + .02) / (1 - .3) or (r+i) / (1-t) Buttom line it all comes down to priority of transactions: nominal - taxes - inflation = real In order for r/(1-t) + i to work the priority should be nominal - inflation - taxes = real and this is not how it works.