Portfolio Management Question Past Paper (2018)


I need help with one of the 2018 exam questions related to portfolio management (Q6-A)

Juan and Mariana Hidalgo, both age 55, meet with their advisor to discuss their IPS. The Hidalgos are residents in the country of Oroplata, where the currency is the ORP and annual inflation is expected to be 3%. Juan recently sold a software company he founded in exchange for equity shares in a publicly listed company. He also recently became disabled and can no longer work. Mariana plans to retire in 10 years. During their meeting, the advisor notes the following.

Income Mariana earned a pre-tax annual salary of ORP 250,000 last year. Her salary will increase each year at the expected inflation rate of 3% and is taxed at 25%. Mariana has a defined-benefit pension plan, and she is fully vested.

Expenses Last year, the Hidalgos’ living expenses were ORP 280,000. These expenses will increase each year at the expected inflation rate of 3%. The Hidalgos will reevaluate their spending upon Mariana’s retirement.

Assets The Hidalgos’ taxable investment portfolio is valued at ORP 4,000,000. The portfolio includes ORP 1,000,000 in the equity shares that Juan received from the sale of his company. In the rest of the portfolio, the Hidalgos prefer short-term fixed income and cash investments rather than equities. They own a home with no mortgage, valued at ORP 1,250,000, which is excluded from the investment portfolio. Investment returns are taxed at 25%.

Funding Goal The Hidalgos’ funding goal is to maintain the after-tax real value of their portfolio after making a donation to support a research organization. The donation is not deductible for tax purposes. They want to determine the maximum amount they can donate immediately that will allow the remaining portfolio to continue to fund their net cash need next year. Their advisor expects the portfolio to have a real after-tax return of 2.75% per year.

A. Determine, given the Hidalgos’ funding goal for the next year, the maximum amount (in ORP) that can be donated immediately. Show your calculations. Note: Assume that annual income and expenses are end-of-year cash flows.

I calculated the funding gap for the next year which came to 95,275 (matches with the official guide) but then i proceeded to calculate the size of portfolio using nominal return (2.75%+3%) while the official answer uses just the real number. I cant get my head around this as to why they used the real number and not the nominal number. Obviously the answer is significantly different when u use real vs when you use nominal.

S2000 magician … i request you to please weave your magic here

bumping up!!!

You have to work with what they’re giving you here. Their goal is to maintain the real value of their portfolio and the advisor gives you the real return after-tax. No need to add inflation back to the return given because its already been accounted for. It’s tricky but just look out for the key words!

To maintain the “real value” the portfolio has to grow over and above the expected inflation of 3%. This means, my rate of return should be high enough to account not just for inflation but any withdrawal that I make thereon. At least that is my thought process :frowning:

You got it. But the advisor already gives you real rate of return (nominal - inflation). So essentially he’s telling you the nominal rate is 5.75% (2.75% + 3%). If you add another 3% on this you’re basically assuming a nominal rate of return of 8.75% which is not correct. You’re overthinking this. If the question gives you a real rate of return and tells you the goal is to maintain the real value of the portfolio, there’s no need to add inflation back to the real return given.

Had problem with this question as well. Not sure why they did not add the inflation to make the value nominal.

"that will allow the remaining portfolio to continue to fund their net cash need next year"

If the question doesn’t explicitly say it, do we assume the portfolio must continue and maintain its purchasing power?

My guess is that they don’t care about what happens after next year.

Here’s another question. Why is the current year’s cash needs not subtracted from the portfolio?

Income and expense happen at the end of the year.

So this year they are $92,500 short.

expense: 280,000

after tax sal: 187,500

Needs: 92,500

Where is that coming from?

The guideline answer calculates some part in nominal terms, some part in real terms, which leads to incorrect result.

Can’t believe this was in a real exam.