FIN 6160 California Miramar University Cost of Debt Vs Cost of Equity Discussion

Description

Topic:
Is cost of debt higher or cost of equity? Explain why.
PROFESSOR’S GUIDANCE FOR THIS WEEK’S LE:
A company can obtain capital either through issuing debt or equity. Each of them has its own cost. Discuss which one has a higher cost for company and why.
 
Post 1
by Ngoc Dinh Learning Engagement # 5 Topic: Is cost of debt higher or cost of equity? Explain why. A company can obtain capital either through issuing debt or equity. Each of them has its own cost. Discuss which one has a higher cost for the company and why. There are two main sources of capital companies rely on—debt and equity. Both provide the necessary funding needed to keep a business afloat, but there are major differences between the two. And while both types of financing have their benefits, each also comes with a cost. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company’s profit margins. Debt is also cheaper than equity from a company’s perspective is because of the different corporate tax treatments of interest and dividends. In the profit and loss account, interest is subtracted before the tax is calculated; thus, companies get tax relief on interest. Cost of Debt Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans. These loans may be long-term or short-term such as overdraft protection. Debt capital does not dilute the company owner’s interest in the firm. But it can be cumbersome to pay back interest until its loans are paid off—especially when interest rates are rising.  Companies are legally required to pay out interest on debt capital in full before they issue any dividends to shareholders. This makes debt capital higher on a company’s list of priorities over annual returns. While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return. This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or may require collateral, especially for businesses that are in trouble (Boyte-White, 2021). Cost of Equity Equity capital typically comes from funds invested by shareholders, the cost of equity capital is slightly more complex. Equity funds don’t require a business to take out debt which means it doesn’t need to be repaid. But there is some degree of return-on-investment shareholders can reasonably expect based on market performance in general and the volatility of the stock in question.  Companies must be able to produce returns—healthy stock valuations and dividends—that meet or exceed this level to retain shareholder investment. The capital asset pricing model (CAPM) utilizes the risk-free rate, the risk premium of the wider market, and the beta value of the company’s stock to determine the expected rate of return or cost of equity (Watson & Head, 2013). References. Boyte-White, C. (2021). How Do Cost of Debt Capital and Cost of Equity Differ? BUSINESS. CORPORATE FINANCE & ACCOUNTING. Investopedia Watson, D., Head, A. (2013). Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall492 words
Post 2
by Jana Kmetova Thakur (n/A) describes the cost of debt as the expected rate of return for the debt holder. It is usually calculated as an effective interest rate that can apply to a company’s liability. In addition, it is an internal par of discounted valuation analysis that calculates the company’s present value by discounting future cash flows by the expected rate of return to its equity and debt holders. Usually, the cost of debt can be calculated before or after taxes; the total interest expense upon total debt availed by the company is the expected rate of return and can be incurred by a company in any year it is before. The cost of debt calculation must include:Total interest cost.Aggregate debt (at the end of the fiscal year).The tax rate (the average rate that the company is taxed). Mukhopadhyay (n/a) states that the cost of equity calculates the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; in addition, it may go to other opportunities with higher returns. For instance, if we have $1000, we would invest them into the company ABC, which has a low-risk stock. The company’s current stock price is $8, with an expected rate of return for us would be 15%. By calculating the cost of equity, we will know that we can get 15% or more if we invest in the company. If not, we can find other investment opportunities.In general, the cost of equity is higher than the cost of debt. The reason is that investors take more risk when investing in a new company stock compared to investing in the company’s bond. Other reasons can be – Capital gains are not a guarantee, a company has no legal obligation to issue dividends, and the stock market has higher volatility than the bond market. On the other hand, it can happen that cost of debt can be higher. It happens when the company has too much debt, which raises the cost of debt over equity. The main factor that influences the cost of debt is the interest rate (CFI, 2021). References:Thakur M. (n/a). What is Cost of Debt (Kd)?, https://www.wallstreetmojo.com/cost-of-debt/?nowpr…Mukhopadhyay S. (n/a). Cost of Equity, https://www.wallstreetmojo.com/cost-of-equity-capm…CFI. (2021). Debt vs Equity Financing: Which is best?, https://corporatefinanceinstitute.com/resources/kn…436 words

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CHAPTER 9
The Cost of Capital
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1
Topics in Chapter
?
Cost of capital components
?
?
?
?
?
?
Debt
Preferred stock
Common equity
WACC
Factors that affect WACC
Adjusting cost of capital for risk
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2
Determinants of Intrinsic Value:
The Weighted Average Cost of Capital
Net operating
profit after taxes
Free cash flow
(FCF)
Value =
Required investments
in operating capital
?
=
FCF1
FCF2
FCF?
+
+
···
+
(1 + WACC)1
(1 + WACC)2
(1 + WACC)?
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Cost of equity
Firm’s debt/equity mix
Firm’s business risk
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What types of long-term
capital do firms use?
?
Long-term debt
?
?
?
?
Some firms also use permanent short-term
debt
Other firms have temporary short-term
debt for seasonal fluctuations in inventory,
but this is usually not part of the capital
structure
Preferred stock
Common equity
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4
Capital Components
?
?
?
Capital components are sources of funding
that come from investors.
Accounts payable, accruals, and deferred
taxes are not sources of funding that come
from investors, so they are not included in
the calculation of the cost of capital.
We do adjust for these items when
calculating the cash flows of a project, but
not when calculating the cost of capital.
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5
Before-tax vs. After-tax Capital
Costs
?
?
?
Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
Most firms incorporate tax effects in the
cost of capital. Therefore, focus on
after-tax costs.
Only cost of debt is affected.
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6
Historical (Embedded) Costs
vs. New (Marginal) Costs
?
The cost of capital is used primarily to
make decisions which involve raising
and investing new capital. So, we
should focus on marginal costs.
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7
Cost of Debt
?
?
?
Method 1: Ask an investment banker
what the coupon rate would be on new
debt.
Method 2: Find the bond rating for the
company and use the yield on other
bonds with a similar rating.
Method 3: Find the yield on the
company’s debt, if it has any.
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8
A 15-year, 12% semiannual bond
sells for $1,153.72. What’s rd?
0
rd = ?
-1,153.72
INPUTS
1
30

60
60
30
N
OUTPUT
2
60 + 1,000
-1153.72 60
I/YR
PV
PMT
1000
FV
5.0% x 2 = rd = 10%
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
Component Cost of Debt
?
Interest is tax deductible, so the after
tax (AT) cost of debt is:
rd AT = rd BT(1 – T)
rd AT = 10%(1 – 0.40) = 6%.
?
?
Use nominal rate.
Flotation costs small, so ignore.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
Cost of preferred stock: Pps = $116.95;
10%Q; Par = $100; F = 5%
Use this formula:
rps =
Dps
Pps (1 – F)
0.1($100)
=
=
$116.95(1 – 0.05)
$10
= 0.090 = 9.0%
$111.10
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11
Time Line of Preferred
0
rps = ?
-111.1
1
?
2

2.50
2.50
2.50
DQ
$2.50
$111.10 =
=
rPer
rPer
$2.50
rPer =
= 2.25%; rps(Nom) = 2.25%(4) = 9%
$111.10
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12
Note:
?
?
?
Flotation costs for preferred are
significant, so are reflected. Use net
price.
Preferred dividends are not deductible,
so no tax adjustment. Just rps.
Nominal rps is used.
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13
Is preferred stock more or less
risky to investors than debt?
?
?
More risky; company not required to
pay preferred dividend.
However, firms want to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, and (3) preferred
stockholders may gain control of firm.
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14
Why is yield on preferred
lower than rd?
?
?
?
Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost to the
issuer are higher on preferred than on debt,
which is consistent with the higher risk of
preferred.
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15
Example:
rps = 9%, rd = 10%, T = 40%
rps, AT = rps – rps(1 – 0.7)(T)
= 9% – 9%(0.3)(0.4) = 7.92%
rd, AT = 10% – 10%(0.4)
= 6.00%
A-T Risk Premium on Preferred = 1.92%
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16
What are the two ways that
companies can raise common equity?
?
?
Directly, by issuing new shares of
common stock.
Indirectly, by reinvesting earnings that
are not paid out as dividends (i.e.,
retaining earnings).
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17
Why is there a cost for
reinvested earnings?
?
?
?
Earnings can be reinvested or paid out
as dividends.
Investors could buy other securities,
earning a return.
Thus, there is an opportunity cost if
earnings are reinvested.
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18
Cost for Reinvested Earnings
(Continued)
?
?
Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
They could buy similar stocks and earn
rs, or company could repurchase its own
stock and earn rs. So, rs, is the cost of
reinvested earnings and it is the cost of
common equity.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
19
Three ways to determine
the cost of equity, rs:
1. CAPM: rs = rRF + (rM – rRF)b
= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-JudgmentalRisk Premium: rs = rd + Bond RP.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
20
CAPM Cost of Equity: rRF = 5.6%,
RPM = 6%, b = 1.2
rs = rRF + (RPM )b
= 5.6% + (6.0%)1.2 = 12.8%.
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21
Issues in Using CAPM
?
Most analysts use the rate on a
long-term (10 to 20 years)
government bond as an estimate
of rRF.
(More…)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
Issues in Using CAPM
(Continued)
?
?
Most analysts use a rate of 3.5% to
6% for the market risk premium
(RPM)
Estimates of beta vary, and
estimates are “noisy” (they have a
wide confidence interval).
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
23
Dividend Growth Cost of Equity, rs:
D0 = $3.26; P0 = $50; g = 5.8%
rs =
D1
P0
+g=
D0(1 + g)
P0
+g
= $3.12(1.058) + 0.058
$50
= 6.6% + 5.8%
= 12.4%
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24
Estimating the Growth Rate
?
?
?
Use the historical growth rate if you
believe the future will be like the past.
Obtain analysts’ estimates: Value Line,
Zacks, Yahoo!Finance.
Use the earnings retention model,
illustrated on next slide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
25
Earnings Retention Model
?
?
Suppose the company has been
earning 15% on equity (ROE = 15%)
and has been paying out 62% of its
earnings.
If this situation is expected to
continue, what’s the expected future
g?
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26
Earnings Retention Model
(Continued)
?
Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.
This is close to g = 5.8% given earlier.
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27
Could the dividend growth approach
be applied if g is not constant?
?
?
YES, nonconstant g stocks are
expected to have constant g at some
point, generally in 5 to 10 years.
But calculations get complicated. See
the Web 9A worksheet in the file Ch09
Tool Kit.xls.
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28
The Own-Bond-Yield-Plus-Judgmental-RiskPremium Method: rd = 10%, RP = 3.2%
?
?
?
?
rs = rd + Judgmental risk premium
rs = 10.0% + 3.2% = 13.2%
This judgmental-risk premium ? CAPM
equity risk premium, RPM.
Produces ballpark estimate of rs.
Useful check.
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29
What’s a reasonable final
estimate of rs?
Method
Estimate
CAPM
12.8%
Dividend growth
12.4%
rd + judgment
13.2%
Average
12.8%
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30
Determining the Weights for
the WACC
?
?
The weights are the percentages of
the firm that will be financed by each
component.
If possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital.
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31
Estimating Weights for the
Capital Structure
?
?
If you don’t know the targets, it is
better to estimate the weights using
current market values than current
book values.
If you don’t know the market value of
debt, then it is usually reasonable to
use the book values of debt, especially
if the debt is short-term.
(More…)
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32
Estimating Weights
(Continued)
?
Suppose the stock price is $50, there
are 3 million shares of stock, the firm
has $25 million of preferred stock, and
$75 million of debt.
(More…)
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33
Estimating Weights
(Continued)
?
?
?
?
Vs = $50(3 million) = $150 million.
Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75
= $250 million.
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34
Estimating Weights
(Continued)
?
?
?
?
ws = $150/$250
wps = $25/$250
wd = $75/$250
= 0.6
= 0.1
= 0.3
The target weights for this company are the
same as these market value weights, but
often market weights temporarily deviate
from targets due to changes in stock prices.
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35
What’s the WACC using the
target weights?
WACC = wdrd(1 – T) + wpsrps + wsrs
WACC = 0.3(10%)(1 ? 0.4) + 0.1(9%)
+ 0.6(12.8%)
WACC = 10.38% ? 10.4%
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36
What factors influence a
company’s WACC?
?
Uncontrollable factors:
?
?
?
?
Market conditions, especially interest rates.
The market risk premium.
Tax rates.
Controllable factors:
?
?
?
Capital structure policy.
Dividend policy.
Investment policy. Firms with riskier projects
generally have a higher cost of equity.
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37
Is the firm’s WACC correct for
each of its divisions?
?
?
NO! The composite WACC reflects the
risk of an average project undertaken
by the firm.
Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk
and capital structure.
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38
The Risk-Adjusted Divisional
Cost of Capital
?
?
Estimate the cost of capital that the
division would have if it were a
stand-alone firm.
This requires estimating the division’s
beta, cost of debt, and capital
structure.
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39
Pure Play Method for Estimating
Beta for a Division or a Project
?
?
?
Find several publicly traded companies
exclusively in project’s business.
Use average of their betas as proxy for
project’s beta.
Hard to find such companies.
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40
Accounting Beta Method for
Estimating Beta
?
?
?
Run regression between project’s
ROA and S&P Index ROA.
Accounting betas are correlated
(0.5 – 0.6) with market betas.
But normally can’t get data on new
projects’ ROAs before the capital
budgeting decision has been made.
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41
Divisional Cost of Capital
Using CAPM
?
?
?
?
?
?
Target debt ratio = 10%.
rd = 12%.
rRF = 5.6%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.
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42
Divisional Cost of Capital
Using CAPM (Continued)
Division’s required return on equity:
rs = rRF + (rM – rRF)bDiv.
rs = 5.6% + (6%)1.7 = 15.8%.
WACCDiv. = wd rd(1 – T) + wsrs
= 0.1(12%)(0.6) + 0.9(15.8%)
= 14.94% ? 14.9%
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43
Division’s WACC vs. Firm’s Overall
WACC?
?
?
Division WACC = 14.9% versus
company WACC = 10.4%.
“Typical” projects within this division
would be accepted if their returns are
above 14.9%.
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44
What are the three types of
project risk?
?
?
?
Stand-alone risk
Corporate risk
Market risk
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45
How is each type of risk used?
?
?
?
?
Stand-alone risk is easiest to calculate.
Market risk is theoretically best in most
situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
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46
A Project-Specific, Risk-Adjusted
Cost of Capital
?
?
Start by calculating a divisional cost of
capital.
Use judgment to scale up or down the
cost of capital for an individual project
relative to the divisional cost of capital.
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47
Costs of Issuing New Common
Stock
?
?
When a company issues new common
stock they also have to pay flotation
costs to the underwriter.
Issuing new common stock may send a
negative signal to the capital markets,
which may depress stock price.
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48
Cost of New Common Equity: P0 = $50,
D0 = $3.12, g = 5.8%, and F = 15%
re =
D0(1 + g)
P0(1 – F)
+g
$3.12(1.058) + 5.8%
=
$50(1 – 0.15)
= $3.30 + 5.8% = 13.6%
$42.50
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
49
Cost of New 30-Year Debt: Par = $1,000,
Coupon = 10% paid annually, and F = 2%
?
Using a financial calculator:
?
?
?
?
?
N = 30
PV = 1,000(1 – 0.02) = 980
PMT = -(0.10)(1,000)(1 – 0.4) = -60
FV = -1,000
Solving for I/YR: 6.15%
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
50
Comments about flotation
costs:
?
?
?
Flotation costs depend on the risk of the firm
and the type of capital being raised.
The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
We will frequently ignore flotation costs when
calculating the WACC.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
51
Four Mistakes to Avoid
?
Current vs. historical cost of debt
Mixing current and historical measures
to estimate the market risk premium
Book weights vs. Market Weights
Incorrect cost of capital components
?
See next slides for details.
?
?
?
(More…)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
52
Current vs. Historical Cost of
Debt
?
?
When estimating the cost of debt, don’t
use the coupon rate on existing debt,
which represents the cost of past debt.
Use the current interest rate on new
debt.
(More…)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
53
Estimating the Market Risk
Premium
?
?
When estimating the risk premium for the
CAPM approach, don’t subtract the current
long-term T-bond rate from the historical
average return on common stocks.
For example, if the historical rM has been
about 12.2% and inflation drives the current
rRF up to 10%, the current market risk
premium is not 12.2% – 10% = 2.2%!
(More…)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
54
Estimating Weights
?
?
?
Use the target capital structure to determine
the weights.
If you don’t know the target weights, then
use the current market value of equity.
If you don’t know the market value of debt,
then the book value of debt often is a
reasonable approximation, especially for
short-term debt.
(More…)
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