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Risk Analysis: An Extended Look


Risk Analysis: An Extended Look Dr. Nancy Mangold California State University, East Bay Credit Risk A firm s ability to make interest and principal payments on ... – PowerPoint PPT presentation

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Title: Risk Analysis: An Extended Look

Risk Analysis An Extended Look
  • Dr. Nancy Mangold
  • California State University, East Bay

Credit Risk
  • A firms ability to make interest and principal
    payments on borrowings

Bankruptcy Risk
  • The likelihood that a firm will file for
    bankruptcy and perhaps subsequently liquidate

Financial distress continuum
  • Failing to make a required interest payment on
  • defaulting on a principal payment on debt
  • filing for bankruptcy
  • liquidating a firm

Financial Distress
  • Analysts concerned with the economic loss of a
    portion or all of the amount lent to or invested
    in a firm can examine a firms position on this
    financial distress continuum.

Broader definition of risk
  • To explain the differences in market rates of
    return of common stocks
  • Economic theory holds that the differences in
    market return must relate to differences in
    perceived risk

Risk measure Market equity beta
  • Market equity beta used as the measure of risk
  • Market equity beta measures the covariability of
    a firms returns with the returns of all
    securities in the market

Sources of Debt Financing Commercial Banks
  • Commercial banks lend funds to firms to finance
  • working capital needs
  • accounts receivable
  • inventory
  • Accounts receivable and inventory serve as
  • Usually short-term less than one year
  • Appear in Current liabilities - notes payable

Sources of Debt Financing Commercial Banks
  • Commercial banks also provide funds to purchase
    equipment, buildings, and other long-term assets
  • These loans extend for periods of 20 or more
  • Specific assets financed used as a collateral
  • appear in the long-term debt payable category

Sources of Debt Financing Other Financial
  • Firms may also obtain funds from
  • Insurance companies
  • finance companies
  • other financial institutions
  • Finance long-term assets
  • Assets serve as collateral for the borrowing

Sources of Debt Financing Commercial paper Market
  • Firms issue commercial paper for very short-term
    needs for cash
  • meet payroll before collecting cash from accounts
    receivable monthly
  • Unsecured
  • Included in notes payable- current liabilities

Sources of Debt Financing Commercial paper Market
  • Large established firms with solid credit status
    most easily access the commercial paper market
    for funds
  • Lenders in the commercial paper
  • financial institutions
  • business enterprises with excess cash
  • money market mutual funds

Sources of Debt Financing Unsecured Debt Market
  • Firms needing long-term sources of funds can
    issue bonds on the open market
  • Bonds are unsecured
  • Priced according to
  • the overall credit quality of the issuer
  • the term to maturity of the bonds
  • the general level of interest rates in the market

Sources of Debt Financing Unsecured Debt Market
  • In Bankruptcy
  • First secured (collateralized lenders
  • second bonds holders
  • third preferred stockholdrs
  • last common stockholders
  • Long term debt payable on balance sheet
  • investors financial institutions, mutual funds,
    pension funds and individuals

Sources of Debt Financing Suppliers
  • Suppliers of various goods and services that do
    not require firms to pay immediately implicitly
    provide funds to the firm
  • Suppliers of raw materials or merchandise
    inventories may require that the inventories
    serve as collateral for the delayed payment

Credit Risk Analysis
  • Circumstances leading to need for the loan
  • Cash Flows
  • Collateral
  • Capacity for Debt
  • Contingencies
  • Character of Management
  • Conditions

Circumstances leading to need for the loan
  • The reason that a firm needs to borrow affects
    the riskiness of the loan and the likelihood of

W.T. Grant Company
  • Discount retail chain filed for bankruptcy in
  • Between 1968 and 1975 Grant experienced
    increasing difficulty collecting accounts
  • Borrow short-term funds from commercial banks to
    finance the buildup of its accounts receivable

W.T. Grant Company
  • Lending to satisfy cash flow needs related to an
    unsolved problem or difficulty can be highly risky

Toys R Us
  • Purchases toys, games, and other entertainment
    products in September and October in anticipation
    of heavy demand during the end-of-the year
    holiday season
  • Typically pays its suppliers within 30 days for
    these purchases, but doesnt collect cash from
    customers until December, January or later

Toys R Us
  • Borrow short term funds from its banks to finance
    its inventory
  • Repays these loans with cash collected from
  • Lending to satisfy cash flow needs related to
    ongoing seasonal business operations is generally
    relatively low risk
  • Toys R Us has an established brand name and
    predictable demand and diverse product line

Wal-Mart Stores
  • Grows the number of its stores at a rate of 12
    per year during the last five years
  • The fastest growth is in its superstores ( a
    combination of its traditional discount store and
    a grocery store).
  • Borrows a large portion of the funds needed to
    construct new stores using 20- to 25-year loans

Wal-Mart Stores
  • Also enters into leases for a significant portion
    of the space needed for its new stores
  • Such loans are relatively low risk
  • given Wal-Marts operating success in the past
  • the land and buildings that serve as collateral
    for the loans

Data General Corporation
  • mMaintained a presence in the midsize computer
    market for several decades
  • Technological advances and aggressive marketing
    by competitors have eroded its share of the
    computer market .

Data General Corporation
  • Wanted to develop new technologies for internet
  • Needed to borrow funds to finance its research
    and development effort

Data General Corporation
  • Such a loan would be relatively high-risk
  • embarking on a new line of business for which it
    does not necessarily have a competitive advantage
  • rapid technology change
  • RD expenditures may not result in assets that
    can be serve as collateral for the loan

Lower credit risk
  • Lending to established firms for ongoing
    operating needs

Higher credit risks
  • Lending to firms experiencing operating problems
  • Lending to emerging businesses
  • Lending to support investments in intangible
    assets typically carry higher risks

Cash Flows
  • Lenders want firms to generate sufficient cash
    flow to pay interest and repay principal on a
    loan so they dont have to rely on selling the

Cash Flows
  • Tools for studying the cash-generating ability of
    a firm
  • examination of the statement of cash flows for
    recent years
  • computation of various cash flow-based financial
  • study of projected financial statements

Statement of Cash Flows
  • Indicators of potential cash flow problems if
    observed for several years in a row
  • Growth in accounts receivable or inventories that
    exceeds the growth rate in sales
  • Increases in accounts payable that exceed the
    increase in inventories

Indicators of potential cash flow problems
  • Other current liabilities that grow at a faster
    rate than sales
  • Persistent negative cash flow from operations
    because of net losses or substantial increases in
    net working capital

Indicators of potential cash flow problems
  • Capital expenditures that substantially exceed
    cash flow from operations
  • indicates a firms continuing need for external
    financing to sustain growth
  • Reductions in capital expenditures over time
  • signal declines in future sales, earnings, and
    operating cash flows

Indicators of potential cash flow problems
  • Sales of marketable securities in excess of
    purchases of marketable securities
  • signal the inability of a firms operations to
    provide adequate cash flow to finance working
    capital and long-term investments

Indicators of potential cash flow problems
  • A substantial shift from long-term borrowing to
    short-term borrowing
  • signal a firms inability to obtain long-term
    loans because lenders are uncertain about a
    firms future
  • A reduction or elimination of dividend payments
  • a negative signal about a firms future prospects

Cash Flow Financial Ratios
  • Cash Flow from operations
  • Average Current liabilities
  • Indicates the ability of a firm to generate
    sufficient cash flows from operations to repay
    liabilities coming due with the next year

Cash Flow Financial Ratios
  • Cash flow from operations
  • Average Total Liabilities
  • Indicates a firms ability to generate sufficient
    cash flow to repay all liabilities

Cash Flow Financial Ratios
  • Cash flow from operations
  • Capital Expenditures
  • Indicates the ability of a firm to finance
    capital expenditures with operating cash flows
  • lt1 indicates a will need to continue to find
    various sources of capital to finance capital
    expenditures to continue its growth

Projected Financial Statements
  • Projected financial statements , Pro Forma
    financial statements represent forecasted income
    statements, balance sheets, and statements of
    cash flows for some number of years into the
  • Lenders require potential borrowers to prepare
    such statements to demonstrate the borrowers
    ability to repay the loan with interest as it
    comes due

Projected Financial Statements
  • The credit analyst should question each of the
    important assumptions underlying these projected
    financial statements
  • sales growth
  • cost structure
  • capital expenditure plans
  • Should also assess the sensitivity of the
    projected cash flows to change sin key assumptions

  • The availability and value of collateral for a
  • If cash flows are insufficient to pay interest
    and repay the principal on a loan, the lender has
    the right to obtain any collateral pledged in
    support of the loan

  • Marketable Securities reported at at market value
    on balance sheet (lt 20 ownership)
  • Assess whether the market value of securities
    pledged as collateral exceeds the unpaid balance
    of a loan

  • Accounts Receivable
  • Assess whether the current value of accounts
    receivable is sufficient to cover the unpaid
    portion of a loan collateralized by accounts

  • Examine
  • changes in provision for uncollectible accounts
    relative to sales
  • the balance in allowance for uncollectible
    accounts relative to gross accounts receivable
  • the amount of accounts written off as
    uncollectible relative to gross accounts
  • the number of days receivables are outstanding

  • Examine
  • Changes in inventory turnover rate
  • Cost of goods sold to sales percentage
  • Mix of raw materials, work in process
    inventories, and finished goods inventories to
    identify possible inventory obsolescence problems

  • LIFO inventories market value exceed the book
  • FIFO inventories will be closer to market value
  • Using footnotes on the excess of market or FIFO
    value over LIFO cost permit the analyst to assess
    the adequacy of LIFO inventories to cover the
    unpaid balance on a loan collateralized by

Property, Plant and Equipment
  • Fixed assets as collateral for long-term
  • Determining the market values of such assets is
    difficult using reported financial statement
    information because the use of historical cost
  • Market values of unique, firm-specific assets are
    particularly difficult to ascertain.

Property, Plant and Equipment
  • Clues indicating market value declines include
  • restructuring charges
  • asset impairment charges related to such assets
  • recent sales at a loss

Nonsecured lending
  • Study the notes to the financial statements to
    ascertain how much of the borrowers assets are
    not already pledged or restricted
  • The liquidation value of such assets represents
    the available resources of a firm to repay
    unsecured creditors

Nonsecured lending
  • For small business, additional source of
    collateral may be
  • personal assets of management or major

Capacity for Debt
  • A firms capacity to assume additional debt
  • A firms cash flows and collateral represent the
    means to repay the debt
  • Most firms do not borrow up to the limit of their
    debt capacity
  • Lenders want to make sure that a margin of safety

Capacity for Debt Debt Ratios
  • long-term debt ( total liabilities )
  • / total assets
  • long-term debt ( total liabilities )
    /shareholders equity
  • consider off-balance sheet obligations
  • operating lease commitments
  • underfunded pension
  • health care benefit obligation

Capacity for Debt Debt Ratios
  • The higher the debt ratios
  • The higher the credit risk
  • The lower the unused debt capacity of the firm

Capacity for Debt Interest Coverage Ratio
  • Operating income before interest and taxes /
    interest payments
  • A measure of margin of safety provided by
    operations to service debt

Capacity for Debt Interest Coverage Ratio
  • When firms make heavy use of operating leases for
    their fixed assets, the analyst might convert the
    operating leases to capital leases for the
    purpose of computing the interest coverage ratio
  • add back the lease payments to net income
  • include the lease payments in the denominator

Capacity for Debt Interest Coverage Ratio
  • lt2 high credit risk
  • gt 4 capacity to carry additional debt

  • Is the firm a defendant in a major lawsuit
    involving its principal products
  • Negative legal judgments will likely have a more
    pronounced effect on smaller firms
  • less resource to defend themselves
  • less resource to sustain such losses
  • may not carry adequate insurance

  • Has the firm served as guarantor on a loan by a
    subsidiary, joint venture, or corporate officer

  • Has the firm committed itself to make payments
    related to derivative financial instruments that
    could adversely affect future cash flows if
    interest rate, exchange rates or other prices
    change significantly in an unexpected direction?

  • Is the firm dependent on one or a few
  • key employees,
  • contracts
  • license agreements, or
  • technologies
  • whose loss could substantially affect the
    viability of the business?

  • Examine notes to the financial statements
  • Ask questions of management, attorneys and

Character of Management
  • Has the management team successfully weathered
    previous operating problems and challenges that
    could have bankrupted most firms?

Character of Management
  • Has the management team delivered in the past on
    projections made with regard to
  • sales level
  • cost reductions
  • new product development
  • other operating targets

Character of Management
  • Does the firm have a reputation for honest and
    fair dealings with suppliers, customers, bankers,
    and others?
  • Do managers have a substantial portion of their
    personal wealth invested in the firms common
  • managers have incentives to operate the firm
    profitably and avoid defaulting on debt to
    increse the value of their equity holding

  • Lenders often place restrictions or constraints
    on a firm to protect their interests
  • Minimum level of certain financial ratios
    (current ratio gt 1.2))
  • maximum level of certain financial ratios
    (debt/equity ratio lt 75)
  • Restrictions on paying dividends
  • Limit on new financing

  • Debt covenants can protect the interest of
    senior, collateralized lenders
  • protection again undue deterioration in the
    financial condition of a firm
  • They can place less senior lenders in jeopardy if
    the firm must quickly liquidate assets to repay
  • increase the likelihood of default or bankruptcy
    if the constraints are too tight

The Bankruptcy Process
  • firms may file under Chapter XI of the National
    Bankruptcy Code
  • Firms have four months to present a plan of
    reorganization to the court
  • After four months, creditors, employees and
    others can file their plans of reorganization

The Bankruptcy Process
  • The court decides which plan provides the fairest
    treatment for all parties concerned
  • When the court determines that the firm has
    executed the plan of reorganization successfully
    and appears to be viable entity, the firm is
    released from bankruptcy

The Bankruptcy Process
  • A Chapter XII filing for bankruptcy entails an
    immediate sale or liquidation of the firms
    assets and a distribution of the proceeds to the
    various claimants in the order of their priority.

Models of Bankruptcy Prediction
  • Univariate Bankruptcy Prediction Models examine
    the relation between a particular financial
    statement ratio and bankruptcy

Univariate Bankruptcy Prediction Models
  • Beaver studied 29 financial statement ratios for
    the five years preceding bankruptcy for a sample
    of bankrupt and non-bankrupt firms

Univariate Bankruptcy Prediction Models
  • The six ratios with the best discriminating power
  • (long-term solvency risk
  • NI before depreciation, depletion and
    amortization/ Total Liabilities
  • Profitability
  • NI/Total Assets

Univariate Bankruptcy Prediction Models
  • Long-term solvency risk
  • Total Debt/ Total Assets
  • Short-term liquidity risk
  • Net working capital/Total Assets
  • Short-term liquidity risk
  • Current Assets/ Current Liabilities
  • Short-term liquidity risk
  • Cash, marketable securities, accounts
    receivable/operating expenses

Multivariate Bankruptcy Prediction Models
  • Multiple Discriminant Analysis (MDA)
  • The best-known MDA bankruptcy prediction model is
    Altmans Z-score

Altmans Bankruptcy Prediction Model
  • Z 1.2(NWC/TA) 1.4(RE/TA) 3.3(EBIT/TA)
    .6(MV-EQ/BV-Liab) 1.0(S/TA)
  • MWC/TA1(current assets - current
    liabilities)/total assets
  • measure the proportion of total assets
    representing relatively liquid net current assets
    (ST liquidity risk)

Altmans Bankruptcy Prediction Model
  • RE/TA retained earnings / total assets
  • measures accumulated profitability and relative
    age of a firm
  • EBIT/TA EBIT / total assets
  • measures current profitability

Altmans Bankruptcy Prediction Model
  • MV-EQ/BV-Liab market value of preferred and
    common equity / book value of total liabilities
  • markets overall assessment of the profitability
    and risk of the firm
  • S/TA sales / total assets
  • measures ability of a firm to use assets to
    generate sales

Altmans Bankruptcy Prediction Model
  • If Z gt 2.99 assign to nonbankrupt group, low
    probability of bankruptcy
  • If Z lt 1.81 assign to bankrupt group, higher
    probability of bankruptcy
  • 1.81 lt Z lt 2.99 gray area

Multivariate Bankruptcy Prediction Models
  • James Ohlson used Logit Analysis to discriminate
    bankrupt from non-bankrupt firms
  • y-1.32 - 0.407(SIZE) 6.03(TLTA) - 1.43(WCTA)
    0.0757(CLCA) - 2.37)NITA) -
  • 1.83 (FUTL) 0.285 (INTWO) - 1.72 (OENEG) -
    0.521 (CHIN)

Multivariate Bankruptcy Model Logit Analysis
  • Size larger firms have greater flexibility to
    curtail capacity, sell assets, and attract debt
    or equity capital than smaller firms
  • TLTA (Total Liabilities/ Total Assets)
  • Long-term solvency risk
  • Higher debt ratios increase the probability of

Multivariate Bankruptcy Model Logit Analysis
  • WCTA (Working capital/Total Assets
  • the higher the proportion of net working capital
    to total assets,
  • the more liquid are the assets
  • the lower the probability of bankruptcy

Multivariate Bankruptcy Model Logit Analysis
  • CLCA (Current Liabilities/Current Assets)
  • An excess of current liabilities over current
    assets is also an indicator of short-term
    liquidity risk

Multivariate Bankruptcy Model Logit Analysis
  • NITA (Net Income/Total Assets)
  • the higher the rate of profitability,
  • the less likely a firm will experience difficulty
    servicing debt
  • the lower the probability of bankrupty

Multivariate Bankruptcy Model Logit Analysis
  • FUTL (Funds (Working capital) from operations/
    Total Liabilities)
  • the greater the ability of working capital from
    operations to cover total liabilities
  • the lower the probability of bankruptcy

Multivariate Bankruptcy Model Logit Analysis
  • INTWO (one if net income was negative for the
    last two years and 0 otherwise)
  • A recent history of net losses increases the
    probability of bankruptcy

Multivariate Bankruptcy Model Logit Analysis
  • OENEG (One if total liabilities exceed total
    assets and zero otherwise)
  • appears redundant with TLTA
  • coefficient should be positive but is negative

Multivariate Bankruptcy Model Logit Analysis
  • CHIN (Net income (t) - Net Income (t-1))/(INet
    Income (t)I Inet Income (t-1)I
  • The change in net income indicates the direction
    and magnitude of earnings growth or decline.
  • Increasing (decreasing) earnings coupled with the
    negative coefficient suggest a lower (higher)
    probability of bankrupty

Synthesis of Bankruptcy Prediction Research
  • Investment Factors
  • Relative Liquidity of a Firms Assets
  • Rate of Asset Turnover

Relative Liquidity of a Firms Assets
  • Firms with relatively large proportions of
    current assets tend to experience less financial
    distress than firms whose dominant assets are
    fixed assets or intangible assets
  • Expected return on the more liquid assets is
    usually less than the expected return from fixed
    and intangible assets reflecting its lower risk

Relative Liquidity of a Firms Assets
  • Firms must balance their mix of assets to obtain
    the desired return/risk profile
  • Ratios include
  • Cash/Total assets
  • Current assets/total assets
  • net working capital/total assets

Rate of Asset Turnover
  • The more quickly assets turn over, the more
    quickly funds work their way toward cash on the
    balance sheet
  • Retailer has same fixed assets to total assets as
    a manufacturing firm, but higher turnover ratios
    thus more liquid.

Rate of Asset Turnover
  • Ratios include
  • total assets turnover
  • accounts receivable turnover
  • inventory turnover
  • the working capital turnover
  • fixed asset turnover

Financing Factors
  • Relative Proportion of Debt in the Capital
  • the higher the proportion of liabilities in the
    capital structure
  • the higher the probability that firms will
    experience bankruptcy
  • Firms with lower levels of debt tend to have
    unused borrowing capacity that they can depend on
    in times of difficulty

Financing Factors
  • Relative Proportion of Short-Term Debt in the
    Capital Structure
  • The more imminent due dates of debt exacerbate
    the risk of bankruptcy
  • Ratio include
  • Current liabilities/total assets

Operating Factors
  • Relative Level of Profitability
  • Profitable firms ultimately turn their earnings
    into cash
  • Firms with low or negative profitability must
    often rely on available cash or additional
    borrowing to meet financial commitments as they
    come due
  • Weak profitability and high debt ratios usually
    spells financial distress

Operating Factors
  • Profitability ratios
  • net income/assets
  • income before interest and taxes/assets
  • net income/sales
  • cash flow from operations/assets

Operating Factors
  • Variability of Operations
  • Firms that experience variability in their
    operations (cyclical sales patterns) are more in
    danger of bankruptcy than firms with less
  • measure
  • change in sales
  • change in net income from the previous year

Other Possible Explanatory Variables
  • Size
  • Larger firms generally have access to a wider
    range of financing sources as well as more
    flexibility to redeploy assets than smaller firms
  • Larger firms are less subject to bankruptcy than
    smaller firms

Other Possible Explanatory Variables
  • Growth
  • Rapidly growing firms often need external
    financing to cover cash shortfalls from
    operations and permit acquisitions of fixed
  • they display high debt ratios and weak
  • But their growth potential provides access to
    capital that permits to survive

Other Possible Explanatory Variables
  • Qualified Audit Opinion
  • has much the same predictive accuracy as the
    models based on financial ratios

Market Risk
  • Economic theory teaches that differences in
    expected rates of return for different investment
    alternatives should relate to differences in risk

Market Rate of Return
  • Return on common stock
  • Risk Free interest rate Market beta ( market
    return - risk free interest rate)
  • The beta coefficient measures the covariability
    of a firms returns with those of all shares
    traded on the market

Market Risk
  • Beta captures the systematic risk
  • The pricing of common stock rewards shareholders
    they assume
  • An investor can eliminate nonsystematic risk by a
    diversified portfolio

Market Beta
  • Three principal explanatory variables
  • Degree of operating leverage
  • Degree of financial leverage
  • Variability of sales

Market Beta
  • Firms with a market beta of 1 experience
    variability equal to the average
  • Firms with a market beta of more than 1experience
    greater variability than the average
  • Firms with a beta of less than 1 experience less
    variability than the average firm
  • Exhibit 9.6

  • Have capital-intensive facilities and use
    extensive borrowing to finance their acquisition
  • lowest assets turnover ratios
  • highest capital structure leverage ratios
  • ROCE is smallest of all the industries
  • Their market beta is the smallest

Metals and Metal Products
  • The metals industry takes iron ore and other
    minerals and processes them into steel and other
    intermediate products
  • Capital intensive
  • Products tend to portray commodity characteristics

Metals and Metal Products
  • The metal products industry takes steel and other
    intermediate products and processes them into
    final products that have an element of
  • less capital intensive
  • faster asset turnover than the metals industry

Metals and Metal Products
  • Similar capital structure leverage ratios
  • ROCE is higher for the metal products segment -
    differentiated product
  • Market beta of metal products is less than that
    for metals

Grocery Stores, Food Processors and Restaurants
  • Less variability in the ROCE of grocery stores
    (.74) and food processors (.79) (demand is
    relatively price -inelastic) than restaurants
    (.90) where demand has greater price elasticity

Amusements and hotels
  • Heavy investments in fixed assets and debt
  • Economic conditions affect the demand for their
  • Amusement industry experienced much less
    variability in its ROCE than hotels
  • The amusements industry is also less capital
    intensive and debt intensive than hotels
  • Amusement (.74) smaller beta than Hotel (.95)

Printing and Publishing, Lumber, and Paper
  • Paper industry is more capital-intensive and
    debt-intensive than the printing and publishing
    industry and the lumber industry
  • Expect market beta for printing lower than lumber
    lower than paper industry
  • But 3 market betas are similar (.88, .89, .89)

  • Capital and debt intensive
  • Std deviation of ROCE relatively high
  • Market beta the smallest of 22 industries

Bankruptcy risk and Market Beta Risk
  • High proportions of fixed assets in the asset
    structure provide relatively illiquid assets
    (increasing bankruptcy risk) and high fixed costs
    (increasing market beta risk).

Bankruptcy risk and Market Beta Risk
  • High proportions of debt in the capital structure
    require regular debt servicing (increasing
    bankruptcy risk) and high fixed costs for
    interest (increasing market beta)

Bankruptcy risk and Market Beta Risk
  • Variability of sales raises the possibility that
    a firm may not have sufficient liquid assets to
    service debt (increasing bankruptcy risk) and
    creates fluctuation in earnings (increasing
    market beta risk)

Bankruptcy risk and Market Beta Risk
  • Bankruptcy risk relates primarily to an
    illiquidity problem
  • Market beta risk relates more to an earnings
  • Bankruptcy risk when it becomes important for a
    particular firm intensifies the underlying market
    beta risk
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