For example… If you have 250k and need 1 million in 10 years but will be withdrawing 50k per year for living expenses, that output would not need to be adjusted for inflation because it is already stated in nominal terms, correct?
Depends. I’ve seen it both ways. 2007 case was an Irr problem with an adjust for inflation at the end.
What the q says. 2007 says expenses will grow with inflation, so you add it at the end. Others just target a terminal value w/o growth in the payment (2008 & 2010 cases). There you would not add inflation at the end.
2007 - Ingram case - they have a 200K requirement - inflation of 2.5%, with the first distribution to OCCUR IMMEDIATELY.
So 205K goes into the IRR calculation.
and 200K comes out of the PV portion (current portfolio).
According do Schweser, I believe that it does (i.e do not include inflation additionally) if dealing with nominal figures. However, if you are asked for the return required for the first year of retirement (return for a specific year), we should assume the portfolio’s real value should be maintained an include inflation. I actually just dealt with this issue tonight while reviewing the live/online Schweser mock.
i think you guys are confusing the inflation of the expenses vs. maintaining the real value of the portfolio.
in the 2007 case, the inflation was added on at the end to maintain the real value of the portfolio. nothing to do with the expenses. the expenses for year 1 of retirement were already input into the TVM calc (205,000), so there was no further need for inflation adjustment for expenses.
if you look at maclin case (#13 in EOC Q), its the same type of problem as 2007 IPS, but no inflation is added at the end. nothing to do with expenses.
in both questions inflation grows with grows with expenses. but in the 2007 question, they want the terminal value to be inflation adjusted as well (it says they want their gifts to children to maintain purchasing power). in the maclin case, it doesnt say that and doesnt even provide an inflation rate. they dont care about inflation or purchasing power. it just says they want a 2M terminal value–you are essentially just looking for an IRR that equates PV to FV given a PMT and N.
thats why in 2007 question you add inflation at the end and in maclin case u dont. in 2007 Q, every year a portfolio of the portfolio needs to be replinished for inflation.
could someone clarify this please?
inflation can be incorporated in two ways :
[a] Cash flow section : where we multiply expenses by (1+inflation) if we assume expenses grow with inflation BUT income does not. If both income AND expenses grow at inflation, there is no need to adjust the cashflow section for inflation.Also if the figures already incorporate inflation,there is no need to adjust.
[b]Return objective section: we would add inflation (or chain link in a multiplicative fashion) if we are asked to maintain real value ,asked to calculate nominal rates.
thanx for any help
[a] i wouldnt try to memorize. just do what they tell u. get yourself to next year’s (or whatever year they want) expenses. if they already give you next years expenses and income, great youre done. if you get todays carefully read whether they increase with inflation or are fixed and adjust accordingly. even if both increase with inflation, of course u still need to adjust. if income is 100,000 and expenses are 50,000 then your net inflow is 50,000. if both grow by 3%, your net inflow changes–it is not 50,000.
In the 2008 exam, the first question, they did not adjust for inflation, they just calculated the necessary rate of return
- it is a FIXED mortgage payment - already has inflation built in.
Though they provided an inflation number of 4% - that is used to INCREASE both Salary and Living Expenses by the same amount. In case their Salary had not been the same as Expenses - and there was a difference because of that - it would have shown up in the Expense in the first year (instead of 55K - it would have been higher or lower).
[And then our estimate of IRR - may have not been possible - given that the amount is not going to be a constant payout from the Portfolio].
Since the only payment was a Mortgage, and it is fixed - it is a nominal payment.
you’re right, but in 2010 case and macinns case in book income grows at the rate of inflation so it doesn’t matter.
the show is right - you add inflation to protect portfolio from inflation. But you also add it to maintain the real value of the distribution. It’s a 2 for 1 sale y’all!
In the 2007 case you add inflation once to acquire NEXT year’s expenses (205,000), and a second time to maintain the real value of the portfolio (add 3%). I’m positive about this.
What I’m not completely positive about is what the implications are in the Maclin case of not adding on the inflation at the end. Are we to assume that an erosion of principal is okay? I guess if that’s the case, it would be incorrect in the formulation of the objection to write that they want to “maintain the real value of the portfolio”. The “note” that the answer gives doesn’t really make sense, or at least is not really relevant.
You can only add on inflation if they provide you a number, can you?
They only provide you with a statement that offsets after tax salary increases with living expenses.
agree, thats what made this calc pretty simple. so would u say that writing they want to maintain the real value of the portfolio is incorrect? if we agree that tacking on inflation at the end serves the purpose to maintain the real value of the portfolio, then adding this phrase is wrong.
In the MAclin case his salary increases at the rate of inflation so it offsets the increase in expenses. Thus, the portfolio is allowed to grow “uninhibited” to the target value.
In the 2008 example, the mortgage payment stays fixed, so again, the portfolio can grow to the target without having to offset inflation.
In 2007, the expenses are growing at the rate of inflation, but there are no inflows growing at the rate of inflation to offset it. Thus, the portfolio must do it–thus the addition of inflation.
I think that’s right.
i havent done the 2008 question yet but just going by the other two examples, i dont agree with u on the maclin case. again, the purpose of adding a 3% inflation to the required return is to maintain the real value of the portfolio. it has NOTHING to do with expenses. If your real return is 5% and you add 3%, that means that every year, you need to make 8%: 5% to pay your expenses and 3% to be retained in the portfolio to replenish the losses for inflation.
so in the 2007 case, after the first year, the 2M falls to like 1.9M in real terms, but the extra return earned to cover inflation gets it back up to 2M.
therefore, in the maclin case, the expenses and salary offsetting are inconsequential to the value of the portfolio. i just dont see how the portfolio can maintain its real value without an inflation adjustment. so my hunch is that portfolio depletion is allowed and real value of the portfolio does not need to be maintained, i know that the note in the answer says that no inflation adjustment is needed because expenses and salary offset, but i dont see how thats right. maybe i am misunderstanding.
I’m just going by the solution-- which states no inflation adjustment is made because his salary grows at the rate of inflation that cancels out the increase in living expenses.
“i just don’t see how the portfolio can maintain its real value without an inflationa djustmnet.”
you’re correct, but in these cases,you’re calculating the return needed to GROW the portfolio to a target value. if inflation is cancelled out by (e.g. salary increases at the rate of inflation) or not a factor because expenses do NOT grow at a rate of inflation (e.g fixed mortgage payment), the portfolio then does not need to earn an “extra” return to fight off inflation. thus, no inflation adjustment.
guys, you are torturing my little little brain!
i have a few questions non the less!!
 According to your post daveyc18, the decision to include inflation in the return requirement (+inflation) depends on whether we are looking at a ‘Grow asset base of X to Y’ or a ‘Traditional’ question type?
Also daveyc18,you said that the reason for not including inflation in the maclin case is due to income/expenses increasing at the rate of inflation…but in the case it merely says that ‘after tax salary increases will offset any future increases in expenses’ which are two different statements no?
for example : in the inger case,both income/expenses increase at inflation rate (we adjust CFs @ (1+infl)) AND we want to preserve purchasing power (we add inflation in return req).
…so if your statement about ‘‘both income/expenses increasing at inflation would eliminate the need for adding inflation to ret req’’ were true, the inger example would be wrong…??
 Wouldn’t the inger case be the evidence that adjusting CFs for inflation and adding inflation to return requirement are seperate issues?
if [a]only expenses or [b] both expenses/income increase at inflation, we would adjust CFs by (1+inf). If in addition we want to preserve the real value of the portfolio, we also add inflation to the end (ret requirement section).