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How Corporations Issue Securities


INTRODUCTION
This chapter describes the procedures used by companies for raising long-term funds in the capital
market. It provides a wealth of institutional details and guidance to managers on decisions about
long-term capital. The chapter describes the process of venture capital financing in some detail
through an extension of the Marvin Enterprises you saw in Chapter 11. This chapter is structured
to show the different ways in which companies raise finance in the capital markets. It starts by
describing the provision of venture capital to young companies and then describes what happens
when a company makes an initial public offering (IPO). The subsequent sections describe the
general cash offer used for most public issues of debt or equity securities in the United States.
Equity issues made directly to existing shareholders are called privileged subscription issues or
rights issues, and these are described in Appendix A. The chapter also discusses the role of the
underwriter and the costs of different types of issues. The chapter also covers private placements
and their importance in financing small- and medium-sized companies.
Financial managers concerned with raising finance need to decide the method of issue, the size of
the issue, the pricing of the security, the use of an underwriter, and the type of underwriting
arrangement. The manager should also be concerned with the effect the issue will have on the
firms market value. All these are closely related to market efficiency. In general, it is very
unlikely that financing decisions will enhance the market value of the firm as a whole. It is,
however, quite possible that there may be wealth transfer between one group of security holders
and another. The manager will do well to remember the lessons of market efficiency learned in
Chapter 13. Here are some implications of market efficiency relevant to this chapter.
Financing Decisions and Stockholder Wealth: Financing decisions seldom affect total security
holders' wealth. Furthermore, it is reasonable to assume that most financing decisions have a net
present value of zero. This is because a positive NPV financing decision is one where the money
raised exceeds the value of the liability created. In the highly competitive capital market, it is very
unlikely that any firm could consistently fool investors in this way.
Financing Decisions and the Distribution of Wealth: Financing decisions can, however, affect
the distribution of wealth between security holders. If new securities are under-priced, new
holders will obtain a bargain at the expense of existing holders. This is not a problem, however, in
the case of rights issues, where existing holders are given rights to subscribe in proportion to the
size of their holdings. The worked example should help you to handle the kind of calculations
that arise with rights issues.
The Importance of Market Prices: When a company is deciding on the issue price for new
securities, the best guide to what a company can hope to obtain is the price of closely comparable
securities, which are already traded.
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There Are No Financial Illusions: It is the effect of financing decisions on stockholders' wealth
that matters, and it is difficult to imagine that stockholders will believe one share at $20 is worth
more than two shares at $10. Bear this in mind when you read about rights issues.
It is Helpful to Separate Investment and Financing Decisions: If the market believes the
investment projects for which the issue proceeds are destined will provide inadequate returns, the
stock price will fall. This is the result of a poor investment decision and has nothing to do with
the financing operation or the issue method employed.
KEY CONCEPTS IN THE CHAPTER
Venture Capital: Equity investment in the early stages of a business is often called venture
capital. Venture capital is key to the success of any growing business as the original investors and
founders of the business are unlikely to have the needed capital. The investment is risky, but is
rewarded by the high returns of the successful ventures. Specialist investors who are often
organized as partnerships typically provide this type of financing. Wealthy individuals and
financial institutions are also important players in the venture capital business. In order to monitor
the progress of the business and to limit the risk of the investment, venture capital financing is
provided in stages with each additional stage of funding contingent on successful completion of
some set targets or milestones. First-stage financing generally is based on a business plan. The
business plan describes the exact nature of the proposed business: the product, the market, the
resources it will use, and the income it will generate. In obtaining an injection of equity capital,
the after-the-money valuation is important in putting an implicit valuation on the entrepreneurs'
existing equity. Successful completion of the first stage will lead to second-stage financing and
possibly further stages before the company is ready to go public with an initial public offering.
The United States has a well-developed venture capital market. Specialist partnerships pool funds
from a variety of investors and seek out fledgling companies to invest in. The nature of these
investments is that for every 10 first-stage venture capital investments, only two or three may
survive as successful businesses, but if one becomes very successful, it will make up for all the
others.
The Initial Public Offering: The initial public offering or IPO is the first issue of shares to the
general public. Generally, IPOs are done when the business has made considerable progress and is
on its way to successfully establishing itself in the market. The IPO establishes a market value of
the investment made by the founding entrepreneurs and the venture capitalists. A primary
offering is one where shares are sold to raise additional cash for the company. Often a primary
offering is combined with a secondary offering where existing shareholders (the venture
capitalists and sometimes the founding entrepreneurs) sell some of their shares. An underwriter is
used to sell the offered shares to the general investor. Underwriters are investment banks and
provide a host of services related to the issue.
The first formal step of an IPO is the approval of the issue by the board and by stockholders if an
increase in authorized capital is necessary. A registration statement is then prepared for
submission to the Securities and Exchange Commission (SEC). This statement presents
information about the proposed financing, the firm's history, existing business, and plans for the
future. The first part of the registration statement is usually distributed as a preliminary
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prospectus, also called a red herring. It contains a statement printed in red ink, which draws
attention to its preliminary status and that securities are not permitted to be sold until the
registration becomes effective. Meanwhile, the SEC studies the documentation and requests
changes to it. Finally, an amended statement is filed with the SEC. After registration, the final
prospectus is issued, giving the issue price, which is fixed at this stage. A registrar is appointed to
record any issues of stock and to prevent unauthorized issues' taking place. A transfer agent is
also appointed to look after the transfer of the newly issued securities.
Winners curse may be a problem with some IPOs. This means that a successful bidder in an
auction is likely to have overvalued the asset. Thus, investors, being unaware of other investors`
valuation of the stock, can end up paying a high price. This may be the reason why IPOs are
often underpriced.
Public issue can be expensive. The costs include the administrative and transaction costs as well
as the cost due to underpricing of the shares. The company and its underwriters discuss and
agree on the issue price. The company would, of course, like to secure the highest possible
price, but too high a price and the issue will fail, leaving the underwriters in particular with a
disaster on their hands. Underwriters make their profit by buying the issue from the company
at a discount from the price at which they resell it to the public. There are other more hidden
costs of under-pricing: on average the new investors also get a bargain when they buy new
issues. A study of nearly 9,000 new issues from 1960 to 1987 indicated average underpricing of 16 percent. Some of the recent Internet IPOs had relatively high under-pricing
costs. The administrative costs include preparation of all the documentation by management,
legal counsel, and accountants, besides other fees, printing and mailing costs. While these
costs add up to a substantial amount, the hidden costs can be much higher.
Types of Issues: Public issue of securities can be either general cash offers or rights issues.
General cash offers are made to the public and in the United States, this is the most commonly
used mode for all debt and equity issues. In some other countries it is common to find rights
issues (also known as privileged subscription issues) where the issue is offered to the existing
shareholders as a right. The shareholders can sell their rights to subscribe to the issue in the
market.
Companies can file a single shelf registration statement covering financing plans for up to 2 years
into the future. This provides prior approval to issue a stated amount of securities over this
period and without being tied to particular underwriters. The company is then able to issue
securities gradually to the market, and it can make those decisions on short notice. Large, wellestablished companies often issue securities in more than one country and these are known as
International issues.
There is considerable economy of scale in issue costs. The percentage cost is smaller for large
issues than for small ones. (See Table 15-2 and Figure 15-3) We also have to consider the effects
of under-pricing and price pressure. The announcement of new issues of common stock on
average results in a decline in the stock price of about 3 percent (for industrial issues in the United
States), which represents nearly one-third of the new money raised by the issue. This is probably
an information effect: managers are more likely to issue stock when they think it is overvalued.
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Dilution, Investment, and Financing: Under-pricing does not affect the value of the company.
It can transfer wealth from one group of security holders to another. When people talk about
dilution, they often mean that new issue of stocks leads to lower per share earnings and therefore
lower price. Dilution can be real only if the proceeds of the issue are to be used to finance poor
investment projects. However, any fall in share price which this may give rise to on the issue
announcement is due solely to the poor investment decision and has nothing to do with the
financing decision. Always try to avoid confusing the effects of the investment and financing
decisions.
Underwriter: The marketing of a general cash offer is handled by underwriters, who also provide
advice and usually underwrite or guarantee the issue's subscription. Their remuneration is the
spread between the issue price (or offering price) and the price at which they buy the securities
from the company. Where a new issue of common stock is unusually risky, the underwriter may
handle the issue on a best-efforts basis (not guaranteeing to sell the entire issue) or on an all-ornone basis (where the deal is called off completely if the entire issue is not sold).
A syndicate of underwriters usually handles large issues. In this case, the syndicate manager keeps
about 20 percent of the spread, a further 20 to 30 percent goes to pay the members of the group
who buy the issue, and the remainder goes to the firms who actually sell the issue. For each
public issue, a "tombstone advertisement is published that lists the names of all the underwriters.
Members of the underwriting syndicate are not allowed to sell securities at below the issue price,
although they may be allowed to "support" the market by buying them at the market price. If the
issue cannot be sold, the syndicate will be broken.
Underwriting is just like insurance. The underwriters guarantee the issue's success, promising full
subscription at the issue price in return for a fee. It is worthwhile as long as the value of the
guarantee is worth at least as much as the fee paid. The value of the guarantee depends on the
risk of the issue failing.
Private Placements: A private placement is an alternative to public issue and has certain
advantages compared to a public offering. Private placements do not involve registration and is
limited to a few buyers. Transaction costs will be lower. The placement can be made very
quickly. There are disadvantages too. The securities issued in this way are very illiquid and are
held for long-term investment rather than resale. This is a greater disadvantage for issues of
common stock than for debt issues, so private placements of common stock (called letter stock)
are rare. Bond issues, particularly of small- and medium-sized firms, account for the bulk of
private placements. They are often negotiated directly with the lender, while for larger issues an
investment banker will act as agent. By 1989, the proportion of corporate debt issues made as
private placements had increased to almost one-half. Since 1990, large financial institutions
(known as qualified institutional buyers) have been allowed to trade unregistered securities
among themselves, and this has provided a further boost to this market.
Rights Issue (The Privileged Subscription): Rights issue can be a very effective and
inexpensive way of raising additional funding. The issue is offered to the firm's existing
stockholders in proportion to their current holding in the company. The stockholders can transfer
or sell their rights in the market. Rights issue effectively avoids wealth transfer between existing
stockholders and new stockholders, since they are one and the same. Therefore, the actual pricing
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of the issue is of little consequence. If N is the number of existing shares required to receive one
right (i.e. it will give you the right to buy one new share), the value of a right can be written as:
Value of one right = (rights-on price issue price)/(N+1)
The expression is derived in the worked-out example.
WORKED EXAMPLES
1. The entrepreneurs' original investment in Marvin Enterprises amounted to $100,000. Firststage financing raised $1 million and placed a $2 million after-the-money valuation on the
firm. At the next stage, the enterprise was valued at $10 million.
a. What (paper) return and increase in value had the entrepreneurs enjoyed by each of these
two stages?
b. How would your answer to the previous question change if they had agreed on a firststage after-the-money valuation of $1.50 million instead of $2 million and a second stage
valuation of $9 million?
SOLUTION
a. The original stockholders have a paper value to their stock of $1 million at the first stage.
With an additional $1 million raised, they have 50 percent of the stock. At the second
stage, company value of $10 million is worth $5 million. These valuations represent 10fold and 5-fold increases in the two stages, representing returns of 900 percent and 400
percent respectively.
b. At a $1.5 million firm valuation, the original stockholders would have a paper value to their
stock of $0.5 million at the first stage. With an additional $1 million raised, they have only
one-third of the companys stock, which at the second stage, company value of $9 million
is worth $3 million. These valuations represent 5-fold and 6-fold increases in the two
stages (returns of 400 percent and 500 percent respectively).
2. Jackrabbits Corporation is making a rights issue to raise $6 million. Just before the issue,
Jackrabbits stock price was $20, and the terms of the issue are 1 for 4 at a subscription price
of $15. Calculate (a) the expected price of the stock ex-rights and (b) the value of one right.
(c) Baby Rabbit owns 20,000 shares. How many rights will he have to sell to maintain the
same ($400,000) investment in the company? (d) Show that in general, the value of a right is
given by the formula (rights-on price - issue price)/(N + I) when the terms of the issue are 1
for N.
SOLUTION

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a. After the issue is completed, all shares will be ex-rights. For every 4 shares worth $20
before the issue, there will be 5 shares worth $20 x 4 + $15 (= $95) after the issue. Each
share will, therefore, be worth $95/5, so the ex-rights price is $19.
b. The value of one right is the difference between the rights-on price (the share price before
the issue) and the ex-rights price. This is $1.
c. Baby Rabbit will get 5,000 rights and if he were to keep all his rights, he would end up
with 25,000 shares valued at a total of 25,000 x $19 = $475,000. In order to retain his
original investment, he should have $400,000/$19 = 21,053 shares. Therefore, he needs to
keep only 1,053 rights and sell the remaining 3,947 rights. This will give him $3,947.
d. N shares at the rights-on price gets an additional share subscribed to at the offer price. This
gives the basic equation:
N x (rights-on price) + issue price = (N + 1)(ex-rights price)
Alternatively, this can be written as:
[(N + 1) x rights-on price] - (rights-on price - issue price) = (N + 1) ex-rights price
Value of a right = right-on price - ex-rights prices
= rights-on price - issue price/(N+1)

SUMMARY
This chapter provided a summary description of the procedures used by corporations for raising
finance through the issue of securities. Companies raise finances through a variety of ways with
venture capital funding for start-up and young companies and seasoned issues for established and
mature companies. The chapter highlighted some very important implications for the financial
manager. These can be summarized as below:

Larger is cheaper. This suggests that there is economy of scale in raising money and the
manager can take advantage of this by avoiding small issues.

Beware of under-pricing. Perhaps the most significant of the hidden costs of financing is
under-pricing of the security. This is especially true for the IPOs. Underwriters may be
tempted to go too far to reduce the fear of winners curse make an impression on the investor.

Winners curse may need to be addressed in IPOs and careful design of issue procedures is
needed.

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New stock issues cause lowering of stock price. This may be due to information the market
might be reading into the companys actions. Managers would do well to keep the market
fully informed.

Take advantage of shelf-registration, which is particularly useful for debt issues of established,
financially strong firms.

LIST OF TERMS
After-the-money valuation
All-or-none
Best efforts
Business plan
Dilution
First-stage financing
General cash offer
Initial public offering
Issue price
Letter stock
Offering price
Preemptive rights
Primary offering
Private placement
Privileged subscription
Prospectus

Red herring
Registrar
Registration statement
Rights issue
Road show
Seasoned stock issue
Secondary offering
Shelf registration
Spread
Tombstone
Transfer agent
Under-pricing
Underwriting
Unseasoned issue
Venture capital

EXERCISES
Fill-in Questions
1. Equity investment in young private companies is generally known as __________________.
2. In order to obtain capital, the young company must first prepare a detailed ______________.
3. The first injection of equity capital from the venture capital market is known as __________.
4. The proportion of the company, which the original owners will have to give up, depends on
the _________________ of the company.
5. The first issue of a security by a company is known as a(n) _______________ or a(n)
___________.
6. Before a general cash offer or a large public issue, companies often put up a ______________
to familiarize the investors with the company.
7. When new shares are sold to raise additional cash for the company, it is called ___________.
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8. When shares of existing shareholders are offered to the public, it is called ______________.
9. An issue of securities that is offered to the general public or investors is called a(n)
________________.
10. An issue of securities that is offered to current stockholders is usually called a(n)
________________.
11. Rights issues are also known as _____________________ issues.
12. For most public issues, a(n) ___________________________ must be submitted to the
Securities and Exchange Commission.
13. Information about an issue is provided in its ______________________, which must be sent
to all purchasers and to all those who are offered securities through the mail.
14. The preliminary prospectus is called a(n) ____________________.
15. A(n) ____________________ is an advertisement, which lists the underwriters to an issue of
securities.
16. A financial institution is usually appointed as _____________________ to record the issue
and ownership of the company's securities.
17. A(n) ______________________ may be appointed to look after the transfer of newly issued
securities.
18. The sale of a public issue is normally handled by a(n) _____________________, who
provides financial and procedural advice and usually buys the security for less than the offering
price and accepts the risk of not being able to resell it.
19. The underwriter's _________________________ is the difference between the price at which
the underwriter buys an issue from a company and the _________________ or
____________________.
20. Occasionally, the underwriter does not guarantee the sale of an entire issue but handles the
issue on a(n) ____________________ basis, promising only to sell as much of the issue as
possible.
21. _______________________ underwriting is where the entire issue is cancelled if the
underwriter is unable to resell it all at the offer price.
22. ____________________ occurs in a general cash offer when securities are sold at an offer
price which is below their market price.

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23. __________________ is the name given to the potential diminution of share value through
the value of the firm being shared between a larger number of stockholders.
24. Stock for which there is an existing market goes by the spicy name of _________________
stock.
25. The ___________________ right of common stockholders (to anything of value distributed
by the firm) includes the right to subscribe to new offerings.
26. The ___________________ provides an alternative to making a public offering.
27. Privately placed common stock cannot easily be resold. It is often called ________________
because the SEC requires a letter from the purchaser stating that the stock is not intended for
resale.
28. ____________________ allows large companies to obtain prior approval for their financing
plans for up to 2 years into the future.
Problems
1. DuckBills is a young company started by two brothers, Bill and Larry, with their savings
amounting to $200,000. The firm received venture capital financing two years after its startup. The venture capitalists provided first-stage financing of $2.5 million and valued the firm
after-the-money at $5 million. Two years later, the firm received second-stage financing from
the same venture capital company. DuckBills received $6 million and was valued at $20
million after-the-money. A year later, DuckBills was ready for its IPO and the underwriters
valued the company (before the IPO) at $60 million. Calculate the returns for the brothers
and the venture capital firm at each stage of financing.
2. Marvin Enterprises' first-stage financing had placed a $1 million dollar paper value on the one
million shares held by the original entrepreneurs. The venture capitalists put in another $1
million and held 50 percent of the equity. A further $4 million was raised at its second-stage
financing, which placed a $14 million after-the-money valuation on the company. By the time
third-stage funds were needed, the enterprise was valued at $42 million.
a. What return and increase in value had the entrepreneurs enjoyed between the first-stage
and second-stage and between the first-stage and third-stage?
b. How would your answer to the previous question change if they had agreed a secondstage after-the-money valuation of $8 million instead of $14 million, with the before-themoney third-stage valuation of $42 million unchanged?
3. ABX Corp. decides to issue the stock via a general cash offer. The board believes it can raise
the $18 million the company requires by issuing shares at $36. The company has 5 million
shares outstanding and the current stock price is $40. Ignoring the underwriter's spread,
calculate the following:
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a.
b.
c.
d.
e.

The number of new shares that ABX will have to offer.


The expected price of the shares after the issue.
The loss per share to existing holders.
The percentage reduction in value of an existing stockholder's investment in the company
The net present value of purchasing 100 shares via the general cash offer.

4. ABX is considering the alternative of a privileged subscription stock issue to raise $18 million.
The terms of the issue are 1 for 10 at $36, and the corporation's current stock price is $40.
Calculate the following:
a.
b.
c.
d.

The market value of the corporation's equity prior to the issue.


The percentage increase in market value due to the issue.
The expected price of one right.
The expected price of the stock ex-rights.

5. United Fasteners is issuing a 20-year bond to raise $10 million. The corporation can either:
a. Issue the bond publicly, in which case it will be sold at par and will carry a 9 percent
coupon. The underwriter's spread would be 0.5 percent, and there are no other issue
costs.
b. Issue the bond through a private placement, in which case it will be sold at par and carry a
9 1/8 percent coupon. The total cost of the private placement will be $20,000.
Which option should United Fasteners choose?
Essay Questions
1. Discuss the following statement: Venture capital is essential for a young, growing company,
but it is also an expensive way of raising money.
2. Describe the main features of the process by which a young company might raise venture
capital.
3. Discuss the following statement: Rights issue is the best way to raise new equity for an
established company, as one does not have to worry about underpricing.
4. Discuss the relative merits of a public issue versus a private placement for a company wishing
to raise new debt finance. What factors should be taken into account in pricing the bond
issue?
5. Compare and contrast the role of the investment banker (or underwriter) in (a) general cash
offers of either stock or bonds and (b) private placements of bonds
6. Describe how the costs of raising new capital depend on the type and amount of financing
raised.
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ANSWERS TO EXERCISES
Fill-in Questions
1. Venture capital
2. Business plan
3. First-stage financing
4. After-the-money valuation
5. Initial public offering, unseasoned issue
6. Road show
7. Primary offering
8. Secondary offering
9. General cash offer
10. Rights issue
11. Privileged subscription
12. Registration statement
13. Prospectus
14. Red herring

15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.

Tombstone
Registrar
Transfer agent
Underwriter
Spread; issue price; offering price
Best efforts
All-or-none
Under-pricing
Dilution
Seasoned
Preemptive
Private placement
Letter stock
Shelf registration

Problems
1. The brothers initial investment of $200,000 became $2.5 million in the first stage financing
providing 12.5 fold increase or 1,150 percent return. During the next phase, the $2.5 million
became $7 million (half of $20 million - $6 million). This is now 35 percent of the value of the
firm. The return during this phase is 180 percent. At the time of IPO, the brothers stake is
valued at $21 million ($60 million x 0.35) and the return during this phase is 200 percent. The
venture capitalists initial investment of $2.5 million became $7 million at the time of second
financing providing a return of 180 percent. During the next phase their investment of $13
million became $39 million to give a return of 200 percent.
2. a. The original entrepreneurs have a paper value to their stock of $5 million at the second
stage. With an additional $4 million raised at a share price of $5 per share, there were
now 2.8 million shares issued and outstanding. At the third stage this has now increased
to a value of $15 per share, and the paper value of the original entrepreneurs holdings is
now $15 million. These valuations represent 5-fold and 15-fold increases from stages 1 to
2 and 1 to 3, respectively (that is, returns of 400 percent and 1400 percent), and gains of
$4 million and $14 million.
b. At an $8 million second-stage after-the-money valuation, the second-stage share price
would have been $2 instead of $5. To raise $4 million, it would have been necessary to
sell a further 2 million shares, making 4 million shares outstanding altogether, instead of
2.8 million. The subsequent $42 million firm valuation now imputes a share value of
$10.50. These valuations represent 2-fold and 10.5-fold increases to the two stages (that
is, returns of 100 percent and 950 percent), with gains of $1 million and $9.5 million.
3. a. Number of new shares = $18,000,000/$36 = 500,000 shares
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b.

Value of company after issue = $200,000,000 + $18,000,000 = $218,000,000


Share price after issue $218,000,000/5,500,000 = $39.64

c. Loss per share to existing holders = $40 - $39.64 = $0.36


d. Percentage reduction in value = ($0.36/$40) x 100 percent = 0.90 percent
e. NPV purchasing shares via offer = $39.64 - $36 = $3.64
4. a. Value of equity before issue = 5,000,000 x $40 = $200,000,000
b. Increase in value = $18 m/$200 m x 100 percent = 9%
c. Value of right = (rights-on price - issue price)/(N+ 1) = ($40 - $36)/11 = $0.36
d. Ex-rights price = (rights-on price - value of right) = $40 - $0.36 = $39.64
5. a. Cost of public issue = $10,000,000 x 0.5 percent = $50,000
b. Cost of private placement = $20,000 + additional interest cost
Additional interest = $10,000,000 x 1/8 percent = $12,500 per year for 20 years
If we discount these interest payments at 9 percent, i.e., the market rate for identical cash
flows which are traded in the capital market, we obtain
Total cost of private placement = $20,000 + ($12,500 x 9.129) = $134,113
That is, shareholders will be better off if United Fasteners makes a public issue.

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