CFA CFA Level 3 Schweser Practice Exam 3 AM – Question 9a

# Schweser Practice Exam 3 AM – Question 9a

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• vincentt
Participant
• CFA Level 3
0

The text:

“Wilson wants to enter law school, which should take three years and cost \$45,000 the first year, increasing annually by the rate of inflation of 3%.”

“Wilson is particularly interested in establishing a law practice after graduation from law school. He estimates start-up costs for the practice will total \$200,000. He expects his living expenses and care for his brother, which totalled \$175,000 this year, to increase at the general rate of inflation of 3% per year.”

Question:
Formulate the return portion of Wilson’s investment policy statement (IPS) for his taxable investment portfolio and calculate the total after-tax return that portfolio must earn next year, his first year in law school. Show your calculations.

Portfolio value = \$7,875,000

Required after-tax real return = [ \$45,000 + (\$175,000) (1.03)] / \$7,875,000 = 2.86%

Required after-tax nominal return = (1.0286) (1.03) – 1 = 5.95%

My question:
1.
Why is the solution only multiply the living expenses by 3% and ignoring the college fees which clearly states that it will increase by 3% as well?

2.
On top of that, isn’t that double inflating and shouldn’t the calculation be:

(\$45k + \$175k) / 7,875k = 2.794%

and then to include inflation
1.02794 * 1.03 = 5.88%

@RaviVooda
â€Œ @Alta12â€Œ

• 4

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

• 4

@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%

• vincentt
Participant
• CFA Level 3
4

@alta12 no i intepret 45k as this year, as there’s another question in schweser (look for the name Jackson), she wanted to go to college and the portfolio manager thinks it’s best for her to do so now. I mean come on, how likely is it that after your IPS discussion you could enroll to a college right away?

Hence, i figured it should be the same year for this question as well. So if 45k is this year’s amount, for next year’s it will require to inflate it at 3% same goes to the 175k for this year, to inflate at 3% (for next year’s amount), assuming the portfolio amount is invested this year were to earn 3% minimum, then it’s pointless to inflate the amount for 45k and 175k since it will grow at the same ratio (numerator and denominator).

But after you raised the point, looking at it, 45k will be for next year, hence doesn’t require inflating but to obtain next year’s cost we need to inflate 175k which you pointed out ðŸ˜€

• 4

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.

• RaviVooda
Participant
• CFA Level 3
3

@vincenttâ€Œ ,@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? ðŸ™‚

• vincentt
Participant
• CFA Level 3
3

@RaviVoodaâ€Œ based on what i’ve done so far, when the question did not specify, we will assume they wanted nominal return especially when inflation rate is given, unless specified otherwise.

• RaviVooda
Participant
• CFA Level 3
3

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

• RaviVooda
Participant
• CFA Level 3
2

@vincenttâ€Œ , @alta12 these kind of things are really irritating. the wording next year, coming year, last year…. are very confusing . They keep killing our marks ðŸ™‚

• vincentt
Participant
• CFA Level 3
2

@-) geez it’s that simple! i was expecting some complicated reasons! lol

@Alta12
â€Œ @RaviVoodaâ€Œ

• 1

@ravivooda do you interpret coming year as next year?

• RaviVooda
Participant
• CFA Level 3
1

@Alta12â€Œ 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.

• vincentt
Participant
• CFA Level 3
0

@alta12 just saw your updated post on Jackson, I find this question less confusing. The annual living expenses (155k) which will grow by inflation.

Assuming first year this 155k / x = y ratio
In the second year the y ratio should be the same (assuming the portfolio is able to earn the minimum required return of inflation + annual liquidity).

For my question is a little different, they wanted the next up coming liquidity which is 45k (next year’s) and 175k (this year’s) * inflation (making it next year’s).