Schweser Practice Exam 3 AM – Question 9a

@vincentt law school cost $45,000 the first year. So no need to add inflation for the first year.

@vincentt @ravivooda @sophie I’m getting very confused with when to x inflation for income/ expenses individual components first to calculate required return and when to calculate return based on this year’s income/ expenses and then add inflation for the answer to required return. Is there a logic?

Q (source: Schweser 1AM – Q1): Calculate required pre-tax nominal return for the coming year.

Jackson won the lottery and will receive $3.7m after tax.
Owes $158,000 in legal bills and $57,000 in credit card debt.
Will quit job to earn degree. Insurance which was previously paid by company is available for $1,250 per month (not tax deductible) and is estimated to increase in cost at the same rate as inflation (expected to be 3.5%).
Expense: $125,000 after tax and degree will cost $15,500.

A: Expenses [$125,000 + $15,500 + ($1,250 x 12)] = $155,500
Investable assets = $3,700,000 – $158,000 – $57,000 – $385,000 = $3,100,000

Req’d return = $155,500/ $3,100,000 = 5.02% + 3.5% inflation = 8.52%

*Why wasn’t the insurance, expenses and degree adjusted for inflation separately first to get to req’d return and then add inflation again?

My Answer: Req’d return + $155,500 (1.035) / $3,100,000 = 5.2% + 3.5% inflation = 8.69%

Am I double counting here? Please help me to clarify this. So confused.

Yes guys, it’s difficult as I don’t see any particular rule either. But always read the text carefully, show your calculation steps and assumptions, and be brief in your answers (you don’t need to write an essay). Showing steps is important in collecting (some) points and getting the answer ‘wrong’ wouldn’t get you zero completely if the right steps are shown.

@vincentt‌ ,@alta12 one doubt here.
The question says “calculate the total after-tax return that portfolio must earn next year” when he says total after tax return, should we calculate nominal return or real return? I did not add inflation because I felt it did not ask. Was my understanding of question and english incorrect? 🙂

@vincentt‌ I hope in the exam they are clear. In such a situation I would rather present both then to be on the safer side

@vincentt‌ , @alta12 these kind of things are really irritating. the wording next year, coming year, last year…. are very confusing . They keep killing our marks 🙂

@ravivooda do you interpret coming year as next year?

@Alta12‌ This is a very painful area for me.

From the problems, my interpretations are

1. See what they are asking in final answer, before or after inflation, before or after taxes
2. Write Cash Flows and Investable assets.
3. Bring both of them in step-2 to both standard. Means both after taxes or before taxes (ex: If all are before taxes and only retirement income not taxed, you can either split and calculate return or change retirement income as if taxed. )
4. Calculate Return as per need

– When they say something is indexed with inflation like retirement income, exclude that from calculating return as you do not need to earn any more.
– When you do have expenses keeping pace with inflation, need to include them in calculating return
– When expenses are flat seperate them while calculating return. example: we have 100,000 growing with inflation, 20K flat expense. and you have 1mil assets. Calc return as (100,000/1,000,000)+inflation and (20,000/1,000,000). Add these both.
– In some cases, expenses grow faster than return, then we eat into the principal . No other choice
– In some cases, we have fixed amount needed from principal, despite return earned. Keep that into “PMT” while calculating return.

Hope this helps. Better not to worry much into it. As we get points for each step in the answer and wrong calculation might not cost that much as we are worrying.