However, looking at CFAI past questions, sometimes they include inflation rate into this equation and sometimes they don’t use it.
Based on my research (please confirm):
The spending rate is composed of year end value de from the previous year so simply calculating required return will neglect the inflation component. However, if the question mentions they would like to maintain the real value of the portfolio, we would include the nominal rate?
I appreciate the help in this matter (hopefully s2000 magician graces this post with his presence [lol]).
if the spending rate is based on THIS year end value then inflation is already included and you neglect it (you might take into account the growth of the operating expenses…)
If it is based on year end value of last year, then you have to include it.
where I don’t understand the calculation with the inflation rate:
I added it to the spending rate (which is a journal subscription fee for a library) and added it again so the asset base would preserve its real value after having paid the yearly subscription fee.
Anyone has done this question recently and could help me out?
I’m not seeing the confusion… why would you add the inflation rate twice?
For the basic: r = ((Annual cost) / (remaining capital after immediate payment)) + (investment fees + inflation rate including additional inflation, which is given)
= (800k / 20.5m) + (0.5% + 2% + 1%) = 7.4%
You don’t need to inflate the 800k to next year because inflation would already be accounted for when calculating the rate of return needed needed going forward. The question says to use arithmetic rather than geometric.
Can you show your calculations so we see where you went wrong?
Next year the subscription fee will be 800K +2% +1% (inflation +1%) + 0.5% AM fee + 2% inflation to preserve the real value.
Subscription fee in $ terms: 1,414.5
Required rate of return = 9.4% In $ terms $1,927 K.
Calculating it back:
$20,500 earns $1,927.
We deduct the subscription fee of $1,414.5 and the AM fee of $102.5.
We end up with $410 which is 2% of the original investable asset base to preserve the PP.
In my understanding the increase by the amount of inflation is required both
by the spending rate (because the journal subscription fee annually increases by the amount of inflation)
and the portfolio to grow it with the amount of inflation.
True, this way the portfolio will be larger and larger each year, while the endowment does not need to spend it - so here I already felt I’m going in a wrong direction, but the way the data was given was/is not clear for me and I find it difficult to draw a general conclusion for similar questions.
Yikes. Ok, there’s a few issues here and it’s easy to get lost and start all these calculations. Don’t do that.
The key is to recognize that the required return calculation this year will include all these numbers (inflation, fees, etc.) - so there is no need to project out the expense next year. Moreover you only need to add inflation once. The added inflation rate in the investment return will compensate for the increase in subscription fee due to inflation.
It’s really as easy as dividing this year’s expense (800k) into the portfolio value today (market value less up front fee). This will get you the base return needed assuming no inflation, fees, etc. (800k/20.5m = 3.9%)
Then simply add the inflation rate (2% + 1%) and the management fee (0.5%) to the base rate (3.9%) and voila, the return requirement is 7.4%.
You have to get your head around this because all the IPS calculations asking for a return requirement this year are calculated the same way (maybe a tax adjustment, but in essence it’s the same). Just do similar questions and it should start to click.
Thanks, I get it (at least in this example), I’ll look for similar questions to make sure I’m OK, because inflation is mixed into the IPS everywhere and it throws me out of my balance.