Hi all, I was doing Schweser Practice Exam 2 last night. Question 1 states that their total assets is 2.5 + 1.25 = $3.75 million, annual salary $48,750, annual expense $150,000, tax rate 25%, inflation 2%. However it also talks about that the family wants an emergency reserve. So I figured 6 month of living expense should be deducted out of the asset base. This makes a little bit of difference since without the reserve, required return is 5.11%, with the reserve required return is 5.17%. Then Question 6 is even more confusing. Asset base is $5 million, annual expense $150,000, donation in a year $750,000, inflation 3.5%, management fee 0.8%, tax rate 25%. I have several issues with the answer. First they don’t inflation-adjust the annual spending; second why the donation is not tax deductable and to a lesser extent whether the management fee should be tax deductable; third why it uses multiplicative form of return calculation in this question and additive form in Question 1. It really bothers me that they leave so many loose ends in the question. If I get a different return number from Question 6-A, then all my Question 6-B and 6-C answers will be off. Do I loose a significant portion of points because of that? In summary, my questions are, 1. When to consider tax, when not to: I know for sure living expenses and salary should consider tax effects 2. When to adjust living expense for inflation: if they say this year’s expense is a certain number, we should adjust and if they say annual living expense we don’t adjust? 3. When to use multiplicative form, when to use additive form. 4. When to build an emergency reserve
#1: The exam will state how they want to see the return (before or after taxes, real or nominal). The problem will also state which parts of their income are affected by tax and which aren’t. #2: If inflation is mentioned, you will probably have to adjust for it, or at least include it in the return calculation. Watch to see if the problem says growth in expenses and salary offset each other or something like that. That could mean you don’t have to adjust for it. If they don’t give you an inflation number explicitly, you probably won’t have to worry about it. #3: Either should be fine for an individual return calculation but the multiplicative rule is more accurate. #4: Only account for a reserve in your return calculation if it is explicitly stated in the problem. Otherwise, you could mention 6 months in the Liquidity section.
I had same problem. 1. I agree with you. I think they are not consistent. 2. Depends on the timeline. This is the tricky part. 3.Both are acceptable. 4. The reserve should not be taken out of the assets base. You need to allocate to cash.