000. LACHLAN'S COMPANY WILL PAY HIM AN AFTER-TAX PENSION OF AUD 51...

237,000. Lachlan's company will pay him an after-tax pension of AUD 51,000 starting in one year

when he retires, with the payments increasing by the rate of inflation, which is expected to be 3%

annually. His employer will continue to pay all of the Martins' medical costs until death. Both the

pension and health benefits will continue to accrue to Lachlan's wife, if he dies first. The Martins

expect their living expenses will also continue to grow at the rate of inflation until one of them

dies. At that time, they expect the survivor's living expenses will decrease to 75% of their

combined expenses and then continue to grow at the rate of inflation.

The Martins intend to fund their living expenses during retirement with Lachlan's pension and the

investment income generated from the assets invested in from the inheritance. The Martins

consider their investment base to be large given the inheritance, want their portfolio to be

invested conservatively, and want to maintain the real value of their investable assets over time.

They plan to leave any assets left in their estate to charity. All income and realized capital gains

are taxed at 25%. The assumed annual effective tax rate is 20%.

...

A. Calculate the before-tax nominal rate of return required for the Martins' first year of

retirement. Show your calculations. Do not assume any tax effects related to the mortgage.

Grading Guide

Answer for Question 2-A

Retirement starts in one year: first year cash flow needs:

Lachlan's After-Tax Company Pension AUD 51,000

Living expenses (263,000 × 1.03 inflation) -270,890

Year 1 net required after-tax cash flow AUD -219,890

Net Investable Assets

Inheritance, after-tax AUD 9,000,000

Mortgage debt repayment -3,700,000

Other debt repayment -160,000

Investable asset base (beginning Year 1) AUD 5,140,000

Return Objective

Year 1 after-tax required cash flow AUD -219,890

Divided by investable asset base AUD 5,140,000

Equals after-tax real return 4.28%

Plus expected inflation 3.00%

Equals after-tax nominal rate of return 7.28%

Before tax nominal return: 7.28 / (1 - 0.2) = 9.10%

Or

Geometrically (1.0428)(1.03) - 1 7.41%

Before tax nominal return: 7.41 / (1 - 0.2) = 9.26%

Candidate discussion:

1 point each for 1) components of need, 2) 219,890, 3) components of asset base, 4) 5,140,000,