Let’s say you calculate the after-tax required rate of return to meet a portfolio’s objective (before inflation) = 4%. That 4% covers living expenses and so forth. Let’s also say that the inflation rate is 2% and the tax rate is 25%.
We know Pre-Tax Return = After-Tax Return / (1 - Tax Rate).
Calculate the Pre-tax return BEFORE inflation and then add-back inflation:
= .04 / (1 - .25) +.02 = .0733
2.Add inflation to the after-tax return and then calculate pre-tax return?
=( .04 + .02) / (1 - .25) = .08
What about how its done in question 1 of 2009 AM?
I have been told INFLATION ALWAYS LAST.
so the first way is right (and consistent with 2009 AM question).
This has been beaten and there’s no “official” answer.
However, as CPK said with 2009, AND all the schweser materials saying inflation last, go inflation last
First method is the right one and reason is:
Inflation factor is added to pre tax return so that it ends as the “growth” part…in other words, it is unrealized capital gains and you dont realiize it and thus you dont pay tax for that.
In exam ALWAYS add inflation to PRE-TAX Real return (as in first method). NOT After tax Real Return.