I have attached the case study and the rubric for this. can I get help here to organzie an answer?

CATERPILLAR, INC: THE IMPACT OF DECISION BIASES AND RISK ON CAPITAL BUDGETING Timothy D. West Associate Professor Grant Thornton Faculty Fellow Northern Illinois University Tammy R. Waymire Assistant Professor Northern Illinois University Corresponding author: Timothy D. West tdwest@niu.edu 815.753.6252 (Office) 314.660.3924 (Cell) Electronic copy available at: http://ssrn.com/abstract=2132944 CATERPILLAR, INC: THE IMPACT OF DECISION BIASES AND RISK ON CAPITAL BUDGETING In many respects, capital budgeting decisions define an organization's leadership. Capital budgeting decisions establish strategic priorities, allocate resources and establish accountability. The scope of these capital investment decisions requires managers to assemble and communicate information across traditional organizational boundaries, e.g., marketing, engineering, production, and accounting. The information is evaluated within a rational cost/benefit decision framework by analyzing cash inflows and outflows over time. Typically, capital budgeting analysis accommodates an investment's relative riskiness by discounting estimated cash flows using riskadjusted discount rates in net present value (NPV) and internal rate of return (IRR) models. Alternatively, simple payback models also supplement more sophisticated NPV and IRR analyses. Regardless of method, however, capital budgeting decisions require managers to use their judgment when essentially predicting the future, i.e., what will future sales levels be, how costs will change, and what uncertainty will the project face. Managers at the Caterpillar plant in Aurora, Illinois were facing a request from senior executives at the home office in Peoria, Illinois for a \"Footprint Study\" - Identify the best global source (location) for production of the company's new hybrid/electric exoloader. Caterpillar engineers in conjunction with marketing strategists identified global sales opportunities for the exoloader - a new line of dual purpose equipment that functionally combines two existing product lines: (1) excavators, i.e., rapid, medium volume digging capability, and (2) loaders, i.e., high mobility, large volume lifting capability. The goal of the study was to provide global exoloader production capacity, create a new market niche and improve enterprise profitability. Company executives believed that the exoloader would prove especially attractive to potential customers in emerging markets with limited resources who needed the functionality provided by Caterpillar's excavator and loader machines. Accordingly, the capital budgeting analysis for the footprint study would consider sales opportunities in emerging markets, local labor costs, logistics costs across hemispheres, additional supply chain costs and investment costs. Currently, Page 1 Electronic copy available at: http://ssrn.com/abstract=2132944 excavator production was centered in two locations - Akashi, Japan (near Kobe) and Aurora. The plants produced products for five excavator product lines: mini, small, medium, and large excavators plus an ultrahigh demolition (UHD) line.1 Loader production utilizes facilities in Aurora, Belgium, Brazil and China. As part of North American loader production, the Aurora plant produced components for various loader product lines. Because the Aurora facility was familiar with both excavator and loader production, senior executives in Peoria assigned Aurora plant executives the task of completing the footprint study. The results of the study would directly impact these communities and perhaps other communities Caterpillar might consider as possible locations for a new exoloader production facility. Caterpillar's DecisionMaking Environment As the global industry leader in the design, manufacture and sales of construction, mining and forestry machinery, the worldwide economic crisis proved painful for Caterpillar. As shown in Table 1 - Panel A, 2009 revenues dropped over 30 percent compared to 2008 levels. Ultimately, the company had to focus on prioritizing investments opportunities that would yield the best return. Returns that should be adjusted to reflect the risks associated with each investment alternative. In 2005, company leadership established Vision 2020 - the strategy to align company decision making for the next 15 years. As described in a June 8, 2010 press release, Caterpillar updated its strategy and provided a vision of the future where (See Figure 1 for the company's revised Vision 2020 model): 1. 2. 3. 4. 5. 6. Caterpillar is the recognized leader everywhere we do business. Our products, services and solutions help our customers succeed. Our distribution system is a competitive advantage. Our supply chain is recognized as world class. Our business model drives superior results. Our people are talented and live Our Values in Action (Integrity, Excellence, Teamwork and Commitment). 7. Our work today helps our customers create a more sustainable world. 8. Our financial performance consistently rewards our stockholders. 1 The city of Akashi has a population of approximately 300,000, while the city of Aurora (a western suburb of Chicago) has a population of approximately 200,000. The plants are just over 9,000 miles apart and a time difference of 14 hours (when it is 9:00AM in Aurora it is 11:00PM in Akashi). Page 2 Electronic copy available at: http://ssrn.com/abstract=2132944 In the same press release, the company identified three areas in which success will be measured: financial (earnings per share growth, operating profit after capital charge - OPACC, and cash flow, people (talent development, worldclass safety and inclusion), and market leadership (product quality, percent of industry sales - PINS, and aftermarket parts growth). As Chairman and CEO Doug Oberhelman indicated: From a stockholders perspective, our goals are focused on delivering total shareholder returns over the business cycle in the top 25 percent of the S&P 500. To do that, I believe we need to deliver compound annual earnings per share growth of 15 to 20 percent over the business cycle. The strategic direction was clear, invest in high return projects that leveraged the company's distribution system and supply chain expertise to increase global market share and return superior earnings and cash flows, while simultaneously mitigating risk factors that could undermine success. Caterpillar's Global Marketplace The company focuses on delivering products that help solve customers' problems by providing a full line of products that meet the endcustomers' needs. Sales essentially occur through two channels - sales through its dealer network, and direct customer sales (confined to unique large customer such as governments). As shown in Table 2, Caterpillar operates in four reportable product lines: (1) machinery sales in construction industries (infrastructure and building construction applications), (2) machinery sales in resource industries (mining and quarrying applications), (3) power systems (engines, turbines and replacement parts across a variety of industries) and (4) financial products (financing for customers and dealers to purchase and lease Caterpillar equipment). Exoloader production essentially creates a new line of products within the construction industries segment that bridges the earthmoving/loader and the excavation product lines. Caterpillar products are sold in four geographic regions: North America, Latin America, Europe AfricaMiddle East (EAME) and Asia/Pacific. As shown in Table 2 - Panel A, in 2011, North American sales and revenues accounted for almost 36 percent of the company's total sales and revenues (down Page 3 from 38% in 2010). North America also was home for just over 44 percent of Caterpillar's employees and not quite 30 percent of its dealers. However, regional sales growth over the past four years highlights the importance of emerging markets (see Table 3 - Panel B). The 4year compound annual growth rate (CAGRs) show sales in the Asia/Pacific region have increased at an annual rate of almost 20 percent. Moreover, Latin America has experienced sales growth of just over 12 percent. The North America and EAME regions, however, have shown sales declines during the same period. As Caterpillar executives say, \"The need for infrastructure drives our sales - countries in Asia and Latin America need infrastructure.\" Caterpillar's World Class Supply Chain Caterpillar operates a fully integrated global sourcing supply chain. As shown in Figure 2, the company's supply chain typically stretches from the suppliers to the \"point of use.\" Essentially, Caterpillar must manage relationships with three types of suppliers: (1) raw material suppliers, (2) external suppliers - external to Caterpillar, and (3) internal suppliers - Caterpillar divisions that provide key component parts. Steel plates represent the dominant raw material used in exoloader production. Typical shipments consist of approximately 5 to 20 plates that collectively weigh more than 20 tons (plate weight depends on plate thickness). External suppliers provide highly engineered components like circuit boards. To maintain the highest levels of quality control, internal suppliers provide machine critical components such as engines and transmissions. The planned production process consists of seven general steps from cutting/prepping raw materials for production, to assembly and inspection. A key aspect of the supply chain involves the logistics of bringing the right materials and labor, to the right place, at the right time, to make the right products. Logistics costs associated with the exoloader could make or break product line profitability. Ultimately, logistics questions within the supply chain can be framed as follows - which alternative is less costly: Page 4 1. North American production: Incur the higher costs associated with shipping finished exoloaders to customers/dealers in the emerging Asian and South American markets and reduce the costs associated with acquiring and coordinating the raw materials and component parts used in production, or 2. Asian production: Incur the higher costs associated with acquiring and coordinating the raw materials and component parts used in production and reduce the costs associated with of shipping finished exoloaders. Moreover, the steps in the production process require a highly trained workforce. The decision to build a new production facility in Asia would beg the question - What will worker training cost in Asia and perhaps will cultural differences result in unexpected costs? The Footprint Study By introducing the exoloader, Caterpillar is creating a new market niche. Significant competition, however, already exists from existing makers of excavators and loaders. The competition places significant downward pressure on projected operating margins. The footprint study would need to focus on eliminating/reducing the overall production and delivery costs throughout the supply chain. The Scenarios The team responsible for the Footprint study considered a variety of options and decided that two scenarios offered the greatest potential. Scenario A involved expanding and refocusing an existing production facility to accommodate the new exoloader production volumes. A facility in Japan was considered, however, the location was essentially land locked and offered little if any potential for expansion. An alternative involved the Aurora production facility. The team believed that the Aurora location could be reconfigured to effectively handle exoloader production; however, questions remained concerning the potentially lengthy delivery times required to meet product demand in Caterpillar's growth markets. Scenario B focused on building a new production facility in China. Under this scenario, exoloader delivery times for would be reduced in Asian markets, however, the team had concerns about delivery times to South America. Moreover, questions emerged concerning how to best coordinate the delivery Page 5 of raw materials and component parts from global suppliers to a Chinese facility. Ultimately, Caterpillar must stand behind its products regardless of where production occurs. The team had concerns about overall costs and production quality given the extensive coordination of activities required throughout the supply chain. Basic Assumptions The assumptions developed by the Footprint study team fall into four major categories: (1) benefits (sales) - see Table 3: Panel A, (2) operating costs - see Table 3: Panel B, (3) freight and duty costs - see Table 4, and (4) capital spending - see Table 5. The assumptions were developed through discussions with a wide range of Caterpillar managers, government officials (in the U.S. and China), suppliers and logistics experts (inside and outside Caterpillar). Risk and the Hurdle (Discount) Rate As a starting point, companies often determine the discount rate by computing the weighted average cost of capital (WACC). A WACC calculation requires a company to determine its cost of debt (aftertax interest rates on short and longterm debt) and cost of equity (both preferred and common stock). The resulting WACC serves a proxy for the company's discount rate on \"average\" risk projects. The rate should be adjusted to reflect project specific risk factors, i.e., higher (lower) risk increases (decreases) the discount rate. NOTE: To obtain a simple estimate of Caterpillar's WACC, access the ValuePro website (http://www.valuepro.net/) and enter the company's ticker symbol (CAT). Caterpillar management has committed to investing in projects that generate an economic profit: accounting profit minus a \"capital charge.\" The discount rate used to analyze competing investment alternatives serves as the basis for establishing a capital charge - the riskadjusted return required on an investment. Accordingly, when product line managers were evaluating exoloader footprint options, decisions were made about how best to adjust the WACC for various optionspecific risk factors. Page 6 Caterpillar's Capital Budgeting Template Similar to most large, capital intensive companies, Caterpillar uses a standardized capital budgeting template to evaluate investment alternatives. A standardized model offers several benefits: 1. Consistency in analysis - A template requires that all projects apply the basic capital budgeting tools consistently and creates a common terminology for evaluating investment alternatives. 2. Consistency in assumptions - A template creates a reminder of the key assumptions project sponsors must address when preparing the capital budget. Costs and benefit categories are specified and hurdle rates must be justified. 3. Objectivity - A template provides a basis for rational and objective decision using a cost/benefit framework. Investment priorities are established based upon the relative \"return\" provided by competing projects (i.e., investment alternatives compete for limited financial resources). 4. Ease of review - A template enables a comparable review of dissimilar projects by top management. By having comparable analyses across competing projects, top managers can evaluate projects more effectively and efficiently. On the surface, the decision to \"fund\" the highest return projects appears fairly straightforward based upon results from the standardized capital budgeting analyses. However, capital budgeting requires managers to develop many assumptions, assumptions that potentially are subject to specific biases that influence managers' judgments. For example, capital budgeting decisions can be influenced by decision makers' escalation of commitment, i.e., a continued commitment to previous decision. In other words, managers could overstate the potential benefits associated with an additional investment to complete a project that has lagged behind initial expectations. A confirmation bias can lead managers to seek only information that supports their position while ignoring disconfirming information. A project sponsor's past success can create overconfidence that can result in overlyoptimistic assumptions. Also, project framing could influence funding decision, i.e., if the project is viewed as a gain managers are risk averse, however, if framed as avoiding a loss managers are risk seeking (Prospect theory). Appendix A provides an overview of the decision biases that can inadvertently impact rational decision making. Accounting professionals must understand how these biases might influence decisions that seem rational on the surface (capital budgeting) but fall prey to potentially flawed assumptions. Page 7 Required: Prepare formal writeups for each question. Start each question on a new sheet of paper and include page numbers in the bottom right corner of each page. Staple all your answers. Include your name in the header of each page. As an Appendix, include the Capital Budgeting Templates you completed for each Scenario. The templates should be in landscape view, however, you can just use the Excel printouts and you do not need to number the pages 1. For each financial statement line item in Table 1, compute the mean, standard deviation, coefficient of variation and CAGR. Also prepare both horizontal and vertical analyses and an annual Dupont analysis for fiscal years 200811. Include a calculation of annual \"free cash flow,\" (net cash flow from operations minus capital expenditures). Prepare a visually impactful graphic that illustrates the key results from your financial analysis. NOTE: Use the Financial Statement Analysis Template provided on Blackboard. 2. Obtain the company's 10K for 2011 and read Items 1A (Risk Factors) and 7 (MD&A). Identify Caterpillar's key risk factors and discuss how those factors might affect specific financial statement line items. How might the company mitigate those risks? 3. Review Caterpillar's capital budgeting template. Develop a list of assumptions embedded in the data needed to complete the template (e.g., sales projections). Prepare a 22 matrix that classifies your assumptions on the following two dimensions: (1) importance of the assumption (high or low), and (2) uncertainty of the assumption (high or low). Provide a comprehensive justification for your classification of these assumptions. NOTE: Download the Capital Budgeting Template from Blackboard. 4. Establish riskadjusted hurdle rates for each plant location scenario. Build the rate by adjusting the companywide WACC for the risk factors considered in item 2 and project uncertainties discussed in item 3. 5. Complete a capital budgeting template for Scenario A (Aurora plant location) and compute the IRR and NPV for the project. Summarize the results of your capital budgeting analyses in a single table that presents your recommendations about the scenario's viability. Also, identify potential factors, if any, which might be missing from the standardized template? 6. Complete a capital budgeting template for Scenario B (China plant location) and compute the IRR and NPV for the project. Summarize the results of your capital budgeting analyses in a single table and present your recommendations about the scenario's viability. Also, identify potential factors, if any, which might be missing from the standardized template? 7. During the semester, we have discussed a variety of decision biases that make rational decision making essentially impossible. Select and define four decision biases and specifically identify how those biases might affect the assumptions used in the capital budgeting templates. Indicate how you might identify the extent to which of those biases exist in the analyses. Discuss how the capital budgeting template AND aspects of the capital budgeting \"process\" might limit the impact of the decision biases in the analysis. 8. Based upon your answers to the previous questions, prepare arguments that support Scenario A. Also, identify counter arguments that you would anticipate for each of your supporting arguments. Page 8 APPENDIX A Overview of Decision Making Concepts and Decision Biases Bounded Rationality In the 1950's, Herbert Simon introduced the concept of bounded rationality; an idea based upon the premise that decision makers' rationality was limited by: (1) problem misspecification (an inability to correctly identify the root cause of problems), (2) information constraints (cost and time required to search for decision alternatives prohibits obtaining \"perfect\" information), (3) cognitive limitations (constraints on the amount of information a decision makers can attend to at one time), and (4) weighting errors (inability to accurately weight the decision criteria and apply the criteria to decision alternatives). Ultimately, decision makers intend to act rationally, however, because of the four limitations discussed above, they often rely on decision heuristics (rulesofthumb) to facilitate decision making. The intendedly rational manager is goal oriented and adaptive to their environment - they want to make rational decision but they cannot always do so. Cognitive limitations and emotions often cause managers to fail when making important decisions (Jones 1999). The reliance on decision heuristics to facilitate and expedite decision making can be both good and bad. For example, expertise gained from performing a task can create a fast and effortless decision process. However, when expertise gain in one area is applied in another context, the application of the underlying decision heuristic can cause poor decisions. For example, a home builder may have great expertise when estimating the cost of building a new home, however, the same decision rules may not apply when the builder decides to bid on commercial building projects. Judgment The cognitive aspects of the decisionmaking process that results the forming of ideas, opinions, or estimates about objects, events, states or other types of phenomenon. Judgments tend to take the form of predictions about the future or an evaluation of a current state of affairs, and judgments also reflect one's beliefs. Decision making Decision making refers to making up one's mind about the issue at hand and taking a course of action. Decisions typically follow judgments and involve a choice among various alternatives. Decisions also reflect preferences for factors such as risk and money. Decision heuristics Decision heuristics represent the rules of thumb (simplifying strategies) managers use when making decisions. For example, what decision rules do you use to select a checkout lane at the grocery store? Or, how \"yellow\" does a traffic light need to be for you to stop from going through an intersection? And, why did the driver in the car next to you go on through the intersection? Heuristics help us cope with complexity in our decision making environments. Experience vs. Expertise Decision makers seldom come to a decision with all the knowledge (information) they need and having the knowledge organized in all the necessary ways (Bonner 2008, 56). Experience represents knowledge gained from exposure to certain situations or perhaps observation of certain activities. The concept of experience tends to focus on insight gained over time or from exposure to similar situations. Alternatively, expertise focuses on the taskspecific ability to perform at a higher level than individuals with less expertise (or novices). Experts use the mental models constructed over time to dictate their actions. As a result, they often need less information, process selected information faster, and generate high quality outcomes. General experience does not equate to expertise. Expertise is task specific and questions remain about how transferable expertise in one domain might be to another domain. For example, LeBron James has great expertise on the basketball court but questions remain about his expertise as a football player. He has a lifetime of experience in athletics, the same physical attributes in both domains but not the same expertise. Managers can take significant risks when they assume their expertise in one decisionmaking area is transferrable to another. Page 9 Glossary of Decision Biases (a Partial List) BIAS DESCRIPTION Biases Associated with the Availability Heuristic 1. Ease of recall Individuals judge events that are more easily recalled from memory, based on vividness or recency, to be more numerous than events of equal frequency whose instances are less easily recalled. 2. Retrievability Individuals are biased in their assessments of the frequency of events based on how their memory structures affect the search process. Biases Associated with the Representativeness Heuristic 3. Insensitivity to base rates When assessing the likelihood of events, individuals tend to ignore base rates if any other descriptive information is provided - even if it is relevant 4. Insensitivity to sample size When assessing the reliability of sample information, individuals frequently fail to appreciate the role of sample size. 5. Regression to the mean Individuals tend to ignore the fact that extreme events tend to regress to the mean on subsequent trials. Biases Associated with the Confirmation Heuristic 6. Confirmation trap Individuals tend to seek confirming information for what they think is true and fail to search for disconfirming evidence. 7. Anchoring Individuals make initial value estimates based upon initially available information and typically fail to adequately adjust from that anchor when making a final value estimate. 8. Overconfidence Individuals tend to be overconfident of the infallibility of their judgments when answering moderately to extremely difficult questions. 9. Hindsight bias After finding out whether or not an event occurred, individuals tend to overestimate the degree to which they would have predicted the correct outcome. In effect, individuals tend to believe that they knew it all along. 10. Curse of knowledge Once individuals know something, they have difficulty accepting that others might not know the same thing. Moreover, the better we become at generating ideas based upon on expertise, the more difficulty we have communicating those ideas to others Additional Decision Biases 11. Affect heuristic Individuals' emotional reaction to their environment influences their decision making. For example, positive affect (good feeling) can lower decision makers risk perceptions. 12. Bounded awareness When faced with information overload, individuals unconsciously and automatically filter out information deemed extraneous. As a result, decision makers fail to notice useful, observable and relevant data. Examples include: inattentional blindness and change blindness. 13. Framing (Prospect theory) Individuals faced with situations framed as gains (positive outcomes) are risk averse, while individuals faced with situations framed as losses (negative outcomes) are risk seeking. For example, consider the behavior of traders in brokerage houses. 14. Escalation of commitment An increasing commitment to a failed course of action. The perception that just a bit more effort (or money) will save a project from failure. Managers frequently lack the willingness to stop a failing project. Also known as the sunk cost phenomenon. 15. Halo effect (Rosenzweig The influence of specific trait or characteristic on an individual's overall perception of another 2007) person or object. For example, if a company is profitable, investors infer that management is doing a good job. NOTE: Perhaps nothing lends itself to the Halo Effect more leadership! 16. Not invented here Individuals often become enamored with their own ideas to the exclusion of potentially better alternatives, i.e., if I (or we) didn't invent it, then it's not worth much. 17. Endowment effect Individuals overvalue what they own or what they have created. For example, home owners think their homes typically are worth more than buyers are willing to pay. 18. Pseudocertainty Individuals value the creation of certainty more than an equal value shift in uncertainty, e.g., individuals will pay more to move from 10% probability of an event occurring to zero, than a similar 10% shift in probability from 20% to 10%. 19. Status quo bias Individuals prefer that things stay relatively the same. A fundamental reason change is hard to achieve and sustain. Page 10 FIGURE 1 Caterpillar, Inc.: Vision 2020 Strategic Focus NOTE: The Vision 2020 graphic was replicated from the original figure in the Chairman's Message included in the 2010 Annual Report. Page 11 FIGURE 2 Supply Chain Overview Page 12 TABLE 1 Caterpillar, Inc: Summary Financial Information Balance Sheet 2006 2007 2008 2009 2010 2011 Total current assets Property, plant and equip (net) Other longterm assets $23,663 8,851 18,935 $25,477 9,997 20,658 $31,633 12,524 23,625 $27,217 12,386 20,435 $31,810 12,539 19,671 $38,128 14,395 28,923 Total assets $51,449 $56,132 $67,782 $60,038 $64,020 $81,446 Total current liabilities Longterm debt (LTD) $19,822 24,768 $22,245 25,004 $26,069 35,102 $18,975 31,763 $22,020 30,675 $28,561 39,483 Total liabilities Total SE (before MI) 44,590 6,859 47,249 8,883 61,171 6,611 50,738 9,300 52,695 11,325 68,044 13,402 Check figure $51,449 $56,132 $67,782 $60,038 $64,020 $81,446 2006 2007 2008 2009 2010 2011 Sales and Revenues: Machinery & equipment Financial products $38,869 2,648 $41,962 2,996 $48,044 3,280 $29,540 2,856 $39,867 2,721 $57,392 2,746 Total sales and revenues 41,517 44,958 51,324 32,396 42,588 60,138 Operating costs: Cost of goods sold Selling & administrative Other 29,549 3,706 3,341 32,626 3,821 3,590 38,415 4,399 4,062 23,886 3,645 4,288 30,367 4,248 4,010 43,578 5,203 4,204 Total operating expenses 36,596 40,037 46,876 31,819 38,625 52,985 Operating Profit Interest Income taxes Other income(expenses) 4,921 274 1,405 295 4,921 288 1,485 393 4,448 274 953 336 577 389 270 437 3,963 343 968 48 7,153 396 1,720 109 Profit $3,537 $3,541 $3,557 $895 $2,700 $4,928 Income Statement Page 13 TABLE 1 (cont.) Statement of Cash Flow 2006 2007 2008 2009 2010 2011 $3,537 1,602 660 $3,541 1,797 2,597 $3,557 1,980 750 $895 2,336 3,268 $2,700 2,296 13 $4,928 2,527 445 5,799 7,935 4,787 6,499 5,009 7,010 1,593 1,082 2,428 1,307 1,700 1,340 2,961 1,593 2,445 1,566 4,314 2,029 1,540 968 2,181 1,173 1,575 1,011 489 502 2,515 1,409 1,127 6,376 Net investing cash flow 3,796 4,408 6,296 846 1,595 11,427 Cash flow from financing: Dividends paid Treasury stock purchased Proceeds from debt issued Payments on debt Other 726 3,208 11,269 10,375 447 845 2,405 11,039 10,888 130 953 1,800 17,930 14,439 2,227 1,029 0 12,291 12,687 3,790 1,084 0 8,324 12,461 608 1,159 0 15,460 10,593 258 2,593 12 2,969 34 2,965 158 5,215 1 4,613 76 3,966 84 Net change in Cash and ST Investments Cash & ST investments Beginning 578 1,108 592 530 1,614 1,122 2,131 2,736 1,275 4,867 535 3,592 Cash & ST investments Ending $530 $1,122 $2,736 $4,867 $3,592 $3,057 Cash flow from operations: Profit Depreciation and amortization Other Net operating cash flow Cash flow from investing: Capital expenditures Expenditures for leased equip Chg in finance receivables (net) Other Net financing cash flow Effect of exchange rates on cash Page 14 TABLE 2 Global View of Operations Panel A: Geographic operations as a % of total Caterpillar operations 2011 Sales & Revenues (in millions): Construction industries Resource industries Power systems Other segments and eliminations Machinery & Power System Sales North America $5,985 4,963 8,331 938 20,217 Latin America $3,045 2,831 2,363 102 8,341 EAME $4,768 3,228 5,752 581 14,329 Asia/ Pacific $5,869 4,607 3,668 361 14,505 Total $19,667 15,629 20,114 1,982 57,392 Financial products Corporate items and eliminations Financial Products Revenues Total 1,687 171 1,516 $21,733 361 29 332 $8,673 438 28 410 $14,739 517 29 488 $14,993 3,003 257 2,746 $60,138 % of Total Sales 36.14% 14.42% 24.51% 24.93% 100.00% Employees CAT Dealers 54,880 55 19,111 31 22,330 56 28,778 49 125,099 191 Sales & Revenues (in millions): Construction industries Resource industries Power systems Other segments and eliminations Machinery & Power System Sales North America $4,108 2,866 6,376 1,172 14,522 Latin America $2,048 1,809 1,900 100 5,857 EAME $2,941 1,737 4,393 524 9,595 Asia/ Pacific $4,475 2,255 2,868 295 9,893 Total $13,572 8,667 15,537 2,091 39,867 Financial products Corporate items and eliminations Financial Products Revenues Total 1,773 202 1,571 $16,093 308 11 297 $6,154 427 427 $10,022 438 12 426 $10,319 2,946 225 2,721 $42,588 % of Total Sales 37.79% 14.45% 23.53% 24.23% 100.00% Employees CAT Dealers 48,540 55 15,220 31 17,753 58 22,977 44 104,490 188 2010 Page 15 TABLE 2 (cont.) Panel A: Geographic operations as a % of total Caterpillar operations (cont.) 2009 Sales & Revenues (in millions): Construction industries Resource industries Power systems Other segments and eliminations Machinery & Power System Sales North America $2,532 2,085 5,093 935 10,645 Latin America $1,087 1,155 1,319 74 3,635 EAME $2,057 1,341 4,405 604 8,407 Asia/ Pacific $2,831 1,276 2,572 174 6,853 Total $8,507 5,857 13,389 1,787 29,540 Financial products Corporate items and eliminations Financial Products Revenues Total 1,968 254 1,714 $12,359 282 14 268 $3,903 495 495 $8,902 394 15 379 $7,232 3,139 283 2,856 $32,396 % of Total Sales 38.15% 12.05% 27.48% 22.32% 100.00% Employees CAT Dealers 43,999 56 10,776 31 16,248 40 22,790 51 93,813 178 Sales & Revenues (in millions): Construction industries Resource industries Power systems Other segments and eliminations Machinery & Power System Sales North America $5,809 3,886 7,395 1,124 18,214 Latin America $2,305 1,528 1,828 19 5,680 EAME $5,461 2,769 6,417 884 15,531 Asia/ Pacific $3,188 2,071 2,988 372 8,619 Total $16,763 10,254 18,628 2,399 48,044 Financial products Corporate items and eliminations Financial Products Revenues Total 2,253 252 2,001 $20,215 342 14 328 $6,008 590 590 $16,121 376 15 361 $8,980 3,561 281 3,280 $51,324 Employees CAT Dealers 54,284 57 14,403 32 17,217 40 26,983 51 112,887 180 2008 Page 16 Panel B: 3Year Compound Annual Growth Rates (CAGRs) from 200811 Sales & Revenues (in millions): Construction industries Resource industries Power systems Machinery & Power System Sales North America 1.00% 8.50% 4.05% 3.54% Latin America 9.72% 22.82% 8.93% 13.66% EAME 4.42% 5.25% 3.58% 2.65% Asia/ Pacific 22.56% 30.54% 7.07% 18.95% Total 5.47% 15.08% 2.59% 6.11% Financial Products Revenues Total 8.84% 2.44% 0.40% 13.02% 11.43% 2.94% 10.57% 18.63% 5.75% 5.42% Employees CAT Dealers 0.36% 1.18% 9.89% 1.05% 9.05% 11.87% 2.17% 1.32% 3.48% 2.00% NOTE: No CAGR calculations are included for the following segment categories: (1) Other segments and eliminations and (2) Corporate items and eliminations. These categories result from several methodological differences between Caterpillar's segment reporting and external reporting. The Panel B CAGR calculations focus solely on changes in operational segments Page 17 TABLE 3 Footprint Study Assumptions Panel A: Expected sales volumes Projected Annual Growth Rates 2015 (Units) 1,800 1,200 600 900 4,500 Market N America S America EAME Asia Total 2016 5.00% 20.00% 50.00% 100.00% 2017 5.00% 10.00% 20.00% 40.00% 2018 0.00% 5.00% 5.00% 25.00% 2019 0.00% 3.00% 0.00% 10.00% 2020 10.00% 3.00% 15.00% 5.00% 2021 15.00% 0.00% 20.00% 0.00% 2022 0.00% 5.00% 0.00% 10.00% Panel B: Per unit margin analysis Aurora Location Asset Class List Price China Location $91,000 $91,000 5% 10% $1,000 $1,000 Material Cost Per Unit $30,000 $25,000 Variable Cost Per Unit $18,000 $13,000 Period (Fixed) Cost Per Unit $20,000 $18,000 Average Discount % Warranty Weighted Avg. Freight Per Unit Page 18 TABLE 4 Freight and Duty Assumptions Panel A: Freight and Duty Estimates Produced in Aurora Geographic Markets (Col 1) North America South America EAME Asia/Pacific Freight (Col 2) $2,000 $6,000 $7,000 $8,000 Duties (Col 3) $0 $4,000 $0 $2,000 Produced in China Total (Col 4) $2,000 $10,000 $7,000 $10,000 Freight (Col 5) $8,000 $8,000 $6,000 $3,000 Duties (Col 6) $0 $7,000 $0 $0 Total (Col 7) $8,000 $15,000 $6,000 $3,000 Panel B: Example calculation of Per Unit Weighted Average Freight and Duty Cost Geographic Markets (Col 1) North America South America EAME Asia Total Weighted Sales Volume1 (Col 2) 1,800 1,200 600 900 4,500 Freight & Duty2 (Col 3) $2,000 $10,000 $10,000 $7,000 Total (Col 4 = Col 2 Col 3) $3,600,000 $12,000,000 $4,200,000 $9,000,000 $28,800,000 4,500 $6,400 1 The sales volume numbers are from Table 3 - Panel A, projected sales for Fiscal 2013. 2 The freight & duty costs are from Table 4 - Panel A, costs associated with producing the exoloader in Aurora, IL. Page 19 TABLE 5 Capital Spending Estimates Panel A: Expand Current Facility (Scenario A) Asset Class 2013 2014 2015 2016 2017 2018 Land Total $0.00 Buildings $30.00 $21.00 $9.00 Machinery, Equipment, and Vehicles $33.00 $33.00 $17.50 Office Furniture and Equipment $1.50 $0.50 Communication and Associated Equipment $0.50 Personal Computers (Desktop/Laptop) and (effective January 2002) Servers $0.60 Supplier Durable Tooling and Patterns (Considered part of machinery and equipment) $1.00 $60.00 $16.50 $100.00 $2.00 $0.50 $3.60 $0.80 Other $5.00 $1.00 $0.00 Total Capital Expenditures $64.60 $59.60 $27.80 $16.50 $0.00 $0.00 $168.50 Total Startup Expenses (see Note) $9.69 $8.94 $4.17 $2.48 $0.00 $0.00 $25.28 $74.29 $68.54 $31.97 $18.98 $0.00 $0.00 $193.78 Total Investment ($M) USD NOTE: Caterpillar expenses Startup Expenses as incurred. Page 20 TABLE 5 (cont.) Panel B: Build New Facility in China (Scenario B) Asset Class 2013 2014 2015 Land $23.00 Buildings $28.00 $14.00 $7.00 Machinery, Equipment, and Vehicles $33.00 $33.00 $17.50 Office Furniture and Equipment $1.50 $0.50 Communication and Associated Equipment $0.50 2016 2017 2018 Total $23.00 $49.00 $24.50 $108.00 $2.00 $0.50 Personal Computers (Desktop/Laptop) and (effective January 2002) Servers $0.60 $3.60 $0.80 Supplier Durable Tooling and Patterns (Considered part of machinery and equipment) $1.00 $2.00 $3.00 Other $5.00 Total Capital Expenditures $90.60 $54.60 $28.80 $24.50 $0.00 $0.00 $198.50 Total Startup Expenses $13.59 $8.19 $4.32 $3.68 $0.00 $0.00 $29.78 $104.19 $62.79 $33.12 $28.18 $0.00 $0.00 $228.28 Total Investment ($M) USD $5.00 $6.00 $5.00 Page 21 FIN 630 Module Six Short Paper Guidelines and Rubric Overview: For this assignment, you will read the Harvard case study titled Caterpillar, Inc.: The Impact of Decision Biases and Risk on Capital Budgeting, which analyzes the Caterpillar organization and the impact of emerging markets on capital investment decisions. Caterpillar is expanding to foreign markets with the introduction of their new hybrid/electric exoloader. Using Caterpillar's capital expenditure model (CapX), you will evaluate two scenarios: Scenario A: Expanding and refocusing an existing production facility in Aurora, IL Scenario B: Building a new facility in China In this short paper, you will closely examine the alternative models available to decision makers. Prompt: In your paper, pay special attention to the following elements of the case study: Benefits of the expansion Operating costs Capital spending Risks to the overall company The case study is based on data from financial statements from 2011. You will use current financial statements for your answers. Specifically, the following critical elements must be addressed: I. Download the current yearly financial statement (10-K) for Caterpillar (CAT). You can use SEC Edgar Company Filings. Note that the Caterpillar fiscal year end is December 31. They have 120 days to file with the SEC, but generally they release new financial statements in February. II. Using the financial statements, determine the discount rate and calculate WACC. In order to do that, you need to calculate: A. Cost of debt B. Cost of equity: Think CAPM (Capital Asset Pricing Model) or SLM (Security Market Line). C. Can Caterpillar use preferred stock financing? (Analyze financial statements and answer yes or no; explain how you arrived at your answer.) Helpful hints for this step: Use the ValuePro website to obtain an approximate estimation of WACC for Caterpillar. You can use Calculating Weighted Average Cost of Capital (WACC) or other YouTube videos as a guide on how to calculate WACC using financial statements. III. An optional article in Module Five, Understanding Weighted Average Cost of Capital: A Pedagogical Application, also provides a WACC calculation guide Risk Analysis: Read items 1A (Risk Factors) and 7 (Management's Discussion and Analysis of Financial Condition and Results of Operations) in the 10-K financial statements. Then, address the following: A. How would these risk factors impact the two projects? B. Consider the risk factors and calculate each project's risk-adjusted hurdle rate: i. Scenario A: Is the risk-adjusted hurdle rate higher or lower than the WACC? ii. Scenario B: Is the risk-adjusted hurdle rate higher or lower than the WACC? C. How would you mitigate the risks? Helpful resource for this step: How to Set the Hurdle Rate for Capital Investments. (See more detail in the Module Six Required Resources section.) Rubric Guidelines for Submission: Your paper should be 2-3 pages long, double spaced, with 12-pt. Times New Roman font, one-inch margins, APA citations, and at least two references. Show your WACC calculations either directly in the Word document or attached as a separate Excel file (if you have calculated WACC in an Excel spreadsheet). Instructor Feedback: This activity uses an integrated rubric in Blackboard. Students can view instructor feedback in the Grade Center. For more information, review these instructions. Critical Elements Calculate WACC Preferred Stock Financing Risk Analysis: Risk Factors Risk Analysis: RiskAdjusted Hurdle Rate Risk Analysis: Mitigate Proficient (100%) WACC is correctly calculated, and all calculation work is shown, including cost of debt and cost of equity The question is answered correctly and supported with an appropriate explanation Provides analysis that demonstrates complete understanding of risk factors for both projects Provides correct answers that demonstrate complete understanding of risk-adjusted hurdle rate for both scenarios Draws informed conclusions regarding risk mitigation that are justified with evidence Needs Improvement (70%) WACC is correctly calculated, but not all calculation work is shown Not Evident (0%) WACC is not correctly calculated Value 20 The question is answered correctly but not supported with an appropriate explanation Provides analysis that demonstrates understanding of some risk factors for both projects Provides one correct answer that demonstrates some understanding of riskadjusted hurdle rate for scenarios The question is not answered correctly 10 Does not provide analysis, and/or shows lack of understanding of risk factors Does not provide correct answers regarding risk-adjusted hurdle rate for both scenarios 20 Draws logical conclusions regarding risk mitigation but does not defend with evidence Does not draw logical conclusions regarding risk mitigation 20 20 Writing (Mechanics/Citations) No errors related to organization, grammar and style, and citations Some errors related to organization, grammar and style, and citations Major errors related to organization, grammar and style, and citations Total 10 100%