Question #2 in reading 10 EOC practice problems.
When her annual expenses - art sales are divided by the base ($1,120,000) the required return is approximately 4.5%. This gets classified as a real return.
However, when comparing this against what the portfolio will earn, $82,500 divided by the base, the return comes out to 7.4% BUT inflation of 3% is removed to make the comparison in the answer.
Why is one real and the other considered nominal?
Nominal = real + inflation.
When we are talking about the current year, we need to adjust return for the current inflation. Therefore, 7.4% - 3% = 4.4%. In subsequent years, however, we are assuming that both income and expenses will increase by the same inflation percentage wise. We do not make adjustments since we know that in real terms, 50k (income gap) needs to be generated on asset base of 1.12M. If you multiply both values (50k and 1.12M) by inflation you get the same result.
Very helpful - the current year is what was throwing me off. Cheers!