How to account for inflation

CFA Level III Portfolio Management
#1

Let’s say we have annual income of EUR 120,000 per year for 10 years. There is no growth/decline rate.

Inflation is 5% per year.

Which is the correct method to calculate the real value of the EUR 120,000 in 10 years?

  • Method 1: 120,000 * (1- 0.05)^10
  • Method 2: 120,000 / (1 + 0.05)^10
#2

Method 2.

#3

Thanks @S2000magician, it’s really weird because CFAI used Method 1 in one of their solution keys. Thanks anyway!

#4

I know that they do.

I have no idea why. It makes no sense.

#5

Yeah I also find that strange, since I also have seen CFAI use Method 1 numerous times.
My understanding of the difference is that Method 1 seems to account for inflation by converting the return to a real rate, meanwhile Method 2 seems to account for inflation by converting the discount rate to a nominal rate.

I am curious when to assume one versus the other, or if for exam purposes we should just assume Method 2, since that is the “correct” method according to S2000.