Chapter Objective:

This chapter discusses the methodology that a multinational firm can use to analyze the Fourth Edition investment of capital in a foreign country. EUN / RESNICK

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

l l

l l l

Review of Domestic Capital Budgeting The Adjusted Present Value Model Capital Budgeting from the Parent Firm’s Perspective Risk Adjustment in the Capital Budgeting Process Sensitivity Analysis Real Options

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-1

Chapter Outline l

Chapter Eighteen

INTERNATIONAL FINANCIAL MANAGEMENT

EUN / RESNICK

18-0

18

Review of Domestic Capital Budgeting 1.

Identify the SIZE and TIMING of all relevant cash flows on a time line.

2. Identify the RISKINESS of the cash flows to determine the appropriate discount rate. 3. Find NPV by discounting the cash flows at the appropriate discount rate. 4. Compare the value of competing cash flow streams at the same point in time.

18-2

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Domestic Capital Budgeting The basic net present value equation is T CFt TVT NPV = ∑ + − C0 t (1 + K )T t =1 (1 + K )

Where: CF t = expected incremental after-tax cash flow in year t, TVT = expected after tax terminal value including return of net working capital, C0 = initial investment at inception, K = weighted average cost of capital. T = economic life of the project in years. 18-4

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-3

Review of Domestic Capital Budgeting The NPV rule is to accept a project if NPV ≥ 0 T

NPV = ∑ t =1

CFt TVT + − C0 ≥ 0 t T (1 + K ) (1+ K )

and to reject a project if NPV ≤ 0 T

NPV = ∑ t =1

18-5

CFt TVT + − C 0 ≤ 0. t T (1 + K ) (1+ K ) Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

1

Review of Domestic Capital Budgeting For our purposes it is necessary to expand the NPV equation. CFt = (Rt – OCt – D t – I t)(1 – τ) + Dt + It (1 – τ) Rt is incremental revenue

I t is incremental interest expense

OCt is incremental operating cash flow τ is the marginal tax rate Dt is incremental depreciation

CFt = (Rt – OCt – D t – I t)(1 – τ) + Dt + It (1 – τ) CFt = (NI t + D t + I t (1 – τ) CFt = (Rt – OCt – D t(1 – τ) + Dt CFt = (NOI t)(1 – τ) + Dt CFt = (Rt – OCt)(1 – τ) + τ Dt CFt = (OCFt)(1 – τ) + τ Dt

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-6

Alternative Formulations CFt

Review of Domestic Capital Budgeting We can use CF t = (OCF t)(1 – τ) + τ D t

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18-7

The Adjusted Present Value Model T

NPV =

T

Σ

CF t TVT + – C0 t = 1 (1 + K) t (1 + K) T

as: T

Σ

(OCF t)(1 – τ) + τ Dt (1

t=1

+ K) t

+

TVT – C0 (1 + K) T

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-8

T

Σ

APV =

T

Σ

t=1

(OCF t)(1 – τ) (1 + Ku

)t

+

τ Dt τ It TVT + + – C0 (1 + i) t (1 + i) t (1 + Ku ) T

The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually. Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

t

t=1

(OCF t)(1 – τ) (1 + Ku ) t

t

+

TVT – C0 (1 + K) T

+

τ Dt τ It TVT + + – C0 (1 + i) t (1 + i) t (1 + Ku ) T

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-9

Domestic APV Example Consider this project, the timing and size of the incremental after-tax cash flows for an all-equity firm are: -$1,000

$125

$250

$375

$500

0

1

2

3

4

CF0 CF1

The unlevered cost of equity is r0 = 10%: = –$1000 The project would be rejected by an all-equity firm: = $125

CF2 = $250 CF3 = $500

18-10

Σ (1τ+DK)

By appealing to Modigliani and Miller’s results.

The Adjusted Present Value Model APV =

(1 + K) t

T

+

Can be converted to adjusted present value (APV)

t=1

NPV =

(OCF t)(1 – τ)

t=1

to restate the NPV equation NPV =

Σ

18-11

I

= 10

NPV = –$56.50 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

2

Domestic APV Example (continued) l

l

Now, imagine that the firm finances the project with $600 of debt at r = 8%. The tax rate is 40%, so they have an interest tax shield worth τ×I = .40×$600×.08 = $19.20 each year.

-$1,000

$125

$250

$375

$500

0

1

2

3

4

The APV of the project under leverage is: T

Σ

APV =

(OCF t)(1 – τ)

t=1

APV =

(1 + Ku ) t

+

τ Dt τ It TVT + + – C0 (1 + i) t (1 + i) t (1 + Ku ) T

$125 $250 $375 $500 + + + 1.10 (1.10)2 (1.10)3 (1.10)4

$19.20 $19.20 $19.20 $19.20 + + + + – $1,000 1.08 (1.08)2 (1.08)3 (1.08)4 APV = $7.09 The firm should accept the project if it finances with debt. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-12

Capital Budgeting from the Parent Firm’s Perspective T

Σ

APV =

(OCF t)(1 – τ)

t=1

l

l

(1 + Ku ) t

+

τ Dt τ It TVT + + – C0 (1 + i) t (1 + i) t (1 + Ku ) T

The APV model is useful for a domestic firm analyzing a domestic capital expenditure or for a foreign subsidiary of a MNC analyzing a proposed capital expenditure from the subsidiary’s viewpoint. The APV model is NOT useful for a MNC in analyzing a foreign capital expenditure from the parent firm’s perspective.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-14

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-13

Capital Budgeting from the Parent Firm’s Perspective l

Donald Lessard developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment. T St OCFt (1 − t ) T S t t Dt S tI +∑ +∑ t t t t t (1 + K ud ) t= 1 t =1 (1 + id ) t = 1 (1+ id ) T

APV = ∑ +

T STTVT S LP − S0 C0 + S0 RF0 + S 0CL0 + ∑ t t t T (1 + K ud ) t =1 (1+ id ) Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-15

Capital Budgeting from the Parent Firm’s Perspective T

APV =

T

T

(1 – τ) SτD SτI +Σ +Σ Σ S(1OCF +K ) (1 + i ) (1 + i ) t

t=1

+

t

t

ud

t

t=1

t

d

t

t

t=1

T

t

d

t

APV =

t

t=1

Σ

T S tTVT S tLPt – S 0 C0 + S0 RF0 + S0 CL0 + (1 + Kud) T t = 1(1 + id ) t

T

T

(1 – τ) SτD SτI +Σ +Σ Σ S(1OCF +K ) (1 + i ) (1 + i ) +

t

t

ud

t

t=1

t

d

t

t

t=1

t

d

t

Σ

T S tTVT S tLPt – S 0 C0 + S0 RF0 + S0 CL0 + (1 + Kud) T t = 1(1 + id ) t

The operating cash flows must The operating cash flows be translated back into the must be discounted at the parent firm’s currency at the unlevered domestic rate spot rate expected to prevail in each period. 18-16

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-17

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3

Capital Budgeting from the Parent Firm’s Perspective T

APV =

T

T

(1 – τ) SτD SτI +Σ +Σ Σ S(1OCF +K ) (1 + i ) (1 + i ) t

t

t=1

+

t

ud

t

Capital Budgeting from the Parent Firm’s Perspective

t

t=1

d

t

t

T

t

t=1

d

APV =

t

Σ

The marginal corporate tax rate, τ, is the larger of the parent’s or foreign subsidiary’s.

+

Use PPP, IRP et cetera for the predictions.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-20

Capital Budgeting from the Parent Firm’s Perspective: Example l

We can use a simplified APV: T

APV =

T

t

+

t

t

ud

t

t=1

t

d

t

t

t=1

18-22

d

t

t

t=1

t

d

t

Σ

T S tTVT S tLPt – S 0 C0 + S0 RF0 + S0 CL0 + T (1 + Kud) t = 1(1 + id ) t

Denotes the present value (in the parent’s currency) of any concessionary loans, CL0 , and loan payments, LPt , discounted at id .

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

l

l

A U.S.-based MNC is considering a European opportunity. It’s a simple example n n

n

There is no incremental debt There is no incremental depreciation There are no concessionary loans There are no restricted funds

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-21

Capital Budgeting from the Parent Firm’s Perspective: Example

t

d

t

Σ

T S tTVT S tLPt – S 0 C0 + S0 RF0 + S0 CL0 + T (1 + Kud) t = 1 (1 + id ) t T

APV =

t=1

A U.S. MNC is considering a European opportunity. The size and timing of the after-tax cash flows are:

T

(1 – τ) SτD SτI +Σ +Σ Σ S(1OCF +K ) (1 + i ) (1 + i )

t=1

t

t

Capital Budgeting from the Parent Firm’s Perspective: Example

n

3. Calculate NPV using the home currency cost of capital.

T

t

ud

18-19

Capital Budgeting from the Parent Firm’s Perspective One recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to the home currency at the predicted exchange rate.

t

S 0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-18

t

t=1

T S tTVT S tLPt – S 0 C0 + S0 RF0 + S0 CL0 + T (1 + Kud) t = 1(1 + id ) t

OCF t represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm.

T

(1 – τ) SτD SτI +Σ +Σ Σ S(1OCF +K ) (1 + i ) (1 + i )

S tOCF t(1 – τ) – S C 0 0 t = 1 (1 + K ) t ud

Σ

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

–€600

€200

€500

€300

0

1

2

3

The inflation rate in the euro zone is π€ = 3%, the inflation rate in dollars is π$ = 6%, and the business risk of the investment would lead an unlevered U.S. based firm to demand a return of Kud = i$ = 15%. 18-23

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

4

Capital Budgeting from the Parent Firm’s Perspective: Example –€600

€200

€500

€300

0

1

2

3

The current exchange rate is S 0($/€) =

Capital Budgeting from the Parent Firm’s Perspective: Example $257.28 €200

0

€200

€500

€300

0

1

2

3

CF 0 = (€600)× S 0($/€) =(€600)× $1.25 = $750 €

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

–$750 –€600

–$750 –€600

$1.25 €

Is this a good investment from the perspective of the U.S. shareholders? To address that question, let’s convert all of the cash flows to dollars and then find the NPV at i$ = 15%. 18-24

Capital Budgeting from the Parent Firm’s Perspective: Example

Finding the dollar value of the initial cash $1.25 flow is easy; convert at the spot rate: S 0($/€) = € Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-25

Capital Budgeting from the Parent Firm’s Perspective: Example

€500

€300

–$750 –€600

$257.28 €200

$661.94 €500

€300

2

3

0

1

2

3

1

The exchange rate expected to prevail in the first year, S1 ($/€), can be found with PPP: 1 +π 1.06 $1.25 S 1($/€) = 1 + π$ × S0 ($/€) = × = $1.2864/€ € 1.03 €

1.06

CF 2 =

1.03

×

1.06 1.03

×

$1.25 €

× €500 = $661.94

CF 1 = €200 × S 1 ($/€) = €200 × $1.2864/€ = $257.28 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-26

Capital Budgeting from the Parent Firm’s Perspective: Example –$750 –€600

$257.28 €200

$661.94 €500

0

1

2

CF 3 =

1.06 1.03

×

1.06 1.03

×

1.06 1.03

×

$408.73 €300 3

$1.25 €

× €300 = $408.73

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-27

Capital Budgeting from the Parent Firm’s Perspective: Example –$750

$257.28

$661.94

0

1

2

Find the NPV using the cash flow menu of your financial calculator and and interest rate i$ = 15%:

CF1 = $257.28 CF3 = $408.73

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

3

CF0 = –$750

CF2 = $661.94 18-28

$408.73

18-29

I

= 15

NPV = $242.99 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

5

Capital Budgeting from the Parent Firm’s Perspective: Example –$750

$257.28

$661.94

0

1

2

$408.73 3

Without a financial calculator, the NPV can be found as: NPV = –$750 +

$257.28 $661.94 $408.73 = $242.99 + + 1.15 (1.15)2 (1.15)3

Capital Budgeting from the Parent Firm’s Perspective: Alternative Another recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Estimate the foreign currency discount rate. 3. Calculate the foreign currency NPV using the foreign cost of capital. 4. Translate the foreign currency NPV into dollars using the spot exchange rate

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-30

18-31

Foreign Currency Cost of Capital Method – €600

€200

€500

€300

Foreign Currency Cost of Capital Method l l

0 π€ = 3%

1

2

3

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Before we find i€ let’s use our intuition. Since the euro-zone inflation rate is 3% lower than the dollar inflation rate, our euro denominated discount rate should be lower than our dollar denominated discount rate.

Let ’s find i€ and use that on the euro cash flows to find the NPV in euros.

i$ = 15%

Then translate the NPV into dollars at the spot rate. $1.25 The current exchange rate is S 0($/€) = € π$ = 6%

18-32

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Finding the Foreign Currency Cost of Capital: i€ Recall that the Fisher Effect holds that

inflation rate

(1 + e) =

nominal rate

18-34

(1 + π$)

1.15 e=

Finding the Foreign Currency Cost of Capital: i€ (1 + e$) =

So for example the real rate in the U.S. must be 8.49% (1 + i$)

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

If Fisher Effect holds here and abroad then

(1 + e) × (1 + π$) = (1 + i$) real rate

18-33

– 1 = 0.0849

(1 + π$)

and

(1 + e€) =

(1 + i€) (1 + π€)

If the real rates are the same in dollars and euros (e€ = e$ ) we have a very useful parity condition: (1 + i$) (1 + π$)

1.06

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

(1 + i$)

18-35

=

(1 + i€) (1 + π€)

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

6

International Capital Budgeting: Example

Finding the Foreign Currency Cost of Capital: i€ If we have any three of these variables, we can find the fourth: (1 + i$) (1 + i€) = (1 + π$) (1 + π€)

i€ =

(1.06)

–1

18-37

– €600

€200

€500

€300

0

1

2

3

€200 €500 €300 + + = €194.39 1.1175 (1.1175) 2 (1.1175) 3

l

$1.25 = $242.99 €

€194.39 ×

n

l

APV =

t

+

t

t

ud

t f

t=1

€194.39 ×

$1.25 = $242.99 €

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

l

Change the foreign cash flows into dollars at the exchange rates expected to prevail. Find the $NPV using the dollar cost of capital. Find the foreign currency NPV using the foreign currency cost of capital. Translate that into dollars at the spot exchange rate.

18-39

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

l l

Clearly risk and return are correlated. Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.

T

(1 – τ) SτD SτI +Σ +Σ Σ S(1OCF +K ) (1 + i ) (1 + i )

t=1 S0

18-40

S0

T

= 11.75

Risk Adjustment in the Capital Budgeting Process

Using the intuition just developed, we can modify Lessard’s APV model as shown above, if we find it convenient. S0

I

NPV = €194.39

If you watch your rounding, you will get exactly the same answer either way. Which method you prefer is your choice.

Back to the full APV

T

3

You have two equally valid approaches: n

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

S0

2

International Capital Budgeting

Without a financial calculator, the NPV can be found as:

l

1

CF3 = €300

Capital Budgeting from the Parent Firm’s Perspective: Example

18-38

0

CF2 = €500

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

NPV = –€600 +

€300

CF1 = €200

(1.15) × (1.03) i€ = 0.1175

18-36

€500

CF0 = –€600

(1 + i$) × (1 + π€ ) (1 + π$)

€200

Find the NPV using the cash flow menu and i€ = 11.75%:

In our example, we want to find i€ (1 + i€) =

– €600

t

d

t

t

f

t=1

t

d

t

f

T S tTVT – S 0 C0 + S0 RF0 + S0 CL0 + S tLPt (1 + Kud) T t = 1(1 + id ) t f f S 0 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Σ

18-41

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7

Sensitivity Analysis l

l

l

Real Options

In the APV model, each cash flow has a probability distribution associated with it. Hence, the realized value may be different from what was expected. In sensitivity analysis, different estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment.

l

n

n n

n

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-42

Value of the Option to Delay: Example A French firm is considering a one-year investment in the United Kingdom with a pound-denominated rate of return of 15%. The firm’s local cost of capital is i€ = 10% –£1,000

£1,150

0

1

The application of options pricing theory to the evaluation of investment options in real projects is known as real options. A timing option is an option on when to make the investment. A growth option is an option to increase the scale of the investment. A suspension option is an option to temporarily cease production. An abandonment option is an option to quit the investment early.

18-43

Value of the Option to Delay: Example l

l

Suppose that the bank of England is considering either tightening or loosening its monetary policy. It is widely believed that in one year there are only two possibilities: n n

The cash flows are l

The current exchange rate is S0(€|£) = €2.00 £ Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 18-44

S1 (€|£) = €2.20 per £ S1 (€|£) = €1.80 per £

Following revaluation, the exchange rate is expected to remain steady for at least another year. 18-45

Option to Delay: Example l

If S1(€|£) = €1.80 per £ the project will have turned out to be a loser for the French firm:

l

If S1(€|£) = €2.20 per £ the project will have turned out to be a winner for the French firm:

€2,070

–€2,000

€2,530

0

1

0

1

18-46

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Option to Delay: Example

–€2,000

IRR = 3.50%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

IRR = 26.50% Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

l

An important thing to notice is that there is an important source of risk (exchange rate risk) that isn’t incorporated into the French firm’s local cost of capital of i€ = 10%.

l

Even with that, we can see that taking the project on today entails a “ win big—lose big” gamble on exchange rates. Analogous to buying an at -the-money call option on British pounds with a maturity of one year.

n

l

That’ s why there are no NPV estimates on the last slide.

18-47

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

8

Option to Delay: Example l

l l

Option to Delay: Example

The remaining slides assume a knowledge of the material contained in chapter 7. Especially the notion of a replicating portfolio. But also basic things like a call options gives the holder the right to buy a specific asset at a specific price for a specific amount of time.

l

S1 (€|£)

l

= €2,530

€1.80/£

€2,070 = €2,070 + €0

= €2,070

18-49

l

l

l

€2,070 1+ i€

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-50

Suppose that our option dealer quotes an option premium of €0.05 per pound and our banker quotes the euro-zone risk-free rate at i€ = 6%. The NPV of the project at time zero to the French firm is NPV0 = –€2,000 + €115 + €2,070 = €67.83 1.06 Before we accept a positive NPV project, we should make sure that we are not bypassing alternative projects with higher NPVs. § Waiting a year to start the same project is an alternative. 18-51

Option to Delay: Example l

l

l

If S1(€|£) = €2.20 per £

–€1,800

€2,070

–€2,200

€2,530

0

1

0

1

IRR = 15% NPV1 = €81.82 = –€1,800 + €2,070 1.10 18-52

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Do The Right Thing

If the firm can wait a year to start the project the cash flows look like If S1(€|£) = €1.80 per £

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Option to Delay: Example

So the present value of the project at time zero can be found by getting a quote from an option dealer on an at-the-money call on £2,300 and adding to that the present value of €2,070 at the euro-zone risk-free rate. The Net Present Value of the project is that sum less the cost of the project, –€2,000: NPV = –€2,000 + value of option +

Replicating = Portfolio

€2,530 = €2,070 + €460

Option to Delay: Example l

British Call Investment = Bond + Option

€2.20/£

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-48

The payoff in one year of portfolio consisting of an at -themoney call option written on £2,300 plus a risk-free bond with a future value of €2,070 equals the payoff of the British investment:

IRR = 15% NPV1 = €100

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

l

We have a choice: to invest in the project today or to wait a year. If we jump in today, the NPV0 is €67.83 and the FV in one year is NPV1 = €74.61 = 1.10 × €67.83 Clearly it’s better to wait a year. n Worst case, NPV1 = €81.82 and there is a chance that the NPV at time one is €100 n Both of these outcomes beat €74.61

18-53

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9

End Chapter Eighteen

18-54

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10