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Takeover implies the acquiring firm is larger than the target Reverse takeover if the target is larger than the acquirer
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Q1) What are the various ways a Corporate can achieve growth?
There are essentially two ways a Corporate can achieve growth. They are: Organic Route: In such a strategy, the Corporate undertakes projects and builds capacities by itself. Such a strategy is time consuming as the projects will have high gestation periods. Inorganic Route: M & A fall under this strategy. In such a case the Corporate takes over another existing firm
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The key benefit in this case is the reduction in gestation period. In these cases if the Corporates would have gone by the organic route, it would have been a couple of months, even years to add capacity. The same objective can be achieved in a significantly shorter time by a properly executed inorganic route. There are other significant benefits also.
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= = =
In such a case, by reducing the fixed cost/unit, the co. will be able to price its products better. This is the advantage of global capacities. Note: China has been using this technique and practicing dumping.
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Economics of scope:
Is aiming to reduce marketing expenses. By producing multiple products jointly at the cost lower than when production was spread across multiple firms. combining marketing or distribution for different types of related products, maybe horizontal or concentric In such a case, we find that the co. is looking at reducing its marketing expenses.
For e.g.: if a pharma co. XYZ has 100 salesman and other ABC has 50, then by taking over ABC and removing the 50 salesmen, the two units after merging can bring down its overall marketing costs. Both Economies of Scope and Economies of Scale will result in synergy (Synchronized energy). This essentially indicates that the whole unit formed after M &A is greater than sum of the merging units. In short 2 plus 2 equals 5.
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B. Acquisition of Intangibles: Often M & As are for acquisition of Intangibles like brands, patents, goodwill etc. In such cases the intangible assets are acquired at a heavy premium. c. Diversification. In this case the firms involved can offer better variety of products. Often firms resort to M & A as they can get access to new markets a prime example is that of Tata Steel with Corus. d. Technology / Skilled man power. Often Corporates go in for M & A to get access to new technology. All the M & As happening in the technology space are prime examples of the same. Also they may go in for M & A to get access to skilled management and manpower as seen in financial services investment banking firms. These are all examples of value creation. Apart from that, there could be the added advantage of value capture.
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Q4) What are the various ways in which M & A can be classified?
Ans. M & A can be further classified as: Inbound Deals: Foreign companies acquiring Indian corporates are examples of the same for e.g. Daichi of Japan taking over Ranbaxy. Outbound Deals: Indian Corporates acquiring foreign Corporates or brands are examples of the same. Hindalco of the Aditya Birla Group acquiring Novellis is an example of the same. Domestic Deals: These refer to the deals between Indian Companies. For e.g. the merger of Global Trust Bank with Oriental Bank of Commerce. It is significant to note that the outbound deals are increasing significantly showing increasing risk appetite of Indian Corporates.
Also though used interchangeably, there are significant differences between the terms Mergers and Acquisitions.
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Economies of scale
Combining company can reduce duplicate departments or operations Lowering the costs of the company Leading to profit average costs decline over a broad range of output
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Synergy
Underlying Principle for M&A Transactions 2+24 Additional Value of Synergy Synergy is ability of merged company to generate higher shareholders wealth than the standalone entities
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Taxes
A profitable company can buy a loss maker to use the targets tax write off. In U.S rules are placed in such an order that Limiting the tax motive of an acquiring company.
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Resource Transfer
Resources are unevenly distributed across firms Interaction of target and acquiring firm resources can create value through Overcoming information asymmetry Or by combining scarce resources
Ex: WIPRO acquired Nerve ireInc. (U.S) Reliance Info Com acquired Flagcom ( U.K)
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Vertical Integration
Vertical Integration : Internalization of crucial forward or backward activities Vertical Forward Integration Buying a customer Indian Rayons acquisition of Madura Garments along with brand rights Vertical Backward Integration Buying a supplier IBMs acquisition of Daksh
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Managers Hubris:
Managers overconfidence about expected synergies from M&A results in overpayment for the target company.
Managerial hubris is the unrealistic belief held by managers in bidding firms that they can manage the assets of a target firm more efficiently than the target firm's current management. Managerial hubris is one reason why a manager may choose to invest in a merger that on average generates no profits.
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1) Neoclassical Theories
a) Market Power Increases b) Efficiency Increases
2) Non-neoclassical or Behavioral
a) b) c) d) e) f) g) h)
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Speculative Motives The Adaptive Firm Hypothesis The Market for Corporate Control The Economic Disturbance Hypothesis Financial Efficiencies The Capital Redeployment Hypothesis The Life-Cycle-Growth-Maximization Hypothesis The Winners Curse- Hubris Hypothesis
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i.
ii. iii.
iv.
Herfindahl index
The Herfindahl index, also known as Herfindahl-Hirschman Index or HHI, is a measure of the size of firms in relation to the industry and an indicator of the amount of competition among them. It is an economic concept widely applied in competition law, antitrust and also technology management The theory behind the use of the H-index is that if one or more firms have relatively high market shares, there is of even greater concern than the share of the largest four firms
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E.g.1: In one market four firms each hold 15% market share and the remaining 40% is held by 40 firms,
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E.g.2: In another market 1 firm has 57% market share and the remaining 43% is held by 43 firms, each
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For e.g.: Two cases in which the six largest firms produce
90 % of the output:
Case 1: All six firms produce 15% each, and Case 2: One firm produces 80 % while the five others produce 2 % each. Assuming that the remaining 10% of output is
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competitive index.
A HHI index below 0.1 (or 1,000) indicates an unconcentrated index. A HHI index between 0.1 to 0.18 (or 1,000 to 1,800) indicates moderate concentration.
Since a horizontal merger increases industry concentration, it increases H, it must also increase the industry price-cost margin and profits.
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Vertical mergers
Vertical mergers occur between firms in different stages of production operations Upstream & Downstream Mergers. by increasing the barriers
iv.
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Conglomerate mergers
Conglomerate mergers involves firms engaged in unrelated types of business activity.
a market in which the sellers also face one another in other markets
than when such multimarket contact is not present. This motive may also be the cause of purposeful diversification mergers.
Product extension mergers Market extension mergers Pure Conglomerate mergers
Motive:
Diversification of risk.
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C D
E
Output
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Vertical mergers
Can increase the efficiency of the merging firms by eliminating steps in the production process, which reduces the transaction costs from bargaining due to asset specificity Asset Specificity refers to the relative lack of transferability of assets intended for use in a given transaction to other uses. Highly specific assets represent sunk costs that have relatively little value beyond their use in the context of a specific transaction. Williamson has suggested six main types of asset specificity: Site, physical asset, human asset, brand names, dedicated assets, temporal specificity
High asset specificity requires strong contracts or internalization to combat the threat of opportunism. Small subcontractors locating and investing next to only customer who could potentially turn to alternative suppliers (site- and physical asset specificity).
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Conglomerate Mergers
Economies of scope (ESC) arise when the production of two different products by the same firm leads to lower production costs for one or both products. Example: warehousing and delivery of products
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In such an industry, one would expect the merging firms to be smaller than non-merging firms, because the expected cost reductions are greter for pairs of small firms.
Empirical Evidence:
In Belgium, Germany, USA, and UK merging firms were significantly larger than non-merging firms In France, the Netherlands, and Sweden merging pairs were in significantly different in size from randomly selected nonmerging companies.
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Non-neoclassical or Behavioral
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Fee Revenue from underwriting and M&A transactions in 1998 (Saunders and Srinivasan, 2001 )
Investment Bank Morgan Stanley Goldman Sachs Merrill Lynch Credit Suisse First Boston DLJ Citibank Lehman J.P. Morgan Bankers Trust NationsBank Montgomery Average Fee Revenue from Underwriting (equity & debt) (1) 1253.8 1087.8 1496.9 386 491.8 913.2 516.3 358.9 252.2 132.7 688.9 Fee Revenue from Merger Advice (2) 302.9 531.2 321.3 287.4 200 189.1 199.2 70.9 56.9 26.2 218.5 (2) / (1) 19.50% 32.80% 17.70% 42.70% 28.90% 17.20% 27.80% 16.50% 18.40% 16.50% 23.80%
Total
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6889.6
2185.1
31.72%
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Two implications:
Mergers should follow a counter-cyclical pattern. Why dont we see merger waves during recessions? Profit rates of acquirers should be higher than targets
Empirical Evidence
Most studies of mergers in the USA have found that acquired firms have the same average profit rates as similar non-acquired companies During the conglomerate merger wave acquiring companies had below average profit rates and also profit rates lower than the firms they acquired.
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Tobin Q
The q-ratio Tobin (1969) measured Kt as the replacement cost of the firms asset and called qt = Mt / Kt.
Ratio of the market value of the firm's securities to the replacement costs of its assets
High q-ratio reflects superior management Depressed stock prices or high replacement costs of assets cause low q-ratios
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Riskpooling
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Theories Of Merger
Variety of reasons for M&A and the diversify of their consequences have given rise to a range of hypotheses. These hypotheses can be of 3 types: 1. Internalisation theory 2. Technological competence theory 3. Transaction cost theory
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Internalisation theory
It focuses on to acquire others because they want to produce intangible assets that generally give them a competitive advantage. Corporation must have intangible assets, and corporation make them profitable. It may include knowledge of a particular market, know how in a particular technology or an enviable reputation for product quality. These assets usually have 2 characteristics:
They must have the attributes of a public good ( their running costs within the corporation must be zero.) They must have high transaction costs so that most profitable way of acquiring them is through M&A rather than purchase or rental
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Corporations that engage in M&A are attempting to internalise technological advantages by acquiring the corporations that possess them.
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2nd attributes technological competence. Intangible assets. This theory has certain consequences: 1. When target corporation with high technology, potential purchasers will be more inclined to install R&D capacity, thus enhancing local innovation. 2. When local corporation have low technology , M&A may increase the Technology content. 3. When corporation engage in research but are not on the cutting edge of technology M&A may results in the complete absorption of the targeted industry.
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Other Theories
1. 2. 3. 4. 5. 6. 7. Efficiency theory Monopoly theory Valuation theory Empire-building theory Process theory Raider theory Disturbance theory
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8. Information and signaling 9. Agency problems and managerialism 10. Free cash flow hypothesis 11. Market power 12. Taxes 13. Redistribution
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Efficiency Theories
1. Differential managerial efficiency 2. Insufficient management 3. Operating synergy
4. Pure diversification
5. Strategic realignment to changing environments 6. undervaluation
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management of firm B and if after firm A acquires firm b, the efficiency of firm b is brought up to the level of efficiency of firm A, efficiency is increased by merger.
Differential efficiency would be most likely to be a factor in mergers between firms in related industries
1(2)Insufficient management
May simply represent management that is incompetent in an absolute sense. Almost anyone could do better.
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1(6) Undervaluation
It states that mergers occur when the market
Undervaluation continued
A second possibility is that the acquirers have inside information. It is not much different from the inefficient
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Efficiency theory
It aims to achieve synergies. Three types of synergies : 1. Financial Synergy: to achieve lower cost of capital through lowering the systematic risk of the acquirer, lower tax (Debt/equity ratio), cost reduction ( economies of scale),
2.Monopoly theory
It viewed that acquisition were executed to achieve market power. 3 ways of doing it: 1. Conglomerates use it to cross subsidies products 2. To limit competition in more than one market 3. To discourage the potential entrance of competitors into its market.
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3. Valuation theory
Acquisition being executed by managers, have superior information than the stock market about their exact targets unrealized potential value The acquirer possesses valuable and unique information to enhance the value of a combined firm through purchasing an undervalued target. LBO can be fit in this category. LBO signifies the acquisition of a business with the help of debt capital or borrowed capital.
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4.Empire-building theory
It holds that managers maximise their personal goals
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5.Process theory
Strategic decisions are outcomes of processes governed by bounded rational theory Central role of organization routine Political power Rather than rational choices.
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6.Raider Theory
Raider is a person who causes wealth transfer from the shareholders of a target firm to the shareholders of the acquiring firm. One of the wealth transfer media is lavish compensation after a successful acquisition transaction, called golden parachute.
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7.Disturbance theory
It holds that the motives of acquisitions occur as a result of economic disturbances (ED).
ED cause changes in individuals expectations and increase the general degree of uncertainty.
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No particular action by the target firm or any others is necessary to cause the revaluation.
This is called sitting on a gold mine explanation (Bradley, Desai and Kim, 1983)
The other hypothesis is that the offer inspires target firm management to implement a more efficient business strategy on its own. No outside input other that the merger offer itself is required for the upward revaluation. This is called kick in the pants explanation.
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9.Agency problems
Agency problems may result from a conflict of interest between managers and shareholders and between shareholders and debt holders . Takeovers are viewed as the last resort to discipline self serving managers. Agency problems arise basically because contracts between managers (decision or control agents) and owners (risk bearers) cannot be enforced. May result from conflict of interest between managers and shareholders or between shareholders and debt holders
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Managerialism
Takeovers are a manifestation (sign) of the agency problem, not its solution.
Self serving managers embark on mergers to expand their empire and improve their own career prospects.
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11.Market power
Market power advocates claim that merger gains are
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industry.
On contrary, some economists hold that increased
12.Tax effects
Tax implications may be important to mergers , although they do not play a major role.
Carry over of net operating losses and tax credits, substitution of capital gains for ordinary incomes are among the tax motivation for mergers.
Carry over of net operating losses and tax credits: a firm with accumulated tax losses and tax credits can give positive earnings of another firm with which it is joined
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13.Redistribution hypothesis
Gains from a merger may come at the expense of other stakeholders in the firm.
appropriate stakeholders may include bond holders, government and organized labour. Value increases in mergers by redistribution among the stakeholders of the firm. Possible shifts are from debt holders to stock holders and from labor to stockholders.
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Any business, or part of a business can choose which strategy to employ, or which mix of strategic options to use.
Ansoffs product/market growth matrix suggests that a business attempts to grow depend on whether it markets new or existing products in new or existing markets.
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Ansoffs growth opportunities: Market penetration Market development Product development These are grouped as a Intensive growth opportunities by Kotler And diversification as a separate class of opportunities It consists of
Concentric diversification Horizontal diversification Conglomerate diversification
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Market development
Market development is the name given to a growth strategy where the business seeks to sell its existing products into new markets. There are many possible ways of approaching this strategy, including: New geographical markets; for example exporting the product to a new country New product dimensions or packaging: for example New distribution channels Different pricing policies to attract different customers or create new market segments Ex:cRecently Gujarat Tea Processor and Packers Ltd. (GTPPL), popularly known as Wagh Bakri Tea Group, launched its product in Mumbai and parts of Maharashtra
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Product development
Product development is the name given to a growth strategy where a business aims to introduce new products into existing markets. Improved products for its present market This strategy may require the development of new competencies and requires the business to develop modified products which can appeal to existing markets. Ex: HLL had launched Surf in India in 1959. Then In 1996 improved version Surf Excel Launch of Diet Coke/Diet Pepsi Launch of LCD TVs, Plasma TVs Launch of newer and better models of car Microsoft Nokia
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Diversification
Diversification is the name given to the growth strategy where a business markets new products in new markets. This is an inherently more risk strategy because the business is moving into markets in which it has little or no experience. For a business to adopt a diversification strategy, therefore, it must have a clear idea about what it expects to gain from the strategy and an honest assessment of the risks.
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Concentric Diversification
Seeking to ad new products that have technological or marketing synergies with the existing products. Launch of Tata Sumo and Indica by Tata Motors
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Horizontal Diversification
Seeking to add new products that could appeal to its present customers though technically unrelated to its present product line.
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Conglomerate Diversification
Seeking to add new products for new classes of customers with no relationship to the companys current technology.
ITC is into many unrelated business From cigarettes, hotels paper and paperboard, biscuits and flour(atta)
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Efficiency Theories
The differential efficiency theory says that more efficient firms will acquire less efficient firms and realize gains by improving their efficiency. Differential efficiency is likely to be a factor in mergers between firms in related industries. The inefficient management theory suggests that target management is so incompetent that virtually any management could do better. This could be an explanation for mergers between firms in unrelated industries. The operating synergy theory assumes economies of scale/scope and complementarity of capabilities.
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Efficiency Theories
The financial synergy theory emphasises complementarity in the availability of investment opportunities and internal cash flows.
Is diversification justified? Shareholders can diversify more easily.
But managers and other employees are at greater risk if the single industry in which their firm operates should fail.
Firms may diversify to encourage firm specific human capital investments which make their employees more valuable and productive.
The organization and reputation capital of the firm is more likely to be preserved by transfer to another line of business in the event there is a decline in the prospects for the earlier business.
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External acquisitions of needed capabilities allow firms to adapt more quickly and with less risk than developing capabilities internally.
The undervaluation theory states that mergers occur when the market value of the target firm stock for some reason does not reflect its true or potential value or its value in the hands of alternative management. Firms may be able to acquire assets for expansion more cheaply by buying the stocks of existing firms than by buying or building assets when the targets stock price is below the replacement cost of its assets.
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Information/Signaling Theory
The tender offer sends a signal to the market that the target companys shares are undervalued.
The offer may signal information to the target management which motivates them to become more efficient. The target managements response to the offer and the means of payment may also have signaling value.
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Market Power
Market gains are the results of increased concentration leading to collusion and monopoly effects. But anti trust authorities are on the follow.
Firms with FCF are those where internal funds exceed investment required for positive NPV projects
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Investments may be in form of acquisitions where managers over pay but reduce likelihood of their own replacement
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Factors that result in the hubris spirit desire to avoid a loss of face, media praise, urge to project as an aggressive firm, inexperience, overestimation of the synergies, overenthusiastic investment banker etc.
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109
Negative
Positive
More Negative
Negative
110
Zero
Positive
MODELS OF TAKEOVER BIDDING The winners curse bidder in takeover risk overpaying
Bidders can shade bids lower but risk losing possible deals Alternative:
If concerned about value of target, can offer stock Shares risk of combined firm between bidder and target
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Termination fee bidder making formal offer often requires a termination fee in agreement Toehold
Use of toehold helps to recoup bidding costs Size of toehold is a function of expected synergies from the merger
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Deal began as a hostile bid by Northrop and evolved into merger Reasons given for the merger
Economies of scale in defense industry Complementary product mix
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