Calling out all those who have understood this concept pretty well. Can you help noobs like me to understand the basics. I am pretty lost with all those 1. before and after tax 2. nominal and real 3. adjusting cash flows for taxes etc etc etc. so far what I am trying to do is 1. Figure out total portfolio size and deduct if any recent outflow has to be made. 2. Write down income sources. Made inflation adjustment if needed. 3. Write down expenditures. Make inflation adjustment if needed. 4. If simple return calculation for one year then (Expenses-Income)/Portfolio size. If before tax return is asked then we divide return by (1-tax rate). Add inflation to get before or after tax nominal returns. Anyway, my head is messed up.
Bump. +1 for me too…
if they ask for the nominal return you add inflation. total portfolio size = asset base you are calculating your required return on. deduct any immediate cash flows from your asset base that are required now. for the spending needs, make sure you increase the annual spending need by inflation if its 1 year ahead.
Programmer did a pretty good description of it. The only time you divide by (1-tc) is when you are searching for the BEFORE TAX required return.
The other addition to the return calculations is to think about the final portfolio value for long term goal.
“for the spending needs, make sure you increase the annual spending need by inflation if its 1 year ahead.” whats that mean? exaxmple?
Joe has $1 million. Joe expects to spend $100,000 after-inflation annually. Expected inflation is 5%. The required return is not 15% (10% spending plus 5% inflation). The required return is 15.05%, because the first year’s spending rises to $105,000.
- Total portfolio includes all current assets reduced by immediate expenses to incur within the next year. If there are outflows in 5, 10, 15 years then you do not reduce the asset base by them (only reduce by immediate expenses) unless you are given the present value of those. 2. Only time I have seen income increased by inflation is if you you have to compute the FV of the portfolio at retirement date to compute the asset base. 3. Only time I have seen increasing expenses by inflation to calc outflow is if they state that the expenses occurs “immediately” and continues annually adjusted for inflation or in example in #2 4. If before tax is asked then use the (after tax cash flows/asset base)/(1-t)+inflation. If cash outflows are pretax then you do not need to divide by (1-t) as your cash flows are already pre-tax.
3 is if they give you current living expenses for this year and ask for next years return requirement. Should have to inflate by this years expenses for next years return requirement.
seemorr Wrote: ------------------------------------------------------- > Joe has $1 million. Joe expects to spend $100,000 > after-inflation annually. Expected inflation is > 5%. > > The required return is not 15% (10% spending plus > 5% inflation). The required return is 15.05%, > because the first year’s spending rises to > $105,000. Maybe you had a typo, but the required return in this case is 15.5% (1.1*1.05)-1=15.5% This can be broken down into 3 components: 1. Portfolio increase = 5% * $1M = $50K (necessary to preserve purchasing power) 2. Current spending = $100K 3. Spending increase = 5% * $100K = $5K TOTAL = $155K Percentage = $155K / $1M = 15.5%
robbyrazz shouldn’t it be (aftertax+inflation)/(1-t). 2009 exam docet though, although you are taxed obviously on nominal returns
My confusion comes from whether we should apply inflation before tax or after tax. Suppose I have $1000, inflation rate is 5%, and spending rate is 4%. Tax rate = 20%. What’s my required return? (1000*4%+1000*5%)/1000/(1-0.2) = 11.25% or (1000*4%)/1000/(1-0.2) + 1000*5%/1000 = 10%. Help me please.
Assuming I have a taxable account.
there’s no officially correct way to do it. if i remember from last year, the old exams and the book calculated it differently. just pick a way that makes sense and run with it
What really helps me is a matrix Y1 Y2 Inflows Inflows Outflows Outflows (incl. i if necessary) Sum Y1 Sum Y2 Deduct from principal if the amounts are not covered, usually no need to go beyond Y2 as this would be another multi-stage-term Hints: LOOK FOR EXPECTED INVESTMENT INCOME, too! Take salary gross of taxes and substract taxes later, this way you will include taxes payable from realized capital gains for example. Regarding your question, glacier88: 1. Usually, they ask for after tax returns or pre-tax returns (but then has also pre-tax outflows) 2. if not, think logically: First: get the needed pre-tax return and THEN add inflation I dont understand your way of performing the calcs at all, so how I would calc it: 5% return after tax 20% taxes 3% inflation 5/.8=6.25 --> (1.0625)(1.03)=9.44% (before tax and inflation adjusted) you could add inflation for private investors (for endowments multiplying is recommended) but either way will go This is the way, Schweser explains this in their “Required Return Calculation” Handbook on p.4 (you can download it from their homepage if you at least bought the notes from them).
nailer Wrote: ------------------------------------------------------- > robbyrazz > > shouldn’t it be (aftertax+inflation)/(1-t). 2009 > exam docet though, although you are taxed > obviously on nominal returns This has been an area of confusion. I have seen it done both ways. Mainly I have seen it done as ((outflow/base)/(1-t))+ inflation. I am not sure when to use which method though so if anyone has any clarity please share.
I think the distinction might be if the INCOME in the portfolio is taxed, then the whole return is divided by (1-t), but if it is the WITHDRAWAL that is taxed (say from a TDA), then you divide only the real return which represents the cash outflow by (1-t), and then add inflation afterwards, since in a TDA it wouldn’t be taxed while it grows in the fund. Thoughts?
glacier88 Wrote: ------------------------------------------------------- > My confusion comes from whether we should apply > inflation before tax or after tax. > > Suppose I have $1000, inflation rate is 5%, and > spending rate is 4%. Tax rate = 20%. > > What’s my required return? > > (1000*4%+1000*5%)/1000/(1-0.2) = 11.25% > > or > > (1000*4%)/1000/(1-0.2) + 1000*5%/1000 = 10%. > > Help me please. I would say none of the above. Here is how I would calculate it (applying inflation before the tax rate): required after tax real return = spending rate / portfolio value = 4% required nominal before tax return = ((1.04*1.05)-1)/0.8 = 11.5% You can work your way backwards to verify the answer: Portfolio value now = $1000 Before tax income during year 1 = $1000 * 11.5% = $115 Tax during year 1 = $115 * 0.2 = $23 Spending during year 1 = $40 + inflation = $40 * (1.05) = $42 Sum these up to get portfolio value at end of year 1 = $1000 + $115 - $23 - $42 = $1050 So your portfolio grew by 5% in order to keep up with inflation and thereby preserve purchasing power into the future. I could be wrong about this, but the short answer is apply inflation before applying taxes.
LB, your are the same as mine that we apply tax after inflation. The difference is you link then via geometric and mine simple addition. Lawyer: you applied tax before inflation. My question is whether we should apply tax before inflation or after inflation. Q1 of 2009 tax before inflation. I,e, after tax return rate -> before tax rtn -> inflation adjusted rtn. I tend to think this is wrong. Did I miss anything?
glacier88 Wrote: ------------------------------------------------------- > LB, your are the same as mine that we apply tax > after inflation. The difference is you link then > via geometric and mine simple addition. > > Lawyer: you applied tax before inflation. > > My question is whether we should apply tax before > inflation or after inflation. Q1 of 2009 tax > before inflation. I,e, after tax return rate -> > before tax rtn -> inflation adjusted rtn. > > I tend to think this is wrong. Did I miss > anything? This is right the capital gains in the portfolio grow tax deferred as only the income is taxed, no need to add tax on a yearly basis to all portfolio returns, i.e the 3% inflation adjustment. If all returns taxed on a yearly basis such as income produced from a income security. Return requirement becomes (Return)(Inflation)/(1-t) If just taxed on what you are taking out and assuming return = what you are taking out. (Return)/1-T It all comes from the tax formula in the next chapter if you think about them thoroughly.