Hi guys, A quick clarification on IPS pls: in a question, if a liquidity requirement is stated as before-tax dollars or after-tax dollars, how does the either scenario impact the portfolio’s required return calculations?

All cash needs are (normally) stated in after tax. Have not seen it in before tax, but I may not have done as many exercises as you have done, so I appreciate any example. If it is, I believe you have to restate in after tax to make all input on after tax basis --> required return in after tax --> calculate before tax and inflation to the after tax required return

For the required return calculation, it’s easier to just write out the sources and uses. See the example on p. 114 of V2. So a before-tax liquidity requirement would lower the required return, all things equal (because your net cash outflow is lower). Curious if this is related to a particular problem?

Neveruse_95%_everagain, V2? do you mean Book 2? CFAI text or schweser ?

Right, Book 2 of CFAI text

Ok thanx. I’ve come across a some questions that include statements such as “… the retiree needs $125,000 in after-tax dollars for living expenses…” how do you incorporate this figure in after-tax dollars in your required returns calculations? Thanx.

Please advise if the tax effect ( --> required return in after tax --> calculate before tax and inflation to the after tax required return) shall be adjusted before the multiplying by the inflation rate or after the multiplying by the inflation rate ? In example 1 on P.131 of CFAI text V2, the return requirement of 10.8% is calculated as : [3%+4%)/(1-0.35) but I remember that I ever seen (may be in Schweser note) the return requirement is calculated in this way :{[1+3%/(1-0.35)] x (1+0.04)}-1=8.8%. Which way shall be correct ? Anyone can clarify ?

It is either [3%+4%)/(1-0.35) or [(1+3%)*(1+4%)-1]/(1-0.35) (most correct). Either way gives approx 11%. {[1+3%/(1-0.35)] x (1+0.04)}-1=8.8% is wrong since it assumes you don’t have to pay any tax for the inflation, like any increase of your salary from now on will be tax free. Wish it is true :-).

elcfa, I think you are right. I always calculate in the way of [(1+3%)*(1+4%)-1]/(1-0.35) but I found may cases that calculate in the way of [3%+4%)/(1-0.35). If both the required return and the inflation rate are high, it makes quite a big difference. TKVM !

Hi, I come back here because one guy rasised a question why in CFAI 2009 Morning Exam Q1 Part A answer CFAI calculate in the same way as I originally did. (Please refer to my April 8 post). CFAI 2009 Morning Exam Q1 Part A answer : {[1+[(45K/1000K)/(1-0.2)] x (1+0.04)}-1=9.85% I am really confused again ! Anyone can clarify ?

After tax need 45K Asset base 1 000 K tax rate 20% inflation 4% As posted by me, I believe the most correct answer: [[1+ (45/1000)]* (1+4%) -1 ]/(1-20%) =10,9% Next correct answer is [(45/1000)+4%]/(1-20%) =10,6% As mentioned in previous posting, the crux of the matter is whether you HAVE TO PAY INCOME TAX on the ADDITIONAL required return to compensate for inflation. In this example, it is approx 1%= 4% /(1-20%) - 4% (CFAI exam method). I believe that CFAI exam answer does not take into account this effect. To illustrate my point, let me change the question a bit: the Tracy’s does not need to withdraw any money, but still want to “maintain the real (inflation adjusted) value of their asset base” as given in the exam. According to the methodology given in the CFA exam answer, the required return would be 0% +4% = 4%, while my formula would give 5%. If you assume that you pay your gains annually (as commonly assumed to make calculation simple), thus no tax drag (If you don’t like that assumption, you will need quite complex tax drag calculation, see reading 15), then you have to pay 20% of the gains, so you need 5% pretax to get 4% after tax to have your asset base keep up with annual inflation. The right answer, in practice, is probably lower because of the tax drag depending on how often you churn your portfolio. 4% answer is, in any case, wrong even you can drag your tax, since you will EVENTUALLY have to pay cap gains thus will not keep up with inflation after you pay 20% cap gains in that distant (or not distant) future. Therefore, with all respect to CFAI and being awfully aware of the risk of being stupidly arrogant (lowly elcfa believing the several thousands of CFAI candidates as well as the meticulous exam judges not seeing this), I still believe the answer is wrong. Appreciate anyone pointing any blind points in my logic or if I am not clear.

Let me qualify my previous postinga bit further and show a few supporting facts from the exam: 1. Since the questions concerns the REQUIRED for the Tracy’s FIRST YEAR ONLY, the answer given by CFAI would be right (and consistent with my formula), if either the Tracy’s uses - REGULAR investment account AND there is NO churning in the Tracy’s portfolio, thus maximum tax drag. This hypothesis is not consistent with the text since it says “Alexander’s history of making frequent changes in their portfolio greatly annoyed Patricia” --> assuming a lot of churning. - OR the account is a TAX-DEFERRED investment account. It may be the case here (though the text does not say explicitly) since it says “Briscoe expects a tax rate of 20% to apply to the Tracys’ withdrawals from the investment account”. As you know, one pays tax on the withdrawal from the tax-deferred account (reading 12) http://www.analystforum.com/phorums/read.php?13,1126504,1126515#msg-1126515 2. Otherwise, the text says “The Tracys currently have all their assets in inflation-indexed, short-term bonds that are expected to continue to earn a return that would match the inflation rate AFTER taxes” --> consistent of my argument that the return has to take into account of tax even for inflation.

elcfa, You mean the calculation in CFAI 2009 Morning Exam Q1 Part A answer shall be correct because it is just for 1st year Tracys’ retirement. If not just for 1st year Tracys’ retirement, then the calculation shall be :[[1+ (45/1000)]* (1+4%) -1 ]/(1-20%) =10,9% ?

AMC Wrote: ------------------------------------------------------- > elcfa, > > You mean the calculation in CFAI 2009 Morning Exam > Q1 Part A answer shall be correct because it is > just for 1st year Tracys’ retirement. > > If not just for 1st year Tracys’ retirement, then > the calculation shall be :[[1+ (45/1000)]* (1+4%) > -1 ]/(1-20%) =10,9% ? I am saying: CFAI 2009 Morning Exam would be correct if the following is mentioned: 1. Maintain real (inflation adjusted) value of their asset base (stated) AND 2. just for 1st year (as stated in exam) AND 3. no tax on cap gains for the capital not withdrawn (stated), like TDA account AND 4. MOST IMPORTANT: this tax on cap gain will NOT be paid EVER, not only later (not stated). Since the exam does not state the fourth condition, it is wrong, I believe, to use CFAI’s proposed answer, since even you don’t pay cap gain tax now (as in TDA), you still have to pay later --> on paper, the value of your (TDA) account keeps up with inflation, but it is misleading since it also contains deferred tax liability that you need to pay. Other than that, you need to use 10,9%, if you want to maintain the real (inflation adjusted) value of asset base, since you need to pay tax “on the inflation”. Having said so, it is a minute, subtle point so in exam, if it says the above- mentioned three conditions, I would - use the CFAI answer, well aware that is not 100% correct, OR - calculate both and explain the difference. Otherwise, 10,9% should be used (e.g., for long time frame or not tax deferred). To be 100% correct, the right answer would NOT be 10,9% since we assume that cap gains tax = 20% since the text does not say what tax rate to be used for cap gains. It only says tax on WITHDRAWAL, so I assume it is the same as cap gains tax to derive at the 10,9%. As it has been complained before, the tax aspect of this question is quite clumsy and leads to a lot of confusion. It is certainly a strange question which I hope will not turn up again. http://www.analystforum.com/phorums/read.php?13,1128500,1128507#msg-1128507 http://www.analystforum.com/phorums/read.php?13,1129337,1129432#msg-1129432 Sorry, if it is a long posting, but it is not easy to explain.

elcfa, It seems that the return objective questions are so complicated if all tax issues are considered and we shall be very careful, otherwise we will lose our direction. Epecially under the time pressure in AM exam. Shall we spend a lot of time in calculating the return objective while it is so easy to make a mistake in AM exam ?

Moreover, if CFAI exam questions are vague (it is not uncommon, sometimes they seem not consider seriously/carefully/clearly) then we can not catch CFAI direction !

As Bill Clinton would say “I feel your pain” :-). I think as long as you understand the principle and demonstrate that in the exam by showing your assumptions clearly in your answer, I believe you will be OK. If it is any comfort, you are not the only one to be confused.

Yes, I think that I am not the only one who is confused ! TKVM for your comfort !

elcfa – I am one of the dudes raised the 09 exam Q1 PartA questions earlier this week. I really appreciate your detailed explanation that helps to know that most of us feel the same pain. I am still confused (not with your analysis but CFAI answer), however, at least I know many others are as well. I believe CFAI has always asked us to answer questions directly in the exam in order to get the full credits. I feel bad that now CFAI provides such vague questions/answers. I don’t know making two assumptions in the exam would be my best bet–I will quickly run out of time. And trust me, we are able to assumes here because we’ve already seen the “model” answer. Anyone disagree? Word-by-word, CFAI asks: “Calculate the pre-tax nominal rate of return that is required for the Tracys’ first year of retirement if they retire at age 60. Show your calculations.” Obviously this will be in Tracys’ retirement stage time horizon. The “return objective” should be constant within the same stage. It would be odd to spare out first year to do a separate rate of return. elcfa also mentioned CFAI didn’t make all the statements required for its answer. I just want to summarize everybody’s confusion and not try to distract anyone from studying. I failed last yr. in my 1st try and do note how important to stay focused after ambiguityand frustration while in the real exam.

James@Houston, Glad to see you here. I checked CFAI’s text, no definite/clear answer to this. But I think elcfa has provided us impressive/reasonable explanation. I may follow his way & hope CFAI will do the same. elcfa, TKVM for your time & efforts !