Caterpillar, Inc: The Impact of Decision Biases and Risk on Capital Budgeting

Abstract

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. Using Caterpillar’s capital expenditure model (CapX model), students must decide whether to recommend expanding and refocusing an existing production facility in Aurora IL (Scenario A), or building a new facility in China (Scenario B). On the surface, the standard capital budgeting template looks like a clear manifestation of the rational decision making model. Decision makers, however, are subject to a predictable set of psychological biases (decision heuristics) that may surreptitiously influence the underlying assumptions used to produce a “rational decision” (Bazerman, 2009; Kahneman et al. 2011). The case introduces students to a variety of these decision biases in the context of the capital budgeting decision. Students are required to examine how the assumptions underlying Caterpillar’s capital budgeting template could be influenced by individuals’ decision biases. Furthermore, the case provides an opportunity for students identify the risk factors identified in Caterpillar’s 10-K and consider how the overall risk environment influences the company’s financial statements. Given their assessments of the overall risk environment, student must incorporate their assessments into a determination of the investment hurdle rates appropriate for the alternative capital expenditure scenarios. Ultimately, students must identify the assumptions underlying the CapX model and evaluate these assumptions on two dimensions: (1) importance of the assumption, and (2) uncertainty of the assumption. Students can use the resulting 2 × 2 matrix of assumptions to think about how they would prioritize their time in terms validating the model assumptions and assess how decision biases might influence assumptions uncertainty. In the terms of class implementation, the case is structured to essentially create a debate between those who support Scenario A (U.S. production) and those who support Scenario B (China production). For every argument in support of Scenario A, students also must develop a counter-argument against Scenario A and in favor Scenario B. The objective is to increase students’ ability to think using a 360° perspective. By pursuing a 360° perspective students open themselves up to a wider decision making perspective that might include innovative and potentially superior decision alternatives.

Keywords: capital budgeting, decision biases, risk assessment

JEL Classification: D81, M31, G31