2010 Paper - Question 1 Required return?!

CFA Level III Portfolio Management
#1

Hi Level 3 candidates!

Can you please help me with question 1 on the 2010 paper, specifically part Bii.

The question asks us to calculate the pre-tax nominal required return. My methodology was as follows:

  1. Find the post tax income ($105,000) and then find the spending shortfall between this and the expenses (there was a surplus of $9,000).
  2. Since this was a saving I used a figure of -9,000 under PMT in the calculator.
  3. Entered PV as $225,000 as given to us in the text.
  4. Set FV to $2,000,000 as given to us in the text.
  5. Find I/Y and then divide this by 1-T as this is asking for a pre-tax return.

The CFAI answer has the following differences: - Does not find the post tax income in order to arrive at the shortfall (surplus) figure - Does not divide I/Y by 1-T to arrive at the pre-tax return figure.

Can you help me understand why? Virtually all questions I have had which ask me to find the pre-tax return figure have followed the above methodology…bit confused here!

#2

The problem with your approach is that the 9,000 is after taxes, whereas the vignette is clear that contributions to the TDA are before taxes (see Exhibit 1). Therefore, you have to get the before-tax numbers today and use them in your calculation.

And, of course, if you’re already doing your calculations before taxes, you don’t divide by (1 − t) at the end.

#3

Thanks for your answer. So the reason the solution grossed the expenses, was because the contribution to the TDA was on a pure pre-tax basis? Therefore, since we always assume the expenses are post tax (unless stated otherwise), we had to make them pre-tax here to match with the pre-tax income?

#4

Yup.