Internal Reconstruction | Preferred Stock | Equity (Finance)

1.

INTRODUCTION
What is Reconstruction?
Re-construction is a process of re- organization of a company. It takes place when the financial position of the company is not good due to overvaluation of assets, accumulated losses etc. It is reorganization with a view to run the company efficiently in the future. It involves writing off accumulated losses, fictitious assets and overvaluation of assets out of the sacrifice of the shareholders viz. shareholders, debenture holders and creditors so as to give a realistic view of financial position of the company.

Need for Internal Reconstruction: Internal Reconstruction is necessary due to the following reasons: 1. Final statements not True & Fair:
When the company is making heavy losses, the financial statement do not show true and fair view of the state of affairs of the company.

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2. Assets:
The asset side of the balance sheet of a company may have intangible assets, fictitious assets, accumulated losses, deferred revenue expenditure etc. The real assets are shown at a high value. Due to losses adequate depreciation may not be provided, stock may be valued at a higher rate. No provision may be made for bad and doubtful debts.

3. Liabilities:
The Company may have secured and unsecured loans which may be repaid. It may become overdue Interest on loan may be in arrears. Creditors may be long overdue. Preference dividend on preference shares may be in arrears over a long period.

4. Capital:
Capital of a company is lost due to drastic fall in the value of assets. It is not represented by the by the real value of assets.

5. Reconstruction:
Due to continuous losses, basic structure of the company gets damaged. The pillars on which the super structure is based become weak and the company may collapse at any time. Hence the company has to be placed on strong foundation in order to ensure stability in future.

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2. TYPES OF RECONSTRUCTION
Company Reconstruction:
A term used to describe the drastic formal changes in a company·s capital structure as a result of certain circumstances. There are two types of reconstruction.

(1) External Reconstruction:
When a company has no power to operate his own business due to heavy loss and it sells his all business to a new company. It will be external reconstruction.

(2) Internal Reconstruction:
Internal Reconstruction means to do every action for bringing the company out of losses. If a company is suffering heavy losses, company can use the provision 94 of Indian Company law 1956 and reduce its capital.

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3. PROVISIONS OF COMPANY LAW
(1) Alteration of share capital
o Increase of Authorized Capital There should be a provision in the MOA and AOA for increasing share capital. In case there is no provision in the MOA and AOA, the company must change them.  The company is required to give a notice to the Registrar as regards this resolution within 30 days of its passing.  Alteration of share capital beyond the authorized does not require permission of the court.  Sanction of the SEBI Is necessary if the shares to be offered are more than the certain value.  Board resolution is necessary to effect alteration.

o Consideration of shares There must be a specific provisions for the consideration of
the A/A.

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Board resolution must be passed to convene a general
meeting of a share holder. 

An ordinary resolution passed by the general meeting is
necessary to undertake consolidation. 

Notice of consolidation of shares must be sent to the
Registrar of companies within one month.

o Subdivision of shares AOA must make a provision for sub-division of shares.  Resolution passed by general meeting is necessary.  A notice is to be sent to the Registrar of company. o Conversion of shares into stocko Only fully paid up shares can be converted into stocks. o A/A must provide for conversion. o Resolution at general meeting is necessary. o Permission of stock exchange is necessary if the shares are
listed with a stock exchange.

o A notice to be sent to the Registrar of Companies.

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Cancellation of shares 
A Company must be authorized by its A/A to effect the
change. 

A resolution passed an extra ordinary general meeting must
sanction such a change.

(2) Capital Reduction
Legal Aspect 
A company is permitted to reduce its share capital under Section 100 in any of the following ways: y By reducing the liabilities on any of its shares in respect of share capital not called. y By paying off any paid up capital which is in excess of the requirements of a company. y By cancellation of any paid up capital which is lost or which is not represented by available assets. y By any other method which may be approved by available assets.  A company cannot reduce its share capital unless it is authorized by its AOA.  A special resolution for reduction of capital must be passed by the company.  Capital Reduction must be approved by the court.

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The court may order confirmation of capital reduction on such terms and conditions as it may think fit.  The court may order the company to add the words ´and reducedµ to the name of the company for such period as it may deem fit.  The order of the court must be produced before the Registrar of the company and a certified copy of the same and of the minutes should be filed with the Registrar of Companies for registration.  A company must publish reasons for reduction for public information, if the court orders.  A company must publish notice of registration in such a manner as the court may direct.  Every Balance Sheet subsequent to the reduction must show the reduced figures with the date of reduction in place of the original cost.

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4. BASIC JOURNAL ENTRIES
Basic Journal Entries to be known before starting up with the problem are as follows-

1) 20,000 Equity share of Rs. 100 each are reduced to share of Rs. 40 each fully paid up.
Equity share capital (of 100 each) A/c «Dr 2000000 To Equity share capital 800000 To Capital reduction A/c 1200000 (The face value has changed from Rs.100 to Rs.40.)

2) 20,000 Equity share of Rs. 100 each are reduced to share of Rs. 40 each Rs.20 paid up.
Equity share capital (of 100 each) A/c « Dr 2000000 To Equity share capital A/c 400000 To Capital reduction A/c 1600000

3) 20,000 Equity share of Rs. 100 each are reduced to share of Rs. 60 each fully paid up.
Equity share capital A/c «Dr To Capital reduction A/c
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800000 800000

(The face value has been retained at Rs.100. the paid up value is being reduced.)

4) 20,000 Equity share of Rs. 100 each are reduced by Rs. 30 per share. a) If it is assumed the face value has reduced then,
Equity share capital (Rs.100 each) A/c «Dr 2000000 To Equity share capital (of 70 each) 1400000 To Capital reduction A/c 600000

b) It is assumed that face value remains the same,
Equity share capital A/c «Dr To Capital reduction A/c 600000 600000

5) Arrears of preference dividend.
a) If it is cancelled ² No entry. b) If it is settled (To the extent it is paid) Capital reduction A/c «Dr To Cash/Bank A/c (Or) To Equity share Capital A/c

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6) Holders of 20000 11% Pref. share of Rs.100 each are allotted 20000 13% pref. share of Rs.20 each.
11% pref. share capital A/c «Dr 200000 400000 1600000

To 13% Preference share capital A/c To Capital reduction A/c

7) Balance sheet.
7% Debenture Accrued interest 60000 4200 64200 Free hold land & building 34000

A piece of land valued in the books of Rs.6000 has been taken over by debenture holders in part repayment of the principle at an agreed value of Rs.14000. The debenture int. is settled in cash. The remaining freehold land & building is revalued at Rs.40000. a) Appreciation of land & building. Free hold Land & Building A/c «Dr To Capital reduction A/c b) Takeover by 7% Debenture holder. 7% Debenture A/c «Dr To freehold Land & building A/c
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8000 8000

14000 14000

c) Payment of Accrued interest. Accrued interest A/c «Dr To Cash/Bank A/c d) Appreciation of Bal. freehold land& building Freehold land & building A/c To Capital reduction A/c Total freehold land & building 34000 6000 Takeover by Deb. Holders for Rs.14000 28000 Appreciation to Rs.40000 (therefore appreciation Rs.12000) Dr.12000 12000 4200 4200

8) If the outstanding Deb. Interest appearing in the Balance sheet is canceled then it would result into a profit.
Accrued interest on 7% A/c «Dr To Capital reduction A/c

9) Payment of unrecorded liability. In this case the treatment would be similar to contingent liabilities for example - arrears of profit dividend.
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10) The creditors of Rs.50000 agreed for a remission of the liability. On the condition that 25% of the net liability is paid immediately. The balance is postponed and would be paid after four years.
Creditors A/c «Dr (20% of 50000) To Capital reduction A/c (25% of 40000) To Cash/Bank A/c 20000 10000 10000

The liability of Rs.30000 is to be paid after 4 years. Current liabilities should include amounts which is payable within a period of 12 months. Hence such balance of Rs.30000 should be reflected under the head unsecured loans.

11)

Sale of assets

Cash/Bank A/c «Dr Capital reduction A/c (if loss) «Dr To Assets A/c (Book value) To Capital reduction A/c

12)

Fresh issue of shares
Cash/Bank A/c «Dr To Share capital A/c

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13)

Expenses of reconstruction
Capital reduction A/c «Dr To Cash/Bank A/c

14) If there are any existing reserves i.e. reserves appearing on the liabilities side of the balance sheet than it can be utilized for w/off the losses. In this case transfer the reserve to the Capital reduction A/c.
Reserves A/c «Dr To Capital reduction A/c (The reserves should be utilized only if instructions are given.)

15) Write off the accumulated losses intangible assets, fictitious assets and other assets (to the extent overvalued).
Capital reduction A/c «Dr To Profit/Loss A/c To Goodwill, Patents etc. To Misc. expenditure A/c To Other assets A/c (To the extent over valued)

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16) If there is any credit balance in the capital reduction A/c than it should be transferred to capital reserve.
Capital reduction A/c «Dr To Capital reserve A/c

17)

Consolidation of shares

100000 equity shares of Rs.10 each are consolidated into 10000 equity shares of Rs.100 each.
Equity share capital A/c (10 each) «Dr 1000000 To Equity share capital A/c (100 each) 1000000

18)

Sub division of shares

10000 equity shares of Rs.100 each are being subdivided into 100000 equity share of Rs.10 each.
Equity share capital A/c (100 each) «Dr 1000000 To Equity share capital A/c (10 each) 1000000 (Neither consolidation nor sub division would affect the capital reduction A/c)

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5. ILLUSTRATIONS
(Q.1.) The following is the summarized balance sheet of X Ltd. As on 31st March, 1990: Liabilities Amount (Rs.) Assets Amount (Rs.)
1,20,000 2,67,000 2,55,000 75,000

Authorized and Issued Capital:
30,000 Preference Shares of Rs. 10 each 6,00,000 Equity Shares of Rs. 1 each 6% Debentures (Secured on land and building) 1,20,000 Accrued Int. 6,000 Bank Overdraft (Secured on stock) Directors Loans Sundry Creditors 3,00,000 6,00,000

Goodwill
Land and Building Plant Shares in Subsidiary Ltd. (at cost) 1,26,000 1,65,000 75,000 2,70,000

Stock Debtors Profit and loss A/c Deferred Expenditure: Advertisement

2,25,000 2,70,000 2,64,000

60,000

15,36,000
NOTE:

15,36,000 

There is a contingent liability for damages of Rs. 30,000.  Preference Shares are cumulative and dividends are in arrears for 3 years
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A capital Reduction Scheme setting the following terms was duly approved: 1) The Preference Shares to be reduced to Rs. 8 per share and the Equity Shares to 25 paisa each and to be consolidated as shares of Rs. 10 each and Rs. 1 each fully paid respectively. The preference shareholders waived 2/3rd of the dividend in arrears and received equity shares for the balance. The Authorized capital to be restored to 30,000 preference shares of Rs. 10 each and 6,00,000 equity shares of Rs. 1 each. 2) The shares in Subsidiary Ltd. Are sold to an outsider for Rs. 1,50,000. 3) All intangible assets are to be eliminated and bad-debts of Rs. 21,000 and obsolete stock of Rs. 30,000 to be written off. 4) The debenture holders to take over the companies land and building (book value-Rs. 54,000) at a price of Rs. 60,000 in part satisfaction of the debentures and to provide further cash Rs. 45,000 on a floating charge. The arrears of interest are paid. 5) Directors refund Rs. 10,000 of the fees previously received by them. 6) The contingent liability materialized in the sum stated but the company recovered Rs. 15,000 of these damages in action against one of its directors. This was debited to his loan account of Rs. 24,000. The balance of which was paid in cash on his resignation. 7) The remaining directors agreed to take equity shares in satisfaction of their loans. You are required to: A) Pass Journal Entries, including cash transactions, B) Draft revised balance sheet.

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SOLUTION:

JOURNAL ENTRIES IN THE BOOKS OF X LTD

Date
(1)
(i)

Particulars

L Debit F (Rs.)
3,00,000

Credit (Rs.)

Rs.10 Preference Shares A/c« Dr To Rs.8 Preference Shares A/c To Capital Reduction A/c (Being preference shares of Rs. 10 each reduced to Rs.8 per share.) Rs.1 Equity Shares A/c « Dr To Rs. 0.25 Equity Shares A/c To Capital Reduction A/c (Being equity shares of Rs. 1 each reduced to Rs. 0.25 per share.) 30,000 Preference Shares A/c (Rs.8 )« Dr To 24,000 Preference Shares A/c (Rs.10) (Being preference shares consolidated of Rs. 10 each as fully paid.) 6,00,000 Equity Shares A/c (Rs. 0.25)« Dr To 1,50,000 Equity Shares A/c (Rs. 1) (Being equity shares consolidated of Rs. 1 each as fully paid.)

2,40,000 60,000

(ii)

6,00,000 1,50,000 4,50,000

(iii)

2,40,000 2,40,000

(iv)

1,50,000 1,50,000

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(v)

Capital Reduction A/c« To Equity Share Capital A/c (Being 2/3rd of dividend waived and received equity shares for the balance.) Bank A/c« To Shares in Subsidiary Ltd. A/c To Capital Reduction A/c (Being shares in subsidiary ltd. are sold.) Capital Reduction A/c« To Goodwill A/c To Profit and Loss A/c

Dr

18,000 18,000

(2)

Dr

1,50,000 75,000 75,000

(3)

Dr

4,95,000 1,20,000 2,64,000 60,000 21,000

To Deferred Advertisement A/c To Debtors A/c To Obsolete Stock (Being intangible assets, obsolete stock and baddebts written off.) (4) (i) Debentures A/c« Dr To Land and Building A/c To Capital Reduction A/c (Being land & building taken over by debenture holders for Rs. 60,000.) Bank A/c« To Debentures A/c (Being Rs. 45,000 cash provided on floating charge.) Interest A/c« To Bank A/c
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60,000 54,000 6,000

(ii)

Dr

45,000 45,000

(iii)

Dr

6,000 6,000

(Being arrears of interest paid.)

(5)

Bank A/c« To Capital Reduction A/c (Being director·s fees refunded.)

Dr

10,000 10,000

(6) (i) Director·s Loan A/c« Capital Reduction A/c« To Bank A/c (Being contingent liability recovered to the extent Rs. 15,000.) (ii) Director·s Loan A/c« To Bank A/c (Being balance to the extent of Rs. 9,000 of director·s loan was paid in cash.) (7) Director·s Loan A/c« To Equity Share Capital A/c (Being directors were given equity shares in satisfaction of their balance loan amount.) Dr 51,000 51,000 Dr 9,000 9,000 Dr Dr 15,000 15,000 30,000

(8)

Bank Overdraft A/c« To Bank A/c (Being bank overdraft written off.)

Dr

1,60,000 1,60,000

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CAPITAL REDUCTION A/C
Dr. Cr.

Particulars
To Equity Share Capital A/c

Amount (Rs.)
18,000

Particulars
By Preference Share capital A/c By Equity Share Capital A/c By Bank A/c By Debentures A/c

Amount (Rs.)
60,000

To Goodwill A/c

1,20,000

4,50,000

To Profit and Loss A/c To Deferred Advertisement A/c To Debtors A/c To Obsolete Stock A/c To Bank A/c To Capital Reserve A/c (Balancing Figure)

2,64,000 60,000

75,000 6,000

21,000 30,000 15,000 73,000

By Bank A/c

10,000

6,01,000

6,01,000

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BALANCE SHEET AS ONt (REVISED)
Liabilities
Authorized Share Capital
30,000 Preference Shares of Rs. 10 each 6,00,000 Equity Shares of Rs. 1 each 3,00,000 6,00,000

Amount (Rs.)

Assets
Fixed Assets
Land and Building Plant

Amount (Rs.)

2,13,000 2,55,000

Issued, Subscribed and Paid up Capital
2,19,000 Equity Shares of Rs. 1 each fully paid 24000 6% Preference Shares of Rs. 10 each 2,19,000

Current Assets, Loans and Advances
Stock 1,95,000

2,40,000

Debtors

2,49,000

Reserves and Surplus
Capital Reserve 6% Debentures Bank Overdraft Sundry Creditors 73,000 1,05,000 5,000 2,70,000

Bank

-

9,12,000

9,12,000

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(Q.2.) The following is the summarized balance sheet of Not so Well Ltd. as on 31st December, 1990:

Liabilities

Amount (Rs.)
5,00,000 3,00,000

Assets

Amount (Rs.)
2,00,000 2,00,000

Equity Shares Capital in Rs. 100 shares 8% Preference Capital in Rs. 100 shares 18% Convertible Debenture Loan from Bankers (Secured) Capital Reserve Forfeited Shares A/c Sundry Creditors

Land and Building Plant and Machinery

90,000 1,10,000 40,000 10,000 1,60,000

Invention and Promotion Expenses Discount and Issue Expenses on shares and debentures Profit and Loss A/c Stock in Hand Sundry Debtors

1,00,000 30,000 2,80,000 3,00,000 1,00,000

12,10,000

12,10,000

The dividend on preference shares were in arrears for last 3 years. The company had a very valuable property which stood highly understated in the balance sheet and which is not afforded to sell. The said being required for the business.

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It was believed that worst was now over and companies new invention was certain to bring sizeable profit in future. In view of these share holders, debenture holders and the creditors agreed upon the following scheme of reconstruction: 1) All fictitious assets including invention and promotion expenses were to be written off. 2) Rs. 30,000 from debtors, Rs. 2,00,000 from stock and Rs. 1,50,000 from plant and machinery were to be written off. 3) The convertible debentures were given the option of subscribing equity shares of Rs. 30 each up to 50% of their face value, or subscribing preference shares of Rs. 50 each up to 25% of their face value and the remaining 25% was to be paid them in cash. All the debenture holders exercised this option. 4) All capital reserves were to be utilized. 5) The creditors being unsecured agreed to reduce their claim by 25% on the condition that they will be paid off before 31st December, 1995. They also agreed not to charge any interest till the date of payment. 6) Preference shares were reduced to Rs. 50 per share and equity shares were reduced to Rs. 30 per share. 7) Land and Buildings were revalued at such a figure so as to put through the entire scheme. 8) Bankers were to be paid of fully. For this purpose, the company was to issue 6,000 Equity shares of Rs. 30 each for cash. 9) The preference share holders agreed to waive the arrears of dividend. Assuming that the scheme had been duly sanctioned by the court, Pass Journal Entries; Prepare the Capital Reduction Account and the new Balance Sheet.

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SOLUTION:

JOURNAL ENTRIES IN THE BOOKS OF NOT SO WELL LTD.

Date
(1)

Particulars
Capital Reduction A/c«Dr To Invention and promotion Expenses A/c To Discount and Issue Expenses A/c To Profit and Loss A/c (Being all fictitious assets written off.) Capital Reduction A/c«Dr To Debtors A/c To Stock A/c To Plant and Machinery A/c (Being debtors, stock and plant written off.) Debentures A/c«Dr To Equity Shares A/c To Preference Shares A/c To Cash A/c (Being debenture holders exercised their option.) Capital Reserve A/c«Dr To Capital Reduction A/c (Being capital reserve utilized.) Creditors A/c«Dr To Capital Reduction A/c (Being creditors agreed to be reduced by 25 %.)

L Debit F (Rs.)
4,10,000

Credit (Rs.)
1,00,000 30,000 2,80,000

(2)

3,80,000 30,000 2,00,000 1,50,000

(3)

90,000 45,000 22,500 22,500

(4)

40,000 40,000

(5)

40,000 40,000

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(6) (i)

Equity Shares A/c«Dr To Equity Shares A/c To Capital Reduction A/c (Being equity shares reduced to Rs. 30 per share.) Preference Shares A/c«Dr To Preference Shares A/c To Capital Reduction A/c (Being preference shares reduced to Rs. 50 per share.)

5,00,000 1,50,000 3,50,000

(ii)

3,00,000 1,50,000 1,50,000

(7) (i)

Loan from Bankers A/c«Dr To Cash A/c (Being bankers paid off fully.) Cash A/c«Dr To Equity Shares A/c (Being 6000 equity shares of Rs. 30 each issued for cash.) Land and Building A/c«Dr To Capital Reduction A/c (Being balance of capital reduction account.)

1,10,000 1,10,000

(ii)

1.80,000 1,80,000

(8)

2,10,000 2,10,000

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CAPITAL REDUCTION A/C
Dr. Cr.

Particulars

Amount (Rs.)
1,00,000

Particulars

Amount (Rs.)
40,000

To Invention and Promotion Expenses A/c To Discount and Issue Expenses A/c To Profit and Loss A/c

By Capital Reserve A/c

30,000

By Creditors

40,000

2,80,000

By Equity Share Capital A/c By Preference Share capital A/c By Land and Building A/c (Balancing Figure)

3,50,000

To Debtors A/c

30,000

1,50,000

To Stock A/c

2,00,000

2,10,000

To Plant and Machinery A/c

1,50,000

7,90,000

7,90,000

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BALANCE SHEET AS ONt (REVISED)
Liabilities
Issued, Subscribed and Paid up Capital
12,500 Equity Shares of Rs. 30 each fully paid 3,75,000

Amount (Rs.)

Assets
Fixed Assets
Land and Building

Amount (Rs.)

4,10,000

3,450 Preference Shares of Rs. 50 each

1,72,500

Plant

50,000

Current Liabilities, Loans and Advances

Current Assets, Loans and Advances
1,20,000 Stock 1,00,000

Sundry Creditors

Forfeited Shares

10,000

Debtors Bank

70,000 47,500

6,77,500

6,77,500

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6. CONCLUSION
With the completion of this project we had come to know how internal reconstruction and why is it done. If the balance sheet of the loss making company is made, losses in the debit side will be seen. These shows zero assets, it is clear indication to all creditors that company has no resources and all past resources are utilized in bad project. So, to come out of this situation the company has to generate profit. The profits can be generated when the sacrifice would be made by the equity share holders, preference share holders, debenture holders and creditors. For the scheme of reconstruction the approval of all the interested parties and the sanction of the court are necessary. So, either shareholders or creditor can do above or take the action to liquidate the company.
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7. BIBLIOGRAPHY
We have complied the information of this project with the help of the following sources-

o Books ² 
TYBCOM Text Book (Choudhary Chopde)  TYBAF Text Book (SHETH Publications)

o Internet Sites ² 
www.flickr.com/photos/olive.../sets/72157619644288 304/  www.madisonscw.com/SubPage.aspx?page=2664  powerelectronics.com/.../power_internal_construction _boosts/  www.levelfive-audio.com/internal-construction.htm
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