See how our partners can help you ace your CFA exams.
When presented with an inflation rate, we use it to increase the relevant expenses for the upcoming year. However, the inflation percentage is again added to the final answer. Is it because inflation is already reflected in the expenses, and the return needs to reflect the inflation percentage in order to maintain the real value?
0 ·
Answers
For example, The living expenses are $100,000, projected to grow at 4%inflation rate.
So the living expenses adjusted for inflation are $104000.
Say the required return(Funds needed/investable base) is 3%. The final answer is 3%+4%inflation = 7%.
My question was why do we add the 4% inflation to the final answer even though it is accounted for in the living expenses of 104000.
The required return is a real return, so you need to take into account inflation so maintain the purchasing power in real terms (i.e. I can buy a Big Mac today at $1 and a Big Mac tomorrow at $1.04 - exaggerated example of daily inflation of 4%! ).
1. The inflation is already accounted for in living expenses.
2. It seemed like incorporating inflation effects twice.
But since meeting living expenses and also maintaining real value is the key, it makes sense to add inflation to the return%. Looking back, I partially answered while I was asking the question.
Thanks @sophie, @sankrutimehta and @pulltopar.