Individual wealth management

Hi All,

I do not comprehend this answer to the EOC # 2 B for Estate planning chapter:

“It is not appropriate to use the expected return of the assets used to fund spending needs to calculate the capitalized value of their core capital needs, because the risk of the spending needs is unrelated to the risk of the investment portfolio used to fund those needs. Although the annual spending cash flows are not riskless, a risk-free rate should be used to calculate the present value of the cash flows as their uncertainty is unrelated to market risk factors that would be priced in a normal asset pricing model, making their beta equal to zero.”

Can somebody clarify for me?

What they’re saying (obliquely) is this:

Even though the expected return on the assets is 8%, you shouldn’t use 8% as the discount rate to compute the present value of your spending needs. You should use the risk-free rate (of, say, 3%). The reason you use a different rate is that the amount of your spending needs doesn’t depend on market returns; there are other factors that determine the spending needs.

So for the spending needs, we always use the risk free return?

use real risk free rate, which is (1+RF)/(1+Inflation)-1

With all due respect, what you’re showing in your calculation is the nominal risk-free rate (which includes inflation); the _ real _ risk-free rate (your _ RF _) does not include inflation.

If your spending requirements are given in real dollars (yen, euro, whatever), then you discount them with the real risk-free rate; if they’re given in nominal dollars (which is more likely), then you discount them with the nominal risk-free rate.

That’s what they’re telling you.

Let’s say the nominal RF rate is 10%, inflation is 3%

the real RF rate (“Real” return on your risk free investment) is (1.1/1.03) - 1 = 6.80%

Am I understanding this wrong?


I misread your post; I didn’t see the “/”, so it looked to me as if you were multiplying.

Sorry about that: I’ve corrected my post.

The rest of my post is correct (thank goodness!): the discount rate you use (real or nominal) has to match the cash flows that you’re discounting (real or nominal); you don’t _ always _ use the real risk-free rate to discount the spending.

Dollops of good advice as always. Spending needs are insensitive to earning requirements and that’s why you discount them at th Rf (Not going in the debate of Real or Nominal)-This is my takeaway, hope I am right.