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measure the worth of investment

proposal.

It is used as a discount rate in

determining the present value of future

cash flows associated with capital

projects.

Conceptually, it is the minimum rate of return

that a firm must earn on its investments so as

to leave market price of its shares unchanged.

It is also referred to as cut-off rate, target rate,

hurdle rate, required rate of return and so on.

In operational terms, it is defined as the

weighted average cost of capital (k

0

) of

all long-term sources of finance. The

major long-term sources of funds are

1) Debt,

2) Preference shares,

3) Equity capital, and

4) Retained earnings.

The theory of cost of capital is based

on certain assumptions. A basic

assumption of traditional cost of capital

analysis is that the firms business and

financial risks are unaffected by the

acceptance and financing of projects

Business risk is the risk to the firm of being

unable to cover fixed operating costs.

Business risk measures the variability in

operating profits [earnings before interest

and taxes (EBIT)] due to change in sales

Financial risk is the risk of being unable to

cover required financial obligations such as

interest and preference dividends.

Capital budgeting decision determines the

business risk complexion of the firm. The

financing decision determines its financial

risk.

The explicit cost of capital is

associated with the raising of funds

(from debt, preference shares and

equity).

The explicit cost of any source of

capital (C) is the discount rate that

equates the present value of the cash

inflows (CI

o

) that are incremental to the

taking of financing opportunity with the

present value of its incremental cash

outflows (CO

t

).

where CI

0

= initial cash inflow, that is,

net cash proceeds received by the firm

from the capital source at time O, CO

1

+

CO

2

... + CO

n

= cash outflows at times 1,

2 ... n, that is, cash payment from the

firm to the capital source.

( )

=

+

=

n

t

t

t

C

CO

CI

1

0

1

If CI

0

is received in instalments, then,

CI

0

It is evident from the above

mathematical formulation that the

explicit cost of capital is the rate of

return of the cash flows of the financing

opportunity

( ) ( ) ( ) ( )

( ) ( ) ( ) ( )

n

n

n

n

C

CO

C

CO

C

CO

C

CO

C

CI

C

CI

C

CI

C

CI

CI

+

+

+

+

+

+

+

=

+

+

+

+

+

+

+

+

1

...

1 1 1

1

...

1 1 1

3

3

2

2

1

1

3

3

2

2

1

1

0

Retained earnings involve no future

cash flows to, or from, the firm.

Therefore, the retained earnings do not

have explicit cost.

However, they carry implicit cost in

terms of the opportunity cost of the

foregone alternative (s) in terms of the

rate of return at which the shareholders

could have invested these funds had

they been distributed to them/or not

retained by the firm

There are four types of specific costs

Cost of Debt

Cost of Preference Shares

Cost of Equity Capital

Cost of Retained Earnings

Cost of debt is the after tax cost of long-

term funds through borrowing. The debt

carries a certain rate of interest. Interest

qualifies for tax deduction in determining

tax liability.

Therefore, the effective cost of debt is less

than the actual interest payment made by

the firm by the amount of tax shield it

provides. The debt can be either

Perpetual/ irredeemable Debt

Redeemable Debt

In the case of perpetual debt, it is

computed dividing effective interest

payment, i.e., I (1 t) by the amount of

debt/sale proceeds of debentures or bonds

(SV). Symbolically

k

i

= Before-tax cost of debt

k

d

= Tax-adjusted cost of debt

I = Annual interest payment

SV = Sale proceeds of the bond/debenture

t = Tax rate

( )

SV

t I

k

SV

k

d

t

=

=

1

) 3 (

1

Example 1

A company has 10 per cent perpetual debt

of Rs 1,00,000. The tax rate is 35 per cent.

Determine the cost of capital (before tax as

well as after tax) assuming the debt is

issued at (i) par, (ii) 10 per cent discount,

and (iii) 10 per cent premium.

In the case of redeemable debt, the

repayment of debt principal (COP)

either in instalments or in lump sum

(besides interest, COI) is also taken into

account. k

d

is computed based on the

following equations:

( ) ( )

( )

( )

( )

( )

=

+

+

+

=

+

+

=

n

1 t

t

d

t

t

d

t

0

d

k 1

COP

t 1

k 1

COI

CI s, instalment in paid is debt When

/2 SV RV

SV/N - RV value, Redeemable t 1 I

K ely, Alternativ

( )

( )

( )

=

+

+

+

=

n

1 t

t

d

t

t

d

t

0

k 1

COP

t 1

k 1

COI

CI s, instalment in paid is debt When

where CI

0

= Net cash proceeds from

issue of debentures or from raising debt

COI

1

+ COI

2

+ ... + COI

n

= Cash outflow on

interest payments in time period 1,2 and

so on up to the year of maturity after

adjusting tax savings on interest payment.

COP

n

= Principal repayment in the year of

maturity k

d

= Cost of debt.

The cost of debt is generally the lowest

among all sources partly because the risk

involved is low but mainly because interest

paid on debt is tax deductible.

Example 2

A company issues a new 10 per cent

debentures of Rs 1,000 face value to be

redeemed after 10 years The debenture is

expected to be sold at 5 per cent discount.

It will also involve floatation costs of 5 per

cent of face value. The companys tax rate

is 35 per cent. What would the cost of debt

be? Illustrate the computations using (1)

trial and error approach and (2) shortcut

method.

Example 3 A company has issued 10

per cent debentures aggregating Rs

1,00,000. The flotation cost is 4 per

cent. The company has agreed to repay

the debentures at par in 5 equal annual

instalments starting at the end of year

1. The companys rate of tax is 35 per

cent. Find the cost of debt.a

The cost of preference share (k

p

) is akin to

k

d

. However, unlike interest payment on

debt, dividend payable on preference

shares is not tax deductible from the point

of view assessing tax liability. On the

contrary, tax (D

t

) may be required to be

paid on the payment of preference

dividend.

Irredeemable Preference Shares

Redeemable Preference Shares

The cost of preference shares in the

case of irredeemable preference shares

is based on dividends payable on them

and the sale proceeds obtained by

issuing such preference shares, P

0

(1

f ). In terms of equation:

( )

( )

( ) f P

D D

k

f P

D

K

t p

p

p

p

+

=

=

1

1

) 8 (

1

0

0

where k

p

= Cost of preference

capital

D

p

= Constant annual dividend payment

P

0

= Expected sales price of preference

shares

f = Flotation costs as a percentage of

sales price

D

t

= Tax on preference dividend

A company issues 11 per cent

irredeemable preference shares of the

face value of Rs 100 each. Flotation

costs are estimated at 5 per cent of the

expected sale price. (a) What is the k

p

, if

preference shares are issued at (i) par

value, (ii) 10 per cent premium, and (iii)

5 per cent discount? (b) Also, compute

k

p

in these situations assuming 13.125

per cent dividend tax

The cost of redeemable preference

shares requiring lump sum repayment

(P) is determined on the basis of the

following equation:

( )

( )

( ) ( )

( )

( )

( ) ( )

=

=

+

+

+

+

=

+

+

+

+

=

n

1 t

t

p

t

t

p

t p

0

n

1 t

n

p

n

t

p

t p

0

k 1

P

k 1

1 D

f 1 P

: s instalment in required repayment of case the In

k 1

P

k 1

1 D

f 1 P

D

D

where P

0

= Expected sale price of

preference shares

f = Floatation cost as

percentage of P

0

D

p

= Dividends paid on

preference shares

P

n

= Repayment of preference

capital amount

ABC Ltd has issued 11 per cent

preference shares of the face value of

Rs 100 each to be redeemed after 10

years. Flotation cost is expected to be 5

per cent. Determine the cost of

preference shares (k

p

).

The computation of cost of equity

capital (k

e

) is conceptually more

difficult as the return to the equity-

holders solely depends upon the

discretion of the company

management.

It is defined as the minimum rate of

return that a corporate must earn on

the equity-financed portion of an

investment project in order to leave

unchanged the market price of the

shares.

One simple basis suggested to

determine cost of equity is to add a

judgmental risk premium of 3 to 5

percentage points to the interest rate

paid by the firm on its own long-term

debt. Such a method may be referred to

as debt-yield plus risk premium

approach

There are two approaches to measure

Ke:

Dividend Valuation Model Approach

Capital Asset Pricing Model (CAPM)

Approach.

As per the dividend approach, cost of equity capital is

defined as the discount rate that equates the present

value of all expected future dividends per share with the

net proceeds of the sale (or the current market price) of a

share.

The cost of equity capital can be measured with the

following equations:

When dividends are expected to grow at a uniform rate

perpetually:

( )

( )

( )

( )

( )

( )

( )

( )

( )

(1 g

P

D

k (11)

g k

D

P

get we 10, Eq. g Simplifyin equation. the of

sides two the equates which rate) (discount return of rate the is 10 Eq. in k

(10)

k 1

g 1 D

k 1

g 1 D

...

k 1

g 1 D

k 1

g 1 D

f 1 P

0

1

e

e

1

0

e

n

1 t

t

e

1 t

1

n

e

n

0

2

e

2

0

1

e

1

0

0

+ =

=

+

+

=

+

+

+ +

+

+

+

+

+

=

=

where D

1

= Expected dividend per share

P

0

= Net proceeds per share/current market price

g = Growth in expected dividends

The calculation of k

e

on the basis of Eq. 12 is based on certain

assumptions with respect to the behaviour of investors and

their ability to forecast future values:

the market value of shares depends upon the expected

dividends;

investors can formulate subjective probability distribution of

dividends per share expected to be paid in various future

periods;

the initial dividend, D

0

, is greater than zero (D

0

> 0);

the dividend pay-out ratio is constant;

investors can accurately measure the riskiness of the firm so

as to agree on the rate at which to discount the dividends.

Note: Under the provisions of Section 115(O), of the Income

Tax Act, 1961, a domestic company is liable to pay tax at a flat

rate of 11.5 per cent (plus surcharge) on dividends

declared/distributed/paid on/after April 1, 2003. The payment

of the dividend tax will reduce the growth (g) in dividends:

B) Under different growth assumptions

of dividends over the years:

( ) ( )

( ) | | ( )

hig be would Dt without g Obviously,

A) (12

P

D 1 DPS EPS

EPS

Dt 1 DPS EPS

P

EPS

b.r g

EPS/P r

tax Dividend Dt where

EPS

Dt 1 DPS EPS

EPS

Dt 1 DPS

1 b

return. of rate r rate, retention b where b.r, g

0

t

0

0

+

=

+

= =

=

=

(

+

=

(

+

=

= = =

( )

( )

( )

( )

yea later in growth Constant g

years earlier in growth of Rate whereg

(13)

k 1

g 1 D

k 1

g 1 D

P

c

h

n

1 t 1 n t

t

e

1 t

c n

t

e

1 t

b 0

0

=

=

+

+

+

+

+

=

=

+ =

Example 6

Suppose that dividend per share of a firm

is expected to be Re 1 per share next year

and is expected to grow at 6 per cent per

year perpetually. Determine the cost of

equity capital, assuming the market price

per share is Rs 25.

In case companys past growth rate has been abnormally

high or low, either due to its own unique situation or due

to general economic fluctuations, historic growth rates (g)

may not be reliable. In such situations, dividend growth

forecasts should be based on factors such as projected

sales, profit margins and competitive factors.

Accordingly, ke would be as follows:

D

1

k

e

= ------ + (Growth rate as projected)

(11.13-A)

P

0

Another method for estimating g can be conceived in

terms of the companys projected retention rate and its

expected future rate of return on equity. More profitable

firms retain a large proportion of their earnings for

reinvestment and will, therefore, tend to have higher

growth rate compared to less profitable firms which

distribute a large proportion of their earnings as

dividends.

However, the dividend growth model

approach is beset with a number of

practical problems and drawbacks. The

major ones are:

(1) It is applicable only to those

corporates which pay dividends. Its

results are really applicable to cases

where a reasonably steady growth is likely

to occur;

(2) Cost of equity is very sensitive to the

estimated growth. As explained earlier, it

is not easy to estimate its value;

(3) The approach does not explicitly

reckon risk factor. There is no allowance

for the degree of risk associated with the

estimated growth rate for dividends.

Example 7

From the undermentioned facts determine the cost of

equity shares of company X:

(i) Current market price of a share = Rs 150.

(ii) Cost of floatation per share on new shares, Rs 3.

(iii) Dividend paid on the outstanding shares over the

past five years:

Year Dividend per share

1 10.50

2 11.02

3 11.58

4 12.16

5 12.76

6 13.40

(iv) Assume a fixed dividend pay out ratio.

(v) Expected dividend on the new shares at the end of

the current year is Rs 14.10 per share.

The CAPM describes the relationship between the required rate of return or

the cost of equity capital and the non-diversifiable or relevant risk of the

firm as reflected in its index of non-diversifiable risk, that is, beta.

Symbolically,

K

e

= R

f

+ b (K

m

R

f

) (14)

R

f

= Required rate of return on risk-free investment

b = Beta coefficient**, and

K

m

= Required rate of return on market portfolio, that is, the average rate or

return on all assets

M = Excess in market return over risk-free rate,

J = Excess in security returns over risk-free rate,

MJ = Cross product of M and J and

N = Number of years

( )

=

2

2

* *

M N M

J M N MJ

Example 8

The Hypothetical Ltd wishes to calculate its cost of equity

capital using the capital asset pricing model approach. From

the information provided to the firm by its investment advisors

along with the firms own analysis, it is found that the risk-free

rate of return equals 10 per cent; the firms beta equals 1.50

and the return on the market portfolio equals 12.5 per cent.

Compute the cost of equity capital.

Solution

K

e

= 10% + [1.5 (12.5% 10%)] = 13.75 per cent

Example 9: As an investment manager you are given the following

information

Investment in equity

shares of

Initial

price

Dividends Year-end

market price

Beta risk

factor

A Cement Ltd

Steel Ltd

Liquor Ltd

B Government of India

Bonds

Risk-free return, 8 per cent

Rs 25

35

45

1,000

Rs 2

2

2

140

Rs 50

60

135

1,005

0.80

0.70

0.50

0.99

You are required to calculate (i) expected rate of returns of market portfolio,

and (ii) expected return in each security, using capital asset pricing model

Solution

(i) Expected Returns on Market Portfolio

Security Return Investment

Dividends Capital

Appreciation

Total

A Cement Ltd

Steel Ltd

Liquor Ltd

B Government

of India Bonds

Rs 2

2

2

140

146

Rs 25

25

90

5

145

Rs 27

27

92

145

291

Rs 25

35

45

1,000

1,105

Rate of return (expected) on market portfolio = Rs 291/Rs 1,105 = 26.33 per

cent

(ii) Expected Returns on Individual Security (in percent)

k

e

= R

f

+ b(k

m

R

f

)

Cement Ltd = 8% + 0.8 (26.33% 8%) 22.66

Steel Ltd = 8% + 0.7 (26.33% 8%) 20.83

Liquor Ltd = 8% + 0.5 (26.33% 8%) 17.16

Government of India Bonds = 8% + 0.99 (26.33% 8%) 26.15

The capital assets pricing model (CAPM) approach to calculate the

cost of equity capital is different from the dividend valuation

approach in some respects. In the first place, the CAPM approach

directly considers the risk as reflected in beta in order to determine

the K

e

. The valuation model does not consider the risk; it rather uses

the market price as a reflection of the expected risk-return preference

of investors in the market.

Secondly, the dividend model can be adjusted for flotation cost to

estimate the cost of the new equity shares. The CAPM approach is

incapable of such adjustment as the model does not include the

market price which has to be adjusted.

Both the dividend and CAPM approaches are theoretically sound. But

major problems are encountered in the practical application of the

CAPM approach in collecting datawhich may not be readily

available or in a country like India may be altogether absent

regarding expected future returns, the most appropriate estimate of

the risk-free rate and the best estimates of the securitys beta.

In brief, various methods of estimating Ke are most likely to provide

different amounts because each method relies on different

assumptions. There are two ways to deal with the situation: (1) Each

estimate of Ke should be looked at to ascertain that its value is

neither too high nor too low. It should intuitively appear to be

reasonable; (2) Average the various estimates of Ke.

Cost of Retained Earnings

The cost of retained earning (k

r

) is equally difficult to

calculate in theoretical terms. Since retained earnings

essentially involves use of funds, it is associated with an

opportunity/implicit cost. The alternative to retained earnings

is the investment of the funds by the firm itself in a

homogeneous outside investment. Therefore, k

r

is equal to

k

e

. However, it might be slightly lower than k

e

in the case of

new equity issue due to flotation costs.

Weighted Average Cost of Capital

Weighted average cost of capital is the expected average

future cost of funds over the long run found by weighting the

cost of each specific type of capital by its proportion in the

firm;s capital structure.

Assignment of Weights

The aspects relevant to the selection of appropriate weights

are:

1) Historical weights

a) Book value weights or

b) Market value weights

2) Marginal Weights

Historical Weights Historic weights either book or market

value weights are based on actual capital structure

proportion to calculate weights.

Market Value Weights Market value weights use market

values to measure the proportion of each type of capital to

calculate weighted average cost of capital.

Book Value Weights Book value weights use accounting

(book) values to measure the proportion of each type of

capital to calculate the weighted average cost of capital

Marginal Weights Marginal weights use proportion of each

type of capital to the total capital to be raised.

Mechanics of Computation

Example 10: Book Value Weights

(a) A firms after-tax cost of capital of the specific sources is as

follows:

Cost of debt

Cost of preference shares (including dividend tax)

Cost of equity funds

8%

14

17

(b) The following is the capital structure

Source Amount

Debt

Preference capital

Equity capital

Rs 3,00,000

2,00,000

5,00,000

10,00,000

(c) Calculate the weighted average cost of capital, k

0

using

book value weights.

Table 1: Solution Computation of weighted average cost of capital (Book

Value Methods)

Source of funds

(1)

Amount

(2)

Proportion

(3)

Cost (%)

(4)

Weighted cost

(3 x 4)

(5)

Debt

Preference capital

Equity capital

Rs 3,00,000

2,00,000

5,00,000

10,00,000

0.3 (30)

0.2 (20)

0.5 (50)

1.00 (100)

0.08

0.14

0.17

0.024

0.028

0.085

0.137

Weighted average cost of capital 13.7%

An alternative method of determining the k0 is to compute, as shown in Table 2, the total

cost of capital and then divide this figure by the total capital. This procedure obviously

avoids fractional calculations.

TABLE 2 Computation of Weighted Average Cost of Capital (Alternative Method)

Sources Amount Cost (%) Total cost (2 3)

(1) (2) (3) (4)

Debt

Preference capital

Equity capital

Total

Rs 3,00,000

2,00,000

5,00,000

10,00,000

8

14

17

Rs 24,000

28,000

85,000

1,37,000

Weighted average cost of capital = [(Rs 1,37,000 / Rs 10,00,000) x 100] = 13.7 per cent

Example 11 (Market Value Weights)

From the information contained in Example 10, calculate the weighted average

cost of capital, assuming that the market values of different sources of funds

are as follows:

Source Market value

Debt Rs 2,70,000

Preference shares 2,30,000

Equity and retained earnings 7,50,000

Total 12,50,000

Solution

(1) The determination of the market value of retained earnings presents

operational difficulties. The market value of retained earnings can be indirectly

estimated. A possible criterion has been suggested by Gitman,19 according to

which, since retained earnings are treated as equity capital for purpose of

calculation of cost of specific source of funds, the market value of the ordinary

shares may be taken to represent the combined market value of equity shares

and retained earnings. The separate market values of retained earnings and

ordinary shares may be found by allocating to each of these a percentage of

the total market value equal to their percentage share of the total based on

book values.

On the basis of the foregoing criterion, the sum of Rs 7,50,000 in Example 11 is

allocated between equity capital and retained earnings as follows:

Source of funds Book value Per cent of book value Market value

(1) (2) (3) (4)

Equity shares Rs 4,00,000 80 Rs 6,00,000*

Retained earnings 1,00,000 20 1,50,000**

*(0.8 Rs 7,50,000) **(0.20 Rs 7,50,000)

(2) After the determination of market value, k

0

is calculated as shown in Table 3.

TABLE 3 Computation of Weighted Average Cost of Capital (Market Value Weights)

Sources Market value Cost (per cent) Total cost (3 2)

(1) (2) (3) (4)

Debt Rs 2,70,000 8 Rs 21,600

Preference shares 2,30,000 14 32,200

Equity capital 6,00,000 17 1,02,000

Retained earnings 1,50,000 17 25,500

Total 12,50,000 1,81,300

k

0

= (Rs 1,81,300/Rs 12,50,000) 100 = 14.5 per cent

Solution The computation is illustrated in Table 4.

TABLE 4 Weighted Average Cost of Capital (Marginal Weights)

Sources of funds Amount Proportion Cost (%) (2 4) Total cost

(1) (2) (3) (4) (5)

Debt Rs 3,00,000 0.60 (60) 8 Rs 24,000

Preference

shares

1,00,000 0.20 (20) 14 14,000

Retained earnings 1,00,000 0.20 (20) 17 17,000

5,00,000 1.00 (100) 55,000

Weighted average cost of capital = (Rs 55,000/Rs 5,00,000) 100 = 11 per cent

Example 12 The firm of Example 10 wishes to raise Rs 5,00,000 for expansion of its

plant. It estimates that Rs 1,00,000 will be available as retained earnings and the

balance of the additional funds will be raised as follows:

Long-term debt Rs 3,00,000

Preference shares 1,00,000

Using marginal weights, compute the weighted average cost of capital.

COST OF CAPITAL PRACTICES IN INDIA

The main features of the cost of capital practices followed by the corporates in India

are as follows:

The most frequently used (67 per cent of cases) discount rate (i.e., minimum

acceptable/required rate of return) to evaluate capital budgeting decision is

based on the overall cost (WACC) of the corporate.

Depending on the risk characteristics of the project, multiple risk-adjusted

discount rates are used by about one-fifth of the corporate enterprises.

The specific cost of capital used to finance the project (i.e. if the discount rate for

a project that will be financed entirely with retained earnings is the cost of

retained funds) is used by one-fourth of the sample corporates.

The CAPM is the most popular method of estimating the cost of equity capital (54

per cent). The Gordons dividend model is equally popular method to compute

the cost of equity capital (52 per cent). The earnings yield approach is used by

one-third of the sample corporates to estimate the cost of equity capital. The use

of the multi-factor model is used by very few corporates (7 per cent).

A significant feature of the methods used to estimate the cost of equity capital is

that while the CAPM is significantly used by the large corporates, the Gordons

discount model is more popular with small firms. Moreover, the highly profitable

corporate (based on ROCE and EAV) give significantly low importance to

dividend yield and earnings yield to compute the cost of equity capital than the

less profitable corporates.

The Government of India (GOI) 10-year bonds are the most widely used risk-free

rate to compute the cost of capital using the CAPM approach. The industry

average beta is the most popular measure of the systematic risk used by the

corporates. Each of the published sources of beta and the self-calculated beta

are also used by about one-fifth of the corporates respectively.

The self-calculated beta is more popularly used by the large and/highly profitable

corporates. The small and low profitable corporates rely more on the published

sources of beta.

The majority of corporates (two-thirds) considers the last 5-year monthly share

price data to estimate the equity beta. The highly profitable firms use weekly

share price data for the purpose.

The average market risk premium (9-10 per cent) is the most widely used

measure by the corporates. The average of historical return and the implied

return on the market portfolio are also fairly popular as an input while using the

CAPM.

As regards the cost of debt, the most widely used method is the interest tax

shield (i.e., tax advantage of interest on debt).

While the majority of the corporates revise their estimates of cost of capital

annually, some of the sample corporates continuously revise it with every

investment.

Apart from project choice criterion, the cost of capital is also used widely for (a)

divisional performance measurement , (b) EVA computation and (c) CVA

computations.

CONTD.

Majority of the sample companies adopt theoretically sound and

conceptually correct basis of determining the cost of capital, namely, the

weighted average cost of long-term sources of finance. However, there is no

systematic procedure followed to compute it. It is more likely to be subjective

in nature. The Indian corporates use of mix of the WACC, marginal cost of

capital of additional funds and management judgment in this regard.

There is wide divergence in the corporate practices as regards the

computation of the cost of equity capital. About one-tenth of the corporates

do not attach any cost to equity capital. Another one-tenth treat the cost of

equity capital as equivalent to primary rate of return available on securities of

balanced mutual funds and debentures issued by blue chip companies.

However, the vast majority of companies (two-thirds of the sample) follow the

conceptually sound methods (i.e. primary rate of return plus risk premium,

dividend valuation model and CAPM) of determining the cost of equity

capital.

About one-fifth of the sample corporates consider retained earnings as a

cost-free source of finance. However, a sizeable proportion of the sample

companies (75 per cent) regard cost of retained earnings either as equivalent

to opportunity cost of using these funds by the corporate/equity-holders or

equal to the cost of equity capital.

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