Hi guys,
I’m refering to the Schweser practice exam book 1, morning session 3, question 9a:
In the vignette one is told to incorporate inflation expectations of 3% p.a. in the required after-tax return calculation.
Why is the annual living expense USD 175k * 1.03 (so taking inflation into account) treated differently than the annual expense of USD 45k for law school (not mulitplied by annual rise in inflation)?
Or better put, why do we already adjust the living expense to inflation in the first step, when we anyways incorporate it at the very final after-tax nominal return calculation? (1.0286*1.03)-1=5.95%
The discussion part did not really help to enlighten me…Thanks!
It might be that the vignette assumes the tuition amount is fixed, whereas the annual living expenses go up with general price inflation.
When increasing cash outflows for inflation, an investor looks to be compensated for that extra cash outflow. The way to compensate is to include it in the required return assumption. You could use only the real return in the required return assumption, but then you have to state your cash outflows on a real basis as well.
But even if the annual living expenses go up with inflation, why would you incorporate it twice?
1st step: USD 175k * 1.03 and then again at the very end (…*1.03)-1=5.95%?
first expenses get bumped up by inflation.
if there were no expenses to be satisfied by the portfolio , would you need zero return , then . No , not true.
.so you come to the second part.
Your portfolio is losing value at the rate of inflation. Its purchasing power is diminishing , getting eaten away by inflation.
So it has to be bumped up by inflation rate a second time