Return on investment: How to estimate and compare the returns on different projects in financial modeling

1. Understanding the Importance of Estimating Return on Investment

One of the most important skills in financial modeling is the ability to estimate and compare the returns on different projects or investments. This is known as return on investment (ROI) analysis, and it can help you make better decisions about how to allocate your resources and optimize your profits. In this section, we will introduce the concept of ROI, explain why it is useful, and show you how to calculate it using different methods. We will also discuss some of the challenges and limitations of ROI analysis, and how to overcome them. Here are some of the topics we will cover:

1. What is ROI and how to measure it? ROI is a ratio that compares the net income or profit generated by an investment to the initial cost or capital invested. It is usually expressed as a percentage or a decimal number. For example, if you invest $1000 in a project and earn $200 in net income, your ROI is $200/$1000 = 0.2 or 20%. There are different ways to measure ROI, such as simple ROI, annualized ROI, or internal rate of return (IRR). We will explain each of these methods and how to use them in different scenarios.

2. Why is ROI useful and how to use it? ROI is useful because it allows you to compare the profitability and efficiency of different investments or projects. You can use ROI to rank and prioritize your options, and choose the ones that offer the highest returns for the lowest costs. You can also use roi to evaluate the performance of your past or current investments, and see if they meet your expectations or goals. ROI can help you answer questions such as: How much money did I make from this investment? How long did it take to recover my initial cost? How does this investment compare to other alternatives?

3. What are the challenges and limitations of roi analysis? ROI analysis is not perfect, and it has some challenges and limitations that you need to be aware of. Some of the common issues are: How to account for the time value of money, which means that money today is worth more than money in the future? How to account for the risk and uncertainty of future cash flows, which may vary depending on different factors? How to account for the opportunity cost of capital, which means the return you could have earned by investing in another project or asset? How to account for the intangible benefits or costs of an investment, such as social or environmental impact? We will discuss how to address these issues and how to adjust your ROI calculations accordingly.

4. How to improve your ROI analysis skills? ROI analysis is a valuable skill that can help you make better financial decisions. However, it is not enough to just know the formulas and calculations. You also need to have a good understanding of the context and assumptions behind each ROI method, and how to interpret and communicate the results. You also need to be able to compare and contrast different ROI methods, and choose the most appropriate one for your situation. To improve your ROI analysis skills, you can practice using real-world examples and case studies, and seek feedback from experts or peers. You can also use online tools and resources, such as , to help you with your ROI analysis tasks.

2. Key Metrics for Evaluating Returns in Financial Modeling

One of the main objectives of financial modeling is to estimate and compare the returns on different projects or investments. However, there is no single metric that can capture all the aspects of a project's profitability, risk, and value. Different metrics may have different assumptions, limitations, and interpretations. Therefore, it is important to understand the key metrics for evaluating returns in financial modeling and how they can be used in different scenarios. In this section, we will discuss some of the most common metrics, such as:

1. Net Present Value (NPV): This is the difference between the present value of the cash inflows and the present value of the cash outflows of a project. NPV measures the absolute value of a project and reflects the time value of money. A positive NPV means that the project is expected to generate more cash than it costs, and a negative NPV means the opposite. NPV is a widely used metric because it accounts for the opportunity cost of capital and the risk-adjusted discount rate. However, NPV does not consider the size of the project, the timing of the cash flows, or the potential changes in the discount rate over time. For example, a project with a large initial investment and a long payback period may have a high NPV, but it may also have a high risk and a low liquidity.

2. Internal Rate of Return (IRR): This is the discount rate that makes the NPV of a project equal to zero. IRR measures the annualized percentage return of a project and reflects the efficiency of the investment. A higher IRR means that the project is more profitable, and a lower IRR means the opposite. IRR is a popular metric because it is easy to compare with the cost of capital or the required rate of return. However, IRR does not account for the scale of the project, the reinvestment rate of the cash flows, or the multiple solutions that may exist for a non-conventional cash flow pattern. For example, a project with a small initial investment and a short payback period may have a high IRR, but it may also have a low value and a low impact on the overall performance of the firm.

3. Payback Period (PP): This is the number of years it takes for a project to recover its initial investment. PP measures the liquidity and the risk of a project and reflects the breakeven point of the investment. A shorter PP means that the project is less risky and more liquid, and a longer PP means the opposite. PP is a simple metric because it does not require any assumptions about the discount rate or the future cash flows. However, PP does not consider the time value of money, the cash flows beyond the payback period, or the profitability of the project. For example, a project with a low initial investment and a high cash flow in the first year may have a short PP, but it may also have a low NPV and a low IRR.

3. A Foundation for ROI Analysis

In the world of financial modeling, estimating cash flows is a crucial step in determining the return on investment (ROI) of different projects. Cash flows represent the inflows and outflows of cash over a specific period, and they serve as the foundation for ROI analysis. By accurately estimating cash flows, businesses can make informed decisions about which projects to pursue and how to allocate their resources effectively.

1. importance of Cash flow Estimation:

Estimating cash flows is essential because it allows businesses to assess the profitability and viability of potential investments. It provides a clear picture of how much money will be generated or consumed by a project, enabling decision-makers to evaluate its financial feasibility. Without accurate cash flow estimation, businesses may risk investing in projects that do not generate sufficient returns or fail to account for the timing and magnitude of cash inflows and outflows.

2. Factors Influencing Cash Flows:

Several factors influence cash flows, and it is crucial to consider them when estimating the potential returns on an investment. These factors include sales revenue, operating expenses, taxes, working capital requirements, capital expenditures, and financing costs. Each of these elements plays a significant role in shaping the cash flows associated with a project.

For example, let's consider a manufacturing company planning to invest in new machinery. The sales revenue generated by the increased production capacity would positively impact cash inflows. However, the additional operating expenses, such as maintenance and labor costs, would contribute to cash outflows. By carefully analyzing these factors, businesses can estimate the net cash flows and determine the project's potential ROI.

3. Time Value of Money:

When estimating cash flows, it is crucial to account for the time value of money. The concept recognizes that a dollar received today is worth more than a dollar received in the future due to the opportunity cost of not having that money available for investment. Therefore, cash flows occurring in different periods must be discounted or compounded to reflect their present value accurately.

For instance, suppose a company expects to receive $1,000 in one year as a result of a project. To determine the present value of this future cash flow, the company needs to discount it by an appropriate rate of return. By applying a discount rate, businesses can compare the value of cash flows occurring at different points in time and make more informed investment decisions.

4. cash Flow estimation Methods:

There are various methods businesses can use to estimate cash flows, depending on the complexity of the project and the available data. Some common techniques include historical data analysis, market research, industry benchmarks, and expert opinions. Additionally, businesses can utilize financial models and forecasting tools to project future cash flows based on assumptions and inputs.

For example, a software development company planning to launch a new product may rely on market research to estimate potential sales revenue. By analyzing similar products and conducting surveys, the company can make reasonable assumptions about the demand and pricing of their offering. These estimates will then serve as inputs for the cash flow projections, allowing the company to evaluate the project's ROI.

5. Sensitivity Analysis:

Sensitivity analysis is a valuable technique used to assess the impact of changes in key variables on cash flow estimates and ROI calculations. By varying assumptions and inputs within a range, businesses can identify the most critical factors influencing the project's profitability. This analysis helps decision-makers understand the project's sensitivity to different scenarios and make adjustments accordingly.

For instance, a real estate developer estimating cash flows for a new housing project may conduct a sensitivity analysis to evaluate the impact of changes in interest rates, construction costs, or occupancy rates. By assessing how these variables affect the project's profitability, the developer can make informed decisions about the feasibility and potential risks associated with the investment.

Estimating cash flows is a fundamental step in ROI analysis and plays a vital role in financial modeling. By accurately projecting cash inflows and outflows, businesses can evaluate the profitability and feasibility of different projects. Through careful consideration of factors influencing cash flows, accounting for the time value of money, employing appropriate estimation methods, and conducting sensitivity analysis, businesses can make informed investment decisions that maximize their ROI.

4. Calculating Present Value of Future Returns

In financial modeling, the discounted Cash flow (DCF) Method is a widely used approach to estimate and compare the returns on different projects. This method takes into account the time value of money, recognizing that a dollar received in the future is worth less than a dollar received today.

When applying the DCF Method, various perspectives can provide valuable insights. Let's explore this method from different angles:

1. Conceptual Understanding: The DCF Method involves projecting future cash flows and discounting them back to their present value. By discounting future cash flows, we adjust for the risk and opportunity cost associated with the timing of those cash flows.

2. discount rate: The discount rate used in the DCF Method reflects the required rate of return or the cost of capital. It represents the minimum return an investor expects to compensate for the risk and time value of money. The discount rate can vary based on factors such as the project's risk profile, industry norms, and prevailing interest rates.

3. Cash Flow Projections: Accurate cash flow projections are crucial for the DCF Method. These projections should consider factors like revenue growth, operating expenses, capital expenditures, and working capital requirements. Sensitivity analysis can be performed to assess the impact of different scenarios on the project's value.

4. Terminal Value: The DCF Method often includes a terminal value, which represents the value of the project beyond the explicit forecast period. This terminal value captures the ongoing cash flows and assumes a stable growth rate. Various approaches, such as the perpetuity growth method or exit multiples, can be used to estimate the terminal value.

5. sensitivity analysis: Sensitivity analysis helps assess the impact of changes in key assumptions on the project's value. By varying inputs like growth rates, discount rates, or terminal values, analysts can understand the range of potential outcomes and identify key drivers of value.

6. Example: Let's consider a hypothetical project with projected cash flows of $1 million per year for the next five years. Assuming a discount rate of 10%, we can calculate the present value of each cash flow by dividing it by (1 + discount rate) raised to the power of the respective year. Summing up these present values gives us the total present value of the cash flows.

Remember, the DCF Method is just one approach among many in financial modeling. It provides a systematic way to estimate the present value of future returns, but it's important to consider other factors and methodologies when making investment decisions.

5. Assessing the Time it Takes to Recoup Initial Investment

When it comes to financial modeling, one of the key factors that investors and businesses consider is the payback period. This metric allows them to assess the time it takes to recoup their initial investment and determine the profitability of a project. The payback period is particularly useful when comparing different investment options, as it provides insights into the liquidity and risk associated with each venture.

From an investor's perspective, the payback period offers a clear indication of how quickly they can expect to recover their invested capital. It helps them evaluate the feasibility and attractiveness of various projects by considering the time it will take to start generating positive cash flows. A shorter payback period implies a faster return on investment (ROI) and reduces the risk of tying up funds for an extended period.

On the other hand, businesses also find the payback period valuable in decision-making processes. By understanding how long it will take to recoup their initial investment, companies can assess the financial viability of a project and make informed choices about resource allocation. Additionally, the payback period assists in managing cash flow and planning for future investments or expansions.

To delve deeper into the concept of the payback period, let's explore some key points:

1. Definition and Calculation:

The payback period represents the length of time required to recover the initial investment. It is calculated by dividing the initial investment by the expected annual cash inflows. For example, if a project requires an initial investment of $100,000 and generates annual cash inflows of $25,000, the payback period would be four years ($100,000 divided by $25,000).

2. Simplicity and Limitations:

One of the main advantages of the payback period is its simplicity. It provides a straightforward measure that is easy to understand and interpret. However, this simplicity comes with limitations. The payback period does not consider the time value of money, discount rates, or future cash flows beyond the payback period. Therefore, it may not provide a comprehensive view of the project's profitability.

3. Risk Assessment:

The payback period is often used as a risk assessment tool. A shorter payback period indicates a quicker return on investment and reduces the exposure to potential risks. However, it is important to note that a shorter payback period does not necessarily imply higher profitability. It is crucial to consider other financial metrics, such as net present value (NPV) or internal rate of return (IRR), for a more comprehensive analysis.

4. Comparing Investment Options:

The payback period is particularly useful when comparing different investment options. By calculating the payback period for each project, investors can assess which one offers a faster return on their investment. For instance, if project A has a payback period of three years and Project B has a payback period of five years, an investor may lean towards Project A due to its shorter payback period.

5. Sensitivity Analysis:

Conducting sensitivity analysis can help evaluate the impact of varying assumptions on the payback period. By adjusting factors such as sales projections, costs, or market conditions, businesses can gain insights into the robustness of their investment decisions. Sensitivity analysis allows decision-makers to understand how changes in key variables affect the payback period and make more informed choices.

6. Payback Period Example:

Let's consider an example to illustrate the concept further. Suppose a manufacturing company is evaluating two projects: Project X and Project Y. Project X requires an initial investment of $500,000 and is expected to generate annual cash inflows of $150,000. Project Y, on the other hand, requires an initial investment of $800,000 and is projected to generate annual cash inflows of $200,000. By calculating the payback period for each project, the company can determine which one offers a faster return on investment and make an informed decision.

The payback period is a valuable metric in financial modeling that allows investors and businesses to assess the time it takes to recoup their initial investment. While it provides a simple measure of liquidity and risk, it should be used in conjunction with other financial metrics to gain a comprehensive understanding of a project's profitability. By considering the payback period alongside factors like NPV, IRR, and sensitivity analysis, stakeholders can make well-informed decisions and maximize their returns on investment.

6. Evaluating the Profitability of Investments

When it comes to evaluating the profitability of investments, financial analysts and investors rely on various metrics and techniques. One such metric that holds significant importance in financial modeling is the Internal Rate of Return (IRR). The IRR is a widely used method for assessing the potential return on an investment by considering both the magnitude and timing of cash flows. It provides a comprehensive measure of the project's profitability and helps decision-makers compare different investment opportunities.

From a theoretical perspective, the IRR can be defined as the discount rate at which the net present value (NPV) of an investment becomes zero. In simpler terms, it represents the interest rate at which the present value of cash inflows equals the present value of cash outflows. This means that if the IRR of an investment exceeds the required rate of return or hurdle rate, the project is considered financially viable.

1. Comprehensive assessment: Unlike other metrics such as payback period or accounting rate of return, the IRR takes into account the time value of money. By considering the timing of cash flows, it provides a more accurate picture of the project's profitability over its entire lifespan. This makes it a valuable tool for decision-making, especially when comparing projects with different cash flow patterns.

For example, consider two investment opportunities: Project A, which generates higher cash flows in the early years, and Project B, which has a more even distribution of cash flows over time. While Project A may have a higher total return, the IRR will reveal whether the higher initial cash flows compensate for the delayed cash flows of Project B.

2. Relative comparison: The IRR enables investors to compare multiple investment options and determine which one offers the highest potential return. By calculating the IRR for each project, decision-makers can identify the most profitable opportunity and allocate resources accordingly.

For instance, suppose an investor is considering three projects: Project X with an IRR of 15%, Project Y with an IRR of 12%, and Project Z with an IRR of 10%. Based on these figures, the investor can conclude that Project X has the highest potential return and may prioritize it over the others.

3. Sensitivity analysis: The IRR allows for sensitivity analysis, which helps assess the impact of changes in key variables on the project's profitability. By adjusting the cash flows or discount rate, analysts can determine how sensitive the IRR is to different scenarios. This provides valuable insights into the project's robustness and helps mitigate risks associated with uncertain factors.

For example, if a project's IRR is highly sensitive to changes in sales volume or production costs, it indicates a higher level of risk. Conversely, if the IRR remains relatively stable despite variations in these factors, it suggests a more resilient investment opportunity.

4. decision-making tool: The IRR serves as a decision-making criterion for accepting or rejecting investment proposals. If the calculated IRR exceeds the required rate of return, it implies that the project generates returns higher than the cost of capital. In such cases, the investment is typically considered favorable, and the project moves forward.

However, it's important to note that relying solely on the irr for decision-making may have limitations. For instance, the IRR assumes that cash flows generated during the project's lifespan are reinvested at the same rate, which may not be realistic in practice. Additionally, the IRR does not consider the scale of the investment or the project's risk profile, both of which are crucial factors in the decision-making process.

The Internal Rate of Return (IRR) plays a vital role in evaluating the profitability of investments. Its ability to consider the timing and magnitude of cash flows provides a comprehensive assessment of the project's potential return. By comparing multiple investment opportunities, conducting sensitivity analysis, and serving as a decision-making tool, the IRR helps investors make informed choices and allocate resources effectively. However, it's essential to consider the limitations of the IRR and use it in conjunction with other financial metrics for a more holistic evaluation of investment projects.

7. Determining the Value of Future Cash Flows

In the realm of financial modeling, one of the most crucial aspects is estimating and comparing the returns on different projects. This allows businesses to make informed decisions about where to allocate their resources and invest their capital. One widely used method for evaluating the profitability of investments is the Net present Value (NPV) analysis. NPV takes into account the time value of money by discounting future cash flows back to their present value. By doing so, it provides a comprehensive measure of the value an investment can generate over its lifetime.

When it comes to determining the value of future cash flows, NPV offers several key insights from different perspectives:

1. Time Value of Money: The concept of time value of money lies at the core of NPV analysis. It recognizes that a dollar received in the future is worth less than a dollar received today due to factors such as inflation, opportunity cost, and risk. By discounting future cash flows, NPV adjusts for this time value, allowing for a fair comparison between cash flows occurring at different points in time.

2. Discount Rate: The discount rate used in NPV calculations reflects the required rate of return or the opportunity cost of capital. It represents the minimum return an investor expects for taking on a particular investment's risks. The choice of discount rate is subjective and can vary depending on factors such as the project's risk profile, industry norms, and the company's cost of capital.

3. Positive and Negative NPV: A positive NPV indicates that an investment is expected to generate more cash inflows than the initial investment outlay. In other words, it implies that the project is expected to create value and increase the wealth of the investor. Conversely, a negative NPV suggests that the investment is not expected to meet the required rate of return and may result in a loss of value. Therefore, projects with positive NPVs are generally considered more attractive than those with negative NPVs.

4. Comparing Projects: NPV allows for the comparison of different investment opportunities by providing a standardized metric to evaluate their profitability. When comparing multiple projects, the one with the highest NPV is typically preferred as it offers the greatest potential for value creation. However, it's important to consider other factors such as project size, duration, risk, and strategic alignment before making a final decision.

To illustrate the concept of NPV, let's consider an example. Suppose a company is evaluating two potential projects: Project A and Project B. Project A requires an initial investment of $100,000 and is expected to generate cash inflows of $30,000 per year for five years. Project B, on the other hand, requires an initial investment of $150,000 and is expected to generate cash inflows of $40,000 per year for four years.

To calculate the NPV for each project, we need to discount the future cash flows back to their present value using an appropriate discount rate. Let's assume a discount rate of 10% for this example. Using the NPV formula, we can determine the value of each project:

Project A:

NPV = (-$100,000) + ($30,000 / (1 + 0.10)^1) + ($30,000 / (1 + 0.10)^2) + ($30,000 / (1 + 0.10)^3) + ($30,000 / (1 + 0.10)^4) + ($30,000 / (1 + 0.10)^5)

NPV = -$100,000 + $27,273 + $24,794 + $22,540 + $20,491 + $18,628

NPV = $13,726

Project B:

NPV = (-$150,000) + ($40,000 / (1 + 0.10)^1) + ($40,000 / (1 + 0.10)^2) + ($40,000 / (1 + 0.10)^3) + ($40,000 / (1 + 0.10)^4)

NPV = -$150,000 + $36,364 + $33,058 + $30,051 + $27,319

NPV = $-23,208

In this example, Project A has a positive NPV of $13,726, indicating that it is expected to generate value for the company. On the other hand, Project B has a negative NPV of -$23,208, suggesting that it may not meet the required rate of return and could potentially result in a loss.

By utilizing the NPV analysis, businesses can make informed decisions about their investments, considering the time value of money and comparing different projects on a level playing field. This helps ensure that resources are allocated efficiently, maximizing returns and ultimately contributing to the overall growth and success of the organization.

8. Assessing the Impact of Assumptions on ROI Estimates

In the realm of financial modeling, accurately estimating the return on investment (ROI) is crucial for making informed business decisions. However, any financial model is built upon a series of assumptions, and these assumptions can have a significant impact on the estimated ROI. sensitivity analysis is a powerful technique that allows us to assess the effects of changing assumptions on ROI estimates, providing valuable insights into the robustness and reliability of our financial models.

1. understanding Sensitivity analysis:

Sensitivity analysis involves systematically varying one or more assumptions within a financial model to observe how these changes affect the calculated ROI. By examining the range of possible outcomes resulting from different assumptions, we gain a deeper understanding of the model's sensitivity to those variables. This analysis helps us identify which assumptions have the most significant impact on ROI estimates and enables us to make more informed decisions.

2. Identifying Key Assumptions:

To perform an effective sensitivity analysis, it is crucial to identify the key assumptions in our financial model. These are the variables that have the most substantial influence on ROI estimates. For example, in a real estate development project, key assumptions might include the sales price, occupancy rate, construction costs, and interest rates. By focusing on these critical factors, we can better understand how changes in these variables affect the overall ROI.

3. Scenario Analysis:

One approach to sensitivity analysis is scenario analysis, where we create different scenarios by adjusting multiple assumptions simultaneously. Each scenario represents a particular combination of assumptions, allowing us to compare the resulting ROI estimates. For instance, in a manufacturing project, we could explore scenarios with varying raw material costs, labor expenses, and production volumes. This method provides a comprehensive view of how different assumptions interact and impact the ROI.

4. One-at-a-Time Analysis:

Another technique commonly used in sensitivity analysis is the one-at-a-time analysis. In this approach, we vary each assumption individually while keeping all other factors constant. By isolating each assumption, we can observe its isolated impact on ROI estimates. For example, in a software development project, we might examine the effect of changing the development time, marketing expenses, or customer acquisition costs one at a time. This method allows us to understand the sensitivity of ROI to specific assumptions.

5. Quantifying Sensitivity:

To quantify the sensitivity of ROI estimates to changes in assumptions, we can use various statistical measures. One such measure is the coefficient of variation, which calculates the standard deviation divided by the mean ROI across different scenarios. A higher coefficient of variation indicates a greater sensitivity to changes in assumptions. Additionally, sensitivity analysis can be visualized through tornado diagrams, spider charts, or scatter plots, providing a clear representation of the relationships between assumptions and ROI estimates.

6. Assessing Risk and Uncertainty:

sensitivity analysis not only helps us understand the impact of assumptions but also assists in assessing risk and uncertainty. By exploring different scenarios and their corresponding ROI estimates, we gain insights into the range of potential outcomes and the likelihood of achieving certain ROI targets. This information enables us to make more informed decisions, considering both upside opportunities and downside risks.

7. Incorporating sensitivity Analysis in Decision-making:

The insights gained from sensitivity analysis can guide decision-making processes. By understanding the sensitivity of ROI estimates to various assumptions, we can focus on mitigating risks associated with highly sensitive variables. For example, if an assumption related to market demand has a significant impact on ROI, we may consider conducting market research or implementing flexible pricing strategies to reduce uncertainty.

Sensitivity analysis plays a pivotal role in financial modeling by allowing us to assess the impact of assumptions on ROI estimates. Through scenario analysis and one-at-a-time analysis, we can identify key assumptions, quantify sensitivity, and evaluate risk and uncertainty. By incorporating sensitivity analysis into decision-making processes, we can make more informed choices and improve the reliability of our financial models. Remember, understanding the sensitivity of ROI estimates is crucial for accurate forecasting and successful project evaluation.

9. Making Informed Investment Decisions

In this section, we will explore the importance of comparing and ranking projects to make informed investment decisions. By considering various perspectives, we can gain valuable insights into the potential returns and risks associated with different projects.

1. Evaluating Financial Metrics: One way to compare projects is by analyzing key financial metrics such as net present value (NPV), internal rate of return (IRR), and payback period. These metrics help assess the profitability, efficiency, and time required to recover the initial investment. For example, a project with a higher NPV and IRR indicates a potentially more lucrative investment.

2. Risk Assessment: It is crucial to evaluate the risks associated with each project. This can be done by analyzing factors such as market volatility, competition, regulatory changes, and technological advancements. By considering these risks, investors can make informed decisions and allocate resources accordingly.

3. Qualitative Factors: Apart from financial metrics, qualitative factors should also be considered. These include market demand, customer preferences, industry trends, and the competitive landscape. For instance, a project aligned with emerging market trends and customer demands may have a higher chance of success.

4. Sensitivity Analysis: Conducting sensitivity analysis helps assess the impact of changing variables on project outcomes. By analyzing different scenarios and their corresponding results, investors can gain a better understanding of the project's sensitivity to various factors. This analysis aids in decision-making and risk management.

5. Case Studies: Including case studies and real-life examples can provide practical insights into comparing and ranking projects. These examples highlight the application of different evaluation methods and showcase the outcomes of investment decisions in specific contexts.

Remember, this section aims to provide a comprehensive understanding of comparing and ranking projects for informed investment decisions. By considering financial metrics, risk assessment, qualitative factors, sensitivity analysis, and real-life examples, investors can make more informed choices when evaluating different projects.

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