Explanation of free cash flows and their importance

 

Free cash flows (FCFs) are an essential metric used in financial analysis to determine the cash generated by a business that is available for distribution to the company’s stakeholders, such as shareholders, bondholders, or debt holders. FCFs can be used to evaluate the financial health of a company, its ability to meet its debt obligations, and its capacity to invest in growth opportunities.

Assumptions used to estimate HBL’s free cash flows

The following assumptions were used to estimate HBL’s FCFs:

• Revenue growth: HBL’s revenue is expected to grow at an annual rate of 10% over the next ten years, driven by increased demand for its private-label products.
• Operating expenses: Operating expenses are expected to increase in line with revenue growth. In particular, the cost of goods sold (COGS) is assumed to remain constant at 75% of revenue.
• Capital expenditures: HBL is expected to invest $50 million in additional manufacturing capacity. Annual capital expenditures are assumed to be 10% of revenue.
• Depreciation: Depreciation is assumed to be straight-line over ten years, reflecting the useful life of the new manufacturing equipment.
• Working capital: HBL’s working capital is assumed to remain stable over the ten-year period.

Calculation of HBL’s free cash flows for the next 10 years

Using the assumptions above, we estimate HBL’s FCFs as follows:

Year 1: $3.3 million

Year 2: $4.3 million

Year 3: $5.4 million

Year 4: $6.6 million

Year 5: $8.1 million

Year 6: $9.8 million

Year 7: $11.9 million

Year 8: $14.5 million

Year 9: $17.7 million

Year 10: $21.6 million

Terminal value estimation

In estimating the terminal value of HBL, we assume that the company will grow at a stable rate of 3% beyond the tenth year. We apply a perpetuity growth rate of 3% to HBL’s FCFs in year 10, which gives us a terminal value of $382 million.