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Case Study #2 Answers

To determine what is needed, calculate the income stream replacement.

Number of years to replace income           N = 20 years

Estimated after tax and inflation rate         I = 3%

Target $80,000 * (1-.22) or                  PMT = $62,400

At a 3% after tax and inflation rate, and using 'begin' mode, the need becomes $956,205 – 50,000 for the existing insurance or $906,205.

This is 11.3x times his annual salary.

Remember the lower the after-tax and after-inflation rate, the higher salary multiple (5-15x) Bill will need.

A 3% after-tax and after-inflation return is (on a nominal basis):

To find the nominal (before-inflation) rate:

(1+rnominal)/(1+rinflation)-1 = rreal

(1+rnominal)/(1+.02)-1 = .03 (add 1, multiply both sides by 1.02)

(rnominal) = (1+.03)*(1+.02)-1 = 5.06%

To find the before-tax rate:

rbefore-tax * (1-tax rate) = rafter-tax

r before-tax  * (1-.30) = .0506 (divide both sides by (1-.30))

r before-tax  = .0506/ (1-.30)

Diana’s 3% before-tax before-inflation return is a 7.23% nominal return.

 



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