Could anybody kindly explain what is meant by “inflation-adjusted”? I am not sure whether it is meant by “inflation-removed” or “inflation- concluded”. Seems to me it has different meanings in different context. 1) In Example 4 on page 229, curriculum vol 2, that the annual spending of ZAR1,000,000 on an “inflation-adjusted basis”, I think it is actually in real terms, not including the inflation rate of 3%, otherwise it should be discounted back at the nominal risk free rate of 5%. Also the similar case in the example on page 227, “…The Webster’s inflation adjusted annual spending needs…”. I think it refers to the spending needs not including inflation, in other words, it is on a inflation-removed basis. 2) But, on the bottom line on page 131, curriculum vol 2, the “inflation-adjusted income” seems to be on an inflation-included basis (also the same case in Q1, 2007 exam, their inflation-adjusted expenses will remain constant…). Now I got totally lost. What on earth is it meant by “inflation-adjusted”? Does it refer to different things in specific context? And do we have to make judgment under specific circumstances? Thanks a lot~
It depends whether it’s an asset or a liability to you. If you are calculating portfolio return, then “inflation adjusted” means reduced by the inflation rate. However, if it’s a cost like living expenses, it’s increased by the inflation rate.
most of the cases are related to living expenses…
mrimer, good question. I made a special note on that page a while ago, thanks for bringing this up. While this seems confusing, there is sanity to the method. The page 230 problem can be solved in two ways-- METHOD#1 you can create a schedule of their spending for each year by inflating (“inflation adjusting”) the spending amount. If inflation was different in each year you would inflate the previous year’s amount by next year’s inflation to come up with *nominal* spending. Fine so far? Now to figure out the PV of this schedule of spending, you’d discount by what? You discount it by the *nominal* risk-free-rate (not the real), again remembering to discount each spending by its corresponding year’s nominal discount rate. METHOD#2 A short-cut method to arrive at the same PV, is NOT to inflate each year’s spending amount, and then discounted it by the *real* risk-free rate. Mathematically the process is identical, as first you compound by inflation to get each nominal FV and then you discount by a rate that includes inflation. I wouldn’t finish the exam if I went with #1, hence #2. Agree they are one and the same?
kind of the method taught in Level II in the Equity chapter on “emerging Markets”. Discount REAL cash flows by REAL rate. Discount NOMINAL cash flows by NOMINAL Rate. both will be the same PV…
Hi folks, thanks for your kind feedback. Right. For Example 4 on page 229, vol 2, we need to do it on an "apple to apple"basis. I am sorry maybe I have not made myself fully understood. What is confusing to me is that the “inflation-adjusted” in above example ( which is in real terms, and inflation is NOT included)seems to be inconsistent with the one on the bottom line on page 131, curriculum vol 2, the “inflation-adjusted income” , and the one in Q1, 2007 exam “their inflation-adjusted expenses will remain constant…” (where the expenses or income is in nominal terms, and inflation is included). In other words, if “inflation-adjusted” comes up on the exam, how can we judge whether the it is referred to as “inflation -removed” (as in the former case) or “inflation- included”(as in the latter case)? Thanks!~
This terminology frustrates me too. Fkn just say real or nominal, asshats