In the book on page 385 they calculate the discount rate as: Risk free rate + income volatility, 4% + 3% = 7%. The do NOT include the wage growth of 2%.
However, on 2017 III mock AM Q15 they use risk free rate 3% + wage growth 5% + income volatility 1% = 9%
When do we know when to include wage growth and not?
Yeah, in the book in the 2 BB examples they don’t include it both times. Maybe its a mistake on the mock?
If you compound for earnings growth rate in numerator, you also need to adjust discount rate to nominal basis in denominator.
Flashback’s response is the correct answer. Your numerator and denominator need to match. If the numerator you are using Real figures, your denom also needs to be in Real terms. Nominal with nominal. Good luck!
But take a look at page 385 in Behavioral finance, is that not exactly what they are doing calculating wages from year 1-5? They are including wage growth in the numerator, but not in the denominator?
I find this confusing as well, got the question wrong as I used the same calculation as shown in the blue box (exclude wage growth rate from total discount rate).
Does this mean the CFAI blue box is incorrect?
Which method should we use for the exam?
edit: checked the formula shown in the blue box as well, doesn’t have the wage growth in the denominator either…
The correction is wrong, they published the errata. https://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91356847
The right formula is:
discount rate = risk-free rate + income volatility
I’m with you guys I think the top part of the blue box on page 385 is incorrect that should be 9% in the example. They specifically show the bottom part to provide an example of real to real, excluding the growth of 2% in the numerator and the denominator.
@ Acoxen
There have been errata in the blue box as well
>> In the example “Estimating the Present Value of human Capital” (p. 385 of print), the Wage growth rate is not part of the calculation of the Total Discount Rate.