Real quick question. If given the different components of an IPS’ required return (inflation, management fees, payouts, etc) do you add them or multiply them. I’ve come across some questions on practice exams where they were added, and some where they were multiplied. Is there an appropriate time to use one technique over the other? Hopefully this makes sense because I forgot which exams I saw this. Thanks.
For foundations and endowments, you definitely compound the numbers. For individuals, it’s less clear; CFA Institute seems to accept both adding and compounding. Do whichever you prefer and don’t give it another thought.
Hey monkey, I’m using the equation (1+s)(1+i)(1+c) - 1 for required return (institutional). Saw it in the CFAI text and believe it’s the way to go. Tho it looks like from the guideline answers that for the individ IPS return calc you can do either way, since both answers are there. Maybe could apply to insitutional as well.
I have a separate but related question. When you’re given inflation rate and after-tax return, how do you calculate before-tax return? Would that be
(1) (after-tax return + inflation) / (1 - tax rate); or
(2) after-tax return / (1-tax rate) + inflation?
Schweser says it’s (2). Page 190 of the Book 2 says (1). The question doesn’t clarify whether inflation is pre-tax or post-tax, or whether inflation is taxed or not.
If (1) is right, this means the true pre-tax inflation is inflation / (1 - tax rate). The book has to make a distinction between pre-tax inflation vs. post-tax inflation.
If (2) is right, the assumption is that inflation is pre-tax. But this gives rise to another issue: how would you then go from the resulting return in (2) to post-tax return?? Apply the tax rate to the total before-tax return including inflation, thereby making the inflation component = inflation x (1 - tax rate)? Or do you separate out inflation from total before-tax return, apply tax rate to net of inflation before-tax return, and add inflation?
Is there like a universally known CFAI-method to go from after-tax real to before-tax nominal or vice versa?
First convert from real to nominal, then after-tax to pretax. If you do the reverse order, you’re basically saying that the portion of return that is the inflation-adjusted component isn’t taxable…which is not correct. Whatever the reason for adding to return (inflation or any other reason), the full return is still taxable (except for munis/treasuries…whatever). This is how I’ve been doing it and has been consistent with guideline answers on mocks/historical cfai questions.
But illustrative answer for Exam 2009 Q1 seems to convert to pre-tax first and then add inflation. Thoughts?
I’ve never seen a question from CFA Institute in which they weren’t quite clear whether or not to tax inflation.
Take a look at the article I wrote on this; maybe it’ll help: http://financialexamhelp123.com/inflation-in-required-rate-of-return-to-tax-or-not-to-tax/.
Wow this page addresses exactly my question and is what I was looking for. Thanks
This question (or the illustrative answer to it) actually seems to have another issue… The resulting answer does not give me the amount that preserves portfolio’s purchasing power. 1.1M x 9.850% x (1 - 0.2) + 80K - 125K = 41,680, and to preserve the purchasing power, this should be 4% of the BOY assets, right? However, dividing 41,680 by 1.1M gives me 3.79%. I have no idea why this would be anything other than 4% when I used the multiplicative method.
The true purchase-power-preservation return is 10.11%, which would make the EOY asset exactly increase by purchase power if return was netted. What I fear about is, would I get any points deducted if I write 10.11% and show all my math, even though this is more correct?
Or is my logic completely flawed or missing some assumption that the currculum is making?