Hello,
Let’s say we want to calculate the real value of distributions from a portfolio after accounting for taxes and inflation.
Assumptions:
- Current portfolio value: EUR 4,000,000
- Annual pretax capital gains return: 6.5% per year
- Time horizon: 10 years
- Yield on the portfolio (from dividend-paying stocks and interest-bearing bonds): 2%
- Tax rate on stock dividend and bond interest: 40% per year
- Inflation: 5% per year
I have seen two approaches.
Method 1:
- Future nominal value of portfolio = EUR 4,000,000 * (1+0.065)^10 = EUR 7,508,550
- Future nominal post-tax distributions = 2% * EUR 7,508,550 * (1 - 40%) = EUR 90,101
- Real post-tax distributions = EUR 90,101 / (1 + 0.05)^10 = EUR 55,314
Method 2 (as per CFAI in the practice question)
- Future real value of portfolio = EUR 4,000,000 * {[1 + 0.065]^10 – (1 – 0.05)^10} = EUR 5,113,600
- Real post-tax distributions = EUR 5,113,600 * 2% * (1 - 40%) = EUR 61,363
Which method is correct? Method 2’s way of calculating the real value (after inflation) doesn’t make sense to me