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2013 G.

Sertsios 0-1
SECTION 0: REVIEW OF THE TIME VALUE OF MONEY


Learning Objectives

The objective of this section is to familiarize you once again with the basic techniques associated
with moving cash flows through time. You are expected to understand discounting,
compounding, present values, future values, constant annuities, growing annuities, constant
perpetuities and growth perpetuities. This section provides you with a self-directed study that is
intended to bring you up to speed.

To get started, put yourself in the shoes of a manager who is offered a choice between two
projects. The first will bring in a one-time payoff of $100,000 in one year, whereas the second
will bring in the same $100,000 payoff in four years. Of these two, which would you prefer?

Obviously, you should take the project with the $100,000 payoff only one year away. At the
very least you could invest this $100,000 received one year from today and invest in risk-free
three-year Treasuries, say. (Treasuries are I.O.U.s issued by the U.S. Government, which
makes them nearly risk-free; we will talk about treasuries a couple of times in this course.) Such
a strategy guarantees you a payoff of more than $100,000 at the end of four years.

Now suppose that the first project remains unchanged, but the second will pay not $100,000, but
$135,000 in four years. Is it still obvious which project you should pick? What additional piece
of information might you want to know?

An important aspect of the field of finance involves measuring the value of cash flows that are
expected to be received at different points in time. As the example above shows, we may need to
compare sums of money at different points in time. This allows you to compare the values of
alternative investments that your firm could undertake (or the balance remaining on your
mortgage, the payments on your car, etc.) This section will help you freshen up your skills in
dealing with the time value of money, and an opportunity to practice the calculations.

0-2 2013 G. Sertsios
Calculation Recommendations

There are three primary approaches to solving time valuation problems:


- Using the formulas and a standard calculator. You will need basic algebra skills and a
calculator that will raise numbers to a power and take roots. If you take this approach, you
will be able to solve all but a few problems. Note that there are no algebraic solutions to
internal rate of return (IRR) or yield to maturity (YTM) problems. (Financial calculators use
iterative algorithms to solve IRR and YTM problems; using spreadsheet software, you can do
the same, or you can more simply plot curves and approximate the solution.)


- Using Excel on a personal computer. Excel contains built-in functions that will perform
most time value of money calculations. The appendix to this section details the basics of
using these Excel functions. Like the financial calculator, however, Excel is not programmed
for working with perpetuity formulas and growing annuities.


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Definitions and Abbreviations


Abbreviation Definition

annuity: a series of payments or receipts having three specific characteristics:
a. each payment is either always the same amount, or the amount is
growing/shrinking at a constant rate
b. payments occur at the end of evenly spaced time periods
c. there are a finite number of payments

CF
0
, CF
1
, etc cash flows: a series of payments or receipts or both. We do not assume the
same dollar amount for each, but we usually assume they are evenly spaced in
time. The subscript indicates the time period.

EAR effective annual [interest] rate: the annual interest rate that reflects the effects
of compounding

FV future value: the accumulated value of an investment once all payments are
made, including interest or return received

g Growth rate: we assume this is constant over time.

r or i interest rate

lump sum: a single payment or receipt (in contrast with annuity or perpetuity)

n or t number of time periods: months, half-years, years, etc.

PMT or C payment: the constant payment or receipt of an annuity or perpetuity

perpetuity: a series of payments or receipts having three specific
characteristics:
a. each payment is either always the same amount, or the amount is
growing/shrinking at a constant rate
b. payments occur at the end of evenly spaced time periods
c. there is an infinite number of payments

PV present value: the value today of an investment or loan, or the value before any
payments are made or return accumulated.

0-4 2013 G. Sertsios
Time Value of Money Formulas


Future value of a lump sum: FV PV r
n
= + ( ) 1


Present value of a lump sum: PV
FV
r
n
=
+ ( ) 1


Present value of a constant perpetuity:
r
PMT
PV =

Present Value of a constant annuity:
1
1
(1 )
n
PMT
PVA
r r
(
=
(
+



Present value of a perpetuity with constant growth: PV
PMT
r g
PMT g
r g
=

=
+

1 0
1 ( )


Present Value of an annuity with constant growth:
1
1
1
1
n
g PMT
PVA
r r g
(
+
| |
=
(
|
+
\ .
(



Effective Annual Interest Rate: 1 1 |
.
|

\
|
+ =
m
m
APR
EAR
2013 G. Sertsios 0-5
Future Value of a Lump Sum

Assume you have $100, which you wish to invest for five years at a 5% annual interest rate.
How much money will you have at the end of the five years?


Time 0 1 2 3 4 5


PV=$100 FV=?


The value of the investment will increase each year by 5%, so if we multiply the beginning value
by 1.05, we will get the end of year value. We can repeat this process five times to get our
answer.


Time 0 1 2 3 4 5


$100 $100
x1.05
=$105.00
$105.00
x1.05
=$110.25
$110.25
x1.05
=$115.76
$115.76
x1.05
=$121.55
$121.55
x1.05
=$127.63


We will have $127.63 if we invest $100 at 5% for five years. Note that what we have done can
be rewritten as:

$100
x1.05
$100
x1.05
2

$100
x1.05
3

$100
x1.05
4

$100
x1.05
5


So to find the future value of any lump sum, we can simply use the following general formula:

Future value of a lump sum:
n
r PV FV ) 1 ( + =

The factor (1+r)
n
can be referred to as the compounding factor, reflecting the compounding of
interest that occurs in this type of problem.
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Present Value of a Lump Sum

Suppose instead we want to know how much money we would have to deposit in the bank today
at 5% if we wanted to have $100 in five years?

Time 0 1 2 3 4 5


PV=? FV=$100


In this case we know our future value, and we need to find the present value. We can rearrange
our future value formula to get:

Present value of a lump sum:
n
r
FV
PV
) 1 ( +
=

Here . 35 . 78 $
) 05 . 1 (
100
5
= We would have to deposit $78.35 in the bank today at 5% to be able to
take out $100 in five years.

While before we were compounding as we went from a present value to a future value, in this
case, we are discounting our future value to bring it back to today. The discount factor is the
fraction 1/(1+r)
n
.

These functions are additive. If we wanted, for example, to withdraw $100 in four years and
another $100 in five years, we can calculate the present values separately and add them together
to determine how much we would have to deposit today to make that possible.

Time 0 1 2 3 4 5


PV=? FV
4
=$100 FV
5
=$100

PV = + = + =
100
1 05
100
1 05
82 27 78 35 160 62
4 5
( . ) ( . )
. . $ .

We will make extensive use of this property.

2013 G. Sertsios 0-7
Calculation Notes

Formulas and standard calculator
There are no specific notes or cautions, but you can see why you need a calculator that will raise
a number to any power.

Financial calculator
A financial calculator will have some version of the following five keys:

n or t i or r PV PMT FV

The PMT key is not used for lump sum calculations, so you will either have to make sure the key
is cleared before beginning the calculation, or you will have to enter 0 as you key the problem.
These notes will always show the 0 for a key that is not included in a specific calculation.

For the original future value of a lump sum problem, the values are:

n=5 i =5 PV=100 PMT=0 FV=?

On some calculators, immediately after keying the first four items, you will press the FV key to
calculate the future value. Other calculators will have a Compute key, which must be pressed
immediately proceeding the FV key.

For the present value of a lump sum, the values are:

n=5 i =5 PV=? PMT=0 FV=100

Excel
You can use the formulas derived in this section. For some calculations, Excel has built-in
functions, see the Appendix on Financial Functions in Excel.

Invoke the FV function to calculate the future value of a lump sum.
Rate=.10 or 10%
NPER=5
PMT=0
PV=100

Invoke the PV function to calculate the present value of a lump sum.
Rate=.10 or 10%
NPER=5
PMT=0
FV=100

For now, you may ignore the Type box.
0-8 2013 G. Sertsios
Before you continue, work the following simple examples to accustom yourself to these basic
calculations. You should not continue in the notes until you are able to get the answers on the
next page. This is also an opportunity to consider how the elements of these formulas interact.

Future value of a lump sum:
FV PV r
n
= + ( ) 1

Present value of a lump sum:
PV
FV
r
n
=
+ ( ) 1

Consider a savings account
that pays 5% per year, where
the money will remain in the
account for 10 years.





Start with an initial deposit of
$1000.

What is the future value?
Assume a savings goal of
$1000.

What is the present value?
What happens if we increase
the interest rate r?

Assume r increases to 7%.






What is the future value?

What is the present value?
Leaving r unchanged, what
happens if we increase the
number of periods n?

Assume n increases to 12
years.




What is the future value? What is the present value?



2013 G. Sertsios 0-9
Future value of a lump sum:
FV PV r
n
= + ( ) 1

Present value of a lump sum:
PV
FV
r
n
=
+ ( ) 1

Consider a savings account
that pays 5% per year, where
the money will remain in the
account for 10 years.





Start with an initial deposit of
$1,000.

What is the future value?

$1,628.89




Assume a savings goal of
$1,000.

What is the present value?

$613.91
What happens if we increase
the interest rate r?

Assume r increases to 7%.






What is the future value?

$1,967.15

With a higher interest rate, our
funds will accumulate to a
larger amount, given the same
time frame.

as r FV
What is the present value?

$508.35

As the interest rate increases,
we can start with a smaller
amount of money and still
reach our savings goal.
as r PV
Leaving r at 7%, what happens
if we increase the number of
periods n?

Assume n increases to 12
years.




What is the future value?

$2,252.19

With more years to compound
interest, our savings
accumulates still more.

as n FV
What is the present value?

$444.01

If we have more time over
which we can earn interest,
our initial amount gets smaller
still.

as n PV

0-10 2013 G. Sertsios
Present Value of a Perpetuity

We often find that payments or receipts do not occur merely once, but follow a repeating pattern
over time. Mathematically, the simplest version of this is a perpetuity, a never-ending stream of
equal payments.

Time 0 1 2 3 n-1 n


PV=? PMT PMT PMT PMT PMT

Where n tends to infinity.

Using the additive nature of our present value formula for a lump sum, we can express this as the
following infinite sum:


n
r
PMT
r
PMT
r
PMT
r
PMT
r
PMT
PV
) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 (
4 3 2
+
+ +
+
+
+
+
+
+
+
=

We can divide that expression by (1+r) for algebraic purposes:

1 5 4 3 2
) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 (
+
+
+ +
+
+
+
+
+
+
+
=
+
n
r
PMT
r
PMT
r
PMT
r
PMT
r
PMT
r
PV


Substracting both terms we obtain:
1
) 1 ( ) 1 ( ) 1 (
+
+

+
=
+

n
r
PMT
r
PMT
r
PV
PV

As n tends to infinity the last term on the right goes to zero. Then, we can multiply by (1+r)
and get:
PMT PV r PV = + ) 1 (
Thus, the present value of a perpetuity is:
r
PMT
PV =

Example: Preferred stocks are frequently perpetuities, having a constant dividend payment
forever.


Calculation Notes

Use the formulas and standard calculator functions. Neither financial calculators nor Excel are
programmed for infinity.

2013 G. Sertsios 0-11
Present Value of an Annuity

Many of the payment patterns we observe are not infinitely lived. Loan payments or savings
plans in particular usually have finite durations. To calculate the value of those, we need to
consider annuities.

When we discuss annuities, we are using the term generically to describe a pattern of cash flows,
not referring to a specific type of investment vehicle. An annuity simply has a finite number of
constant payments at regular intervals. In this context, a home mortgage is an annuity. We need
to be able to find the value today of a future stream of payments. For example, how much would
you be willing to loan to someone who offered to pay you back in five annual payments of $100
if your interest rate is 8%?

Time 0 1 2 3 4 5


PV=? $100 $100 $100 $100 $100

We could find the present value of each individual cash flow and add them up.

PV = + + + + =
100
1 08
100
1 08
100
1 08
100
1 08
100
1 08
399 27
1 2 3 4 5
( . ) ( . ) ( . ) ( . ) ( . )
$ .

Alternatively, we can use a formula for the present value of an annuity.

Present value of a constant annuity:
1
1
(1 )
n
PMT
PVA
r r
(
=
(
+




Our calculation is simplified:
5
1 100
1 $399.27
(1.08) .08
PVA
(
= =
(



Annuities appear regularly in both business and everyday life. The amount you borrow on a loan
with fixed payments is the present value of an annuity, so this formula can be used to calculate
how much house you could purchase for a given monthly payment. Solving for the payment
amount, you can calculate the monthly payment for a car.

0-12 2013 G. Sertsios
Present Value of an Annuity: Derivation of the Formula


This formula is derived from the formula for a perpetuity that we saw earlier. Consider the
pattern of payments for any annuity:


0 1 2 3 n-1 n n+1 n+2


PMT PMT PMT PMT PMT

We can duplicate this pattern using two perpetuities, one starting in one period and one starting
at time n+1. Since we already have the formula for the present value of a perpetuity, we can also
calculate the present value of each of the perpetuities.

Perpetuity 1

0 1 2 3 n-1 n n+1 n+2


PMT PMT PMT PMT PMT PMT PMT PMT PMT PMT PMT


r
PMT
PV =
1


Perpetuity 2

0 1 2 3 n-1 n n+1 n+2


PMT PMT PMT PMT PMT PMT


n n
r r
PMT
r
r
PMT
PV
) 1 ( ) 1 (
2
+
=
+
=

Since we can subtract perpetuity 2 from perpetuity 1 to duplicate the payment pattern of our
annuity, we can subtract the present value of perpetuity 2 from that of perpetuity 1 to get a
formula for the present value of an annuity.

Present Value of an Annuity
1
1
(1 ) (1 )
n n
PMT PMT PMT
r r r r r
(
= =
(
+ +




2013 G. Sertsios 0-13
Present Value of a Perpetuity with Constant Growth

There are times when we may need to consider a pattern of constant growth. We can derive a
perpetuity formula to accommodate that. Suppose we want the scholarship we mentioned above
to increase by 3% per year, to keep up with inflation. We would use the formula for a perpetuity
with constant growth to determine the new amount of our initial investment.

Present value of a perpetuity with constant growth:
g r
PMT
PV

=
1
0


Note that we are including subscripts for the time period in this equation. The value today of our
growing perpetuity depends on the payment one period from now. If we want the scholarship to
be $5000 next year, with 3% increases in subsequent years, we calculate

PV
0
5000
10 03
71 428 57 =

=
. .
$ , .

To accommodate inflation, we would now have to make an initial investment of $71,428.57
instead of the $50,000 we calculated earlier.


Note: this formula can be used to value stocks when constant growth is expected. A simple
example:

Investors expect an annual return of 14% from investing in XYZ Corporation. If next years
dividend is expected to be $2, and long term growth is expected to be 5% per year, what would
you be willing to pay for the stock today?


2
Price $22.22
.14 .05
= =




Calculation Notes

Whatever your preferred method of calculation, for perpetuities you have to use the formulas.

If r = g, you cannot use the perpetuity formula, as the present value approaches infinity.

If r <g, the present value as calculated by the perpetuity formula is negative. The formula
cannot be used in these cases. Why? Because each years individual cash flow has a strictly
positive present value; so the sum of the present values must be positive, too.
0-14 2013 G. Sertsios

Annuities with Constant Growth

We may observe a pattern where payments grow at a constant rate over a fixed period of time.
When we consider problems where costs rise every year, this model is the most useful.

The formula for the present value of an annuity with constant growth:


1
1
1
1
n
g PMT
PVA
r r g
(
+
| |
=
(
|
+
\ .
(



Like our earlier annuity formula, this is derived from the perpetuity formulas.

To see how these might be useful, consider the following examples.

Your eldest child will start college in one year. You know that tuition and expenses this year
will total $20,000 and that costs have been rising about 8% per year. How much money would
you need to have today to pay for four years of schooling? Assume you have invested at 10%.
(Caution: note the time subscript in the formula. What should your initial payment be?)

Assume you will invest $5000 in your 401(k) in one year, and that each year you will increase
your savings by 5%. The fund in which you are investing is expected to earn a return of 12%
annually. In twenty years, what will be the value of your investment? (Including the payment
that you will make in twenty years.)

2013 G. Sertsios 0-15
Calculation Notes:

Again, you can use the formula only if r > g.

Neither financial calculators nor Excel are programmed to allow for a constant level of growth in
the payments. Therefore, these problems must be solved using the formulas and standard
calculator functions. You have to watch the time subscripts on these problems, because they
require the payment one period from now. Both problems above give the current payment, so
the calculations would be:

College tuition problem:

4
1.08 20, 000(1.08)
1 $76, 429.15
1.10 .10 .08
PVA
(
| |
= = (
|

\ .
(



Retirement savings problem: First calculate the present value of the payments, then convert the
lump sum into its future value.

20
1.05 5, 000
1 $ 51,781.52
1.12 .12 .05
PVA
(
| |
= = (
|

\ .
(



20
$51,781.52(1.12) $499,499.67 FV = =





0-16 2013 G. Sertsios
Effective Annual Rate


The usual stated annual interest rate is a rate that does not reflect the effect of compounding over
the course of a year. When working with a stated rate, simply divide by the number of
compounding periods to determine the periodic rate. The effective annual interest rate (EAR) is
the annual growth rate of funds allowing for the effects of compounding.

When comparing interest rates, use effective annual rates.

Effective Annual Interest Rate: 1 1 |
.
|

\
|
+ =
m
m
r
EAR
where m = # of periods per year.

Lets consider the table below, which assumes a stated rate of 6%:

Compounding
periods
Periods
per year
Per period
interest rate, %
Growth factor of
invested funds
Effective
Annual
Rate

1 year 1 6 (1.06)
1
6.0000
Semiannually 2 3 (1.03)
2
6.0900
Quarterly 4 1.5 (1.015)
4
6.1364
Monthly 12 0.5 (1.005)
12
6.1678
Weekly 52 0.11538 (1.0011538)
52
6.1800
Daily 365 0.01644 (1.0001644)
365
6.1831
Continuous infinite - (2.718)
0.06
6.1837

A credit card requiring monthly payments carries an annual rate of 18%. What is the effective
annual interest rate (EAR)?


% . or .
.
EAR 56 19 1956 1
12
18
1
12
= |
.
|

\
|
+ =

Are loans in Chile offered using EAR?






Answer: No. In Chile they offer the compounded rate in mortgage, car,
and other type of loans. In that sense, the loan rates are more
transparent here.
2013 G. Sertsios 0-17
Net Present Value

Net Present Value is a specialized application of what we have learned about the time value of
money. To calculate the Net Present Value of a series of cash flows, find the present value of
each cash flow, positive or negative, and add them all together. Use the cost of capital for the
project or for your company as the discount rate. If the NPV is positive, accept the project; if
negative, reject it.

For example, suppose you are contemplating a project with the following cash flows:

Time 0 1 2 3 4 5


Initial
investment-
$100,000
Cash inflow
$50,000
Cash inflow
$40,000
Cash inflow
$30,000
Cash inflow
$20,000
Cash inflow
$10,000

Assume you have been told the cost of capital for the project is 16%. Should you recommend
going ahead with the project?

Our NPV formula would look like:

65 . 7856 $
16 . 1
000 , 10
16 . 1
000 , 20
16 . 1
000 , 30
16 . 1
000 , 40
16 . 1
000 , 50
000 , 100
5 4 3 2 1
= + + + + + = NPV

Our NPV is positive, so we would recommend the project.

Suppose on the other hand, that our cash flows are initially low but then higher:

Time 0 1 2 3 4 5


Initial
investment-
$100,000
Cash
inflow
$10,000
Cash
inflow
$20,000
Cash
inflow
$30,000
Cash
inflow
$40,000
Cash
inflow
$50,000

What would we recommend in that case? The calculation would be:

03 . 399 , 11 $
16 . 1
000 , 50
16 . 1
000 , 40
16 . 1
000 , 30
16 . 1
000 , 20
16 . 1
000 , 10
000 , 100
5 4 3 2 1
= + + + + + = NPV

Because the larger positive cash inflows are taking place later in the project, our NPV is now
negative. We would reject the project.
0-18
Practice Problems and Solutions

1. Arlene loaned her brother-in-law $1500 five years ago. Last night, after winning big
at Bingo, he paid her back $2000 on the spot. What annual interest rate did she earn on
her money?
2. Cathy is going to save her $5000 year-end bonus, putting the money in a CD with
quarterly compounding and 4 years to maturity. If the APR is 6.5%, how much money
will she have when the CD matures?
3. You are celebrating the birth of your daughter. Assume you will need $250,000 in 18
years to pay for her college education. How much would you need to deposit today to
have $250,000 in 18 years, if you invest the money at 8% per year?
4. Jill is not very good at saving, but she just inherited $100,000. She wants to invest the
money today, then retire when her nest egg reaches $1,000,000, without adding any
additional funds. If she invests the money in CDs with a return of 7% per year, how
many years will she have to continue working?
5. How long will she expect to work if she invests instead in the stock market, where she
expects a return of 12.6%?
6. IBM preferred stock pays dividends of $1.875 per year (no changes expected) and
sells for $26.25. What rate of return are investors demanding?
7. A fortuneteller has just informed you that you will live forever. This changes your
retirement planning considerably. If you intend to have $2,000,000 invested for
retirement at 11% per year, how much can you withdraw each year if you want the
money to last forever?
8. Your financial advisor, who is somewhat conservative, has recommended that you
invest in British Government Consol bonds, which make a constant payment forever.
Assuming no inflation, this could be considered a riskless investment. If the risk-free rate
is 5% and the portfolio he recommends has an annual bond payment of $10,000, how
much would you be willing to pay for these bonds?
9. You wish to endow a modest scholarship to be awarded to a student attending the
college you remember so fondly. If you want the amount to be $2000 next year, with a
4% increase each year to cover rising costs, how much do you need to donate today to
ensure that the scholarship will last forever? The college will invest the funds you donate
at 9%.
10. Bob and his wife are looking at a $200,000 house. If they put 20% down, they can
get a 30 year mortgage at 7.5% APR with no points. What will their monthly mortgage
payment be?

0-19
11. Lisa would like to take five years off from work to pursue a writing career. She
thinks she would need $30,000 each year to live on. If she invests her savings at 10% per
year, how much does she need to save before she quits her job? (Assume that she pays
all her bills at the end of a year.)
12. The credit card statement containing all your charges from your recent vacation just
arrived. Surprise! You owe $10,000! If you make monthly payments of $200, how long
will it take for you to pay it off? Your credit card has an APR of 14%.


20
Solutions

1.

( )
5
1/ 5
2000 1500 1
2000
1
1500
.0592 5.92%
r
r
r or
= +
| |
=
|
\ .
=


2.

FV
FV
= +
|
\

|
.
|
=
5000 1
065
4
647111
16
.
.


3.
( )
PV
PV
=
=
250000
108
62 562 26
18
.
, .


4.

( )
( )
( )
( )
1, 000, 000 100, 000 1.07
10 1.07
ln10 ln 1.07
ln10 ln1.07
2.3026 0.0677
34.0118
n
n
n
n
n
n
=
=
=
=
=
=


Where ln stands for natural logarithm.

5.

( )
( )
1 000 000 100 000 1126
1 000 000
100 000
1126
10 1126
2 3026 01187
19 3985
, , , .
, ,
,
.
ln ln .
. .
.
=
=
=
=
=
n
n
n
n
n





0-21
6.

PV
PMT
r
r
r
r
=
=
=
=
26 25
1875
1875
26 25
0 0714
.
.
.
.
.


7.

PV
PMT
r
PMT
PMT
PMT
=
=
=
=
2 000 000
11
2 000 000 11
220 000
, ,
.
, , .
,


8.

PV
PMT
r
PV
PV
=
=
=
10 000
05
200 000
,
.
,


9.

PV
PMT
r g
PV
PV
=

=
2000
09 04
40 000
. .
,


10.

( )
30 12
1
200, 000 0.8 1
.075
.075
1
12
12
1118.74
PMT
PMT

(
(
=
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+
(

=





22
11.

( )
5
1 30, 000
1
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1.1
113, 723.6031
PV
PV
(
= (
(

=


12.

( )
1 200
10, 000 1
.14
.14
1
12
12
1 200 12
10, 000 1
1.0117 .14
1
1 .5833
1.0117
1.0117 2.3998
ln1.0117 ln2.3998
ln1.0117 ln2.3998
ln2.3998
ln1.0117
75.2561
n
n
n
n
n
n
n
n
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