IPS related calculations: before-tax dollars & after-tax dollars

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 ?

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% ?