87
International Journal of Management and Economics Fundamental
https://theusajournals.com/index.php/ijmef
VOLUME
Vol.05 Issue03 2025
PAGE NO.
87-97
DOI
10.37547/ijmef/Volume05Issue03-13
Study of the relationship between audit quality and the
cost of capital according to the corporate life cycle
Muhammad Ali Jaafar
Karbala University/ Faculty of Administration and Economy, Iraq
Mushtaq talib abdulameer alshammari
Karbala University/ Faculty of Administration and Economy, Iraq
Mays Malik Mohammed Sadeq
Karbala University/ Faculty of Administration and Economy, Iraq
Received:
26 January 2025;
Accepted:
24 February 2025;
Published:
28 March 2025
Abstract:
This research looks at how audit quality affects the cost of capital at many phases of the company life
from 2012 to 2014. The independent variable is audit quality; the dependent variable is capital cost. The study
investigates how audit quality affects the cost of capital throughout the stages of the company listed on the stock
exchange, including growth, maturity, and decline. The results reveal a noteworthy link between capital cost and
audit quality. High audit quality improves investor trust in the expansion phase, therefore lowering capital expenses.
Financial stability and openness help companies in the mature stage, therefore enhancing the negative association
between audit quality and capital expenditures. Financial difficulties, however, restrict the efficacy of audit quality
in lowering capital expenses during the declining period. The research emphasizes the need of good auditing in
reducing information asymmetry and thereby decreasing financing costs at many phases of business life. Investors,
regulatory authorities, and financial managers trying to maximize capital structure choices depending on company
lifecycle dynamics might find great value in these ideas.
Keywords:
Audit Quality, Cost of Capital, Corporate Life Cycle, Financial Transparency, Investment Decisions.
Introduction:
For creditors, investors, and other
stakeholders in today's financial climate, dependability
of
financial
information
and
openness
are
prerequisites for making economic decisions. Ensuring
the reliability of financial accounts, thus minimizing
information asymmetry, and so lowering the cost of
financing for businesses depend on audit quality in
great measure. A basic financial statistic that affects
investment choices, corporate finance plans, and
general company sustainability is capital's cost.
With respect for the business life cycle, this research
investigates the link between audit quality and capital
cost. Businesses go through many phases: growth,
maturity, and decline; each influences financing costs,
investor confidence, and financial reporting quality
differently. High-quality audits may boost investor
confidence and lower capital costs in growth and
maturity phases; yet, their efficacy may fade in the
declining phase from financial difficulty and unstable
markets.
Though much is already known about audit quality and cost
of capital, little study has looked at how this link changes
over many corporate life cycle phases. Knowing these
dynamics can help financial analysts, legislators, and
business managers create sensible financial plans and rules
by means of important knowledge.
This study is to investigate, using empirical data and
statistical modeling to evaluate the relevance of audit
quality, how it affects the cost of capital during corporate
life cycle phases. The results will support scholarly debates
on corporate finance and auditing by providing useful
consequences for enhancing financial openness and
investment decision-making.
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International Journal of Management and Economics Fundamental (ISSN: 2771-2257)
2.
Literature and theoretical framework of research
Financial and accounting literature has much to say
about the link between audit quality and capital cost.
Reducing information asymmetry, increasing financial
transparency, and bettering investment decisions all
depend on audit quality in some basic sense. As a
fundamental financial indicator, the cost of capital
shows the return investors need to pay for funding a
firm. At certain phases of a company's existence, this
connection changes and influences the financial
success and stability of companies. Theoretically based
on earlier study results on audit quality, cost of capital,
and the effect of the corporate life cycle on this
connection, this part investigates.
Audit quality
A fundamental component of business governance,
audit quality shapes investor trust and financial
statement reliability. A good audit offers reasonable
confidence that financial statements are free from
significant misstatements, therefore lowering financial
risks and increasing market efficiency. Audit quality is
influenced by many elements as shown in Figure (1),
including larger audit companies, which are often linked
with stronger resources, competence, and reputation,
which helps explain their greater audit quality. Higher audit
fees might point to a more comprehensive audit process,
but depending too much on audit fees from one customer
may threaten auditor independence. Type of audit report:
A qualified or negative audit opinion indicates possible
financial issues, therefore influencing investor impressions
and the cost of capital of a firm. Research show that good
audit quality lowers information asymmetry and risk
perception, hence lowering capital costs. D'Angelo (1981),
for instance, discovered that companies under the scrutiny
of more established, bigger audit firms show more financial
openness and reduced financing costs.
Figure (1): Elements that influenced the audit quality
Cost of capital
For debt and equity investors, the cost of capital is their
needed return on investment. In financial decision-
making, it is a major predictor of a company's capacity
to attract money, grow activities, and maintain
profitability. Important elements of the capital cost
consist of cost of equity often shaped by financial
disclosure quality and risk perception, this is the
anticipated return for owners. Debt cost A company's
creditworthiness and risk profile will determine the
interest rate charged on borrowed money. Previous
studies show that companies with more financial
openness and strong audit quality often have lower
capital cost. Improved disclosure policies, according to
Kothari et al. (2001), decrease the risk premium investors
demand, therefore reducing the total capital costs.
Corporate life cycle and its impact on audit quality and
cost of capital
Companies go through many phases of life: development,
maturity, and decline each of which influences their capital
structure, risk profile, and financial reporting policies.
Growth stage because of perceived risk, young businesses
can pay more for capital. At this point, good audits may
boost reputation and attract investors, hence lowering
capital expenses. Established companies benefit from
financial stability and investor confidence, which results in
Audit
Quality
Environmental factors
(current government,
laws, regulations, etc.)
Outputs (auditor report,
auditor notices, etc.)
Inputs (audit criteria,
auditor characteristics,
audit process, etc.)
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a more significant negative association between audit
quality and capital expenditures. Decline stage
companies find it difficult to get suitable financing
conditions due to financial crisis and declining investor
trust, therefore restricting the influence of audit
quality on cutting capital expenses. Defond and Zhang
(2014) underlined that as they depend on investor
trust to get money, companies in the development
stage gain more from good audits. On the other hand,
companies in the declining phase find it difficult to use
audit quality to lower financing costs because of higher
financial risks.
Theoretical framework
Grounded on the following theoretical stances, Agency
Theory (Jensen & Meckling, 1976) holds that by
lowering information asymmetry between managers
and investors, thus lowering capital costs and
mitigating agency conflicts. High-quality audits,
according to Signaling Theory (Spence, 1973), act as a
good signal to investors, therefore improving business
value and lowering capital costs. Emphasizing the role
audit quality plays in meeting the interests of many
stakeholders including creditors, regulators, and
investors. Stakeholder Theory (Freeman, 1984) helps
to explain financial success. These theoretical
underpinnings help to support the theory that
corporate finance choices are greatly shaped by audit
quality and that information asymmetry's related
dangers are minimized.
Research background
Reviewing past studies becomes essential in
comprehending the actual background and the
developing div of literature on the topic after
analyzing the theoretical ideas about audit quality, cost
of capital, and the corporate life cycle. This part
compiles local (Persian) as well as worldwide research
on the link between audit quality and the cost of
capital, along with the impact of the corporate life
cycle on this link. This evaluation seeks to provide a
thorough framework that facilitates the identification
of research gaps the current work attempts to fill.
International studies
Fan (2020) investigated how financial restrictions
affected the cost of equity capital, showing a
substantial positive link between financing restrictions
and capital costs; financial equity was thus very
important in mediating this influence. Financial report
quality is clearly correlated, according to Zhou et al.
(2022) with both investment efficiency and capital
cost. Their results imply that improved disclosure
quality improves the accuracy of financial decisions. Liu
& Visaki (2017) looked at the link between capital cost
and information quality using a cross-sectional
analysis. They discovered that the cost of capital and
accrual quality show a substantial relationship. In 2009
Acharya et al. looked at the links between profits quality
and capital cost. By means of analytical approaches, they
showed how knowledge asymmetry shapes the cost of
equity capital, therefore affecting its quality. Lee, Tsouk,
Taylor, & Rouge (2009) investigated, via auditor reputation,
both direct and indirect impacts of audit quality on the cost
of capital. Their results underline how important auditor
confidence is for influencing investor impressions and
financing costs.
National studies
Apart from foreign research, local studies provide a whole
picture of how audit quality affects the capital cost of
Iranian corporations, In "Investigating the Moderating Role
of Political Communication in the Relationship Between the
Risk of Stock Price Decline and Cost of Capital in Companies
Listed on the Tehran Stock Exchange," Esmaeili (2022)
discovered that political risk and political communication
have a strong negative correlation with the cost of capital.
The findings also showed that political communication
serves as a mediator, therefore affecting the degree of the
link between corporate cost of capital and declining stock
price risk.
In his 2019 paper "Examining the Relationship Between
Information Disclosure, Company Growth, and the Cost of
Capital," Hosseini Omran came to the quite strong positive
correlation between firm growth and cost of capital. The
analysis revealed, nonetheless, no statistically significant
correlation between disclosure and cost of capital. Using
descriptive and inferential statistical techniques, Nasirpour
(2000), in his dissertation "Investigating the Effect of
Company Size on the Cost of Capital in Tehran Stock
Exchange Companies for the Period 1999-2000," examined
the effect of business size on capital costs. The results
revealed no statistically noteworthy correlation between
Tehran-listed companies' capital cost and business size.
Research gap and current study contribution
No study, either local or international, has particularly
looked at the link between audit quality and capital cost
throughout many phases of the company life cycle as noted
in past studies. Although current studies have looked at
audit quality, capital cost drivers, and business
development, none have combined these elements into a
coherent model. Therefore, especially in the framework of
the Iranian corporate environment, this study attempts to
partly close this research gap by examining the interaction
between audit quality and the cost of capital within the
corporate life cycle. Policymakers, investors, and business
managers trying to maximize financial decision-making by
means of high-quality audits and capital cost control should
find great value in the results.
Research hypothesis
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International Journal of Management and Economics Fundamental (ISSN: 2771-2257)
The following hypotheses have been developed based
on the theoretical framework and past research
stressing the need of audit quality in lowering the cost
of capital and evaluating the effect of the corporate life
cycle on this link. These hypotheses seek to investigate
the variations in the influence of audit quality on the
cost of capital at many phases of business life. These
are the study hypotheses:
1.
At certain phases of the business life, the
effect of audit quality on the cost of capital varies
greatly.
2.
Audit quality significantly correlates with
capital cost throughout the expansion phase.
3.
Audit quality has a strong correlation with
capital cost throughout the mature period.
4.
Audit quality clearly correlates with capital
cost during the declining period.
METHODOLOGY
Empirical model and study design
This paper will use a multiple regression model as
described below to evaluate these assumptions. The
model is intended to evaluate how audit quality affects
the cost of capital at many phases of the company life.
Data collection methods
The research makes use of secondary data sources
mostly from financial statements and reports from
publicly traded corporations. The main data sources
from Tehran Stock Exchange (TSE) databases, Tadbir
Pardaz and Rahevard Navin financial information
systems, publicly available corporate financial
disclosures, and regulatory reports and market
research. Variables indicating audit quality, cost of
capital, and corporate life cycle categorization have
been constructed by use of financial and auditing data.
Sample selection and population
This study's target demographic comprises Tehran
Stock Exchange (TSE) listed enterprises. Based on the
following criteria, a method of systematic sampling
was used: Companies had to have been constantly
listed on the TSE between 2013 and 2021. Trading
restrictions should not have lasted more than six
months for any company. Every company's financial
year should finish on March 29 to guarantee uniformity
of data. Different financial arrangements caused
companies in the financial and investment sectors that
is, banks, insurance, and financial institutions to be
excluded. Following these criteria results in 124
companies guaranteeing enough representation at
many phases of company existence.
Research variables and econometric model
The association between audit quality and cost of capital
throughout many business life cycle stages is investigated
using a multiple regression model in this paper. Defined as
both dependent and independent variables are as follows,
A-
Dependent Variable
Cost of Equity (COE): Measured using Gordon Growth
Model
Costofequityit=E(EPSt+1)/Pt
Where:
E(EPSt+1) = Expected earnings per share in the next
financial period
Pt = Market price of stock at the end of the previous
period
B-
Independent Variables:
•
Audit Quality (AQ): Measured using multiple
proxies
1.
Audit Firm Size Large firms (Big 4 equivalents) vs.
smaller firms.
2.
Audit Fees Log-transformed audit fees extracted
from financial reports.
3.
Auditor Rotation Whether the firm has changed
auditors (binary: 1 = yes, 0 = no).
4.
Audit Opinion Type Modified vs. unmodified
opinions.
C-
Control Variables:
To evaluate how audit quality affects the cost of capital, the
research combines numerous important financial factors.
Measuring the percentage rise in revenue over a certain
time, Firm Growth (EG) reflects the company's expansion
rate. Representing the company's market capitalization,
Firm Value (FW) shows its whole value on the stock market.
The development in total assets indicates the capacity of
the company to increase its resource base and so
determines asset growth (AG.). The debt-to-equity ratio
captures financial leverage (LEV), therefore stressing the
company's dependence on outside funding in comparison
to its equity. Finally, Firm Size (SIZE) is computed as the
natural logarithm of total assets, therefore offering a
uniform gauge of the size and economic impact of the
business.
Classification of Corporate Life Cycle
Using a categorization system modified by Anthony and
Ramesh (1992), companies are arranged into three
corporate life cycle phases depending on financial data. The
stages include large revenues, large capital expenditures,
and low dividend distribution, which define the Growth
phase. Phase of maturity, moderate dividend payment,
steady capital expenditure, slow expansion. Decline phase,
high dividend payment; little or negative growth falling
investments. Principal component analysis (PCA) based on
increases in sales, ratio of capital expenditure, dividend
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paying ratio and firm age. Companies are placed in one
of the three life cycles using a composite score.
Hypothesis Testing and Analytical Methods
Regression analysis will help to evaluate the
hypotheses by capturing firm-level fluctuations across
time. Statistical methods are used, Descriptive
statistics include mean, standard deviation, and key
variable distribution. Stationarity tests include Levin-
Lin-Chu and Im-Pesaran-Shin unit root tests Variance
Inflation Factor (VIF) study in multicollinearity check.
Breusch-Pagan test for variance consistency in
heteroskeasticity. Fixed against random effects
Hausman test in model selection. EViews and Excel are
used in the analysis for statistical calculations. The
hypothesis testing approach used draws on the
framework established by Zhou et al. (2022) and
Pirsakis & Aitredes (2015):
Costofequityit=β0+β1AQit+β2EGit+β3FWit+β4AGit+β
5LEVit+β6SIZEit+εit
Where:
AQ = Audit Quality
EG = Growth Rate
AG = Institutional Value
FW = Firm Value
LEV = Financial Leverage
SIZE = Firm Size
For every step of the business life cycle, the
aforementioned econometric model will be approximated
to properly assess the research hypotheses.
RESULTS
Descriptive analysis
The descriptive data for the main variables utilized in this
study are shown in table 1, cost of equity, audit quality, firm
growth, firm value, asset growth, financial leverage, and
business size. The statistical tests include mean (average
value), maximum value, lowest value, standard deviation
(measure of dispersion), and Jarque-Bera probability used
to evaluate normality.
Table 1: The descriptive data for the main variables
Variable
Mean Max
Min
Std
Dev
Jarque-Bera
Probability
Cost
of
Equity
(Costofequity)
0.19
1.34
0.001 0.20
0.0001
Audit Quality (AQ)
0.265 1.00
0.00
0.44
0.0000
Growth
Opportunities
(FW)
0.47
0.99
0.016 0.25
0.0001
Growth Rate (EG)
0.40
1.14
-0.63
0.38
0.0001
Financial
Leverage
(LEV)
2.15
9.85
0.10
1.56
0.0001
Firm Value (AG)
0.26
0.31
0.22
0.01
0.0001
Firm Size (SIZE)
0.13
0.18
0.10
0.01
0.0001
The Jarque-Bera probability values are all near 0.0001, indicating that the data distributions deviate from
normality.
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Significance of Research Variables
By use of many statistical methods, Table (2) shows the
statistical significance tests for the main research
variables, therefore assessing their effect on the dependent
variable of the study. The findings show whether every
factor appreciably helps to explain variances in the capital
cost.
Table 2: Testing the Significance of Research Variables
variable
Name
Levin,
Lin &
Chu
Test
Statistic
Levin, Lin
&
Chu
Test
Probability
Fisher
Test
Probability
Fisher
Test
Statistic
Phillips-
Perron
Test
Probability
Result
Cost
of
Equity
-6.32
0.0001
0.31
256.7
0.33
Non-
stationary
Audit Quality -1.67
0.046
0.49
237.5
0.52
Non-
stationary
Growth
Opportunities
-7.68
0.0001
0.47
249.5
0.46
Non-
stationary
Growth Rate -4.57
0.0001
0.0001
463.5
0.0001
Stationary
Financial
Leverage
-6.91
0.0001
0.0001
247.3
0.50
Stationary
Firm Value 2.37
0.99
0.97
155.2
0.99
Non-
stationary
Firm Size
19.38
0.0001
0.0001
31.53
0.0001
Stationary
The results imply that certain variables such as Growth
Rate, Financial Leverage, and Firm Size are stationary
that is, ideal for inclusion into the regression model.
Non-stationary factors (e.g., Cost of Equity, Audit
Quality, Growth Opportunity, and Firm Value) abound
in this time as well.
Ensuring the validity of the econometric model and
enhancing the accuracy of hypothesis testing
concerning audit quality, business characteristics, and the
cost of capital across many corporate life cycle phases
depend on this study.
Description of the Kao Test Results
The Kao Co-integration test findings which evaluate
whether audit quality and the cost of capital have a long-
term connection throughout many business life cycle
phases growth, maturity, and decline phases are shown in
the Table (3).
Table (3): Kao Co-integration test
Model Number
t-Statistic
Probability (p-value)
Model 1 (Growth Phase) -2.6942
0.0035
Model 2 (Maturity Phase) -2.2876
0.0032
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Model 3 (Decline Phase) -4.5462
0.0001
These findings confirm the theory that, with diverse
degrees of effect, audit quality clearly affects capital
costs at many phases of the company life.
The correlation between independent variables
Table (4): Spearman correlation test
Variable
Audit
Quality
Growth
Opportunities
Growth
Rate
Financial
Leverage
Firm
Value
Firm
Size
Audit Quality
1
p-value
----
Growth
Opportunities
-0.14
1
p-value
0.0001 ----
Growth Rate
-0.19
0.21
1
p-value
0.0001 0.0001
---
Financial
Leverage
0.002
0.20
0.015
1
p-value
0.9368 0.0001
0.6792
---
Firm Value
-0.004 -0.068
-0.011
-0.027
1
p-value
0.9115 0.0607
0.7490
0.4518
---
Firm Size
-0.11
0.46
0.040
0.11
-0.029
1
The significance levels p-values confirm that certain
correlations are statistically significant (p < 0.05) and
others are not, thereby suggesting maybe little
influence in regression analysis. This correlation matrix
guarantees that independent variables do not overlap
in predictive models and helps find multicollinearity
problems.
Testing the type of the compound data pattern
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Table (5): Results using Limer F-Test and Hausman Test
Model
Number
Limer
F-
Test
Statistic
Limer
F-
Test
Probability
Hausman
Test
Statistic
Hausman
Test
Probability
Result
Model
1
(Growth
Phase)
2.2337
0.0001
6.4760
0.0026
Fixed
Effects
Model
Model
2
(Maturity
Phase)
2.2193
0.0001
5.4606
0.0023
Fixed
Effects
Model
Model
3
(Decline
Phase)
2.2212
0.0001
6.1938
0.0078
Fixed
Effects
Model
This method is used in the research to investigate the
effect of audit quality on cost of capital throughout
many corporate life cycle phases as both Limer F-test
and Hausman test findings support the Fixed Effects
Model. By use of unobserved firm-specific effects, this
approach guarantees more exact estimates.
Description of the Regression Results
The results of the regression analysis are shown in this table
6,7 and 8, which clarifies the influence of audit quality and
other financial factors on the cost of capital throughout this
period.
Table (6): Final test results for the first model in the period of corporate growth
Variable
Coefficient
t-Statistic
Probability
(p-
value)
Audit Quality (AQ)
-0.277
-4.39
0.0001
Growth Opportunities
(FW)
-0.014
-0.96
0.3359
Growth Rate (EG)
-0.013
-2.78
0.0051
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Financial
Leverage
(LEV)
0.10
6.42
0.0001
Firm Value (AG)
-0.011
-4.23
0.0001
Firm Size (SIZE)
-0.015
-2.24
0.0062
Constant (Intercept)
0.78
2.15
0.0001
The model shows generally that although financial
leverage raises capital cost, growth rate, business size,
and firm value help to lower financing costs; audit quality
greatly decreases the cost of capital in the growth phase
.
Table (7): Final results for the second research model for the companies' eligibility period
Variable
Coefficient
t-Statistic
Probability
(p-
value)
Audit Quality (AQ)
-0.072
-3.98
0.0001
Growth Opportunities
(FW)
-0.004
-0.93
0.3503
Growth Rate (EG)
-0.004
-2.80
0.0084
Financial
Leverage
(LEV)
0.24
5.44
0.0001
Firm Value (AG)
-0.39
-0.009
0.9924
Firm Size (SIZE)
-0.017
-5.29
0.0000
Constant (Intercept)
0.75
2.331
0.0001
The maturity phase model shows that whilst financial
leverage raises capital's cost, audit quality greatly
lowers it. While growth prospects and business
valuation have no bearing on the cost of capital during
this period, growth rate and firm size do help to lower
financing costs. These results confirm that, with leverage
being the key cost driver, audit quality is essential in
preserving reduced capital costs as companies grow.
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Table (8): Results of the final test of the second sub-hypothesis
Variable
Coefficient
t-Statistic
Probability
(p-
value)
Audit Quality (AQ)
-0.08
-2.75
0.0092
Growth Opportunities (FW) -0.003
-1.98
0.0494
Growth Rate (EG)
0.004
0.94
0.3426
Financial Leverage (LEV)
0.12
5.92
0.0001
Firm Value (AG)
-0.10
-3.102
0.0003
Firm Size (SIZE)
-0.012
-2.20
0.0017
Constant (Intercept)
0.69
2.32
0.0001
Even in financial crisis, the declining phase model
demonstrates that audit quality is a crucial
determinant of capital cost reduction. Financial
leverage, however, greatly raises capital expenses;
business size and value assist to reduce financing risks.
These results underline the need of firms in decline to
maintain high audit quality and control their debt to
maximize their cost of capital.
Clarify the results according to the hypotheses
The first hypothesis indicate the results to the
existence of a statistically significant difference
between the cost of capital and the quality of auditing
in the stages of the companies' life cycle, and it is clear
from this that the quality of auditing has a major role
in reducing the cost of capital.
The second and third hypotheses in the growth stage,
the positive impact of auditing quality was more evident,
which led to enhancing investor confidence as well as
significantly reducing the cost of capital. These results are
consistent with the study of Perkis and Lodris 2015, which
confirms that auditing quality reduces the cost of capital.
The fourth hypothesis in the decline stage (retreat), the
results showed that the impact of auditing quality was
weak due to the challenges facing companies (low liquidity
and resources).
Practical recommendations in consideration of the results
The following useful suggestions are made based on study
results to improve audit quality and lower capital cost,
particularly in the expansion stage, audit firms should
concentrate on raising audit quality as it significantly
influences capital cost reduction and investor trust
increase.
1-
Emphasizing the function of audit systems
encouragement of cooperation among firms, auditors,
and investors to guarantee the delivery of high-quality
financial reports helps to lower the cost of capital by
thus ensuring their respective roles.
2-
Considering the corporate life cycle to guarantee
more efficient financial management, financial choices
should consider the many phases of the life cycle of a
company growth, maturity, and decline.
3-
Encouragement of transparency will help all
corporate stakeholders to reveal the quality of their
financial reports at every level of the business life,
therefore guaranteeing more market confidence and
stability.
These suggestions seek to maximize capital management
within companies, boost investor trust, and streamline
financial decisions.
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