Essay Exam 2007: Q5 A (Return Req'd)

Can you guy please check this… Covell University (CU) is a private, tax-exempt, educational institution in the U.S. CU has an endowment with the purpose of providing financial support to the university budget. Currently, the spending rule for the endowment is 4 percent of the market value of its investment portfolio as of the previous year-end. Based on the endowment’s 2006 year-end market value of $500 million, the annual distribution represents 5 percent of the operating budget for CU, just meeting CU’s desired level of endowment support. CU expects a SIMILAR DOLLAR LEVEL of endowment support, indexed to inflation in its costs, in future years. The university’s operating expenses are expected to grow at a nominal rate of 3.25 percent per year for the foreseeable future. The inflation rate in the U.S., as measured by the Consumer Price Index (CPI), is expected to be 2.5 percent per year for the foreseeable future. I’ve put in capital letters the words that I want to highlight… They say they want to provided this level of future support… Then, why would you need to consider the future operating expenses growth rate… The endowment has fixed its level of support to a dollar level, not a % level… Yet in the answer key they write: The Endowment’s return objective is to maintain the real value (purchasing power) of the portfolio and to grow the portfolio in order to provide on-going support equal to 5% of the university budget. The required rate of return for the endowment is 8.08%. This level of return is needed to cover the cost of the 4.00% spending rule, the university’s inflation rate of 3.25%, and the annual investment management expense of 0.65%. This is calculated by a multiplicative formulation: (1.040)(1.0325)(1.0065) – 1.0 = 0.0808 or 8.08% I think the correct answer should be: (1.040)(1.025)(1.0065) – 1.0 = 7.3%… Since they write that will expect a SIMILAR DOLLAR LEVEL… Please advise… Thanks


Vince, I did the same thing. I guess they wanted us to grow at the same level of inflation as the university we are providing operating expenses for, that way we can provide the same level of support. If I see it on the test, I am going to go with the level of inflation that the operating the foundation is covering. If thats what CFAI wants, thats what they will get from me. Obviously this would be up for debate in real life if you were managing this fund. But this is CFAI dreamworld where you get no argument, so lets do as they say.

Too much studying makes us think more than CFAI wants us to…

yeah i feel that same way… the more i study, the worse i do on these damn exams… I started getting 70’s last month and have been working my way downward since. By exam day, I will be lucky if I find the test center.