Calculation of required return in an IPS referring, required, problem

eagles_dare13

Hello!
I’m referring to the CFAI Curriculum Vol. 6, Reading 45 page 110 (No. 4).
While this problem is more pertinent to SS 16, Monitoring it is a very good exercise
for SS4 Individual investors.
The trust fund is supposed to cover the living expenses of $78,000 a year based on a
portfolio of $3,000,000.
I approached the problem by calculating the real required return after taxes:
2.6 % (78,000 / 3,000,000)
Next step is to consider 30% in taxes to calculate the real required return before taxes:
3.71 % = 2.6% / (1 - 0.3)
The last step is to add inflation (additive or multiplicative method, I chose additive method)
to calculate the nominal required return before taxes:
5.71 % - 3.71% from previous step + 2%
Quite clear cut, I thought. However, for some reason CFAI adds inflation first and does the adjustment for taxes in a step later and comes to the result of 6.57% as the required return (this approach is part of the case description, not the answer).
This is confusing, based on a recent issued weekly Study Tip by Schweser (Required Return Calculation Methodologies, IPS for an Individual Investor) where the before tax return is calculated first and inflation is added last.
What is the right way to calculate the required return? Who can help?
Thanks!

king_kong

taxes are nominal ,i.e the govt does not index taxes to inflation , so CFAI method sounds incorrect . Add a nominal tax to a nominal before tax return to get a nominal after tax return

jcole21

Some inconsistencies are in CAFI text & old exams solutions.

ayaz_mahmud369

Correct me if I am wrong but taxes are paid on nominal returns ? Hence, adding inflation first to real required after taxes and then adding inflation sounds ok to me ??

MiniMe7

sorry second sentence should be “Hence, adding inflation first to real required after taxes and then adjuting for taxes sounds ok to me ??

dmrktrading

toofun, I agree.
The calculation that makes most economic sense, and I have seen CFAI do it this way in places:
required return before tax% =[ (1 + required real return after tax%)*(1 + inflation%) - 1]/ (1 - tax%)
The same thing using additive method is:
required return before tax% = (required real return after tax% + inflation%) / (1 - tax%)

mik82

Just looked up schweser “Quicksheet” it has identical formula.