asset & liabilities management chapter 4
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4
C
hapte The Management of
Working Capital
Slides Developed by:
Terry Fegarty
Seneca College
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Chapter 4 Outline (1)
Working Capital Basics Working Capital and the Current Accounts
Working Capital and Funding Requirements
Objective of Working Capital Management
Working Capital Trade-offs
OperationsThe Cash Conversion Cycle
The Operating Cycle and the Cash Conversion Cycle
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Chapter 4 Outline (2)
Permanent and Temporary Working Capital Maturity Matching Principle
Financing Net working Capital
Short-Term vs. Long-Term Financing
Working Capital Policy
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Chapter 4 Outline (3)
Cash Management Objectives of Cash Management
Marketable Securities
Yield on a Discounted Money Market Security
Components of Float
Cheque Disbursement and the Cheque Clearingprocess
Accelerating Cash Receipts Electronic Funds Transfer
Managing Cash Outflow
Evaluating Cash Management Services
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Chapter 4 Outline (4)
Managing Accounts Receivable Tradeoffs in Managing Accounts Receivable
Credit Policy
Terms of Sale
Collections policy
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Chapter 4 Outline (5)
Inventory Management Benefits and Costs of Carrying Adequate Inventory
Inventory Ordering Costs
Inventory Control and Management
Economic Order Quantity Model
Safety Stocks, Reorder Points and Lead Times
Inventory on Hand Including Safety Stock
Tracking InventoriesThe ABC System Just In Time (JIT) Inventory System
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Working Capital Basics
Working Capital Assets/liabilities required to operate
business on day-to-day basis Cash
Accounts Receivable
Inventory
Accounts Payable
Accruals
Short-term in natureturn over regularly
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Working Capital and the CurrentAccounts
Gross working capital = Current assets
Gross Working Capital (GWC) represents
investment in current assets
(Net) working capital =
Current assets Current liabilities
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Working Capital and FundingRequirements
Working Capital Requires Funds
Maintaining working capital balance requires
permanent commitment of funds Example: Firm will always have minimum level of
Inventory, Accounts Receivable, and Cashthisrequires funding
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Working Capital and FundingRequirements
Spontaneous Financing Firm will also always have minimum level of
Accounts Payablein effect, money you haveborrowed Accounts Payable (and Accruals) are generated
spontaneously Arise automatically with inventory and expenses
Offset the funding required to support current assets
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Working Capital and FundingRequirements
Net working capital is Gross WorkingCapital Current Liabilities (including
spontaneous financing)
Reflects net amount of funds needed tosupport routine operations
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Objective of Working CapitalManagement
To run firm efficiently with as little moneyas possible tied up in Working Capital
Involves trade-offs between easier operation
and cost of carrying short-term assets Benefit of low working capital
Money otherwise tied up in current assets can beinvested in activities that generate higher payoff
Reduces need for costly financing
Cost of low working capital
Risk of shortages in cash, inventory
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Working Capital Trade-offs
InventoryHigh Levels Low Levels
Benefit:
Happy customers
Few production delays (always have neededparts on hand)
Cost:
Expensive
High storage costs
Risk of obsolescence
Cost:
Shortages
Dissatisfied customers
Benefit:
Low storage costs
Less risk of obsolescence
CashHigh Levels Low Levels
Benefit: Reduces risk
Cost:
Increases financing costs
Benefit: Reduces financing costs
Cost:
Increases risk
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Working Capital Trade-offs
Accounts ReceivableHigh Levels (favourable credit terms) Low Levels (unfavourable
terms)
Benefit:
Happy customers
High sales
Cost:
Expensive
High collection costs
Increases financing costs
Cost:
Dissatisfied customers
Lower Sales
Benefit:
Less expensive
Accounts Payable and Accruals
High Levels Low LevelsBenefit:
Reduces need for external finance--using aspontaneous financing source
Cost:
Unhappy suppliers
Benefit:
Happy suppliers/employees
Cost:
Not using a spontaneousfinancing source
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Current Assets High Level Low Level
Profitability Lower HigherRisk Lower Higher
Working Capital Trade-offs
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OperationsThe Cash ConversionCycle
Firm begins with cash which thenbecomes inventory and labour
Which then becomes product for sale Eventually this will turn into cash again
Firms operating cycle is time fromacquisition of inventory until cash iscollected from product sales
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Figure 4.1: The Cash ConversionCycle
Product is
converted intocash, which is
transformed intomore product,
creating the cashconversion cycle.
Figure 4 2 me ne ep esen a on
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Figure 4.2: me ne epresen a onof the Cash Conversion
Cycle
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The Operating Cycle and the CashConversion Cycle
Inventory conversion period
plus: Receivable collection period
equals: Operating cycleminus: Payables deferral period
equals: Cash conversion cycle
Shortening cash conversion cycle frees up cashto reinvest in business or to reduce debt andinterest
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InventoryConversion
Period=
365
Inventory Turnover
ReceivablesCollection
Period=
Accounts Receivable 365
Annual Credit Sales
Cash Conversion Cycle Analysis
PayablesDeferralPeriod
=Accounts Payable 365
Cost of Goods Sold
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Cash Conversion Cycle
PurchaseInventory
Pay forInventory
Sell Inventoryon Credit
CollectReceivables
Operating CycleInventory Conversion PeriodReceivables Collection PeriodPayables Deferral PeriodCash Conversion Cycle
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Figure 4.3: Working CapitalNeeds of Different Firms
d
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Permanent and TemporaryWorking Capital
Working capital is permanentto theextent that it supports constant or
minimum level of sales
Temporaryworking capital supports
seasonal peaks in business
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Maturity Matching Principle
Maturity (due date) of financing shouldroughly match duration (life) of asset
being financed Then financing /asset combination becomes
self-liquidating
Cash inflows from asset can be used to pay offloan
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Financing Net Working Capital
According to maturity matching principle Temporary(seasonal) should be financed
with short-term borrowing
Permanentworking capital should befinanced with long-term sources, such aslong-term debt and/or equity
In practice, firms may use more or lessshort-term funds to finance workingcapital
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Figure 4.4(a):Working CapitalFinancing Policies
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Figure 4.4(b):Working CapitalFinancing Policies
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Short-Term vs. Long-TermFinancing
The mix of short- or long-term workingcapital financing is a matter of policy
Use of long-term funds is a conservativepolicy
Use of short-term funds is an aggressivepolicy
Sh t T L T
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Short-Term vs. Long-TermFinancing
Short-term financing
Cheap but risky
Cheapshort-term rates generally lower thanlong-term rates
Riskybecause you are continually entering
marketplace to borrow Borrower will face changing conditions (ex; higher
interest rates and tight money)
Sh t T L T
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Short-Term vs. Long-TermFinancing
Long-term financing Safe but expensive
Safeyou can secure the required capital
Expensivelong-term rates generally higherthan short-term rates
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Working Capital Policy
Firm must set policy on following issues:
How much working capital is used
Extent to which working capital is supportedby short- vs. long-term financing
How each component of working capital is
managed The nature/source of any short-term
financing used
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Cash Management
Cash managementdetermining:
Optimal size of firms liquid asset balance
Appropriate types and amounts ofshort-term investments
Most efficient methods of controlling
collection and disbursement of cash
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Cash Management
Why have cash on hand?
Transactions demand: need money to pay bills(employees, suppliers, utility/phone, etc.)
Precautionary demand: to handle emergencies(unforeseen expenses)
Speculative demand: to take advantage ofunexpected opportunities (purchase of raw materialsthat are on sale)
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Objectives of Cash Management
Cash doesnt earn a return Want to maintain liquidity
Take cash discounts
Maintain firms credit rating
Minimize interest costs
Avoid insolvency
Good cash management implies maintaining
adequate liquidity with minimum cash in bank Can place portion of cash balance into marketable
securities (AKA: near cash or cash equivalents)
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Marketable Securities
Liquid investments that can be heldinstead of cash and earn a modest return
Examples include Treasury bills,commercial paper, bankers acceptances
Many are bought and sold at a discount inmoney market
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Examples of Marketable Securities
Treasury Bills Short-term government notes issued at a
discount with principal repaid at maturity
Commercial Paper Short-term unsecured promissory notes
issued by corporations with good credit
Bankers Acceptances Short-term promissory notes issued by a firm
and accepted (or guaranteed) by a bank
Yi ld Di t d M M k t
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Yield on a Discounted Money MarketSecurity
Annualized yield
100 P 365
P d
where P = Discounted price as apercentage of maturity value
d = Number of days to maturityr = Annualized yield
r =
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Components of Float
Mail Float delay between when cheque is sent to a payee and
is received by payee
Processing Float time between receipt of payment by a payee and the
deposit of the payment in the payees account
Clearing Float time between depositing a cheque and having
available spendable funds
Cheque Disbursement and the
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Cheque Disbursement and theCheque Clearing Process
When you pay a bill, You write cheque and mail to payee (2-3
days ofmail float)
Payee receives cheque and performs internalprocessing (1 day ofprocessing float)
Payee deposits cheque in its own bank (1 dayofprocessing float)
Payees bank sends cheque into interbankclearing system which processes cheque (2days ofclearing float)
Fi 4 5 The Cheq e Clea ing
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Figure 4.5: The Cheque-ClearingProcess
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Accelerating Cash Receipts
Lock-box systems Post office box(es) located near customers in
order to shorten mail and processing float
Local bank empties the box, deposits paymentsinto firms account, and reports payments to firm
May involve significant fees
More cost-effective if small number of largerdeposits
Fi 4 6 A Lock Box System in
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Figure 4.6:A Lock Box System inthe Cheque-Clearing Process
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Accelerating Cash Receipts
Concentration Banking Customers send cheques sent to firms local
collection centres, where they are deposited
Local deposits are transferred electronicallyinto one central concentration account
Reduces mail float
Funds available for paying loans or investingin marketable securities
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Electronic Funds Transfer
Electronic funds transfer mechanismsare reducing the importance of float
management techniques for manycompanies
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Electronic Funds Transfer
Wire Transfers Transferring money electronically
Preauthorized Cheques Customer gives payee signed cheque-like
documents in advance
When payee ships product, it deposits
preauthorized cheque in its bank account Eliminates mail float
Payee must trust payer
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Managing Cash Outflow
Zero balance accounts (ZBAs) Decentralization of cash payments can lead to large
number of cash balances around the country
Divisions write cheques on ZBAsfunded from
central account only when cheques are cleared
Solves problem of idle cash in decentralized bankaccounts
Remote disbursing Using bank in remote location for disbursement
chequing account Increases mail float
Evaluating Cash Management
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Evaluating Cash ManagementServices
Evaluation involves comparison of costsversus benefits of faster collection
Example 4 1: Evaluating Cash
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Example 4.1: Evaluating CashManagement Services
Q: Kelso Systems Inc. has customers in British Columbia that remitabout 500 cheques a year. The average cheque is for $10,000.West coast cheques currently take an average of eight daysfrom the time they are mailed to clear into Kelsos east coastaccount.
A British Columbia bank has offered Kelso a lock box system for$1,000 a year plus $0.20 per cheque. The system can beexpected to reduce the clearing time to six days.
Is the banks proposal a good deal for Kelso if it borrows at 8%?
E
xample
Example 4 1: Evaluating Cash
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Example 4.1: Evaluating CashManagement Services
A: The cheques represent revenue of: 500 $10,000 =$5,000,000 per year.
The average amount tied up in the cheque clearing process is:8/365 x $5,000,000 = $109,589.
The proposed lockbox system will reduce this to: 6/365 x$5,000,000 = $82,192, thus freeing up $27,397 of cash.
Kelso will be able to borrow $27,397 less, thus saving: $27,397x 0.08 = $2,192 in interest
The system is expected to cost: $1,000 + ($0.20 x 500) =$1,100.
The net saving is: $2,192 - $1,100 = $1,092
The banks proposal should be accepted
Exam
ple
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Managing Accounts Receivable
Generally firms like as little money as possibletied up in receivables Reduces costs (firm has to borrow to support the
receivable level)
Minimizes bad debt exposure
But, having good relationships with customersis important
Increases sales
Firm needs to strike a balance on these issues
Trade offs in Receivable
Trade-offs in Managing Accounts
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Trade-offsin ReceivableManagement
Liberal ManagementMore sales and grossmargin, but
More bad debtsHigher collection costs
More discountexpenses
Higher receivablesLonger collections
More interest expense
Strict Management
Less sales and grossmargin, but
Less bad debtsLower collection costs
Less discountexpenses
Lower receivablesShorter collections
Less interest expense
Trade offs in Managing AccountsReceivable
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Managing Accounts Receivable
Policy Decisions Influencing AccountsReceivable
Credit Policy Criteria used to screen credit applications
Controls quality of accounts to which credit is extended
Terms of Sale
Terms and conditions under which credit extended must berepaid
Collections Policy Methods employed to collect payment on past due accounts
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Credit Policy
Must examine creditworthiness of potentialcredit customers Credit report
Customers financial statements
Bank references Customers reputation among other vendors
Conflicts often arise between sales and credit
departments Sales departments job to generate sales
Credit department may refuse credit to high riskaccounts
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Terms of Sale
Credit sales are made according tospecified terms of sale Example: 2/10, net 30 means customer
receives 2% discount if payment is madewithin 10 days, otherwise entire amount isdue by 30 days
Customers pay quickly to save money Firms terms of sale generally follow
industry practice
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Collections Policy
Firms collection policymanner and aggressivenesswith which firm pursues payment from delinquentcustomers Being overly aggressive can damage customer relations
Function ofcollections department to follow up onoverdue receivables (called dunning) Mail polite letter
Follow up with additional dunning letters
Phone calls
Collection agency
Lawsuit
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Inventory Management
Inventory management establishes a balancebetween carrying enough inventory to meetsales or production requirements whileminimizing inventory costs
Inventory usually managed by manufacturingor operations
However, finance department has an oversightresponsibility
Monitor level of lost or obsolete inventory
Supervise periodic physical inventories
Benefits and Costs of Carrying
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Benefits and Costs of CarryingAdequate Inventory
Benefits Reduces stockouts and backorders
Makes operations run more smoothly, improves customerrelations and increases sales
Carrying Costs Interest on funds used to acquire inventory
Storage and security
Insurance
Taxes
Shrinkage Spoilage
Breakage
Obsolescence
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Inventory Ordering Costs
Inventory ordering costs Expenses of placing orders with suppliers,
receiving shipments, and processingmaterials into inventory
Excludes vendor charges
Relate to the number of orders placed
rather than to the amount of inventory held
Tend to vary inversely with carrying costs
Economic Order Quantity (EOQ)
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Economic Order Quantity (EOQ)Model
EOQ model recognizes trade-offs betweencarrying costs and ordering costs
Carrying costs increase with amount of inventory
held ( from larger orders)
Ordering costs increase with the number of ordersplaced (from more orders)
EOQ minimizes total of sum of ordering andcarrying costs
C d h OQ
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Inventory Costs and the EOQ
Q (Order Size)
Cost($)
TotalCost
EOQ
CarryingCost
Ordering
Cost
Economic Order Quantity (EOQ)
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Economic Order Quantity (EOQ)Model
EOQ model is:
whereQ= order size in units
D= annual quantity used in units
F= cost of placing one orderC= annual cost of carrying one unit in stock
denotes square root
c2F DQ
Figure 4 7: Inventory on Hand for a
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Figure 4.7:Inventory on Hand for aSteadily Used Item
Economic Order Quantity (EOQ)
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Economic Order Quantity (EOQ)Model
Other Inventory Formulas
Average Inventory =
Total Carrying Cost: =
Number of Orders =
Total Ordering Cost = FN =
Total Ordering and Carrying Cost =
2
Q
Qc
2
DN=
Q
D
FQ
Q DTC = c +F
2 Q
Example 4 3: Economic Order
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Example 4.3:Economic OrderQuantity
Exam
ple
Q: The Galbraith Corp. buys a part that costs $5. The carryingcost of inventory is approximately 20% of the parts dollar value
per year. It costs $50 to place, process and receive an order.The firm uses 900 of the $5 parts per year.
What ordering quantity minimizes inventory costs?How many orders will be placed each year if that order quantityis used?What inventory costs are incurred for the part with this orderingquantity?
Example 4.3: Economic Order
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p
Quantity
Example
A: Annual carrying cost per unit is 20% x $5 =$1
EOQ = 300 unitsThe annual number of reorders is 900 300 = 3Ordering costs are $50 x 3 = $150 per yearAverage inventory is 300 2 = 150 units
Carrying costs are 150 x $1 =$150 a yearTotal inventory cost of the part is $300
1
900502Q
Safety Stocks, Reorder Points and
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Safety Stocks, Reorder Points andLead Times
Safety stock provides insurance againstunexpectedly rapid use or delayeddelivery
Additional supply of inventory that is carriedat all times to be used when normal workingstocks run out
Rarely advisable to carry so much safety
stock that stockouts never happen Carrying costs would be excessive
Safety Stocks, Reorder Points and
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a y o , o d o a dLead Times
Ordering lead timeadvance noticeneeded so that an order placed will arrivewhen required Usually estimated by items supplier
Reorder pointlevel of inventory at
which order is placed
Figure 4.9: Inventory on Hand
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Figure 4.9: Inventory on HandIncluding Safety Stock
Economic Order Quantity (EOQ)
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Q y ( Q)Model
Other Inventory Formulas (with SafetyStock)
Average Inventory =
Total Carrying Cost: =
Total Ordering and Carrying Cost =
StockSafety2
Q
Qc Safety Stock
2
Q DTC = c SafetyStock + F
2 Q
Tracking InventoriesThe ABC
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gSystem Some inventory items (A items) require great
deal of attention Very expensive Critical to firms processes or to those of customers
Some inventory items do not require great dealof attention (C items) Commonplace, easy to obtain
B items fall between items A & C
ABC system segregates items by value andplaces tighter control on higher cost (value)pieces
Just In Time (JIT) Inventory
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( ) ySystem
Inventory supplied At exactly the right time In exactly the right quantities
Theoretically eliminates the need for factory inventory
Shortens operating cycle Reduces costs
Eliminate wasteful procedures
But:late delivery can stop factorys entire production line
Works best with large manufacturers who are powerfulwith respect to supplier Supplier is willing to do almost anything to keep the
manufacturers business
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