Theoretical Implications Of The U.S. National Debt

As we begin flying missions with the UN in Libya this week, I am reminded of our national debt and how it isn’t getting any smaller with each bomb we drop.  And while this could be a very positive development for our security, I don’t see why our country has to bear the burden of policing Libya when we can’t afford it.  We are the spendthrift with the maxed out credit cards with one more emergency so we break open the new credit card.  And I can imagine that we are also going to provide financial help to Japan, and we should.  Yes I said it… we should help out Japan after this massive disaster that continues to unfold to historic proportions.  Well, I guess it was already historic, but this is truly unprecedented.  So we help out Japan and protect the people of Libya, then how about Iran and North Korea?  Where do we draw the line?

What is our national debt?

Let’s start with money.  The country prints a dollar bill, how does it get into circulation?  It either replaces a dollar bill or it is spent.

So let’s say we have a government of 10 people and we print $1000 each to pay them for gold that they dug out of the ground.  Now there are $10000 in IOU’s from the government and the government has $10,000 worth of gold.  The only reason the gold is worth $10,000 is because that is what we paid for it.  Because the government is holding gold to back the currency, we could be said to be on the gold standard or that the currency is backed with gold.  What if we took our printed money and bought food to give away to starving children in Africa (instead of gold)?  We then have currency outstanding with a face value of $10,000 and what is it backed with?  It’s backed with the holder’s confidence in the government.  You could probably understand what happens if the currency holders lose faith in the currency…

The other portion of our national debt is loans to the government, typically bonds and notes.  These are sold in return for currency and the government pays out interest payments to the holders of treasury bonds and notes.  Why does the government sell this debt really?  To take currency out of circulation so that it is worth more.  Government debt has an inherent value because of it’s interest payments, but is also somewhat backed by the holder’s faith in the U.S. government.  Government debt becomes worth much less if people become concerned that the government will default on its debt: when it is unable to pay its interest payments or unable to pay the face value of the debt when it becomes due.

In our example we have $10,000 worth of currency outstanding.  How can the government spend $10,000 more without increasing the amount of currency outstanding?  They issue $10,000 worth of treasury bonds, collecting the $10,000 outstanding, then spend $10,000 more.  They must now fork up $400 per year to their bond holders but there is still only $10,000 worth of currency outstanding.  They can collect taxes to pay the $400 per year to avoid adding currency into circulation.  What if there is a business person looking to borrow $10,000 to start a business?  Well, unless he can guarantee $400 in dividends, he is likely to lose out to the government that is guaranteeing $400 in interest.  That is one potential implication of national debt: that it takes away the incentive to invest in new businesses or in other more risky investments.

The effect on the individual

There are three ways for the government to fund it’s spending: Taxes, currency, and debt.  There may be more than this but for this discussion let’s just assume that these are the only ways.  So what happens when the government does not want to increase the amount of currency in circulation and nobody wants to buy its debt?  That’s right, taxes go up.  And as we know here in Illinois, taxes don’t go up just a bit when things are bad, they go up a lot.  Our state taxes went up by two thirds to cover the shortfall in the state’s budget as the state is trying to avoid new debt.  It hurts but not as much as it would hurt at the federal level.

Let’s say that your federal taxes went up by half.  That would be pretty big.  It would have a significant effect on your lifestyle.  Now extend that to the country.  People would spend much less than they do today, creating severe economic hardship within the economy.  I’m also thinking that would reduce income taxes the government takes in.  A vicious cycle begins.  But what does the government do instead of raising taxes this time?  Printing more money to improve the economy before it sinks into a depression.  This sounds familiar right?  The Federal Reserve buys government debt to put more cash into the system.  Then buys more and more to prevent the double-dip recession.  So life goes back to normal then what?  You have to take cash out of the system before it becomes inflation.

The China factor

China is a little wildcard that makes things interesting.  China holds a ton of our currency and debt.  Many Chinese businesses also hold our currency because the value is greater than their own currency.  That is on purpose.  The Chinese government depresses their own currency against the dollar by stockpiling dollars and U.S. debt.  As more dollars flow to China for the products they produce, the usual thing that should happen is that they should buy U.S. products.  Makes sense right?  You have U.S. dollars, you buy U.S. goods with them.  Or you trade them with other companies.  Or you sell them on the forex market for your own currency.  That would mean that somebody else wants to trade Chinese currency for U.S. currency.  That would be either the Chinese government or a foreign entity with Chinese currency because of something they sold to China.

What if you’re China and you want to grow your domestic businesses but want to keep foreign businesses out?  I know you’re thinking cheap labor, but eventually with enough wealth, local labor prices go up.  Another way to keep the goods flowing out and not flowing in is to keep your currency value low against foreign currencies.  You sell your currency for dollars, propping up the dollar because you are taking dollars out of circulation.  You can also use your dollars to buy U.S. government debt, transferring even more dollars overseas.  Eventually, though, China is going to want to do something with their dollars.  Buy the Euro?  Buy gold?  Spend money on social programs or military?  Regardless of the scenario, dollars come back into circulation.  Or U.S. government debt is sold, decreasing the value of the debt on the open market.  This would increase the interest rates of outstanding debt and of any new debt issued.  It would also rob from business investment because people could get a pretty good interest rate from U.S. Government debt.

I am not sure how much cash and how much debt China holds, but it’s a bunch.  It could easily depreciate our dollar creating inflation or increase interest rates dramatically.  The U.S. might be forced into cutting important programs and dramatically increasing taxes.

Hyperinflation

Hyperinflation is a situation where people lose confidence in the currency so they stop using it.  People with products to sell won’t trade for paper money, they require gold or another good to trade for.  Could hyperinflation happen in the United States?  While certainly possible, it is somewhat unlikely.  It is more likely to see double-digit inflation, but people will continue to have faith in the currency.  We have never experienced the fear and panic of hyperinflation, I am not sure people would really know what to do.  What do you do when money has no value?

What can be done?

With so much debt outstanding, the U.S. government is limiting it’s options.  It’s important for our national security to pay down our debts.  Just as important to our national security as a stable Libya.

Corporate Tax Time Is Here

When you are a C corporation in the U.S. and your fiscal year is the same as the calendar year, March 15 is your deadline to file your 1120.  And here it is the 7th of March, so there is no time like the present to talk about filing your 1120.  Unlike personal taxes, the 1120 is not really all that bad.  You generally copy over your profit and loss statement into the boxes.  Anything that doesn’t have a box, you add up and put in the other deductions field.  Then you do a little arithmetic, or just copy your totals from the P&L, and you have your net income.  You can now include your net loss from prior years against your income, then you have your income for taxes.

The amount of taxes is figured based on a table, or a straight 35% if you are a personal services corporation.  There is a lot of other information on these forms and in the instructions, so make sure to go over them or have an accountant look over your numbers.  Or better yet, have an accountant prepare them.  I am kind of a do-it-yourself’er and I want to know how to file my 1120, so I do it myself.  I spend a lot of time in the instructions and comparing to last year’s forms, so although it’s fairly straight forward, there are also a lot of gotchas to watch out for.

My thing this year is that I have to pay money on profit that is tied up in accounts receivable.  I have to file as a personal services corporation so they take 35% of my net income.  I mean, I am trying to be profitable and build up my cash reserves, then I am punished by having to pay taxes on it.  Having to file by the 15th and pay may be a bit of a challenge this year also as I am waiting on some payments from my client.  I guess we’ll see how it all works out.

I should be ready with my forms for the Federal Government and the state of Illinois by the 15th at least.  I just had to get over my fear of doing these taxes.  Or just the problem with being so busy right now, having just filed my personal returns, and now having to file my corporate returns.  Just one of those things I guess.

Do you fill out an 1120 every year and how do you take care of it?  Do you do it yourself or do you have an accountant do it?  If you have an S corporation, how is it different for taxes?

Being CFO As Well As CEO

I am a lone wolf in my company at the moment.  I am not just the CEO, I am also the CFO.  CFO stands for Chief Financial Officer and it is a position with an extreme amount of responsibility.  As the CEO, I can have a vision for my company, a grand and glorious one, and I can work with my “Senior Staff” to see if it will work and decide how to implement it.

As I sit in the conference room with the senior members of my staff, my CFO, CIO, and several Senior Vice Presidents I explain in detail what my vision is.  My CFO speaks up and says that it sounds like an expensive idea.  He would have to crunch the numbers but we might have to come up with several thousand dollars beyond what we have coming in as income.  Where will we get the money?

Now of course I am the CFO, so I have to play both parts: The CEO and CFO, which often have conflicting rolls.  The CEO is dreamy and exciting, the CFO is down to earth and realistic.  And how does a corporation get money it doesn’t have?

Well the corporation can do one of the following:

1. Increase income
2. Borrow money from the bank
3. Sell shares of stock
4. Sell bonds
5. Sell assets

Included in these options is the possibility that the CEO will purchase shares of stock from the corporation, if he or she has some extra cash to invest.

Often the CFO doesn’t have the choice to say “No, let’s not do that”.  Sometimes the corporation goes from profit to loss, and although adjustments will be made to plug the leak, there will be near term losses to deal with.  Sometimes the CFO will have to choose whether to try to make a go of it by juggling receivables, payables, and any other asset or liability, or if he wants to try to raise outside money somehow.  There may actually not be a choice here either, as the board of directors may prevent selling new shares of stock or borrowing money.

The CFO may also have to deal with tax consequences of his money management.  For instance, I found myself with a pretty big profit this year, so I took action to push my profit into 2011.  The problem with trying to do this is that I don’t have a whole lot of cash to work with and could not raise outside money, except from myself, by directive of my board of directors.  In other words I could not sell shares of stock to non-family members.  I also could not borrow money from the bank.  So, I bought shares of my own stock and did my best to increase my accounts payable float.  By the way, I had cash flow issues because my accounts receivable is pretty big and my accounts payable is pretty small.  No problem getting paid, it just takes a while.

Once I am on the other side of 2011, as we are today, I can take action to pump up my profits and worry about the tax issues at the end of the year.  With any luck I will have tax issues, and maybe I’ll just book them in 2011.

If you wonder how I “push profits into 2011”, generally this involves investing in such as way to create an expense in 2010 and new income in 2011.  I did this by advertising right at the end of the year.  My advertising is an expense against income, but my advertising will produce income, hopefully, after a few months.  There are probably many other ways to do this, although many investments are expensed over time, such as equipment or buildings, so you have to use the right investments.

Work At Home

I work at home.  I work at home all the time.  I used to work at home when I was employed, for my employer.  With technology these days you can do many jobs for an employer at home.  Or you can work for yourself at home.  So the first question is: Are you looking for a job or for a business?  Personally, I have been self employed now for four months and am very happy being self employed.

My self employment is consulting mostly, which is still selling time for money.  So it’s kind of like employment.  I work three days at the client and two days at home per week typically, not counting the time I’m working on the weekend.  If I work after hours it is typically at home.  I also have quite a bit of administrative work to do since I don’t have employees.  So I am creating my time sheets and status reports, keeping track of expenses, and ordering office supplies I need.  Stuff like that.

You can start a business at home if you like, and long term this makes the most sense assuming you are successful.  The game you have to play in business is about getting the most from your initial investment.  So you constantly have to work at saving money or getting more for the money you do spend.  Still, you are most likely going to spend more than you’re taking in when you first start a business, and will perhaps lack profits for 2, 3, or 5 years.  So you need to be able to handle the losses as you start out.

Many people start out part time in their business pursuits and work a full time job so that they can have an income while they are starting out.  This creates a time crunch especially if you have a family, so you often have to sacrifice things like TV time.  The last couple of weeks I’ve had a hard time even working out, so it can get kind of busy.  And if you do it right, your business will make you more busy than you expect.  Note that your business should drive you not the other way around.  The trick is to generate buzz or somehow have a constant inflow of customers.  Advertising is a good way to do this (free is best).

If you want to go the other route and work from home for an employer, you have to be aware that you are only saving yourself drive time typically.  You will still have to do the work.  If you have distractions around the house you may find that really difficult.  You should look for employment with some flexibility as to when you will work, so you can work after the kids go to bed for example.

Good luck to you and let me know how it goes…

More About Being A Bean Counter

Last week we talked about calculating a return on investment (ROI) from your recruiting costs, whether you are recruiting customers for your product or resellers.  Of course our return on investment calculation is just an estimate based on less than all the facts.  It is still an important calculation, though, and worth the exercise even if ultimately it is way off.  Why?  Because ultimately you want to know what your real return on investment is and you can’t wait for all the facts to come in.  So, you make an estimate based on what you believe, then you revise your number as reality sets in.

Why do you even care what return on investment is?  Return on investment is an important measurement for deciding if you time and money are being spent in the right way.  As a rule of thumb, a 20% return on investment is good for investments with substantial risks.  You can consider a business investment a substantial risk because there will be good times and bad times, and you might now be in a good time (in fact I think now is a great time).  So today your real ROI may be 20% and tomorrow it might be -5%.  So 20% is a good rule of thumb for ROI.

You might want to adjust this ROI for your risk level.  Let’s say that your ROI for new resellers is 18% but it’s likely their business will grow.  So 18% may be a very good ROI.  If your ROI is 8% instead, it might be a good ROI if your investment is US Treasuries that will always pay 8% (i.e. ultra safe).  But it would be an extremely poor ROI if your investment had any risk at all.  So risk is a factor in whether your ROI is a good number or not.

Your ROI is an important number to determine how much money you’ll need before your business begins making a profit.  For instance, you invest $100 per month for a year and your ROI is 20%, meaning you’ll make $20 per month or so.  It will take 5 years to begin making a profit if you never increase your investment.  If instead you sink your profits back into your business, you will earn $100 in revenue before hitting the 5 year mark but you’ll always lose $1200 per year.  You’ll need to back off on your investment to earn a profit.

If you do want to invest $100 per month in your business and reinvest the revenues for 5 years, how much money will you need?  $1200 per year X 5 years or $6000.  Do you have $6000 or can you get it over 5 years?  If not, you will need to borrow the money or find investors.  So the ROI is also important to determine if you’ll do it all by yourself or if you’ll need to seek help from others.  It’ll do this before you actually need the money, giving you time to work with your bank or pitching your relatives on your new business (to drum up investors).

So your return on investment number is important to estimate, then correct, as you initially grow your business.  What other calculations are important?

Reasons To Take Credit Cards

If you sell your product directly to customers, taking cash and cashier’s checks are the safest way to insure you get paid. They are also quick to get your money, usually they are available funds right away when you deposit them in your bank, and you can spend the cash without depositing it. Although depositing all of your receipts does give you a record of the revenue for later when it’s time to fill out your tax forms.

The problem with taking only cash or cash-equivalent payments is that it is inconvenient for the customer.  They have to make a visit to their bank or ATM to get money to pay you, as often people carry very little cash.  You can accept your customer’s personal check to improve the convenience a bit, but ultimately you are going to have to be as flexible as possible so that it’s easy to do business with you.  Accepting all means of payment possible is the best choice, which means accepting credit cards.

Credit cards have fees associated with them, but your customer’s payment will be in your bank account in about 3 days.  For remote orders, either internet or telephone, accepting credit cards reduces accounts receivable significantly, as you don’t have to send out a bill and wait for payment.  You just take the numbers over the phone and run the credit card right then.  You can imagine this is a much safer way to take payment remotely also, as you know you are going to get paid.

One other major advantage of taking credit cards that you may not know is that many people will balk at making a $50 purchase, but putting a $50 on their credit card is not as big a deal.  For some reason people don’t associate a credit card payment with spending money.  For this reason they are likely to spend more.

In our business, we did everything we could to avoid taking credit cards but one thing made it unavoidable: Our business ramped up quickly and we could not afford to wait for money from our customers, often for 30 days or more.  We were selling around $10,000 per week to customers so our accounts receivable was around $50,000, which was unbearable.  I carried a very large balance on my American Express and was fearful of the day I couldn’t pay it.

To take credit cards, you must contact a company that specializes in merchant services.  You fill out some paperwork, get a credit card machine or software for your computer, or connect with your provider through your website, a little set up and then you’re taking credit cards.  Make sure you price your products so that you can afford the fees… they can vary so you may want to shop around a bit.

Do you accept credit cards in your business?  What have you found the advantages to be?

Introduction To Valuing Stock

I have always wanted to write an article about valuing stock.  Even though I know somewhat how to find a value, the process is very subjective.  You may have a different opinion about one of the variables from another person, and you can debate the pros and cons of each side for days.  So lets find a simple way to assess the value, and then we’ll look at an even simpler way.

For the purposes of this article, we’ll assume you are buying shares of stock for personal ownership, not as a company trying to acquire another company or something.  A share of stock is a partial ownership of a company.  The value of a share of stock is equal to whatever somebody else is willing to pay for it, period.  That would be the market value of a share of stock.  Any other value really is trying to second guess the market, assuming that the market is acting in an irrational way, which may value the stock higher or lower than it is truly worth.  The truth, though, is that if you figure a share of stock should be valued at $60 and the market value is $40, it’s worth $40.

Determining Actual Worth

Ok, so you think you can out value the market?  Well then, let’s try to find a method of doing this.  Let’s say there’s a corporation with 100 shares of stock outstanding and it has assets totalling $1000.  Is a share of stock worth $10 then?  Nope.  Asset value has no relevance, unless you are going to liquidate the company and are able to actually get $1000 for the assets after expenses.  A better method is to look at yearly earnings per share or yearly dividends per share.

Yearly earnings is the profit the company makes.  Profit is revenue minus expenses.  Revenue is the total amount of money the company takes in and expenses are all expenses of the company.  For instance, if the company purchases an item for $1 and sells it for $2, revenue is $2 and expenses is $1, making earnings of $1.  There may be other expenses involved, but let’s keep it simple.

Dividends is simply the amount of money the company chooses to pay out to their shareholders.  Notice the word chooses, because this amount may be more or less than earnings.  For instance, say the company has a regular dividend of $1 per share but only has earnings of 50 cents during this period, resulting in paying out more than earnings in dividends.  Most of the time though, dividends will be less than earnings.

Neither earnings or dividends are a perfect method to gauge value because one could say that earnings have no value to the shareholder until dividends are paid, but paying out less dividends than earnings results in a build of company assets, probably cash, which could be paid out at a later date or invested in a project which will create more profit for the company.  So growth in earnings may result by reinvesting earnings.

So how to value a share of stock based on earnings or dividends?  Let’s use dividends for this example.  Let’s say that a company pays out 5% of the market value of it’s stock as dividends.  Is this good or bad?  Well it is more than investing in a savings account at 1% and a little more than investing in a 30 year treasury bond.  So it could be good.  It really depends on how much risk is involved.

Determining Risk

If a company is stable and is expected to have similar earnings, good times or bad, into the foreseeable future, we would expect to have a yearly dividend comparable to a short-term U.S. Treasury Bond, because there is no risk involved.  Generally, though, this is impossible to say about a company because so many things could influence the performance of the company, even to the point where the company would need to reduce it’s dividend.  And the more likely it is to be impacted by adverse circumstances, the greater the risk.

Usually the greater the risk of the investment, the more of a risk premium we would want to be paid.  So a very risky company might have a 15% dividend or higher.  It is really up to the judgement of the shareholder (or analyst) what the risk is, and hence what the risk premium should be.

Valuing Companies With No Dividends

Companies with no dividend at all would represent a very high risk typically because the share would seem to be valueless.  People do pay good money for shares of stock with no dividends, though, so how do you figure a value?  You might use earnings per share to determine value, with a very high risk premium.  If the company is reasonably stable and growing rapidly, you might accept less of a risk premium.  It’s really up to your own judgement.

What to do with your value

You now have a value per share.  How did you get it?  You know that dividend / value = rate, and you’ve determined the rate you’d be willing to accept based on risk.  You should also know the dollars dividend per share.  So we can switch around the formula and get value = dividend / rate.  So lets say the rate is 10% and the dividend is $1 per year.  The value is $1/.10 or $10 per share.  If the current share price is $8, it might be a buy.

Market Pricing is Perfect Pricing

If you bought your share of stock for $8, could you turn around and sell it for $10?  Nope.  The market is willing to pay $8 so you can sell it for $8.  And why is it $8 when you think it should be $10?  Because the market, for some reason, thinks the risk is greater than you do.  Perhaps there is information you haven’t taken into consideration.  Maybe there’s turmoil in the world.  Maybe management at the company has just changed.  It could be anything, or it could be nothing.

If market pricing is perfect, as the theory goes, then why could the reason be nothing?  You have a lot of great people who think about the value of stock, then buy and sell based on their value.  Others will simply buy what they like or sell if the market’s going down, or do many other irrational things.  So the perfect market pricing theory is a little true and a little false.

If you want to believe that market pricing is perfect, that’s great.  Then the price the market is willing to pay today is the value of the share of stock.  Then you would buy a stock just to be invested, catch the share price growth or dividend growth if there is any.  And truthfully, it really could go either way.

A basket full of stocks

As the theory goes, the more different shares of stock you have, the more you have diversified the risk.  In other words, it’s more risky to own $10,000 worth of one stock than owning $10,000 evenly split between 50 stocks.  The overall market will go up and down, but mostly up over time, but an individual stock could soar or go out of business.  You really don’t know for sure.  But buying many stocks virtually eliminates the risk of a big loss because of a bad company.

Summary

Valuing stocks is a tough job for a novice investor.  It is sometimes best to buy good diversified mutual funds rather than invest in individual stocks.  But if you can have a diversified portfolio of stocks, your risks are reduced and you will pay less in fees than owning a mutual fund.  However, you really need to understand what you are doing before you jump in with both feet.  Invest with a small sum of money for a while.

This is the longest article I’ve ever written on any subject and I hope it was informative.  I tried to keep it as simple as possible.  If I got something wrong, I do apologize, I am not a stock analyst by trade.  I am just trying to provide basic information.

How do you choose what shares of stock to buy?

So You Have No Money To Start A Business?

When people think of starting a business, they think of investing money and time for a future return. Is it possible to start a business with no money at all? Anything is possible with a little imagination.

Imagine that you are going to get a job. You interview for the job and get it. Then you start your job and you get your paycheck a little later. This is classic business. You are selling your time for money. You can also sell your time for money in a business. This is called temping or consulting. You find a person or company with a need and you sell them your services: time in return for money.

What kind of services can you sell? Think like a teenager for a moment.  You could deliver papers. You could mow lawns. You could babysit. Now think about what special skills you have. Can you paint? Build furniture or walls? Fix small electronics? Do you have computer skills you can teach people? You are only really limited by your imagination.

Maybe you could sell things you own to raise money. Rather than starting without money, you could sell some of your belongings to raise money.  Do you own bonds?  Do you collect coins?  Do you have an LP collection?  Do you have musical instruments you don’t use?  Do you have unused sports equipment?

You can drop ship or sell on consignment. Many companies allow individuals to sell their products and drop ship to the customer, or even loan goods out to be sold.  Some companies have catalogs you can show customers and then order with their credit card, or get paid first then order.

You can market online for free. You can often get free web space and free advertising on the internet, then market as an affiliate for other companies.  You probably will not make a lot of money right away but you can make money with just your time, a computer, and an internet connection.  If you have no computer or internet connect, you are probably not reading this.  However, the library does offer computers with internet if you are lacking.

That’s about all I can think of at this moment, but there are probably other avenues you can follow.  Just use your imagination and who knows what you can come up with.

The Basics Of Cash Flow

If you have a checking or savings account, you deal with cash flow on a personal level. Start a small business, open a checking account, and now you are dealing with business cash flow. When you are just starting a business, the game is easy. Spend as little as possible and make as much as possible. Usually the latter is a little more sluggish than you would like it to be, so not spending money on silly things is very important. If you cannot do business without spending money on something, by all means come up with the money and spend it. But there are so many opportunities out there to spend money for your business, and not for things to build your business, that you will find yourself broke very quick if you do not watch it.

After your business has grown (and always), cash flow is important to monitor as it may not be as straight forward as it was early in the business.  There may be accounts receivable and accounts payable to work with, as well as just managing a basic checking account.  In other words, there are many more moving parts to cash flow and it is easy to find yourself having a difficult time meeting all of your obligations.  So having a forecast of cash flow is very important.

Most business software, such as Quickbooks, have cash flow reports and forecasts that can be used to figure out what your spending looked like and what things look like in the future.  You can also do it on paper yourself, but you can make better use of your time with good software.

Please review the following resources for more information:

Raising Capital For Your Business

The only real experience I have with raising capital is when I sold shares of stock to myself and when I went to the bank to ask for a loan.  Both cases are easy, especially when you can prove how much money your business makes and how much inventory you have.  Now if you want to go off and borrow money by selling shares to other people or selling off a portion of your business in another way, I am not really an expert.  I do know that you typically have to prove a market for your product by having a decent amount of sales or commitments for orders, and you have to be able to present a good business and marketing plan.  This is a good place to start.  I can tell you that if you have proof your business will work, you will be able to find people to invest.

Here are some resources on raising capital that may be useful to you:

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