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On the Irrelevance of Corporate
Financial Policy
By JOSEPH E. STIGLITZ*
851
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852 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
tor is very small, the decisions of house- The paper will proceed as follows. In
holds with respect to savings are of rela- Section I, the basic model is set up. In
tively little significance in the determina- Section II, I prove my fundamental
tion of the equilibrium of the economy- theorem on the irrelevance of the firm's
are not likely to give us much insight into financial policy from the point of view of
what is really going on: at best they pro- any individual. Section III will comment
vide us with some spurious correlations.' briefly on the assumptions made and their
Moreover, if the maturity structure of limitations. Section IV will show that
debt is of no consequence, it casts some financial policy need not be of concern to
doubt about the validity of the partial any particular firm, even if it is of concern
equilibrium models attempting to relate to individuals, under much weaker condi-
the maturity structure to the term struc- tions than those used to demonstrate the
ture of interest rates (see, for instance, my earlier proposition.
1970 paper).
I. The Basic Model
In the literature, two different but
closely related propositions have been con- A. Firms
fused: they both assert that the financial The various financial decisions of the
policy of the firm has no affect on its firm are very closely related. One of the
valuation. One asserts, however, that the interests in a multiperiod model is to ex-
individual is indifferent to alternative plore these relationships. A decision to in-
financial policies, in particular to debt- crease the amount to be distributed as
equity ratios, and hence there is no de- dividends means that if the firm were to
terminate debt-equity ratio for the econ- leave its investment decision unchanged,
omy as a whole. That is to say, any change it would have to raise additional revenue
in the financial policy of the firm can be to pay for the planned investment. If it
completely offset by the actions of the raises more by issuing bonds, the amount
stockholders (and indeed will be offset in left over for distribution next period will
the new general equilibrium situation). be decreased, and hence either retained
The second proposition asserts that the earnings or dividends next period must be
individual may not be indifferent to al- reduced. If it raises the revenue by issuing
ternative financial policies, that there may shares, it means the amount distributed to
be for instance a determinate debt-equity each shareholder next period (if retained
ratio for the economy as a whole, but the earnings were unchanged next period)
financial policy of any particular firm would be reduced. Thus, the interrelations
makes no difference. The first asserts, in among all the decisions are complex and
other words, the irrelevance of the financialany decision today may have ramifications
structure for the entire economy, and for many periods into the future.3
therefore of the particular firm; the second
only asserts the irrelevance of the financiallatter type: they show that if there are two or more firms
of the same risk class (the same pattern of returns across
structure of an individual firm. Clearly the
the states of nature), then the debt-equity ratio of any
former proposition is a much stronger one particular firm is indeterminate. The author's theorem
than the latter.2 We are concerned here (1969) was of the former type.
3 The importance of these relationships has often
with both kinds of propositions.
been missed by even as astute students of the theory of
1 E.g., the correlation between retained earnings and corporate finance as William Baumol and Burton
investment does not provide an explanation of the de- Malkiel, and Modigliani and Miller. In discussing the
termination of the level of investment. See, for instance, impact of taxation on the optimal financial policy of the
John Meyer and Edwin Kuh. firm, they observe that increasing the debt reduces the
2 The Modigliani-Miller theorem was really of the tax liability of the firm and hence increases its value.
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VOL. 64 NO. 6 STIGLITZ: CORPORATE FINANCIAL POLICY 853
For expositional simplicity, we shall use retained earnings or by issuing new securi-
a "one-commodity" model;4 each period ties.
there is a single commodity input and a (b) If it issues new securities, it can
single commodity output (dollars or yen). use a number of different financial instru-
We shall look at the consequences of al- ments: common stock, bonds, preferred
ternative financial plans on the firm's stock, convertible bonds, etc. Each of these
market valuation, given a "real plan" of financial instruments carries with it differ-
the firm. A real plan is characterized by a ent contractual rights with respect to the
statement of the investment level and distribution of the gross profits of the firm,
choice of technique in each period con- and the part the owner of those instru-
tingent on the state of nature (the set of ments can play in the decision making of
events that have occurred up to that the firm. For instance, bonds yield a fixed
time). Thus, given the real plan, we know sum in every state of nature except when
the level of profits in each period, depend- the firm goes bankrupt, in which case the
ing of course, on the state of nature. Let proceeds of the firm are divided among the
bondholders. However, except when there
Ij(t, 0(t), k)=the level of investment of
is the distinct possibility of the firm not
the ith firm at time t, if the
being able to meet its debt obligations, the
state of nature at that date
bondholders generally have no voting
is 0(t), under plan k.
rights in the management of the firm.
Xi(t, 0(t), k) = the output or gross profits
The return to a common stock, on the
of the ith firm at time t, if
other hand, is variable except when the
the state of nature at that
firm goes bankrupt, in which case it is
date is 0(t) under plan k.5 6
zero. A shareholder is entitled to receive
There are a number of alternative ways a proportionate share of the dividends of
a firm may finance its investment: the firm. The dividends, of course, depend
(a) It can finance its investment with not only on the real policy of the firm but
on the particular financial policy chosen.
For an ongoing firm with a given investment policy, To know the stream of returns, the share-
increasing the debt-equity ratio implies that the firm holder must know both the real and the
retains less of its earnings and thus the capital gains
will be smaller.
financial decisions of the firm. On the other
4 The analysis for the multicommodity model is hand, if our argument that financial policy
identical, except- now a new set of financial decisions is irrelevant is correct, then although
becomes available to the firm: it can denominate its
changes in dividend policy affect the pat-
bonds in terms of money or in terms of some other com-
modity, or some composite commodity (e.g., the cost of tern of returns received by any single share
living index). Indeed, certain decisions which may ap- of the firm, the individual is indifferent to
pear to be "real" are in fact financial: when relative
these changes. The shareholder (like the
prices are uncertain, firms must decide on whether to
buy futures (or hold inventories) of inputs or sell futures bondholder) can sell his shares at any date
(or hold inventories) of outputs. In short, all such and receive what he can for them. Finally,
"hedging" decisions have (under the assumptions be-
low) no affect on the market value of the firm.
ownership of shares generally gives one a
proportionate vote in the stockholders'
I No loss of generality is had by interpreting I, and
Xi as vectors of inputs and outputs. In the proofs, we meeting (although some firms also issue
then need to replace Ii by v* Ii and Xi by v Xi, where v
is the vector of relative prices (at time t, in state 6(t)).
shares which do not have voting rights).
I Since in our simplification there are no other inputs, In the ensuing analysis, we shall assume
the output of the firm and its gross profit (before paying for simplicity that there are only two
interest on debt, etc.) are identical. The modifications
required when there are other inputs are straightfor-
classes of financial instruments, bonds and
ward. common shares.
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854 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
(c) If it decides to issue bonds, it must Si(t) = the number of shares outstand-
decide on what maturity-one year, two ing at the end of the period.
year, etc.-and what the coupon rate will REi(t) = retained earnings.
be. For simplicity we shall assume that
There is, of course, no natural unit for
bonds carry no coupons. Thus, a t period
shares, so it is just as simple to define
bond is a promise to pay in t periods 1 dol-
lar. When it is issued, it obviously sells at
Et (t) = qi(t)Si(t)
a discount.7 Let
as the value of the shares outstanding at
p(t, r, 0(t)) = the price at time t in state 6(t)
the end of the period, while
of a bond which promises to
pay 1 dollar at time r. Ei (t) = qi(t)S(t - 1)
If there is uncertainty, the individual will as the value of the shares outstanding at
not know what the price of such a bond the beginning of the period, i.e., the value
will be in future periods except that, if at t-th period prices of the shares outstand-
there is no bankruptcy, ing at the end of the previous period.
Thus E+(t) -E-(t) is the value of the
p(t, t, 0) = 1 for all 0, t
change in the number of shares outstand-
In the discussion below all variables are ing resulting from issuing new shares dur-
state-contingent, but for notational sim- ing the t-th period; this should not be con-
plicity we omit the 6(t) except when it fused with E (t+ 1)-E+ (t), which is the
would otherwise be confusing. Similarly, change in the value of those shares out-
all real variables (Xi, Ii) are dependent on standing at the end of the t-th period from
the "plan k," but k too will be suppressed. the t-th to the t+ 1st period. The latter is
The relationships among the various the capital gain (or loss) on existing shares.
financial decisions are expressed by the The second accounting identity states
two accounting identities: Total invest- that total income in state 0 at time t must
ment must be equal to the value of the be equal to the income distributed (to
change in outstanding bonds plus the value bondholders and to shareholders) plus
of the change in outstanding shares plus that retained by the firm.8
retained earnings:
(2) Xi(t) = Bi(t - 1, t) + Di(t) + REi(t)
00
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VOL. 64 NO. 6 STIGLITZ: CORPORATE FINANCIAL POLICY 855
x(Ct, es(t))
q q(t, 01 ((t)) (E(t, 91(t)
erlp(t,-r, a,(t))
Household Sector
Investment Stote of Profits and Distribution of New Capitol roised New Investment
noture prices of profits to shore- (issuing shores and
announced securities holders (dividends) debt) which, together
with (shores and bondholders: with retoined eornings
associoted and bonds) remoining profits finance
retained
FIGURE 1
household sector with a dotted line: the ately been substantially narrowed. In
fact that the earnings do not pass through Figure 1 we can, for instance, now com-
their hands directly does not necessarily pletely ignore all but one of the environ-
mean that the household sector does not mental paths passing through t.
include (in some sense) such retained Given the new information embodied in
earnings in their income. As the analysis the announcement of the state 0(t), the
below shows, the retained earnings will be value of the shares and the prices of bonds
directly reflected in the price of outstand- are determined. In particular, the value of
ing shares. the equity of the firm now is Ey(t, 02(t)).
The diagram also serves to clarify the Moreover, at this point, for the particular
timing implicit in our analysis: Let us plan we have denoted by k, we know
break into the diagram at a point where exactly what the firm plans to do this
the firm has just made its "new" invest- period: we know its investment, I(t, 02, k),
ment decision having raised the requisite how much dividends it plans to give out,
capital. The output (profits) next period how much it plans to retain, how many
(which depends not only on investment in bonds and of what maturity it plans to
the period just ended, but on investment issue, how many new shares it plans to
in all preceding periods, as well as the issue, etc. We still don't know, of course,
specification of the environmental path for what its investment will be in the future;
these preceding periods) is unknown; we for this we await further information. But
await the specification of the "environ- we do assume that we know what the firm
ment" for time t, for example, the rainfall, will do in each contingency.9
temperature, etc. The "state of nature" is
I The assumption that the raising of new capital
then announced, i.e., 0(t) is then given. follows (in each period) the distribution of the profits
This means that the set of possible out- and the bond payments is made simply for expositional
convenience. In fact, these two operations may be
comes for t+1 and beyond has immedi- (over)
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856 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
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VOL. 64 NO. 6 STIGLITZ: CORPORATE FINANCIAL POLICY 857
B. Households
invested lo Secrity
Rettan per
Dollor Invested + E p(t, r)(B (t, r)
_ _ I ~~~~~~~~~~~~in Bond r=t+ 1
The fact that the value of the equity of where i(t)-=EI+(t) /E(t) is the fraction
the firm in some state of nature at some of the equity of the ith firm owned by the
date in the future is zero does not mean jth individual at the end of the t-th period.
that the value of the equity will be zero At the beginning of the next period his
today; if there is some chance that the portfolio is worth
firm will not go bankrupt, clearly the
value will be positive. But it does mean (8) w (t + 1) = t a V(t) V (t + 1)
that bonds issued with maturities at the
date of potential bankruptcy or beyond
are risky securities, i.e., their terminal + > p(t + 1, r)(Bj(t, r)
r=3t+ 1
value is uncertain, and clearly the price of
these bonds will not be the same as the
aEoe ()Bj(t, r))
price of a bond whose terminal value is i
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858 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
Thus, substituting (4), (7), and (8) into THEOREM 1: (a) Assume there is no
(9), we obtain bankruptcy of any firm in any state of na-
ture. (b) A ssume that there is a perfect
(10) ck(t)= ZE (t-1) {IXi(t)-Ii(t) market for perfectly safe bonds of all ma-
00
turities. (By perfectly safe, we mean that the
+ V_T (t)-E p (t, r7)Bi(t- 1, T) amount that they pay upon maturity is
7--t known for certain; the price of these differ-
ent maturities at all other dates may be highly
+ E p(t, r)Bj(t-1, T)-w (t),variable.) II (c) A ll firms haze already made
T=-t
C. General Equilibrium
(13) AB(t, ) = ai(t)ABi(t, r) all t, r, j
Market equilibrium requires the total
value of ownership claims on the ith firm i.e., each investor alters his holdings of bonds
equal the value of its equity, i.e., by exactly his stockholder's share of the
change in debt of each maturity of all firms
E,i(t) = a &t(t)E,(t) = E,(t) or and
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VOL. 64 NO. 6 STIGLITZ: CORPORATE FINANCIAL POLICY 859
PROOF
III. Comments on the Theorem
and Its Proof
1. The consumption opportunity set
is unchanged. Consider any feasible con- There are four kinds of comments which
sumption path and its associated portfolio I have to make. In Section lIIA we provide
allocation. From (7), it immediately fol- an intuitive interpretation of the theorem.
lows that if wj+(t), p(t, r), and V+(t) are In Section ItIB we point out how much
unchanged after a given change in financial weaker the assumptions employed in our
policy of a firm, then the changes in port- analysis are than those used in previous
folio allocation described by (13) and (14) proofs. In Section IIIc we discuss briefly
are feasible; and from (10) if these changes the limitations on the proof, and how crit-
are undertaken, then c'(t+?)+ww+(t+1) ical they are for the general validity of the
is unchanged. Thus, if cj(t+ 1) is un- theorem. In Section IIID we discuss the
changed, wj+(t+ 1) is unchanged. Clearly, competitive forces at work to eliminate
if the values of the firm and prices of bonds the "inefficiency" resulting from the re-
are unchanged, the value of wi for dates source allocation to financial management.
before the contemplated change in finan-
A. Intuitive Interpretation
cial policy begins is unchanged.
These statements immediately imply The basic argument of the theorem is
that a consumption stream that was that individuals can exactly "undo" any
feasible in the original situation is feasible financial policy undertaken by the firm.
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860 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
Let us consider verbally what actions of classes, as many states of nature as secur-
the individuals are required to offset vari- ities, or the assumption that returns can
ous actions by the firm. Assume the firm be described by means and variances,
decreases its dividend payout ratio. This assumptions which have been crucial in
means that it has more retained earnings, other proofs of the more limited theorem
so, if the two basic financial accounting on the irrelevance of debt-equity ratios.
identities are to be satisfied, either it must
borrow less (perhaps it even lends) or (b) Competitiveness of capital market. No
issue fewer new shares. To make up for the assumption about the competitiveness of
loss in dividends, i.e., to keep the same the capital market has been made; the
consumption path, individuals buy fewer only assumption is that there be no dis-
new shares in the firm or buy fewer new criminatory pricing, i.e., the price paid by
bonds. Assume the firm simply issued one individual (firm) for a bond (or share)
fewer shares. In one case, the value of the be the same as for all other individuals.
equity grew because of issuing new shares, But the market rate of interest-and
in the other case, the value of the equity hence the interest rate paid by a firm-
grew because of retained earnings. From may be affected by the amount of capital
the point of view of the stockholders, the it raises from the market.
two are perfectly equivalent. This change
in dividend pay-out ratio thus leaves the (c) Rationality of consumers. The only
debt-equity ratio unchanged. On the other restriction on individual behavior is that
hand, if the firm decreases the number of given a set of feasible consumption paths,
bonds issued, it will lead to a lower debt- he always selects the same consumption
equity ratio. Then individuals borrow on path. Thus, the individual may maximize
their own account. One can think of it as his discounted expected utility, but no
if the individual takes the proceeds of the such restrictive assumption is required for
loan to purchase the increased equity in the result to obtain.
the firm (since the two are exactly equal,
this is only a convenient way of looking at (d) "Control" of firm. Even if the indi-
it; since all funds are fungible, there is no vidual does care about his political power
real connection between the two). The (control) within the firm (which he may if
increased borrowing by individuals ex- the real decisions of the firm depend on the
actly offsets the decreased borrowing by stockholders), if the role of each stock-
firms so markets continue to clear. Simi- holder in decision making is simply a func-
larly, if the firm decides to issue more tion of the proportion of the total shares
three-year bonds and fewer five-year he owns, the financial policy makes no dif-
bonds, the individual can undertake ex- ference, since political power of any share-
actly offsetting actions in his own port- holder is identical in the two situations.
folio. One might have argued that a smaller
equity base would make a "take-over"
B. On the Generality of the Theorem more likely; but under the assumption of
(a) Risk classes, Arrow-Debreu securities, no bankruptcy, this would not be true,
mean-variance analysis. It should be em- since the group taking over the firm could
phasized that in the proof, it is not as- borrow on the strength of the equity in the
sumed that there are two or more firms firm as collateral; if in the low equity
which are otherwise identical; the argu- situation, the group taking over could
ment does not require the existence of risk raise the requisite capital for a take-over,
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VOL. 64 NO. 6 STIGLITZ: CORPORATE FINANCIAL POLICY 861
they would have no problem doing so in (h) Market clearing. The particular path
the high equity situation.12 described in the above analysis is an equi-
librium path where individuals make plans
(e) Source of uncertainty. No assumption all of which are consistent with one another,
about the source of uncertainty is re- i.e., they are market clearing. In fact, the
quired.'3 only thing required for the analysis is
market clearing at time 0. In making his
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862 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
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VOL. 64 NO. 6 STIGLITZ: CORPORATE FINANCIAL POLICY 863
believe that in the absence of taxation 4) There is, moreover, no reason that
in the short run the different valuations
financial managements would wither
lead to any inconsistencies or more gen-
away? Not necessarily, or only very
slowly, as the remaining points argue. erally that there are any forces leading
individuals to reformulate their expecta-
2) I have already argued that if indi-
viduals believe that financial policy affects tions so that valuations are independent
firm valuation, then it will, and the firm of financial policies. Even if we have two
firms which are identical in every real
that ignores the popular "prejudices" may
respect (that is, they belong to the same
do worse than one which takes them into
risk class, in the terminology of Modigli-
account. There may have been no rational
reason for the prices of tulip bulbs to rise ani and Miller), there is not necessarily any
method by which individuals can arbi-
as they did in the tulip bulb mania, but
since they were rising, at least in the short trage (over any short- or medium-run16
ing in them (see below). 15 Indeed, one might argue that this signalling effect
of financial policy is one of its more important functions.
3) Moreover, this relationship be-
If firms never issued dividends, simply retaining earn-
tween the firm's financial policy and ex- ings (even in the form of bond purchases) then it might
be possible for firms to postpone letting shareholders
and that of Modigliani and Miller. They assert that know when they are in "bad straits" even longer than
the financial policy is of no consequence. But Modigliani they do at the present. This may provide part of the
and Miller made use of risk classes in their proof, explanation of why, in spite of strong tax advantages
the use of which seemed to imply objective rather for not issuing dividends, firms continue to do it.
than subjective probability distributions over the pos- 16 This qualification is imposed because, under certain
sible outcornes. The mechanism which ensured that the circumstances, it can be shown that if different financial
debt-equity ratio made no difference for the value of the policies are pursued with the firms having different
firm was individual arbitraging among different firms in valuations and equal returns to the individual, then, in
the same risk class. Such arbitrage does not play any finite time, the relative valuations must become infinite.
role in my analysis. Moreover, their argument was But finite, in this context, may be very long indeed.
based on partial equilibrium analysis rather than gen- Such differences in valuations are (at least mathematic-
eral equilibrium analysis. It was not clear from their allv) very similar to the speculative booms (or depres-
analysis whether the theorem held only for competitive sions) which often seem to characterize price move-
markets, nor how the possibility of firm bankruptcy ments on the stock market. For a general discussion of
affected their results. The basic insight of the M-M these problems in a slightly different context, see Karl
analysis, that individual leverage could substitute for Shell and the author.
firm borrowing, remains the basis of my argument. 17 To see this in the extreme case, we need only con-
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864 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
5) Finally, we note that the resources acterized by a given market rate of interest
wasted on financial management may be (on safe bonds), by a given nominal rate of
relatively minor (relative, say, to total interest on the risky bonds of each of the
profits of the firm) and hence the "com- firms which faces a chance of bankruptcy,
petitive forces" to eliminate this ineffi- and by each firm having a given market valu-
ciency may operate with relatively little ation and a financial policy (dividend-
strength. retention ratio, maturity structure of debt,
etc.), and in which a given fraction of the
IV. Irrelevance of Financial Policy shares of thefirm are owned by the i-th indi-
of Any Particular Firm
vidual.
The above proposition established the Let any firm (or any group of firms)
irrelevance of the financial structure of change its financial policy. If financial
the economy as a whole. The crucial as- intermediaries may be established costlessly,
sumption employed was that of no bank- then there exists a new general equilibrium
ruptcy. We can remove this assumption solution for the economy with the same mar-
and prove a weaker theorem about the ket rate of interest, in which every firm has
irrelevance of the financial policy of any exactly the same market valuation as before,
particular firm. and in which the proportion of each firm's
shares owned by the i-th individual, either
THEOREM 2: Assume there is a general directly or indirectly through intermedi-
equilibrium for the economy which is char- aries, is exactly the same as before.
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VOL. 64 NO. 6 STIGLITZ: CORPORATE FINANCIAL POLICY 865
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866 THE AMERICAN ECONOMIC REVIEW DECEMBER 1974
policy; 2) individual borrowing not a per- ing of the implications of these limitations
fect substitute for firm borrowing; 3) bank- and more refined tests to discriminate
ruptcy. Whether these limitations are im- among the alternative hypotheses.
portant in practical applications is a moot
question. But whether they are or are REFERENCES
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the understanding of the physics of mo- D. Cass and J. E. Stiglitz, "The Structure of
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tially identical except for their debt-equity ' "A Consumption Oriented Theory of
the Demand for Financial Assets and the
ratio-do not discriminate between worlds
Term Structure of Interest Rates," Rev.
in which Theorem 1 is valid, those in
Econ. Stud., July 1970, 37, 321-51.
which Theorem 2 is valid but not Theorem
"On Some Aspects of the Pure The-
1, or worlds in which neither theorem is ory of Corporate Finance, Bankruptcies and
valid (in which financial policy is impor- Takeovers," Bell J. Econ., Autumn 1972, 3,
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have selected the set of financial policies ,"Taxation, Corporate Financial Policy,
which maximize the firm's valuation). and the Cost of Capital," J. Publ. Econ.,
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