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Q4 - Fall 2007

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1.

Which of the following bonds is supported by collateral?


a.

unsecured bonds

b.

income bonds

c.

equipment trust certificates

d.

debentures

ANSWER:

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FEEDBACK:
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2.

Default is
a.

failure to meet any of the terms of the indenture

b.

failure to make dividend payments

c.

only failure to make interest payments

d.

failure to maintain more assets than liabilities

ANSWER:

POINTS:

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FEEDBACK:
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3.

Which of the following reduces the investor's risk associated with investing in bonds?
1.

a sinking fund

2.

a variable interest rate

3.

a call feature

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

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4.

Which of the following bonds are exempt from federal income taxation?
a.

zero coupon bonds

b.

debenture bonds

c.

convertible bonds

d.

municipal bonds

ANSWER:

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5.

The yield to maturity on a bond is


a.

the interest paid divided by the price of the bond

b.

the bond's coupon divided by the principal amount

c.

the price appreciation earned by the bond

d.

interest plus price appreciation (or loss) achieved by holding the bond to maturity

ANSWER:

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6.

If a bond is selling for a discount, that implies


1.

interest rates have fallen

2.

interest rates have risen

3.

the yield to maturity exceeds the current yield

4.

the yield to maturity is less than the current yield

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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7.

Which of the following is not true if interest rates rise?


a.

Existing bonds may be called.

b.

Prices of existing bonds fall.

c.

The yield to maturity rises more than the current yield.

d.

The market price of a zero coupon bond falls.

ANSWER:

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8.

If interest rates rise, a firm may retire a bond issue by


1.

calling it

2.

repurchasing it

3.

issuing new bonds and redeeming the old bonds

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 2

ANSWER:

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9.

The current yield on a bond is


a.

interest paid divided by the bond's price

b.

the bond's coupon

c.

the interest rate stated on the bond

d.

the yield over the lifetime of the bond

ANSWER:

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10.

If interest rates in general rise,


a.

the prices of existing bonds rise

b.

the prices of existing bonds fall

c.

the prices of matured bonds rise

d.

the prices of matured bonds fall

ANSWER:

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11.

If investors anticipate that interest rates will fall, they


a.

should buy bonds

b.

should sell bonds

c.

should buy shares in money market mutual funds

d.

should take no action

ANSWER:

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12.

The current price of a bond is not affected by


a.

current interest rates

b.

the risk classification of the bond

c.

the maturity date

d.

last year's interest rates

ANSWER:

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13.

The dividend paid by a preferred stock is usually


a.

tax deductible

b.

variable

c.

paid in stock

d.

fixed

ANSWER:

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14.

Advantages of the corporate form of business include


a.

limited liability for stockholders

b.

avoidance of state taxation

c.

limited life

d.

deductibility of dividends

ANSWER:

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15.

Break-even analysis requires knowing the relationship


a.

between sales and earnings

b.

between sales and total costs

c.

between total revenues and fixed costs

d.

between sales and assets

ANSWER:

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16.

Break-even analysis may be used to show


a.

the relationship between debt financing and earnings

b.

the level of sales necessary to avoid losses

c.

the level of output required to maximize profits

d.

the relationship between sales and equity

ANSWER:

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17.

Break-even analysis is not concerned with


a.

the relationship between financial leverage and risk

b.

the relationship between sales and profits

c.

the relationship between total costs and revenues

d.

the relationship between fixed costs and output

ANSWER:

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18.

To determine the break-even level of output, management must know


1.

fixed costs of operation

2.

per unit variable costs of output

3.

total sales

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

all three

ANSWER:

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19.

A union contract suggests that labor costs may be


a.

variable

b.

fixed

c.

a non-cash expense

d.

undetermined

ANSWER:

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20.

A firm may obtain financial leverage by


1.

issuing debt

2.

leasing

3.

issuing preferred stock

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

POINTS:

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21.

The lower the debt ratio,


a.

the higher is the use of financial leverage

b.

the lower is the use of financial leverage

c.

the lower are the firm's total assets

d.

the higher are the firm's total assets

ANSWER:

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22.

Higher fixed costs are associated with


1.

higher operating leverage

2.

lower operating leverage

3.

increased risk

4.

lower risk

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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23.

The lower the debt ratio,


a.

the higher is the use of financial leverage

b.

the lower is the use of financial leverage

c.

the lower are the firm's total assets

d.

the higher are the firm's total assets

ANSWER:

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24.

The greater the usage of financial leverage, the larger is the variability of
a.

revenues

b.

gross profits

c.

operating earnings

d.

net earnings

ANSWER:

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25.

If a firm's fixed costs rise relative to variable costs, ____ and ____.
a.

operating leverage, risk increase

b.

operating leverage, financial leverage increase

c.

financial leverage, risk increase

d.

operating leverage increases, financial risk decreases

ANSWER:

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26.

Successful use of financial leverage may


1.

increase the firm's earnings per share

2.

decrease the firm's earnings per share

3.

increase investors' return on their funds

4.

decrease investors' return on their funds

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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27.

The increased use of financial leverage may


1.

affect the firm's credit rating

2.

decrease risk

3.

alter the firm's earnings

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

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28.

The cost of equity


1.

is less than the cost of debt

2.

is greater than the cost of debt

3.

depends on the riskiness of the firm

4.

depends on the firm's current ratio

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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29.

Retained earnings
a.

have no cost

b.

are the firm's cheapest source of funds

c.

have a cost that equals the cost of capital

d.

are cheaper than the cost of new common stock

ANSWER:

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30.

If the capital asset pricing model is used, the cost of equity depends on
1.

the firm's earnings growth rate

2.

the firm's beta

3.

the return on the market

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

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31.

The optimal capital structure involves


a.

maximizing the cost of all funds

b.

minimizing the cost of all funds

c.

using no financial leverage

d.

minimizing the weighted average of the cost of funds

ANSWER:

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32.

If equity is negative,
a.

debt exceeds total assets

b.

total assets exceed debt

c.

equity exceeds assets

d.

equity exceeds debt

ANSWER:

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33.

Preferred stock increases common stockholders' return


a.

more than an equal dollar amount of debt

b.

less than an equal dollar amount of debt

c.

more than an equal dollar amount of retained earnings

d.

less than an equal dollar amount of retained earnings

ANSWER:

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34.

The cost of debt is affected by


1.

retained earnings

2.

firm's tax rate

3.

interest rate

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

POINTS:

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35.

The marginal cost of capital


a.

is the firm's cost of debt and equity finance

b.

is constant given an optimal capital structure

c.

declines as flotation costs alter equity financing

d.

refers to the cost of additional financing

ANSWER:

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Problem

36.

You purchase a bond for $875. It pays $80 a year (i.e., the semiannual coupon is 4 percent), and the bond
matures after ten years. What is the yield to maturity?

RESPONSE:
ANSWER:

The yield to maturity equates the present value of the interest payments and principal
repayment. In this problem, that rate is 10%:
($40)(12.462) + ($1,000)(0.377) = $875.48.
(PV = -875; I = ?; N = 20; PMT = 40, and FV = 1000, I = 5 per period or 10 annually.)

POINTS:

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37.

An investor buys a $1,000, 20 year 7 percent (interest paid semiannually) bond at par. After five years have
passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond?

RESPONSE:
ANSWER:

Price of the bond with 15 years (30 time periods) to maturity:


(PV = ?; I = 5; N = 30; PMT = 35.50, and FV = 1000, PV = -777.10.)
Since the investor purchased the bond for $1,000, the loss is $1,000 - $776 = $224.

POINTS:

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38.

The price of a product is $1 a unit. A firm can produce this good with variable costs of $0.50 per unit and
total fixed costs of $100.
a.

What is the break-even level of output?

b.

What is the break-even level of output if fixed costs increase to $180 and variable costs decline to
$0.40 per unit?

RESPONSE:
ANSWER:
a.

break-even level of output:


$100/($1 - $0.50) = 200 units

b.

break-even level of output:


$180/($1 - $0.40) = 300 units

POINTS:

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REF:

39.

Given the following information, answer the following questions.


TR = $3Q
TC = $1,500 + $2Q
a.

What is the break-even level of output?

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b.

If the firm sells 1,300 units, what are its earnings or losses?

c.

If sales rise to 2,000 units, what are the firm's earnings or losses?

d.

If the total cost equation were


TC = $2,000 + $1.80Q,
what happens to the break-even level of output units?

RESPONSE:
ANSWER:
a.

Break-even level of output:


$1,500/($3 - $2) = 1,500 units

b.

Earnings

= $3Q - $1,500 - $2Q


= $3(1,300) - 1,500 - 2(1,300) = ($200)

c.

Earnings

= $3Q - $1,500 - $2Q


= 3(2,000) - 1,500 - 2(2,000) = $500

d.

Break-even level of output:


$2,000/($3 - $1.80) = 1,667 units

POINTS:

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REF:

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40.

You want to start a firm whose output you believe you can sell for $25 per unit. The operation will require
fixed costs of $10,000, and the variable costs are expected to be $18 a unit. What will be the break-even
level of output?

RESPONSE:
ANSWER:

Break-even level of output:


$100,000/($25 - 18) = 14,286 units

POINTS:

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REF:

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41.

Given the following information, what happens to operating income and net income if output is increased
by 10 percent? Verify your answer.
Total assets

$100,000

Debt (12% interest rate)

$80,000

Equity

$20,000

Variable costs of production

$14 per unit

Fixed cost of production

$27,000

Units sold

12,300

Sale price per unit

$19.75

RESPONSE:
ANSWER:

The operating income:


Revenues: $19.75(12,300) = $242,925
Expenses: $14.00(12,300) + $27,000 = $199,200
Operating income: $242,925 - 199,200 = $43,725
Net income: $43,725 - (.12)(80,000) = $34,125
Operating income rose from $43,725 to $50,797.50 for a 16.2 percent increase.
Net income rose from $34,125 to $41,197.50 for a 20.7 percent increase.

POINTS:

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REF:

42.

(This is a simple problem that replicates the example in the chapter.) A firm needs $100 to start and
expects
Sales

$200

Expenses

$185

Tax rate

a.

33% of earnings

What are earnings if the owners invest the $100?

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b.

If the firm borrows $40 of the $100 at any interest rate of 10%, what are the firm's net earnings?

c.

What is the return on the owners' investment in each case? Why do the returns differ?

d.

If expenses rise to $194, what will be the returns in each case?

e.

In which case did the returns decline more?

f.

What generalization can you draw form the above?

RESPONSE:
ANSWER:
a.

and b.

Sales

no financial

with financial

leverage

leverage

$200

$200

185

185

Expenses
EBIT

15

15

Interest

EBT

15

11

Taxes

c.

Net earnings

10

Return on equity

$10/$100 = 10%

3.63
$

7.37

$7.37/$60 = 12.28%

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The return for b is higher because of the successful use of financial leverage.
(Point out that operating income is 15% of assets versus the 10% interest rate
and the reduction in taxes that results from the interest expense.)

d.

Sales

no financial

with financial

leverage

leverage

$200

$200

194

194

Expenses

POINTS:

EBIT

Interest

EBT

Taxes

0.66

Net earnings

Return on equity

$4/$100 = 4%

1.34

$1.34/$60 = 2.23%

e.

The return on equity fell more for the firm that was financially leveraged.

f.

The generalization is that the use of financial leverage to increase the return
on equity works both ways. If revenues fall and/or expenses rise, the use of
financial leverage will magnify the swing in the firm's return on equity.

-- / 1

REF:

43.
a.

Given the following schedules,

cost of

cost of

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debt/assets s

debt

equity

0%

7%

14%

10

14

20

14

30

14

40

16

50

10

18

60

12

20

What is firm's cost of capital at the various combinations of debt and equity?

b.

What is the firm's optimal capital structure? Construct a balance sheet showing that combination
of debt and equity financing.

Balance Sheet for Firm as of XX/XX/XX


Assets

$100

Debt
Equity
$100

c.

If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their
required rate of return if the firm uses its optimal combination of debt and equity financing?

d.

If the above cost of equity is the cost of retained earnings, what happens to the cost of capital if
the cost of new shares is one percentage point higher at the firm's optimal capital structure?

e.

If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital
structure if the firm needs $2,000,000?

RESPONSE:
ANSWER:

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ANSWER:

a.

Determination of cost of capital:

= weight cost of debt + weight cost of equity


= .0(.07) + 1(.14) = 14.00%
= .1(.07) + .9(.14) = 13.30
= .2(.07) + .8(.14) = 12.60
= .3(.08) + .7(.14) = 12.20
= .4(.08) + .6(.16) = 12.80
= .5(.10) + .5(.18) = 14.00
= .6(.12) + .4(.20) = 15.20

b.

The optimal capital structure is 30% debt and 70% equity.


The balance sheet is

Balance Sheet for Firm as of XX/XX/XX


Assets

$100

Liabilities
Equity

$ 30
70
$100

c.

If the firm earns $10 on every $100 of assets (i.e., 10% on assets), the
stockholders will not receive their required return of 14%. With 30% debt
financing, $2.40 must go to creditors ($30 .08 = $2.40), which leaves $7.60
for stockholders ($10 - 2.40). Since the stockholders have invested $70, they
earn a return of 10.86% ($7.60/$70).

For the stockholders to earn their required return, the firm must earn at 12.2%.
Then the firm can pay the creditors $2.40 and have sufficient left over ($9.80)
so that the stockholders earn the 14% required rate of return (i.e., $9.80/$70 =
14%).

d.

If the cost of new equity rises to 15 percent, the cost of capital at the optimal
capital structure becomes:

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.3(.08) + .7(.15) = 12.90.

e.

If the firm has retained earnings of $1,500,000, the breakpoint in the marginal
cost of capital schedule is
$1,500,000/.7 = $2,142,857.

The cost of capital from $0 - $2,142,857 is 12.2%.


The cost of capital above $2,142,857 is 12.9%.

The cost of $2,000,000 is 12.2 percent. The cost of the next $2,000,000 is
$142,857 at 12.2 percent and $1,857,143 at 12.7 percent.

POINTS:

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REF:

44.

Fill in the table using the following information.


Assets required for operation: $2,000
Case A

- firm uses only equity financing

Case B

- firm uses 30% debt with a 10% interest rate and 70% equity

Case C

- firm uses 50% debt with a 12% interest rate and 50% equity

Debt outstanding

300

300

300

Stockholders' equity
Earnings before
interest and taxes
Interest expense
Earnings before taxes
Taxes (40% of earnings)

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Net earnings
Return on stockholders'

investment

What happens to the rate of return on the stockholders' investment as the amount of debt increases? Why
did the rate of interest increase in case C?

RESPONSE:
ANSWER:
A
0

$ 600

$1,000

Debt outstanding

Stockholders' equity

2,000

1,400

1,000

Earnings before

300

300

300

Interest expense

60

120

Earnings before taxes

300

240

180

Taxes (40% of earnings)

120

96

72

Net earnings

$ 180

$ 144

$ 108

Return on stockholders'

9%

10.3%

10.8%

interest and taxes

investment

The rate of return to stockholders rises because the after tax cost of debt in B is .1(1 .4) = 6%. The after tax cost of debt in C is .12(1 - .4) = 7.2%. These costs are less
than the 9 percent the firm earns after taxes on its assets ($180/$2,000). The interest
rate increases because the firm becomes riskier when it uses more financial leverage.
POINTS:

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REF:

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45.

The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm
exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management
believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital
structure.
a.

What is the firm's cost of capital if it uses only retained earnings?

b.

What is the firm's cost of capital if it uses new equity?

c.

How much total financing may the firm have before the marginal cost of capital rises?

RESPONSE:

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ANSWER:
a.

The cost of capital using retained earnings:


(.35)(.08) + (.65)(.14) = 11.9%

b.

The cost of capital using new equity:


(.35)(.08) + (.65)(.149) = 12.485%

Notice that the marginal cost of capital rises after the firm exhausts its
retained earnings and must start using more expensive new equity.

c.

The break-point in the marginal cost of capital schedule:


$23,678/.65 = $36,428

The retained earnings can support up to $36,428 in total financing and still
maintain the optimal combination of debt and equity financing. However, after
$36,428 of total financing, the retained earnings are exhausted, and the firm
must start using more expensive new equity.

POINTS:

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REF:

46.

Given the following information:


interest rate

8%

tax rate

30%

dividend

$ 1

price of the common stock

$50

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growth rate of dividends

7%

debt ratio

40%

a.

Determine the firm's cost of capital.

b.

If the debt ratio rises to 50 percent and the cost of funds remains the same, what is the new cost of
capital?

c.

If the debt ratio rises to 60 percent, the interest rate rises to 9 percent, and the price of the stock
falls to $30, what is the cost of capital? Why is this cost different?

RESPONSE:

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ANSWER:
a.

Cost of debt: .08(1 - .3) = .056 = 5.6%


Cost of equity: $1(1 + .07)/$50 + .07 = 9.1%
Cost of capital:
weights

costs

.4

.056

.0224

.6

.091

.0546
.0770 = 7.7%

b.

The cost of debt and equity are unchanged. Only the weights are changed.
Cost of capital:
weights

costs

.5

.056

.0280

.5

.091

.0455
.0735 = 7.35%

c.

Both the cost of debt and equity are changed.


Cost of capital:
weights

costs

.6

.063

.0378

.4

.106

.0424
.0802 = 8.02%

The cost of capital changes as any of the components are changed. As the
firm initially substitutes cheaper debt financing, the cost of capital declines
(7.7% to 7.35%). However, as the firm uses more debt financing and
becomes more financial leveraged, it becomes riskier, and the cost of capital
rises (7.35% to 8.02%).

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