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