Paybacks For Different Projects Finance Essay

a. What is capital budgeting?

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“ Simply put, capital budgeting is the whole procedure of analysing undertakings and make up one’s minding which 1s to include in the capital budget ” ( Page 344 ) . The five cardinal methods used to measure undertakings for capital budgeting include: ( 1 ) payback period, ( 2 ) discounted payback period, ( 3 ) cyberspace present value, ( 4 ) internal rate of return, and ( 5 ) modified internal rate of return. Using these standards, fiscal ‘analysts seek to place those undertakings that will take to the maximization of the house ‘s stock monetary value ( FM 11_Ch_10_Mini Case ) .

What is the difference between independent and reciprocally sole undertakings?

“ Independent undertakings are undertakings whose hard currency flows do n’t impact one another ” and reciprocally sole undertakings are undertakings that if one undertaking is taken on, the other must be rejected ” ( Page 348 ) .

( 1 ) What is the payback period?

The payback period is “ the expected figure of old ages to retrieve the original investing and was the first normal method used to measure capital budgeting undertakings ” ( 347 ) . Discounted payback period uses the undertaking ‘s cost of capital to dismiss the expected hard currency flows. The computation of discounted payback period is indistinguishable to the computation of regular payback period, except you must establish the computation on a new row of discounted hard currency flows. Note that both undertakings have a cost of capital of 10 % ( FM 11_Ch_10_Mini Case ) .

Find the paybacks for Franchises L and S.

The payback period for Franchise L is 2.38 and the payback period for Franchise S is 1.60, see the tabular array that follows.

L A A A A A

A Time period: 0 1 2 3

A Cash flow: ( 100,000 ) 10,000 60,000 80,000

A Accumulative hard currency flow: ( 100,000 ) ( 90,000 ) ( 30,000 ) 50,000

A

A Payback: 2.38 A

A A

S A

A Time period: 0 1 2 3

A Cash flow: ( 100,000 ) 70,000 50,000 20,000

A Accumulative hard currency flow: ( 100,000 ) ( 30,000 ) 20,000 40,000

A A

A Payback: 1.60 A

A A A

( 2 ) What is the principle for the payback method?

“ The NPV method of capital budgeting dictates that all independent undertakings that have positive NPV should accepted. The principle behind that averment arises from the thought is that all such undertakings add wealth, and that should be the overall end of the director in all respects. If purely utilizing the NPV method to measure two reciprocally sole undertakings, you would desire to accept the undertaking that adds the most value ( i.e. the undertaking with the higher NPV ) .

Harmonizing to the payback standard, which franchises should be accepted if the house ‘s maximal acceptable payback is 2 old ages?

If the maximal acceptable payback is two old ages so firm S with a payback of 1.60 should be accepted versus house L, which has a payback of 2.38.

If Franchises L and S are independent?

If sing the above two undertakings, you would accept both franchises L and S if they are independent.

If they are reciprocally sole?

You would merely accept Project S as it has the higher NPV of $ 19,984.97 versus L which has a lower NPV of $ 18,782.87 if the franchises are reciprocally sole.

( 3 ) What is the difference between the regular and discounted payback periods?

The computation of discounted payback period is indistinguishable to the computation of regular payback period, except the computation of the discounted payback period is based on a new row of discounted hard currency flows ( FM 11_Ch_10_Mini Case ) .

( 4 ) What is the chief disadvantage of discounted payback?

The chief disadvantage of the discounted payback is that it still falls short of to the full analysing undertakings, but does history for clocking issues ( to some extent ) . However, all else equal, these two methods do supply some information about undertakings ‘ liquidness and hazard.

Is the payback method of any existent utility in the capital budgeting determinations?

The payback method does supply existent utility in that they “ do supply information on how long financess will be tied up in the undertaking ( 349 ) .

vitamin D.

( 1 ) Specify the term net present value ( NPV ) .

“ Net nowadays value is defined as a manner to better the effectivity of undertaking ratings through the usage of discounted hard currency flow techniques. To happen the present value of a undertaking, you must first happen the present value of each hard currency flow discounted at the cost of capital. Then, sum the discounted hard currency flows. If the NPV is positive, accept the undertaking. If NPV is negative, reject the undertaking. It is of import to retrieve that if two undertakings are reciprocally sole, the undertaking that has the higher NPV should be selected ” ( 349 ) .

What is each franchise ‘s NPV?

The net nowadays value for Franchise L is $ 18,782.87 and the net nowadays value for Franchise S is $ 19,948.97, see the tabular array that follows.

A

Liter

A

A

A

A

A

A

Time period:

0

1

2

3

A

Cash flow:

( 100,000 )

10,000

60,000

80,000

A

Disc. hard currency flow:

( 100,000 )

9,091

49,587

60,105

A

NPV ( L ) =

$ 18,782.87

$ 18,782.87

A

Second

A

Time period:

0

1

2

3

A

Cash flow:

( 100,000 )

70,000

50,000

20,000

A

Disc. hard currency flow:

( 100,000 )

63,636

41,322

15,026

A

NPV ( S ) =

$ 19,984.97

$ 19,984.97

A

A

A

A

A

A

A A A A A A A

( 2 ) What is the principle behind the NPV method? ?

“ The NPV method is based on a logical attack. An NPV of nothing signifies that the undertaking ‘s hard currency flows are precisely sufficient to refund the invested capital and to supply the needed rate of return on that capital. ” If NPV & gt ; 0, so the undertaking is bring forthing a larger sum of hard currency that required to serve debt and to let a return to stockholders. So if the house takes on undertakings that have positive net nowadays values ( NPV ) so the wealth of stockholders will increase, luring them to increase their investing in the house ” ( 350 ) .

The NPV method of capital budgeting dictates that all independent undertakings that have positive NPV should accepted. The principle that is behind that averment arises from the thought that all such undertakings add wealth, and that should be the overall end of the director in all respects. If purely utilizing the NPV method to measure two reciprocally sole undertakings, you would desire to accept the undertaking that adds the most value ( i.e. the undertaking with the higher NPV ) .

Harmonizing to NPV, which franchise or franchises should be accepted if they are independent?

If sing the above two undertakings, accept both undertakings if they are independent.

Mutually sole?

Merely Project S would be accepted if they are reciprocally sole.

Undertaking NPVs

Liter

Second

WACC

$ 18,782.87

$ 19,984.97

0 %

$ 50,000.00

$ 40,000.00

5 %

$ 33,052.59

$ 29,294.89

8.68 %

$ 22,322.04

$ 22,322.04

10 %

$ 18,782.87

$ 19,984.97

23.56 %

– $ 10,204.71

$ 0.00

18.13 %

$ 0.00

$ 7,225.43

15.0 %

$ 6,665.57

$ 11,827.07

20 %

– $ 3,703.70

$ 4,629.63

25 %

– $ 12,640.00

– $ 1,760.00

( 3 ) Would the NPV ‘s alteration if the cost of capital changed?

Yes, “ a undertaking might hold a positive NPV if it is portion of a ‘normal size ‘ capital budget, but the same undertaking might hold a negative NPV if it is portion of an remarkably big capital budget. ” “ The cost of capital may depend on the size of the capital budget. ” “ This means that the cost of capital leaps upward after a company invests all of its internally generated hard currency and must sell new common stock. In add-on, investors frequently perceive highly big capital investings to be riskier, which may besides drive up the cost of capital as the size of the capital budget additions. ”

vitamin E.

( 1 ) Specify the term internal rate of return ( IRR ) . What is each franchise ‘s IRR?

“ The internal rate of return ( IRR ) is defined as the price reduction rate that equates the present value of a undertaking ‘s expected hard currency influxs to the present value of the undertakings cost or equivalently, the IRR is the rate that forces the NPV to be nothing ” ( 351 ) .

What is each franchise ‘s IRR?

The IRR of L is 18.13 % and the IRR of S is 23.56 % , see the tabular array that follows.

A

A

A

A

A

A

A

A

A

Expected after-tax

A

A

net hard currency flows ( CFt )

A

Year ( T )

Liter

Second

A

0

( $ 100,000 )

( $ 100,000 )

A

1

10,000

70,000

IRR L =

18.13 %

A

2

60,000

50,000

IRR S =

23.56 %

A

3

80,000

20,000

A

A

A

A

A

A

A

( 2 ) How is the IRR on a undertaking related to the YTM on a bond?

“ If you invest in a bond, keep it to adulthood, and receive all of the promised hard currency flows, you will gain the YTM. Precisely the same constructs are employed in capital budgeting when the IRR method is used. The IRR is defined as the price reduction rate that equates the present values of a undertaking ‘s expected hard currency influxs to the present value of the undertaking ‘s costs ” ( Page 351 ) . Additionally, “ when covering with independent undertakings, the NPV and IRR methods will ever give the same accept/reject consequence. ‘However, in the instance of reciprocally sole undertakings, NPV and IRR can give conflicting consequences. One defect of the internal rate of return is that it assumes that hard currency flows received are reinvested at the undertaking ‘s internal rate of return, which is non normally true. The nature of the congruity of the NPV and IRR methods is farther detailed in a latter subdivision of this theoretical account ” ( FM 11_Ch_10_Mini Case ) .

( 3 ) What is the logic behind the IRR method?

The logic behind the IRR method is:

The IRR on a undertaking is its expected rate of return.

If the internal rate of return exceeds the cost of the financess used to finance the undertaking, a excess will stay after paying for the capital, and this excess will accrue to the house ‘s shareholders

Therefore, taking on a undertaking whose IRR exceeds its cost of capital additions stockholders ‘ wealth. On the other had, if the IRR is less than the cost of capital, so taking on the undertaking will enforce a cost on current shareholders. It is this “ breakeven ” characteristic that makes the IRR utile in measuring capital undertakings. ” ( Page 352 )

Harmonizing to IRR, which franchises should be accepted if they are independent?

“ The IRR method of capital budgeting maintains that undertakings should be accepted if their IRR is greater than the cost of capital. Rigorous attachment to the IRR method would foster order that reciprocally sole undertakings should be chosen on the footing of the greatest IRR. In this scenario, both undertakings have IRR ‘s that exceed the cost of capital ( 10 % ) and both should be accepted, if they are independent ( FM 11_Ch_10_Mini Case ) .

Mutually sole?

“ If the undertakings are reciprocally sole, we would take Project S. Recall, that this was our finding utilizing the NPV method every bit good. The inquiry that of course arises is whether or non the NPV and IRR methods will ever hold ” ( FM 11_Ch_10_Mini Case ) .

( 4 ) Would the franchises ‘ IRR ‘s alteration if the cost of capital changed?

Yes, if the cost of capital is changed the franchises ‘ IRR besides changes.

degree Fahrenheit.

( 1 ) Draw NPV profiles for Franchises L and S.

Net Cash Flows

Year

Liter

Second

WACC =

10.0 %

0

– $ 100,000

– $ 100,000

Liter

Second

1

$ 10,000

$ 70,000

NPV =

$ 18,782.87

$ 19,984.97

2

$ 60,000

$ 50,000

IRR =

18.13 %

23.56 %

3

$ 80,000

$ 20,000

Crossover =

8.68 %

At what price reduction rate do profiles traverse?

The NPV profiles for franchises L and S cross at a price reduction rate of 8.68 % where both undertakings have the same NPV. This is the indifference point between the two undertakings ; mention to the graph of the NPV profiles that follow.

If these are independent undertakings and cost of capital is 10 % , they should both be accepted. Both return a positive NPV at the designated cost of capital and would hence be profitable.. If the two undertakings are reciprocally sole at a capital cost of 10 % , franchise S should be selected because its NPV is somewhat greater than L ( The graph of S is above L at a capital cost of 10 % ) . If capital costs are less than 8 % , Franchise L becomes the better trade. Franchise L is a better trade when capital costs are low because it generates more entire income but that income arrives subsequently than franchise S. When capital costs are high, the clip value of money is greater so a undertaking which provides the majority of its income Oklahoman would be more desirable than a undertaking which produces greater income but produces it subsequently.

( 2 ) Look at your NPV profile graph without mentioning to the existent NPVs and IRRs. Which franchise or franchises should be accepted if they are independent?

If these are independent undertakings and cost of capital is 10 % , they should both be accepted. Both return a positive NPV at the designated cost of capital and would hence be profitable.

Mutually sole? Explain.

If the two undertakings are reciprocally sole at a capital cost of 10 % , franchise S should be selected because its NPV is somewhat greater than L ( The graph of S is above L at a capital cost of 10 % ) . If capital costs are less than 8 % , Franchise L becomes the better trade. Franchise L is a better trade when capital costs are low because it generates more entire income but that income arrives subsequently than franchise S. When capital costs are high, the clip value of money is greater so a undertaking which provides the majority of its income Oklahoman would be more desirable than a undertaking which produces greater income but produces it subsequently.

Are your replies correct at any cost of capital less than 23.6 per centum?

The recommendations given are merely good for 10 % cost of capital. Franchise L is merely profitable when capital costs are less than 18 % , whereas franchise S is feasible for capital costs less than approx 23.5 % . Besides, at 10 % capital costs, undertaking S is better, but if capital costs are 6 % so undertaking L is better. The short reply is no, the replies are non right for any cost of capital less than 23.6 %

g.

( 1 ) What is the underlying cause of ranking struggles between NPV and IRR?

A struggle exists if the cost of capital is less than the crossing over rate. Two basic conditions can do NPV profiles to traverse, and therefore struggles to originate between NPV and IRR:

when undertaking size ( or graduated table ) differences exist, intending that the cost of one undertaking is largest than that of the other, or

when clocking differences exist, intending that the timing of hard currency flows from the two undertakings differs such that most of the hard currency flows from one undertaking come in the early old ages while most of the hard currency flows from the other undertaking come in the ulterior old ages ( Page 355 )

( 2 ) What is the “ reinvestment rate premise, ” and how does it impact the NPV versus IRR struggle?

The value of early hard currency flows depends on the return we can gain on those hard currency flows, that is the rate at which we can reinvest them. “ The NPV method implicitly assumes that the rate at which hard currency flows can be reinvested is the cost of capital, whereas the IRR method assumes that the house can reinvest at the IRR ” ( Page 355 ) .

( 3 ) Which methods is the best? Why?

The NPV method is more dependable. The best premise is that the undertakings ‘ hard currency flows can be reinvested at the cost of capital ( Page 355 ) .

H.

( 1 ) Specify the term modified IRR ( MIRR ) . Find the MIRRs for Franchises L and S.

“ The modified internal rate of return ( MIRR ) is the price reduction rate that causes a undertaking ‘s cost ( or hard currency escapes ) to be the ‘present value of the undertaking ‘s terminal value.

Find the MIRRs for Franchises L and S.

The MIRR for Franchise L is 14.84 % and the MIRR for Franchise S is 15.13 % , see the informations that follows on the following page.

WACC =

10 %

MIRRL =

14.84 %

Undertaking S

MIRRS =

15.13 %

10 %

0

1

2

3

4

( 100,000 )

10,000

60,000

80,000

0

Undertaking L

0

1

2

3

4

( 100,000 )

70,000

50,000

20,000

0

22,000.0

60,500.0

93,170.0

P V:

( 100,000 )

Terminal Value:

175,670.0

What are the MIRR ‘s advantages and disadvantages vis-a-vis the regular IRR?

“ The MIRR has an of import advantage over regular IRR. MIRR assumes that hard currency flows from all the house ‘s undertakings are reinvested at the cost of capital, while regular IRR assumes that hard currency flows from each undertaking are reinvested at the undertaking ‘s ain IRR. Since reinvestment at the cost of capital is by and large more right, the MIRR is a better index of a undertaking ‘s true profitableness ” ( 358 ) . Further, the MIRR solves the multiple IRR job, as a set of hard currency flows can hold but one MIRR.

What are the MIRR ‘s advantages and disadvantages vis-a-vis the NPV?

“ If two undertakings are of equal size and have the same utile life, so NPV and MIRR will take to the same decisionaˆ¦If the undertakings are of equal size, but differ in lives, the MIRR will ever take to the same determination as the NPV if the MIRR ‘s are both deliberate utilizing as the terminal twelvemonth the life of the thirster undertaking. ” The advantage of the NPV is that it “ is still the best manner to take sum viing undertakings because it provides the best indicant of how much each undertaking will add to the value of the house.

I. As a separate undertaking ( project P ) , you are sing a marquee at the approaching World ‘s Fair. The marquee would be $ 800,000, and it is expected to ensue in $ 5 million of incremental hard currency influxs during its 1 twelvemonth of operation. However, it would so take another twelvemonth, and $ 5 million of costs, to pulverize the site and return it to its original status. Therefore, Project P ‘s expected net hard currency flows look like this ( in 1000000s of dollars ) :

Year Net Cash Flows

0 ( $ 0.8 )

1 5.0

2 ( 5.0 )

The undertaking is estimated to be of mean hazard, so its cost of capital is 10 per centum.

( 1 ) What are the normal and non-normal hard currency flows?

A normal hard currency flow is one which following the usually expected form of an initial investing ( hard currency escape ) followed by one or more returns ( hard currency influxs ) . A non-normal hard currency flow would be a net hard currency escape which occurs subsequently in the undertaking after a period of hard currency influxs. The costs associated with Restoration of land which has been mined out would be a common illustration.

( 2 ) What is Project P ‘s NPV?

NPV is the current value of all hard currency flows at the relevant cost of capital. NPV for this undertaking at a 10 % cost of capital is – $ 3,868,000 ( work follows ) :

NPV = -.8M + 5M / ( 1 + .1 ) – 5M / ( 1 + .1 ) 2 = ( -.3868M )

NPV = – $ 3,868,000

What is IRR?

The IRR is.25 and the IRR is besides 4 ( work follows ) .

To calculate the IRR, the undermentioned equation demands to be solved for IRR

-.8M + 5M / ( 1+IRR ) – 5M / ( 1+IRR ) 2 = 0

-.8* ( ( 1+IRR ) 2 ) + 5* ( 1+IRR ) – 5 = 0

This has two solutions, IRR = .25 and IRR = 4.

It ‘s MIRR?

The MIRR is 5.59 % ( work follows ) .

To calculate MIRR, compute gross frontward and costs back

Television = 5M * ( 1.1 ) = 5.5M

PV = – 5M / ( 1.12 ) – .8M = -4.9322

To calculate MIRR, PV = Television / ( ( 1+MIRR ) 2 )

4.9322M = 5.5M / ( 1 + MIRR ) 2

MIRR = a?s ( 5.5/4.9322 ) -1 = .0559

MIRR = 5.59 %

( 3 ) Draw Project P ‘s NPV profile. Does Project P have normal or nonnormal hard currency flows? Should this undertaking be accepted?

As can be seen from the NPV graph below, this undertaking has a non-normal hard currency flow. With a capital cost of 10 % , this undertaking should non be accepted because its NPV is negative 3.868 million. Likewise, its MIIR is 5.59 % , which is less than the 10 % cost of capital.

J. In an unrelated analysis, you have the chance to take between the following two reciprocally sole undertakings:

Expected NET CASHFLOWS

Year Project S Project L

0 ( $ 100,000 ) ( $ 100,000 )

1 60,000 33,500

2 60,000 33,500

3 — – 33,500

4 — – 33,500

The undertakings provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable hereafter. Both undertakings have a 10 per centum cost of capital.

A

L WACC: 10.0 %

End of Time period:

A

0 1 2 3 4 5 6

( $ 100,000 ) $ 33,500 $ 33,500 $ 33,500 $ 33,500 $ 0 $ 0

A

NPV $ 6,190

IRR 12.8 %

A

Second

End of Time period:

A

0 1 2 3

( $ 100,000 ) $ 60,000 $ 60,000 $ 0

A

NPV $ 4,132

IRR 13.1 %

( 1 ) What is the undertaking ‘s initial NPV without reproduction?

The NPV for undertaking L is $ 6,190 and the NPV for undertaking S is $ 4,132.

( 2 ) Now apply the replacing concatenation attack to find the undertakings ‘ extended NPV ‘s. Which undertaking should be chosen?

The NPV for undertaking L is $ 6,190 for 6 old ages and NPV for undertaking S with reproduction is $ 79,868, see informations at a lower place.

Liter

End of Time period:

A

0 1 2 3 4

( $ 100,000 ) $ 33,500 $ 33,500 $ 33,500 $ 33,500

A

NPV $ 6,190

IRR 12.8 %

A

Second

A

0 1 2 3 4

( $ 100,000 ) $ 60,000 $ 60,000

A A $ 33,500 $ 33,500 $ 33,500 A A

( $ 100,000 ) $ 60,000 $ 93,500 $ 33,500 $ 33,500

A

NPV $ 79,868

IRR 48.4 %

( 3 ) Now assume that the costs to retroflex undertaking S in 2 old ages will increase to $ 105,000 because of inflationary force per unit areas.

How should the analysis be handled now, and which undertaking should be chosen?

k. You are besides sing another undertaking which has a physical life of 3 old ages ; that is, the machinery will be wholly worn out after 3 old ages. However, if the undertaking were terminated prior to the terminal of 3 old ages, the machinery would hold a positive salvage value. Here are the undertaking ‘s estimated hard currency flows:

Year Project S Project L

0 ( $ 5,000 ) $ 5,000

1 2,100 3,100

2 2,000 2,000

3 1,750 0

Using 10 per centum cost of capital, what is the undertaking ‘s NPV if it is operated for the full 3 old ages?

The undertakings NPV, presuming it operates for 3 full old ages, is – $ 123.22, informations follows.

A

3-Year NPV =

Intial Cost

+

PV of Operating Cash Flow

+

PV of Salvage Value

A

=

( $ 5,000.00 )

+

$ 4,876.78

+

$ 0.00

A

3-Year NPV =

( $ 123.22 )

Would the NPV alteration if the company planned to end the undertaking at the terminal of twelvemonth 2?

If the undertaking is terminated at the terminal of twelvemonth 2 the NPV would be $ 214.88, informations follows.

A

2-Year NPV =

Intial Cost

+

PV of Operating Cash Flow

+

PV of Salvage Value

A

=

( $ 5,000.00 )

+

$ 3,561.98

+

$ 1,652.89

A

2-Year NPV =

$ 214.88

At the terminal of twelvemonth 1?

If the undertaking is terminated at the terminal of twelvemonth 2 the NPV would be – $ 272.73, informations follows.

A

1-Year NPV =

Intial Cost

+

PV of Operating Cash Flow

+

PV of Salvage Value

A

=

( $ 5,000.00 )

+

$ 1,909.09

+

$ 2,818.18

A

1-Year NPV =

( $ 272.73 )

What is the undertaking ‘s optimum ( economic ) life?

The undertakings optimum life is 2 old ages, since at 2 old ages the undertaking has its highest NPV.

( 1 ) After analyzing all the possible undertakings, you discover that there are many more undertakings this twelvemonth with positive NPV ‘s than in a normal twelvemonth. What two jobs might this big capital budget cause?

The two jobs this excess big capital budget may do are an increasing cost of capital and capital rationing. In some instances, the cost of capital may depend on the size of the budget. The floatation costs associated with publishing new debt or equity may be exalted, so the cost of the capital can increase exponentially after a steadfast invests all of it internal financess and must sell new stock. Depending on the size of the house, Investors may comprehend big capital outgos as hazardous which in bend could drive up the cost of capital as the size of the undertaking increases ; therefore the quandary of an increasing cost of capital.

The job of Capital rationing, a pattern that is common, is a state of affairs where the house places a bound on their capital expenditures to an sum that is less what would be required to fund the optimum capital budget. Some of the grounds for this rationing are reluctance to publish new stock, restraints on non-monetary resources, and commanding appraisal prejudice ( 367-368 ) .

It may non be in the best involvements of shareholders to thin the stock by raising equity capital, or the increased adoption could impact bond evaluations or other creditworthiness. The flotation costs of raising new capital may be so high that it would do a decreased mix of undertakings more profitable than making all of them. Besides, rapid enlargement merely may non be portion of the company scheme.

Restrictions on resources and substructure besides place a restriction on the figure of undertakings which can be undertaken. If direction, technology or other substructure is stretched excessively thin, the undertakings will non be undertaken decently. Profitableness could be reduced or the undertakings could neglect as a consequence. Building substructure to manage an anomalous addition in work load which may non go on into the hereafter could make the necessity for layoffs and other unpleasant effects in the hereafter.

It would be nice to be able to make everything, but there is ever a practical restriction on company resources, fabricating capacity, and capital. Part of being a director is taking options. We are all closely familiar with the usage of additive programming to work out the job of making the optimal mix of production given forced resources. These techniques would be applicable here.

Work Cited

Brigham, Eugene F. , Michael C. Ehrhardt. Financial Management. 11th erectile dysfunction.

Mason, Ohio: South Western, 2005.

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