Do we add tax before or after inflation (2009 Q1A as an example)

CFA Level III
#1

Most questions I’ve seen:

-Work out Cash Flow / Assets as a %

-Then add inflation

-Then gross up for taxes

However, this Q (Q1 2009) did the taxes first, then inflation. It doesn’t implicitly or explicitly state either way.

What is correct procedure for us?

#2

There are tax deferred withdrawals thus different steps apply.

You should first calculate each net withdrawal on pre-tax basis. Then add inflation.

Steps with tax deferred withdrawals:

  • After-tax real required return:

e.g. USD 10.000

  • Pre-Tax amount USD:

After tax amount USD 10.000 /(1-T)

  • Pre-Tax real return %:

Pre-Tax amount / Asset base

  • Pre-Tax nominal return:

Pre-tax real return + inflation rate

Normal procedure with no deferred taxes:

  • After-tax real required return

e.g. USD =10.000

  • After-Tax real return %:

After-Tax amount USD 10.000/ Asset base

  • After-Tax nominal return:

After-tax real return + inflation rate

  • Pre-Tax nominal return:

After Tax nominal return / (1-T)

#3

Well and Clearly written.

#4

Thanks. The biggest challenge in such questions is carefully reading. Almost each detail is relevant in Individual IPS questions.

#5

The very first article I ever wrote on my website answered this question: http://financialexamhelp123.com/inflation-in-required-rate-of-return-to-tax-or-not-to-tax/

As a matter of fact, it does state it, explicitly. Go to the bottom of my article.

#6

Wow thanks very much for this

#7

My pleasure.