 Fundamental law of active management has three components:

1) Information coefficient: measure of manager’s skill. Active returns vs forecasted returns.

Active returns vs. expected active returns
2) Transfer coefficient: actual active weights and optimum active weights. For unrestricted
portfolio TC=1
3) Breadth: number of independent bets taken per year

Where information ratio= IC x TC x √breadth

 The expected information ratio is the single best criterion for evaluating active investment
managers’ performance given the same benchmark. Selecting the highest information ratio manager
will produce the highest Sharpe ratio for the portfolio.
 A limitation of the fundamental law with the active management of fixed-income portfolios is the
lack of decision independence. Virtually all bonds have some form of duration risk, credit risk, and
optionality, so their returns are highly correlated in subtler ways.
 Increasing the rebalancing frequency from quarterly to monthly will increase the breadth but only if
active management decisions are uncorrelated over time. Few active management decision
opportunities mean that the information coefficient for a market timing strategy must be high to
achieve even a modest information ratio. The information ratio will also increase assuming the
information coefficient remains at the same level.
 The strategic asset allocation will include target asset class weights and maximum and minimum
permissible asset class weights, which are specified as risk control mechanisms.

 Buyout funds seek out companies with stable cash flows. They generally invest in companies with
low working capital requirements and acquire portfolio companies via auction.

 Private equity funds increase value by taking on high levels of debt on favorable terms. They are
able to offset their borrowing costs by superior reorganization and re-engineering capabilities.

 To calculate fractional ownership, do the following:

o Fraction = Initial investment/POST money valuation

o POST money valuation = NPV of cashflows
o Then use unitary method to calculate shares
 Compensation and audit committee should be composed entirely of independent board members
under corporate governance best practices.
 Justice Theory is based on the idea of a “veil of ignorance” to create an impartial judgment of a
situation. Rights Theory is based on “rights” and “obligations”. Utilitarianism could actually advocate
for low worker pay if it promotes a greater good that is not consistent with the statement.
 Friedman doctrine that maintains that the firm only needs to abide by the rule of law.

 Operating after tax cashflow: Sales − Cash operating expenses − Depreciation × (1 − Tax rate) +
Depreciation
 nominal cash flows should be discounted using a nominal discount rate. Inflation is already included
in the nominal discount rate

 The trade-off of the tax savings of debt versus the value of financial distress cost is an example of
the static trade-off theory of capital structure

 Research showed that 45% of private repurchases between 1984 and 2001 were actually made at
discounts, indicating that many direct negotiation repurchases are generated by the liquidity needs
of large investors who are in a weak negotiating position.

 The sustainable growth rate model assumes that the growth will be financed with the issuance of
debt and only internally generated equity will be used to maintain a target capital structure. No
additional common equity will be issued. The ROE is assumed to be a constant during this period.
 The residual income model uses accounting income estimates and assumes that the cost of debt
capital is properly reflected by interest expense, but because of changing market conditions interest
expense may not be a good proxy for the company’s cost of debt capital
 Enterprise value = market value of common equity + non-controlling interest + market value of debt
– cash
 Investment value conceptualizes a specific buyer taking into account potential synergies. Fair market
value concerns the value at which an asset would change hands between a willing buyer and seller.
 Free cash flow to equity is appropriate for investors who want to take a control perspective and for
companies that are not currently paying regular dividends.
 The Pastor–Stambaugh model adds a liquidity premium as a fourth factor to the Fama–French
model and thus helps make an adjustment for the liquidity concerns surrounding the stock.