Cummins Inc. Equity Valuation and Analysis

Valued at April 1, 2007

John Michell: John.Michell@ttu.edu Clay Snyder: Clay.Snyder@ttu.edu

Brian Cannon: brian@briansparkscannon.com Ali Zandi: Ali.Zhandi@ttu.edu

Alan Jones: ajonesttu@gmail.com

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Table of Contents:__________________

Executive Summary………………………………………..3 Company Overview………………………………………..8 Business & Industry Analysis……………………………10 Accounting Analysis…………………..…………………..20 Ratio Analysis………………………...……………………41 Forecast Financials………………..……………………….68 Valuation Analysis…………………………………………81 Recommandation………………………………………….93 Appendix …………………………………………………..94 References………………………..……………………….100

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Investment Recommendation: Overvalued, Sell CMI – NYSE Revenue (2006) 11,362,000 Market Cap 9.60B Shares Outstanding 104.20M Dividend Yield 2.10% 3-month Avg Daily Trading Volume 2,338,760 Percent Institutional Ownership 53% Book Value Per Share 26.89 ROE 30.65% ROA 9.79% Cost of Capital RSquared Beta Ke Ke Estimation 11.89% 10-year .3247 1.48 11.89% Published Kd 7.13% WACC 9.37%

EPS Forecast-____________________ FYE 06 07 08 09 15.02 10.47 12.76 15.34 Ratio Comparison CMI CAT Trailing P/E 7.0 13.37 Forward P/E 10.23 12.89 P/B 2.3 6.31 P/Sales .62 1.03 P/EBITDA .053 .0124 Multiples Valuations_ CMI Trailing P/E $200.81 Forward P/E $183.04 P/B $397.59 P/Sales $241.28 P/EBITDA $17.07 Intrinsic Valuations Discounted Dividends $24.75 Free Cash Flows $85.95 Residual Income $123.33 Abnormal Earnings Growth $113.34

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Executive Summary

Cummins Inc. is a national and global leader in the design, manufacturing, sales

and services of diesel engines in more than 160 countries. Founded in 1919,

Cummins Inc. has since evolved into four business segments: Engine, Power

generation, Components and Distribution. The majority of sales are produced

from the engine segment, whose largest customer is DaimlerChrysler. The main

competitors of Cummins Inc. are Detroit Diesel Corporation (privately owned),

Mack Trucks, Inc. (privately owned), and Caterpillar Inc. The threat of new

entrants into this industry is low due to the large capital investments involved in

the production process. The industry competes on a mix of brand image and

quality, as well as low cost of production.

The products of Cummins Inc. are under high threat of substitution. Essentially

customers are willing to switch producers of engines if the cost of the engine is

lower and/or is of higher quality and reliability. This is why Cummins Inc. must

provide quality merchandise at the lowest possible cost to keep or increase

market share. The diversified machinery industry is heavily concentrated allowing

some price control in the hands of the firms, but with little product

differentiation, firms must differ in cost and quality. Threat of substitution can

also come from non-diesel engines and alternative power sources. The industry

is heavily regulated for safety standards as well as environmental policies, which

can potentially hinder higher profits in certain situations.

The industry that Cummins Inc. competes in has little bargaining power over the

consumer. Their products are basically undifferentiated and have little switching

costs for the consumer. To combat this, the firm must attain a reputation as

being both reliable and reasonably priced in order to steal costumers from their

competitors as well as retain their current customers. Cummins Inc. has power

over their suppliers because most of their suppliers are in the natural resource

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industry. With few buyers and many suppliers, Cummins Inc. can negotiate lower

prices with little resistance. Firms in the diversified machinery industry must

maintain a mixed strategy for a competitive advantage. It is important that the

firm research in productivity and cost cutting as well as innovation of new

technologies to improve the quality of their products. Cummins Inc. must also

explore and infiltrate new high growth economies to attain more growth, since

more mature markets are harder to gain market share in.

When evaluating Cummins’ key accounting policies, it is important to understand

their success factors. Cummins Inc. has several major accounting factors. One

factor is the high amount of assets that are needed to operate in this industry.

Management’s ability to accurately estimate depreciation expenses, provisions for

warranties and asset impairment have great influence over the financial picture

the firm appears to be in. Cummins Inc. is also involved in investing in

derivatives to hedge against rising input costs, and heavily invests in research

and development to improve efficiency and quality. Pension liabilities also take

careful consideration by management when estimating the obligations for future

periods.

Overall Cummins Inc. accounting policies appear to be more conservative in

nature, and the firm prepares its financial statements in accordance with GAAP

(generally accepted accounting policies). Management does disclose in-depth

every aspect of the firms operations, making the firm more transparent for

shareholders. By evaluating Cummins Inc.’ sales and expense ratios, we were

able to search for any ‘red flags’ found in the annual report. Through our

evaluation, we found no major ‘red flags’ that needed to be addressed.

Management has done considerably well in not over or understating any items

that give rise to suspicion of misstating financial information.

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By examining ratios that examine Cummins’ liquidity, operating efficiency,

profitability and capital structure we were able to understand how the firm

compared to its competitors in the industry. Cummins Inc. liquidity and

productivity ratios imply improvement their ability to cover short-term debt, while

becoming more productive in generating sales over the five year period. The

profitability ratios illustrate a turn-around in strategy that took the firm from low

earnings and returns to rapid growth in profitability and shareholders’ equity.

These ratios tell us that management is focused and working hard to keep

improving the profitability of the company. When we analyzed the capital

structure ratios, we found that management had focused intensively on reducing

debt and focusing on financing growth with cash generated from operations. This

was very attractive to us because the company has taken on little more debt,

which could lead to higher profits and financial stability in an economic

downturn.

We also extended our analysis to four additional ratios that focus more on

specific asset turnovers and earnings associated with non-cash items. These

ratios also were favorable for Cummins Inc. and further instilled the impression

on us that management is achieving attractive productivity and implementing

good financial policy.

We forecasted Cummins’ financial statements ten years into the future using the

data received from the ratios and growth trends of forecast-able line items. We

believe earnings and productivity from assets to continue to impress investors.

Also we forecast sales and cash flows provided by operations to continue

increasing at an attainable growth rate in line with the industry and historical

averages.

We used several different valuation models to find out if Cummins’ stock is

undervalued, fair valued or overvalued. Not every model is reliable when applied

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to different structured firms, so we went through each model in order to decide

which methods were accurate. The method of comparables was the least reliable

of the valuation models because of the extreme concentration of the industry,

which only consists of Caterpillar Inc. another problem when using Caterpillar’s

price multiples to compute Cummins’ share price, is the difference in capital

structures of the two firms. Cummins is heavily leveraged towards financing

through shareholders’ equity and retained earnings, where Caterpillar relies

almost completely on financing through debt, focusing less on earnings growth.

This method is much like comparing apples to oranges in out opinion, and is not

reliable for valuating this particular firm. For the remaining valuation models we

needed to compute the estimated cost of equity and the weighted average cost

of capital to plug into the models. The discounted dividends model does not

evaluate the financial policies of Cummins very well either. Cummins has

basically had flat growth in dividends over the past periods, which means that

dividends paid at the same rate in the future as they are presently are worth less

today (present value of dividends) dragging the value of the firm down to

unreasonable prices. The free cash flows and residual income models where

more accurate than the discounted dividends and method of comparables, but

still were not the most reliable method for valuating Cummins. The abnormal

growth earnings model came closest to our observed price per share of $144.99,

by using a lower cost of equity then our estimated cost of equity, of 9% and 0%

growth in perpetuity, which states that the price per share of Cummins should be

$202.71. When combining all the data we found from each valuation model, it is

our opinion that Cummins Inc. should be valued lower than the observed market

price of $144.99.

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Company Overview

We have reshaped the Company into what we are

calling “The New Cummins” – a company that is less

cyclical, more diversified, more results-oriented and

committed to turning a greater share of its sales into

profits. (From the 2005 Annual Report)

Cummins Inc. boasts a long history since being founded in 1919. Cummins Inc.

is a national and global power leader through the design, manufacture, sales and

services of diesel engines. Their products can be accessed in more than 160

countries, ranging from Mexico to India, through 550 company-owned as well as

independent distribution facilities, and over 5,000 dealers. Cummins Inc. has

teamed up in numerous joint ventures to produce the distribution facilities that

allow them to keep and gain market share on a global scale.

Both domestic and global corporate headquarters are located in Columbus,

Indiana. The corporate structure of Cummins Inc. is constructed from four

business segments: Engine, Power Generation, Components, and Distribution.

The Components segment can be further dissected into four businesses:

Cummins Filtration, Cummins Turbo Technologies, Cummins Emission Solutions

and Cummins Fuel Systems. The Distribution segment network consists of 17

company-owned distributors coupled with 10 joint ventures, operating in 90

countries through 233 locations. The major products these four complementary

business segments produce consist of heavy-duty engines, for on and off-road

vehicles; the sole supplier of diesel engines for DaimlerChrysler in their Dodge

Ram pickups; power generators for use commercially or for consumer needs;

filtration and after-treatment supplies; industrial silencers; turbochargers;

engines and other related products for use in mining, oil and gas, agricultural,

marine and military operations.

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Cummins Inc. is classified as a member of the diversified machinery industry, but

the main competitors the company fights for market share are spread out into

three different industries. These industries consist of: farm and construction

machinery, auto parts and trucks and other vehicles. Through these industries

Cummins Inc. competes against hundreds of domestic and foreign businesses,

but for analysis we break down the competitors to three main rivaling

companies: Detroit Diesel Corporation (privately owned), Mack Trucks, Inc.

(privately owned), and Caterpillar Inc. These companies offer the greatest

competition to Cummins Inc. while also being similar in size and operations.

Cummins Inc. is a large-cap corporation with a market capitalization of 7.28

billion and growing. Recently the corporation recorded sales of $11.36 billion for

2006, which blew away analysts estimates for the second year in a row. Sales

have doubled since reporting $5.68 billion five years previous in 2001. For the

same 5 year period, earnings can be slated at a growth rate of almost 71%, only

beating the industry growth by 1%, but out pacing the S&P 500 by more than

61%. Total assets recorded on the balance sheet of 2001, are $4.34 billion and

in 2006 (in accordance with the 10-k) total to $7.47 billion, that is an increase in

total asset value of $3.13 billion or 72% in a five year period. That gives us a

picture of the growth and size of Cummins Inc. In February of 2002, the stock

was trading at $41.58 and presently, February 1, 2007, the stock closed at

$136.72, that is just under a 229% return if you held the security during this

period.

Cummins Inc. is well diversified within its sector and industry. We can

understand the size and performance of Cummins Inc. through the financial

information published in previous years. The next step in the analysis process is

to dissect the industry and competitors of Cummins Inc. to get a good

understanding of their performance against similar companies and the

competitive environment of the industry.

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Classifying The Industry

In order to understand Cummins Inc., we must first classify the industry in which

Cummins Inc. operates, so that we may have a context in which to compare.

We will first classify the industry, determine how firms create competitive

positions in this industry, and then we will look at Cummins Inc. corporate

strategy to determine how well they are implementing this strategy to achieve

competitive advantage.

Classifying the industry allows us to understand the degree of competition that

our firm must compete in. We will use Porter’s Five Competitive Forces in order

to classify the industry. First we will look at the rivalry among existing firms in

the industry by taking a look at such things as industry growth, concentration,

switching costs, and barriers to exit in the industry. We will then consider the

threat of new entrants into the industry by discussing scale economies, the first

mover advantage, as well as legal barriers in the industry. We will examine the

threat of substitute products and look at the relative price and performance, and

buyers’ willingness to switch to other products.

We can then look at the bargaining power of both the buyers and suppliers in

the industry and try to understand how these relationships affect the firms in the

industry by looking at the switching costs, and the number and volume of both

suppliers and buyers.

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Industry Structure and Profitability

Industry: Diversified Machinery

Rivalry Among Existing Firms

We need to examine the competition among firms already established in the

industry. This is an important first step, as it allows us to determine the degree

to which firms compete; you can have one or the other extreme. In industries in

which competition is aggressive, prices are often pushed towards cost. In

industries in which competition is less aggressive, firms do not compete on price,

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but rather on non-price items such as differentiation. The intensity of rivalry is

influenced by such factors as industry growth, concentration, product

differentiation, switching costs, and technology. Each of these factors will be

discussed.

The Diversified Machinery Industry is an established industry and because of

this, taking market share from competitors is the only way to grow. This is a

very concentrated industry with only a few large, well established companies.

Caterpillar Inc. (CAT), Detroit Diesel Corporation (privately held), and Mack

Trucks Inc. (privately held) are the major players in the industry. Because of this

concentration, the firms in the industry are able to control, to some extent,

pricing levels. Product differentiation is for the most part, negligible, and

therefore firms must compete on other factors. Because of this, firms must

attract, and keep customers on the basis of price.

Diesel Engine Sales

0

2

4

6

8

10

12

14

16

18

2001 2002 2003 2004 2005

Years

Sales in Billions of Dollars

CatCummins

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Another key factor that plays into the rivalry among existing firms is the low cost

of switching amongst products. Because of the undifferentiated nature of the

products produced in the industry, customers will ‘switch’ from one firm to

another on the basis of cost.

With the high degree of governmental regulation in the industry, firms must also

keep up with the Environmental Protection Agency standards. This increases the

level of competition in the industry, because firms are constantly trying to

improve upon current technology in order to meet these ever increasing

standards.

The diversified machinery industry is a well established industry with a high

concentration of firms, an undifferentiated product, and a low degree of

switching costs. In light of this, we believe that the competition among existing

firms is high.

Threats of New Entrants

While existing firms pose a large threat the competitors in an industry, we can

not overlook new firms vying for market share in the industry. New firms trying

to enter into the industry must overcome several barriers to entry. The height of

these barriers dictates the ease to which firms can enter into the industry. Some

significant barriers to entry include: economies of scale, first mover advantage,

and legal barriers.

Inventory, Property Plant and Equipment make up almost 40% of Cummins Inc.

total assets of $6.89 billion. With such large economies of scale, new entrants

find it hard to enter the industry without a significant disadvantage. A company

would have to invest several billions of dollars in order to design a number of

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different types of engines and manufacturing techniques to effectively compete

with the already established companies in the industry.

Another major hurdle is brand image or name recognition, which gives rise to the

first mover advantage. Firms in the industry have already established

themselves as companies that provide a quality dependable product. In the

diesel engine and power generation business, having a reputation for reliability is

the main feature that can attract new customers. This is not something that

occurs overnight, but rather is built through years of quality products, services,

and relationships.

There are many restrictions set forth by the Environmental Protection Agency

(EPA) that require strict adherence. Adherence to these standards set by the

EPA calls for intensive costs brought on by research and development. Because

firms must spend such large amounts on research and development without

seeing immediate benefits, firms entering into the industry will find it hard to

compete.

Due to the height of the barriers to entry such as economies of scale, first mover

advantage, and other legal restrictions, we believe that the threat of new

entrants is low.

Threat of Substitute Products

We cannot limit our analysis to the confines of one industry. We must take into

account the threat of products that could be used as a substitute for the

products made by the firms in the industry. The threat of substitute products

depends largely upon customers’ willingness to substitute other products

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The threat of substitute products is a dangerous one. In the engine segment,

firms in the industry who produce a diesel engine for light-truck applications

have to compete, not only against companies that produce diesel engine, but

other companies outside the industry that produce non-diesel engines for the

same application in the light-truck. Also, as gas prices continue to soar, the

demand for alternative fuel sources are rising. With companies developing

engines that take advantage of these alternative fuels, the threat to the diesel

engine manufacturing industry is compounded.

With companies producing gasoline engines as well as companies trying to take

advantage of alternative fuel sources, we believe that the threat of substitute

products is relatively high.

Bargaining Power of Buyers

The bargaining power of buyers is a key force in determining the level of

competition in the industry. We must consider two key factors in relation to the

bargaining power of buyers: the buyers’ sensitivity to price, and the buyers’

power over the bargaining process.

Diversified machinery manufacturers tend to compete on price and reputation.

Firms in the industry must compete on both, relying heavily on reputation as well

as pay attention to high price sensitivity giving rise to the high bargaining power

of buyers. Because engines are undifferentiated and carry with them few

switching costs, buyers are more price sensitive. To combat this, firms have

tried to develop a reputation for high performance and quality. Engines, power

generators, and high end components tend to represent a high portion of buyers’

final cost which leads to buyers actively in search of the low cost alternatives.

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Also, buyers have relatively higher bargaining power compared to firms. While

there are many buyers, there are many suppliers as well. Since each buyer

tends to buy high volumes, the cost of not doing business is higher for firms in

the industry than to the buyer. Other major factors include the high number of

alternatives along with the low switching costs. Many buyers manufacture

similar products which leaves the door open for reverse engineering by buyers.

With buyers’ sensitivity to price high as well as their overall bargaining power, we

consider the bargaining power of buyers as a high threat.

Bargaining Power of Suppliers

To stay competitive, diversified machinery manufacturers need to be able to

negotiate lower prices with their suppliers. Cummins Inc, with 2006 sales of

$9.92 billion in their engine segment, competes with companies like Caterpillar

who had 2006 sales in the engine segment of $11.08 billion. With the large

volume of sales, this allows companies in the industry to have a strong

bargaining power over their suppliers.

Furthermore, a main supply purchased by firms in the industry, metals, is a

commodity so many substitutes are available and the switching costs are low.

For finished components required for their projects, firms have developed

strategic alliances with a number of companies internationally which help to

maintain lower costs. Due to their relative size, firms in the industry can

negotiate for the lowest price possible allowing firms to keep prices as low as

possible and maintain current relationships thus attracting new buyers.

Due to the large amount of sales that firms in this industry create, we contend

that the bargaining power of suppliers is low.

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Strategies for Creating a Competitive Advantage

A firm’s profitability is dictated not only by the industry that it competes in, but

also by the way in which it positions itself in their respective industry. There are

two basic ways in which we can classify a firm’s competitive strategy: cost

leadership and differentiation.

Cost leadership involves supplying the same products or services at a lower cost.

Employing a cost leadership strategy involves focusing on economies of scale

and scope and efficient production. Cummins deploys a range of strategies in

which to control costs by beginning with implementing the six sigma approach to

manufacturing to cut out unnecessary processes which will improve overall ability

to control quality management and reduce defective products form being created

thus cutting costs and further benefiting both the company and the end

consumer. After the introduction of this strategy in the beginning of 2000,

Cummins has saved 2 percent from its bottom line and is now expanding this

strategy to how it works with it suppliers as well. Cummins also takes cost

leadership approach to how it develops new technologies by partnering with

companies in China and India and sharing development costs with strategic

partners, also Cummins relies on making computer models of what could be the

next product instead of making several prototypes to save R&D costs. (Data

collected from Cummins 2005 annual report)

Differentiation is focused on supplying a unique product or service at a cost

lower than the price premium customers will pay. Cummins differentiates their

products by focusing on superior product quality, variety with different engine

sizes, and also customer service. They invest heavily in brand image and

research and development, with control systems focused on creativity and

innovations.

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Firms in the Diversified Machinery industry must employ a mixed strategy in

order to achieve a competitive advantage. Leaders in the industry must employ

a low-cost strategy while maintaining product quality. Firms in the industry

achieve lower costs through economies of scale and scope. The emphasis on

quality derives from government regulations and market demand for increased

product efficiency and duration.

Investment in brand image and the growing constraints of the Environmental

Protection Agency are causing companies to invest heavily in research and

development. This is an industry that relies heavily on trust. While buyers

concentrate on price, a positive brand image known for quality products

supplemented with superior customer service is also required.

Competitive Advantage Analysis

Cummins Inc. holds a strong competitive advantage in the industry of diversified

machinery despite competing against companies, such as Caterpillar, with a

significantly larger market share. As a global leader in the production and

marketing of large diesel engines, the company is well equipped to flourish

through cost-leadership and quality in a highly concentrated environment.

Despite this concentration, Cummins Inc. understands that customers are very

price-sensitive and demand higher product quality, both focal points of the

company’s operations. Cummins Inc. strives to maintain a cost-leadership role by

continuously searching for lower input costs from less expensive international

markets. Company growth is becoming increasingly dependent on Cummins Inc.

ability to meet government standards and regulations before the competition,

especially in its engine line. Cummins Inc. anticipates high future growth by

expanding the types of products offered to current customers and focusing on

growth in related markets, domestically and internationally.

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Cummins has the potential to attract a lot more business in an increasingly global

economy by further expanding their established international presence. Almost

51% of the company’s consolidated net sales stem from operations abroad.

Cummins has a significant presence in India and China, two of the world’s fastest

growing economies. A future increase in market share is a likely result of their

presence abroad. Growth potential is significantly larger for Cummins abroad.

By incorporating Six Sigma in manufacturing, product design, and procedures

with customers, suppliers, and distributors, Cummins has significantly reduced

costs and improved quality in these areas of the business. The effort to attain

perfection through Six Sigma pays dividends through improved customer

relationships and product quality. The continuous and successful implementation

of Six Sigma is major competitive advantage. However, this advantage will slowly

fade as Cummins forces competitors to adopt the strategy or lose market share.

Six Sigma currently plays a major role in minimizing defects throughout the

company’s business, but financial information concerning the quantitative impact

of Six Sigma is unavailable through public information.

This highly concentrated industry naturally forces companies to grow by seizing a

larger market share. Cummins Inc. has entered into long-term supply

agreements with key customers such as DaimlerChrysler, Volvo Trucks North

America, Inc., and Navistar International Corporation. This move not only

improves customer service relationships with buyers, it guarantees holding an

increased market share for several years.

DaimlerChrysler contributes twelve percent of Cummins Inc. net sales. Although

this a small percentage in some industries, losing their business can potentially

have an adverse effect on the company. This is magnified by the fact that

DaimlerChrysler and other engine customers outsource this portion of their

business to Cummins Inc.. These companies have the capabilities to produce

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their own engines yet continue to outsource to Cummins Inc.. Although this

reveals the quality of product and low-cost of production for Cummins Inc., the

retention of these customers after the duration of the long-term contracts

appears questionable. Customer relations and price are key determinants in

ensuring continued business with these customers.

Accounting Analysis

The purpose behind the accounting analysis is to assess how well a firm’s

accounting captures the reality of the firm’s underlying business reality. In order

to determine the distortion in the accounting numbers, we must first identify

areas that lend themselves to flexibility, and determine the appropriateness of

the accounting policies and estimates used by the firm. The quality of

accounting is influenced by three factors: rigidity in accounting rules, the degree

of accuracy in management forecasts, and management’s selection of certain

accounting choices to achieve a particular end-result. Those account for any

discrepancies between the true underlying economic position of the company

and the state of the company according to management’s best estimates.

Identify Key Accounting Policies

Cummins Inc. employs many different accounting policies in order to provide

relevant information in their consolidated financial statements, and reveal the

company’s current and prospective economic reality. The company’s competitive

business strategy includes a mix of cost-leadership and differentiation. Both

elements in the mixed strategy heavily influence the key accounting policies that

Cummins Inc. Inc. selects. Both the industry and Cummins Inc. rely on

accounting policies that, depending on management’s selection between the

different policies, can significantly impact the financial statements. The key

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accounting policies recognized by Cummins Inc. relate to Research and

Development (R&D), Goodwill, Warranty Provisions, and Inventory Management.

Under the provision of SFAS 2, Research and Development must be expensed in

the time period in which it occurs. The problem with firms that derive such a

benefit from heavy investment in Research and Development is that they are

unable to adequately explain the effect that it has on their financial statements.

One way that the benefit of Research and Development can be directly attributed

to future benefits is through greater access to international markets demanding

compliance with more stringent environmental standards. The development of

engines that comply with U.S. standards puts Cummins Inc. Inc. in position to be

a leader in foreign markets as they continue to grow. The importance of cost-

leadership can be seen in the amount spent on Research and Development in

order to produce a more efficient product. Research and development cost for

2005 accounted for $278 million, which is equivalent to 4.04% of total assets.

For the years 2003-2005 Research and Development costs accounted for an

average of about $240 million, which is equivalent to an overall average of 3.9%

of the total assets over the same time period. Access to these foreign markets

allowed sales to increase by 57.5% from net sales of 6.3 billion in 2003 to 9.9

billion in 2005.

Another major accounting policy deals with accounting for Goodwill. Under the

provisions of SFAS 142, “Goodwill and Other Intangible Assets,” the carrying

value of assets acquired is reviewed annually. Goodwill, which comprised of

$358 million dollars in 2005, could be significantly altered by changes in

estimates or economic conditions. Cummins Inc. Inc. emphasizes the importance

of their brand-image, a key success factor accumulated from mergers and

acquisitions. Goodwill is the “excess of the purchase price paid over the fair value

of net assets acquired in a business combination accounted for as a purchase,”

according to Cummins Inc. 10-K. While impairment is a more appropriate

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accounting policy than amortization, this lends itself to accounting distortions due

to management’s evaluation of the fair value. However, because goodwill

comprises .032% of Cummins total revenues, a relatively small amount,

management discretion on fair value estimates will not materially impact the

company’s state of operations.

Warranty provisions are another key factor in accounting policies. Cummins Inc.

includes warranties on its products to improve the quality of its brand image.

Cummins Inc. Inc. charges estimated warranty costs to earnings at the time

products are delivered to the customer and estimates liabilities associated with

warranty cost using a historical experience of warranty programs. However,

warranty liability estimates can result in higher or lower expenses depending on

management estimates. Revenue is recognized on a straight-line basis over the

contract period. If warranty expense estimates are lower than the actual future

warranty claims, earnings are overstated. Overall during the period of 2002-

2005, Cummins Inc. was relatively consistent in provisions for warranties issued.

Provisions increased at a rate consistent with sales over the same time period.

Cummins Inc.’ estimation of warranty liabilities appears to be more conservative

because of their consistent overstatement of provisions for warranty liability.

Actual warranty payments as a percentage of provisions for warranties were

72.22% in 2004 and 80.27% in 2005. Because of the conservative reporting of

provisions for warranties, net income is understated.

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Warranty Provisions in Relation to Actual Warranty Payments

050

100150200250300350400450

2003 2004 2005

Mill

ions

Provision forWarrantiesActual WarrantPayments

No period before 2003 is relevant as the provision from warranties and the actual

payments were not audited in 2002. Although management estimates for

warranty provisions have improved since 2003 (actual payments made up 49%

of provisions for 2003), it is evident that Cummins consistently overstates

warranty provisions.

Warranty Provisions as Realated to Net Sales (Using a Logarithmic Scale)

1

1000

1000000

2001 2002 2003

Year

$ in

Mill

ions Net Sales

WarrantyProvisions

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Cummins Inc. does not distinguish raw materials from work-in-progress because

of the constant movement of resources from different locations. They also

recognize their inventories using either the lower of cost or the net realizable

value. Inventory management is a huge component of Cummins Inc. key

accounting policies. Choice of accounting policy for valuing inventory can have a

significant influence on the assets of the balance sheet. Cummins Inc. values

78% of its domestic inventory using FIFO and the remaining 22%, comprised

mostly of heavy-duty, high-horsepower engines and parts are valued using LIFO.

Cummins Inc. reported sales of $2.1 billion in their Heavy-Duty truck engine

segment, which accounted for approximately 22% of overall net sales. When

reporting cost of good sold, Cummins Inc. has chosen to use the LIFO method of

accounting for inventory in this heavy-Duty engine segment. By using the LIFO

method, cost of goods sold in the Heavy-Duty truck engine segment is

overstated in a rising price environment. Since this segment makes up almost

Components of Engine Segment (As % of Engine Sales)

32%

14%

17%

27%

10%

Heavy-DutyMedium-DutyLight-DutyIndustrialStationary-Power

- 25 -

22% of sales outstanding, this reduces income taxes payable significantly

through understating gross margin, and ultimately reducing net earnings.

Accounting Flexibility

Cummins Inc.’ management team has many different ways that it can account

for its key accounting policies. Managers in diversified machinery have a choice

of how to classify inventory. Cummins Inc. uses a combination of FIFO and LIFO,

although FIFO comprises for a majority (78%) of the inventory. If a situation

arises where management needs to increase their expenses and lower their tax

base, they could switch to using predominantly LIFO. However, this is a stringent

transition process that the I.R.S. would have to approve. Although FIFO is more

indicative of actual inventory levels, switching to LIFO would reduce the value

created from employing FIFO for tax purposes. Additionally, auditors would

question the switch and raise issues about the underlying motive for pursuing

FIFO, a more transparent inventory policy. Caterpillar uses an accounting

strategy that is almost the complete opposite of Cummins Inc. Caterpillar is

considerably larger than Cummins Inc. with total assets of $47 Billion compared

to that of Cummins Inc. with total assets of $6.9 Billion. Because Caterpillar is

such a large and well-established firm, we believe that they use LIFO in order to

reduce their tax base. Cummins Inc., a smaller company with more growth

potential, uses FIFO to boost earnings and portray as much economic growth as

possible. Cummins Inc. discloses the excess of FIFO over LIFO to be 69 million in

2005, and an average of 65 million for the period of 2003-2005. With gross

margin being overstated, we can assume that at an income tax rate of 35%,

Cummings is distorting income taxes payable by approximately 24 million. This

helps create value by reducing the taxes paid to the Internal Revenue Service.

Management is allowed to use LIFO for tax purposes and Cummins employs LIFO

to reduce taxable income and the associated income taxes payable.

- 26 -

Management has no accounting flexibility when recording Research and

Development in accordance with GAAP. R&D has to be expensed in the time

period it occurs and severely limits management’s ability to accurately convey its

true economic position. The rigidity of accounting standards for reporting R&D

restricts management flexibility in presenting a key success factor of the firm.

Current accounting standards allow significant management discretion in

estimating warranty liabilities. Warranty liability estimates can result in higher or

lower expenses depending on management estimates. Management can increase

warranty liability estimates to increase expenses and smooth earnings or

decrease estimates to reduce the perceived present and future liability

obligations, increasing net income and improving the appearance of the capital

structure.

Cummins Inc., over many years of acquisitions, has increased its focus on brand-

image. This is reflected in its $358 million in goodwill. SFAS no. 142 grants the

company the option to check for goodwill impairment annually. Management’s

estimate on the fair value of goodwill determines whether or not goodwill is

considered impaired. For the period of 2003-2005, Cummins Inc.’ management

has decided not to impair goodwill stating that the individual business segments’

fair value of has exceeded their book value, and therefore in management’s

opinion does not require impairment.

Post-retirement benefits and pension plans make-up a significant portion of

company liabilities and could potentially affect Cummins Inc. ability to achieve

their goal of cost-leadership. Cummins Inc. has a defined benefit plan for hourly

employees and a cash basis formula for salaried employees. The defined benefit

plan creates a greater liability for the company as it states the expected future

outflow of cash to be distributed to employees when they draw down from the

account. Management estimates on the growth of these defined benefit plans

- 27 -

can result in the plan being over or under-funded. The pension plan has 64.7%

invested in equity securities, making the fund more susceptible to systematic

risk. Management could reduce their pension obligations by switching to a

defined contribution plan, making it difficult to under-fund the plan unless it is

drawn down on by the company. However, existing plans cannot be altered

unless Cummins becomes bankrupt. Cummins must respect its current

obligations and instead alter the benefit program for new employees and future

hires. Postretirement benefit plans by Cummins Inc. provide a variety of health

care and life insurance benefits to eligible employees.

Evaluation of Actual Accounting Strategy

All publicly traded companies in the U.S. are required to file the appropriate

financial statements with the Securities and Exchange Commission (SEC). These

financial statements must comply with the Generally Accepted Accounting

Procedures (GAAP) which have been set by the Federal Accounting Standards

Board (FASB). In order to determine how well Cummins Inc. does in reporting

standards, we can look at how they handled a material accounting mistake.

On August 4th, 2003 Cummins Inc. restated its financials for the years 2000-

2002, due to an error in reconciling accounts receivables in two manufacturing

locations, in Fridley Minnesota, and Darlington, United Kingdom. These two

manufacturing locations combined accounted for 15-20% of total revenues. Due

to the material impact of the mistake, Cummins Inc. was required to restate its

financials. In January of 2003, Cummins Inc. notified the SEC that they had

identified a potentially material accounting error. After disclosing the error to the

SEC, Cummins Inc. took the following steps: (From the SECURITIES EXCHANGE ACT OF

1934 Release No. 53236 / February 7, 2006 ACCOUNTING & AUDITING ENFORCEMENT Release

No. 2370 / February 7, 2006 ADMINISTRATIVE PROCEEDING File No. 3-12173)

- 28 -

“(1) it sent trained accounting personnel from the corporate office and the

company’s outside auditor to Fridley to investigate the accounts payable

accounts reconciliation issues and resolve them; (2) it retained special counsel to

conduct an internal investigation; (3) it issued a press release announcing the

potential adjustment; and (4) it fired the accounting personnel responsible for

the delinquent account reconciliations in question.“

The effect of the adjustments was as follows:

Cummins Inc. Restatement 2002

(Millions)

2001

(Millions)

2000

(Millions)

Pre-2000

(Millions)

Previously reported net earnings $72 $(102) $8

Restatement adjustments (after tax) $10 $(1) $6 ($37)

Restated net earnings $82 $(103) $14

As a percentage of restated earnings 12% 1% 43%

According to the SEC report, Cummins Inc. was ordered to “cease and desist

from future violations of the books and records and reporting rules.” Also, it is of

note that the SEC “took into consideration the cooperation and remedial acts of

Cummins Inc. in determining the terms of the settlement.” While this was not

using accounting flexibility to cloud the financial statements, it is of note that

Cummins Inc. was pro-active in response to the accounting mistake which in turn

allowed them to fix the problem without drastic sanctions by the SEC.

Cummins Inc. accounting choice of valuing inventory using FIFO is an aggressive

approach when compared to its largest public competitor, Caterpillar. FIFO

reduces expenses and increases net income. This allows Cummins Inc. to show a

higher net income to support further growth in periods of higher costs. However,

because FIFO gives a more realistic portrayal of actual movements in most

- 29 -

inventories, it is a proper accounting choice for the company. Cummins Inc.

incorporation of LIFO for its heavy-duty engine line shows that it is not being

overly aggressive in its use of accounting flexibility to increase the bottom line.

The discount rate used for determining pension and other postretirement

benefits, at 5.75%, is, in our opinion a little low considering its credit rating is

just below investment grade. An increase in the discount rate will lower the

present value of pension obligations, indicating that the pension fund is well-

funded for the future. The total benefit obligations are currently under-funded by

$377 million, requiring the company to finance claims through retained earnings.

A continuation of this trend could have an adverse affect on Cummins Inc. ability

to be a cost leader or pay their debt obligations. Management’s current

assumption of the compensation increase rate (increase in the cost of living) is at

4%, a modest compensation increase rate considering inflation has historically

grown at around 3%, only leaving a 1% cushion for unexpected spikes in

inflation. Cummins accounting for pension obligations is slightly conservative by

selecting a low discount rate. A slight increase in this rate can materially change

the status of the pension fund from under-funded to profitable.

Evaluation of the Quality of Disclosure

To determine the extent of accounting distortions, we use sales and expense

diagnostic ratios, and compare the firm across a five-year period as well as

against the industry. Earnings management is the process of creating “honey

jar” reserves in good years to pad financial statements in bad years. By running

the firm through the various sales and expense diagnostic ratios, we will be able

to determine how forthcoming Cummins Inc. has been in their financial

statements.

- 30 -

Sales Diagnostic Ratios for Cummins Inc. Inc. are computed below.

Cummins Inc. Inc. 2001 2002 2003 2004 2005

Net Sales/ Cash from Sales 1.10 1.13 1.15 1.14 1.15

Net Sales/ Net Accounts Receivable 10.99 8.66 7.54 8.12 7.55

Net Sales/ Unearned Revenues N/A N/A N/A N/A N/A

Net Sales/ Warranty Liabilities 17.64 18.41 17.59 17.58 17.19

Net Sales/ Inventory 8.33 9.13 8.59 8.31 8.45

Overall, Cummins Inc. has done a good job with disclosure. This is evident by

the consistency of the ratios over the period from 2001-2005. The ratio of Net

Sales/ Cash from Sales tells us that Cummins Inc. is consistently doing a good

job with cash collections from sales. This is further shown in the Net Sales/ Net

accounts Receivable ratio. Warranty Liabilities are being properly accounted for,

and Cummins Inc. is doing a good job with inventory management. We can also

compare the ratios of Cummins Inc. to that of their major competitor Caterpillar.

We will go into a more in-depth discussion of the ratios below.

Caterpillar 2001 2002 2003 2004 2005

Net Sales/ Cash from Sales 1.16 1.18 1.24 1.36 1.28

Net Sales/ Net Accounts Receivable 7.34 6.57 5.22 3.80 4.52

Net Sales/ Unearned Revenues N/A N/A N/A N/A N/A

Net Sales/ Warranty Liabilities 29.18 26.91 33.73 36.10 38.69

Net Sales/ Inventory 6.50 6.75 6.91 6.06 6.51

- 31 -

We can also look at the expense manipulation diagnostic ratios

Cummins Inc. Inc. 2001 2002 2003 2004 2005

Asset Turnover (sales/assets) 1.32 1.21 1.23 1.30 1.44

Changes in CFFO/OI 1.85 0.85 -1.06 1.21 0.41

Changes in CFFO/NOA 1.78 0.11 -0.17 0.31 0.38

Total Accruals/Change in Sales .27 -1.08 -.6 -.12 -.14

Pension Expense/SG&A 0.03 0.03 0.07 0.09 0.09

Other Employment Expenses/ SG&A N/A N/A N/A N/A N/A

Again, Cummins Inc. is doing a good job with disclosure. Asset Turnover has

been relatively steady until 2005 when the Asset Turnover ratio increased by

0.14. This was the result in an almost 18% increase in sales from the year

2004-2005. The drastic change in CFFO/OI was probably due to a 40% increase

in operating income from 2004-2005. Pension expense/SG&A increased over the

five-year period. We also compared the ratios to the industry in order to have a

frame of reference in which to base our assumptions on.

Caterpillar 2001 2002 2003 2004 2005

Asset Turnover (sales/assets) 0.77 0.71 0.57 0.66 0.72

Changes in CFFO/OI 0.17 47.38 -22.73 1.60 6.46

Changes in CFFO/NOA -0.04 0.17 -2.04 0.24 1.81

Total Accruals/Change in Sales -0.65 4.21 33.33 26.60 15.49

Pension Expense/SG&A -0.07 -0.04 0.03 0.09 0.11

Other Employment Expenses/ SG&A N/A N/A N/A N/A N/A

- 32 -

In-Depth Quantitative Analysis

Net Sales/Cash From Sales

1.05

1.10

1.15

1.20

1.25

1.30

1.35

1.40

1.05

1.10

1.15

1.20

1.25

1.30

1.35

1.40

Cummins 1.10 1.13 1.15 1.14 1.15

Caterpillar 1.16 1.18 1.24 1.36 1.28

2001 2002 2003 2004 2005

The ratio between Net Sales and Cash from Sales for Cummins Inc. has been

steady, ranging from 1.1 to 1.15 for the years 2001-2005. Overall both

Caterpillar and Cummins Inc. had a ratio that was between 1 and 1.5 which tells

us that cash collection policies for the two companies were fairly comparable.

This ratio of a little greater than one tells us that cash collections from sales was

significant compared to net sales. In 2004, Caterpillar experienced a slight

increase in this ratio from 1.24 to 1.36, while Cummins Inc. remained steady

over the same time. This could be due a more relaxed accounts receivable

policy. Cummins Inc. is doing a better job collecting cash from sales than

Caterpillar, although by relatively insignificant amount.

- 33 -

Net Sales/ Net Accounts Receivable

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

12.00

Years

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Cummins 10.99 8.66 7.54 8.12 7.55

Caterpillar 7.34 6.57 5.22 3.80 4.52

2001 2002 2003 2004 2005

The ratio of Net Sales to Net Accounts Receivable shows how well the company

is managing their accounts receivable. Both Cummins Inc. and Caterpillar are

doing a good job stating actual revenues. Cummins Inc. accounts receivables

are a smaller percentage of sales than that of Caterpillar, which indicates that

sales are supported by accounts receivable. Cummins Inc. should be aware that

although net sales drastically increased in 2004 and 2005 (33% and 18%

increase respectively), the ratio of Net Sales to Net Accounts Receivable did not

increase. When growth slows, Cummins Inc. will be well-positioned to get cash

quicker from Accounts Receivable. Although this ratio declines with an improving

economy, this ratio remains somewhat steady and supports the validity of the

company’s performance.

- 34 -

Net Sales/ Inventory

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

Cummins 8.33 9.13 8.59 8.31 8.45

Caterpillar 6.50 6.75 6.91 6.06 6.51

2001 2002 2003 2004 2005

The ratio of Net Sales to Inventory tells us that inventory and sales have

remained constant over the period of 2001-2005. Cummins Inc. is doing a better

job of managing their inventory. With the high cost to keep inventory on hand,

Cummins Inc. is showing their ability to forecast sales and keep a proper amount

of inventory on hand. In this industry, cost-leadership is a key success factor.

Cummins Inc. does not have the amount of money tied up in inventory that

Caterpillar does, which allows them to keep risk of an economic downturn at a

minimum. The steadiness of this ratio for both Cummins and Caterpillar indicate

that the industry is well-developed and mature. Inventory levels are on par with

sales throughout the entire period.

- 35 -

Net Sales/ Warranty Liabilities

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

Cummins 17.64 18.41 17.59 17.58 17.19

Caterpillar 29.18 26.91 33.73 36.10 38.69

2001 2002 2003 2004 2005

The ratio of Net Sales to Warranty Liabilities shows that warranty liabilities have

stayed proportional to the fluctuations in sales over the past 5 years. Cummins

Inc. is doing a good job of accurately stating their actual warranty liabilities and

management estimates have been steady. The consistency of warranty liabilities

in relation to sales supports the significant improvement in sales during this

period of economic expansion.

- 36 -

Asset Turnover (Sales/Assets)

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Cummins 1.32 1.21 1.23 1.30 1.44

Caterpillar 0.77 0.71 0.57 0.66 0.72

2001 2002 2003 2004 2005

Asset turnover measures an entity’s capability to efficiently use assets to

accumulate sales. Cummins Inc. has had less fluctuation than Caterpillar and

more efficiently uses its assets to generate sales. Cummins Inc. asset turnover is

very high as it produced over $1.4 dollars in sales for every dollar of assets.

Caterpillar produced less than a dollar in sales for every dollar it holds as assets.

Cummins has a smaller asset base than Caterpillar, explaining why their sales are

- 37 -

lower than Caterpillars.

Changes in CFFO/OI

-10.00

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

60.00

Cummins 1.85 0.85 -1.06 1.21 0.41

Caterpillar 0.17 47.38 -22.73 1.60 6.46

2001 2002 2003 2004 2005

Cummins Inc.’ cash flow is in line with operating income. The ratio fluctuates

around one over the period of 2001-2005. Overstating expense on the income

statement would cause the ratio to increase. Caterpillar has had some large

fluctuation possible due to an overstatement of expenses. In general, a lower

number represents cash flows from operations as opposed to investing. This

means that Cummins cash flows from operations can be clarified by its operating

income.

- 38 -

Changes in CFFO/NOA

-2.50

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

Cummins 1.78 0.11 -0.17 0.31 0.38

Caterpillar -0.04 0.17 -2.04 0.24 1.81

2001 2002 2003 2004 2005

The ratio of CFFO to NOA gives us the firm’s return from operating assets in

terms of cash flow from operations. Both companies showed a decrease in the

in the ratio during the year 2001-2003 but investment in operating assets picked

up after 2003. In 2003 and 2004 Caterpillar experienced negative cash flow

which explains the sharp increase in the ratio. Investing in operating assets to

produce increased cash flows from operations is not a strategy Cummins is

employing.

- 39 -

Pension Expense/SG&A

-0.10

-0.05

0.00

0.05

0.10

0.15

Cummins 0.03 0.03 0.07 0.09 0.09

Caterpillar -0.07 -0.04 0.03 0.09 0.11

2001 2002 2003 2004 2005

This ratio show how pension expenses compare to fixed costs and overhead over

the five year period. The diversified machinery industry is highly unionized,

making pension expenses a significant cost. The industry requires quality pension

plans to attract quality workers in the labor market. However, if pension cost

consisted of a major part of SG&A, companies can have trouble fulfilling its

pension obligations and reduce margins for each item sold. The increase in

pension expenses over SG&A can be attributed to a large number of baby-

boomers retiring. Caterpillar’s pension expenses have increased at an alarming

rate and could become less competitive as it has assumed large obligations.

Cummins Inc. pension expenses have increased to almost 10% of SG&A, but it

has increased at a much slower rate than Caterpillar. Cummins Inc. has done a

relatively better job of minimizing its pension obligations as a proportion of

SG&A. Pension assumptions are not very aggressive, especially concerning the

discount rate. An increase in the discount rate would significantly lower this ratio

for Cummins and truly convey its financial stability in managing long-term

obligations.

- 40 -

Identification of Potential “Red Flags”

To valuate any company properly you must go through all the accounting books

and identify any red flags that might be presented that would make a company

appear more valuable than it really is. Cummins Inc. overall, has sound

accounting methods and practices that deliver mostly a clear view of how the

company is currently standing and where it has potential for future growth. It

does, however, have a few minor sections of its financials that are worth looking

into. The first minor red flag has to do with their operational and capital leases

when Cummins Inc. attempts to state that some of the equipment used to make

the engines that are to be sold is stated as being an operational lease and not a

capital lease as it should be. This is usually done to hide some of the liabilities

from an outside entity and to appear more profitable to investors. The second

minor red flag that arose when analyzing the financial statements had to do with

Cummins Inc. pension program, which was drastically under funded by $653

million and in their statement only reports that the program is under funded by

only $310 million. These numbers might seem large, but when you compare

these numbers to Cummins Inc. total liabilities it comes only to about 7.2%.

Undo Accounting Distortions

As was stated in the red flags section, there are some minor distortions in the

liability side of the balance sheet that can be explained even though they are

minor when looking at the company as a whole. The most impacting distortion

has to do with the pension program and its understatement of its liabilities

towards that program. This program’s obligation was $3 billion in the fiscal year

2005 and had a fair value of around 2.3 at end of year which came out to being

$653 million under funded while in the 10k form it states that the benefit plan is

only under funded by $310 million. The remaining 343 million dollars was

- 41 -

transferred to different accounts to get it off of the liabilities and make it look like

they are meeting their commitment when it is actually not the case. The other

distortion in the financial statements has to do with their equipment that is being

stated as being rented to produce their product when in face should be moved

from an operating lease over to a capital lease and show that they actually owe

money to a bank for the loan payments of that equipment. While having these

two minor distortions, Cummins Inc. Inc. still has a very detailed annual report

and 10K that clearly defines the financial state of this company.

Ratio Analysis

Ratio analysis can provide insightful information about a firm by assessing how

different items of a firm’s financial statement relate to one another. A firm’s

liquidity, profitability, and capital structure can be revealed through aggregating

the results of similar ratios and interpreting the data. We will evaluate Cummins’

(C.M.I.) performance using trend analysis, a time-series comparison of company

performance over the past five years, and industry benchmarks, comparing

Cummins’ liquidity, profitability, and capital structure to that of Caterpillar’s.

Trend analysis can be indicative of Cummins’ past, present, and future

performance. Industry analysis, in the case of Cummins, consists of comparing

selected ratios to the firm’s only public competitor, Caterpillar.

We will employ a variety of ratios that thoroughly explain Cummins liquidity,

profitability, and capital structure. Liquidity ratios provide useful information on a

firm’s ability to maintain adequate cash and other current assets necessary to

meet its obligations in a timely manner. Poor liquidity ratios can spell financial

distress for Cummins in the near future. Too much relative debt can cause C.M.I.

to default on interest and principal payments, a solvency issue investors can

foresee through correct interpretation of the company’s liquidity ratios.

- 42 -

Profitability ratios can be broken down into four vital factors related to profits:

operating efficiency, asset productivity, the rate of return on assets, and the rate

of return on equity. These ratios utilize common size income statements to

explain important factors as a percentage of sales and measure how well the

company generates profit and revenue from equity and assets. The capital

structure of Cummins refers to the sources of financing, liabilities and

stockholder’s equity, used to buy assets. Capital structure ratios can be indicative

of the financing policies of Cummins management, their level of comfort with

leverage, and attitude toward business risk.

Trend and Cross-Sectional Analysis

Cummins liquidity, profitability, and capital structure can be accurately assessed

through trend and cross-sectional analysis. Trend analysis and cross-sectional

analysis are relative benchmarks comparing Cummins present performance to its

performance in the past and to the industry as a whole. A five-year trend

analysis is necessary to understand Cummins’ recent progression and provides

insight to the company’s direction. Cross-sectional analysis allows investors to

gauge Cummins performance to rest of the industry. Results from cross-sectional

and trend analysis are used to make educated forecasts from identified trends.

These two forms of financial analysis bring to light Cummins operating efficiency,

annual trends, and financial hierarchy in its industry.

Liquidity

A company’s ability to maintain a certain percentage of cash equivalent assets

that can be used to pay off its current liabilities is referred to a company’s

liquidity. In the past five years Cummins has become much more liquid which is

giving them the ability to pay off more of their current liabilities and to pay off

more of their long term obligations, this however has made their operation

- 43 -

efficiency ratios go down steadily over the previous years. This section will

analyze these five ratios current ratio and quick asset ratio to judge liquidity, and

to further understand the operating efficiency the inventory, receivables, and

working capital turnover ratios will be used and explained to produce a clear

understanding of Cummins liquidity.

Current Ratio

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

Cummins

Caterpillar

Cummins 1.49 1.53 1.49 1.77 1.87

Caterpillar 1.23 1.33 1.22 1.20 1.20

2002 2003 2004 2005 2006

The current ratio is calculated by dividing current assets by current liabilities. The

ratio measures the ability of the firm to pay its short-term obligations. Cummins

averaged a current ratio of 1.63 for the five year period from 2002 through 2006,

while the industry ratio averaged 1.24, for the same period. Both Cummins and

Caterpillar have sufficient means to cover their current obligations, but while

Cummins is increasing its ratio year over year by 12.24% from 2004 to 2006,

Caterpillar’s ratio has remained stagnant at around 1.2. We think that through

the cost cutting and efficiency programs that Cummins has applied, net earnings

have increased substantially affecting the retained income that is reinvested into

- 44 -

the company, and with low capital expenditures Cummins has been able to

increase the size and growth of their current assets.

Quick Ratio

0.00

0.20

0.40

0.60

0.80

1.00

1.20

Cummins

Caterpillar

Cummins 0.83 0.81 0.84 1.02 1.13

Caterpillar 0.83 0.92 0.82 0.80 0.81

2002 2003 2004 2005 2006

The quick ratio is calculated by adding cash, securities and receivables and then

dividing by the current liabilities. This ratio reveals the amount of liquid assets

the company has on hand to cover their short-term debt obligations. Cummins

averaged .92 and 8.29% growth in for their quick ratio for the five year period,

while Caterpillar averaged .82 and had flat growth for the same period. Cummins

is not outperforming the industry by much, but is growing at an average 8.29%

and will in our opinion be able to break away from the industry and set a new

standard. Much of this growth is attributed to the company’s ability to generate

and retain cash better than Caterpillar.

- 45 -

The Accounts Receivable Turnover

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

Cummins

Caterpillar

Cummins 7.27 6.78 7.27 6.97 6.43

Caterpillar 2.10 2.02 2.40 2.60 2.77

2002 2003 2004 2005 2006

The accounts receivable turnover is found by dividing sales by accounts

receivable. This ratio measures the firm’s ability to collect cash from previous

sales. Cummins had an average turnover of 6.94 which means that it is taking

them 52.56 days to collect on their receivables. One alarming fact is that the rate

at which Cummins collects has been increasing from 50.2 days outstanding in

2002, to 56.76 days in 2006. we are not pleased with managements

ineffectiveness to decrease the collection period. Caterpillar had an average

turnover of 2.38, meaning that their collection period for the five year period

averaged 153.45 days, while reaming relatively flat through the period. While

Cummins may be extending their collection period, they are obviously performing

above the industry average. We attribute the growth into developing economies

as one of the reasons that Cummins has let their turnover ratio slip. These

developing economies are growing at a high rate and have a harder time paying

- 46 -

their short-term debts. By lowering the collection period Cummins could have

more cash to reinvest back into the firm. It would be a bad decision by

management to let this trend continue.

Inventory Turnover

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

Cummins

Caterpillar

Cummins 7.50 7.06 6.65 6.59 6.29

Caterpillar 5.48 5.56 4.81 5.08 4.65

2002 2003 2004 2005 2006

The inventory turnover is computed by dividing cost of goods sold by inventories.

This ratio tells whether inventories are building up or declining. Cummins

experienced an average turnover of 6.94 or 52.56 days of inventory on hand,

while Caterpillar had an average ratio of 5.12 or 72.66 days in the period

between 2002 and 2006. Cummins is performing above the industry average but

has seen a higher increase in the inventory holding period with an average

increase by 7.28% as opposed to Caterpillar’s average increase of 4.51%. We

believe that this trend has been increasing at this alarming rate due to

- 47 -

management’s inability to accurately forecast sales, and this fault is hurting the

firm’s profitability.

Working Capital Turnover Ratio

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Cummins

Caterpillar

Cummins 8.96 8.57 7.84 5.84 5.44

Caterpillar 7.44 5.46 8.55 9.43 10.81

2002 2003 2004 2005 2006

The working capital turnover is calculated by finding the working capital, which is

current assets less current liabilities and then dividing sales by that number.

Cummins averaged a turnover ratio of 7.33 for 2002 through 2006, compared to

Caterpillar’s average turnover of 8.34 for the same period. Cummins is above the

industry with higher working capital compared to sales, and is also decreasing

their turnover rate at 11.32%, compared to Caterpillar’s increasing turnover rate

of 13.73%. A decreasing turnover rate means that the firm is increasing current

assets more than current liabilities, and therefore is using retained earnings to

finance day to day assets and activities rather than using debt. Caterpillar is

using short-term debt to finance their day to day activities. We think that

Cummins’s trend in increasing working capital can continue to improve the

overall liquidity of the firm as well as the profitability in the next few years.

- 48 -

Profitability Analysis

Profitability analysis is composed of six ratios that measure Cummins efficiency in

generating a profit. These various ratios include gross profit margin, operating

expense, net profit margin, asset productivity, return on assets, and return on

equity. The first three are all measures operating efficiency, a factor of

profitability that attempts to reach a given level of sales with minimum

associated costs. The latter three measure the revenue or profit productivity of

resources utilized by Cummins. Profitability analysis provides insight to how

efficiently the company is employing resources and mitigating costs to produce a

profit.

Profitability Analysis for Cummins

2002 2003 2004 2005 2006

Gross Profit Margin 17.85% 17.84% 19.91% 22.04% 22.84

Operating Expense 15.48% 15.25% 13.46% 13.03% 12.93

Net Profit Margin 1.40% 0.79% 4.15% 5.55% 6.29%

Asset Productivity 1.21 1.23 1.29% 1.44 1.52

Return on Assets 1.70% 0.98% 5.36% 7.99% 9.58%

Return on Equity 8.79% 4.66% 21.75% 26.33% 23.40

Profitability Analysis for Caterpillar

2002 2003 2004 2005 2006

Gross profit margin 24.84% 25.56% 25.77% 26.92% 28.83%

Operating expense ratio 18.27% 18.14% 16.91% 16.50% 16.97%

Net profit margin 3.96% 4.83% 6.71% 7.85% 8.52%

Asset turnover 0.62 0.62 0.70 0.77 0.82

Return on assets 2.44% 3.01% 4.72% 6.06% 6.95%

Return on equity 14.58% 12.11% 27.25% 33.85% 51.57%

- 49 -

In summation, all measures of profitability have considerably increased and

improved in almost every consecutive year. This can be attributed to three

dominant factors: (1) management’s focus on creating investor value through

higher profits and lower expenses using programs such as Six Sigma and (2)

expanding into high growth related markets, such as South East Asia and the

Middle East and (3) a rising economic demand for the industry throughout the

entire five year period.

Gross Profit Margin

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

Cummins

Caterpillar

Cummins 17.85% 17.84% 19.91% 22.04% 22.84%

Caterpillar 24.84% 25.65% 25.77% 26.92% 28.83%

2002 2003 2004 2005 2006

The gross profit margin is the percentage of which revenues exceed the direct

costs associated with the revenue. This ratio is affected by the premium

Cummins’ charges, the industry structure and product offered, and the cost

efficiency of the firm’s production. Gross profit margins for the entire industry

- 50 -

have consistently improved over the past five years. Cummins has witnessed the

most year-to-year growth in the period from 2004 to 2006 as a result of the

company’s change in business strategy in 2003. While Caterpillar’s margins are

more favorable (28.84% in 2006 versus Cummins’s margin of 22.84%), Cummins

is improving its margin at faster rate of 7.16% on average, as compared to the

average of 5.78% that Caterpillar has been growing at over the previous three

years. With this higher growth rate, we believe that Cummins should be able to

catch up to Caterpillar’s higher gross profit margins, which we have designated

the industry average, because of the high concentration of the industry.

Although C.M.I.’s gross profit margin falls below the industry average for 2002-

2006, it is improving and is indicative of the company’s growth.

Operating Expense Ratio

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

Cummins

Caterpillar

Cummins 15.48% 15.25% 13.46% 13.03% 12.93%

Caterpillar 18.27% 18.14% 16.91% 16.50% 16.97%

2002 2003 2004 2005 2006

- 51 -

The operating expense ratio compares selling, general, and administrative

expenses to sales, reflecting the efficiency of a firm’s operating structure.

Cummins efficiently utilizes operating expenses as a part of sales relative to

Caterpillar. Cummins has been effectively reducing their margin from 15.48% in

2002 to 12.93% in 2006, a 19% improvement for the entire period and an

average yearly reduction of 4.3%, compared to Caterpillar’s average reduction of

only 1.76%. It should also be noted that SG&A expenses only rose at a rate of

12.43% from 2004 to 2006, while net sales increased at a rate of 22% for the

same period. Cummins is an industry leader in controlling operating expenses,

operating 4% more efficiently than Caterpillar’s operating expense ratio of

16.97%. We believe this to be a great competitive advantage for Cummins as it

can generate more sales without a large increase in SG&A, producing wider,

more profitable margins than the industry standards.

- 52 -

Net Profit Margin

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

Cummins

Caterpillar

Cummins 1.40% 0.79% 4.15% 5.55% 6.29%

Caterpillar 3.96% 4.83% 6.71% 7.85% 8.52%

2002 2003 2004 2005 2006

Net profit margin is the percentage of net income to sales. Cummins has

obtained a net profit margin of 6.29% in 2006. In this low profit industry with a

high level of fixed costs, net profit margins in this range are expected. Compared

to its previous profit margins in the period of 2002 to 2003, Cummins has

significantly improved upon turning a profit. This is attributable to a restructuring

phase the business endured between 2003 and 2004 that focused on

productivity and cost control. The restructuring included the implementation of

the Six Sigma program, an increased push to grab a larger international market

share which in turn boosted sales through accessing related markets in

developing economies. Cummins went from profits of 1.4% and .79% in 2002,

2003 and jumped to 4.15%, 5.55% and 6.29% in 2004, 2005 and 2006.

Cummins net profit margin is almost 2% lower than the industry standard.

Caterpillar experienced an 8.52% net profit margin in 2006, but has only been

- 53 -

able to grow their earnings by an average of 12.72% in the last two years, while

Cummins has grown in the same period by an average of 23.6%. Even though

Cummins is currently underperforming compared to the industry, we believe that

the company is producing earnings at a reasonable level and will not have a

problem reaching the industry level because of their attractive earnings growth

rate.

Asset Productivity

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Cummins

Caterpillar

Cummins 1.21 1.23 1.29 1.44 1.52

Caterpillar 0.62 0.62 0.70 0.77 0.82

2002 2003 2004 2005 2006

Asset productivity measures how efficiently resources are employed in

generating revenue. Asset productivity is derived by dividing sales by total

assets. Cummins asset productivity exceeds Caterpillar’s for the entire period.

This is a result of Caterpillar having trouble finding efficient ways to generate

sales from its enormous asset base. Simultaneously, Cummins was able to grow

sales without investing in new assets and instead, relied on improving previous

- 54 -

capital investments to increase capacity. Cummins has a relatively smaller asset

base although both own tremendous amounts of resources. Cummins asset

turnover averages 1.42 from 2004 to 2006, meaning that they are bringing in

$1.42 in sales for every dollar spent on assets, as opposed to Caterpillar’s

average of $0.76 in sales revenue for every dollar spent on assets in the same

period. Obviously Cummins is outperforming the industry average in this area,

but are they are only growing their turnover ratio by an average of 5.96%, while

Caterpillar is growing theirs at a rate of 7.39%. Cummins is very productive with

its assets, so it is becoming harder and harder to squeeze sales revenue out of

assets that are producing as close to capacity as possible. Although Caterpillar

has been growing its asset base in order to boost sales, they also have plenty of

room to improve turnover by focusing on productivity. This will in turn make it

easier to attain a higher growth rate. For this reason, we believe that Cummins’

asset turnover ratio growth will slow and level off, allowing the industry to

eventually catch up to Cummins’s productive standards. While the growth in

asset turnover for Cummins will most likely start to level off, we believe that the

company can continue to produce an attractive asset turnover ratio in the future

and stay an industry leader in productivity.

- 55 -

Return on Assets

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

Cummins

Caterpillar

Cummins 1.70% 0.98% 5.36% 7.99% 9.58%

Caterpillar 2.44% 3.01% 4.72% 6.06% 6.95%

2002 2003 2004 2005 2006

Return on assets is a comprehensive measure of profitability that observes both

profits and resources utilized to generate profits. The rate of return is found by

dividing net income by assets. Alternatively, the rate of return on assets can be

found by multiplying the profit margin by asset turnover. As discussed above,

Cummins is the industry leader in productivity of assets. Cummins has

outperformed the industry’s average return on assets of 5.91%, with an average

of 7.64% over the last three years. Also they have been able to outgrow the

industry’s average return on asset growth rate by almost 13% for the same

period. This performance level is attributable to Cummins’ ability to control costs

through programs such as Six Sigma and its ability to control capital spending by

investing in already owned assets. Both boost capacity and productivity, two

areas that eventually enhance net income ROA. We believe that Cummins can

continue to grow ROA at such profitable levels because of their past performance

and new operating strategies.

- 56 -

Return on Equity

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

Cummins

Caterpillar

Cummins 8.79% 4.66% 21.75% 26.33% 23.40%

Caterpillar 14.58% 12.11% 27.25% 33.85% 51.57%

2002 2003 2004 2005 2006

Return on equity (R.O.E.) reflects the profitability of the owner’s interest in total

assets. This rate of return measure is found by dividing net income by owner’s

equity. Return on equity is dependent on profit margins, asset turnover, and the

ratio of total debt to owner’s equity (a ratio discussed under Capital Structure

Ratios). Cummins has witnessed 18.4% growth in its R.O.E. since 2003.

Cummins R.O.E. peaked in 2005 at 26.33% and has since leveled off at 23.40%.

Although Cummins has significantly improved its R.O.E., Cummins shareholder’s

should be cognitive of the fact that Caterpillar experienced a 36.44% increase in

its R.O.E. from 2002-2005. This includes a 17.72% improvement in R.O.E. in

2006, a period in which Cummins return on equity experienced a slight decline.

This poses an interesting consideration for Cummins investors who might see

that as an indication that their ownership interest will not improve its profitability

in the future. However, Cummins decline in R.O.E. in 2006 stems mostly from

increasing total shareholder equity from 1,864 billion dollars in 2005 to 2,802

- 57 -

billion in 2006. Net income increased significantly from 2005 to 2006 (30%) so

the variance in R.O.E. between Cummins and Caterpillar should not be of great

concern. Caterpillar increased their R.O.E. through repurchasing 4,075 million

dollars worth of outstanding shares. This financial management policy employed

by Caterpillar has allowed it to possess a superior R.O.E.

Capital Structure Analysis

A company’s capital structure is composed of debt and equity. These are the

financing options used to obtain assets. Analyzing capital structure involves

understanding the amount of relative debt to equity and the ability to cover

principal and interest requirements on debt. Three significant capital structure

ratios are: debt to equity, times interest earned, and debt service margin.

Interpreting these three ratios as a whole provides a balanced picture of a

company’s capital structure.

Capital Structure Analysis

2002 2003 2004 2005 2006

Debt to

Equity

4.18 3.78 3.06 2.30 1.44

Times

Interest

Earned

2.28 2.01 4.94 8.32 12.23

Debt

Service

Margin

1.40 3.22 1.77 4.94 5.12

Overall, Cummins capital structure has improved every year since 2002, a result

of higher income and cash from operations as well as offering more equity

relative to debt.

- 58 -

Debt to Equity Ratio

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

Cummins

Caterpillar

Cummins 4.18 3.78 3.06 2.30 1.44

Caterpillar 4.98 5.00 4.77 4.58 6.42

2002 2003 2004 2005 2006

The debt to equity ratio measures the proportion of total debt relative to equity.

Debt to equity is found by dividing total liabilities by total owner’s equity. A firm’s

debt to equity ratio serves as a good indicator of a company’s credit risk.

Cummins has been decreasing their debt to equity ratio from 4.18 in 2002, to

1.44 in 2006. That is an average decline in debt leverage of 22.7% during the

five year period. Their credit risk also declined and Standard and Poor’s elevated

Cummins credit rating to investment grade with a stable outlook during 2005.

This reduced the company’s cost of debt. Management policies that improved

this ratio include significantly increasing equity financing during 2006 (discussed

under Return on Equity section above) and entering into long-term supply

contracts with suppliers, reducing credit risk and the cost of obtaining debt.

- 59 -

Cummins is well-positioned to repay its obligations in 2007 with a debt to equity

ratio of 1.44. This is important as the industry is anticipating a leveling out or

slight decline in sales for 2007. Caterpillar experienced a slight annual decline in

their debt to equity ratio from 2002 to 2005. In 2006, the company repurchased

4.075 billion dollars worth of outstanding stock, reducing its equity base and

increasing its debt to equity. This indicates that Caterpillar has substantial

leverage and a higher credit risk than Cummins. Caterpillar has increased its

leverage, possessing a 6.42 debt to equity ratio, without reducing its credit

rating. On the other hand, the cost of equity is more expensive than debt,

allowing Caterpillar to continue paying out lower dividends to investors. Cummins

is leading the industry in lower debt to equity through growing by retaining

earnings and acquiring as little debt as possible.

Times Interest Earned

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

Cummins

Caterpillar

Cummins 2.28 2.01 4.94 8.32 12.23

Caterpillar 4.98 7.09 13.03 16.28 19.04

2002 2003 2004 2005 2006

Times interest earned is a ratio that measures the ability of a firm’s income from

operations to cover interest charges. This ratio is found by adding back interest

- 60 -

and taxes to net income (NIBIT) and dividing it by interest expense. From 2002

to 2006, Cummins increased its times interest earned from 2.28 to 12.23, a

437% improvement. The jump can be attributed to a higher growth rate of

income from operations in proportion to interest expense. The high timers

interest earned ratio indicates that the company has substantially enhanced its

ability to pay interest expenses with cash on hand.

While Cummins has plenty of cash to cover interest expenses, Caterpillar has

even more. Caterpillar, an industry leader in this area, increased its times

interest earned ratio from 4.98 in 2002 to 19.04 in 2006. Both firms increased

this ratio at similar annual rates. However, Caterpillar is better positioned to

cover interest expenses with available cash from operations in the event of an

economic downturn. Under current economic conditions, both companies could

increase their dividend per share. However, if future economic conditions

worsen, Cummins would have to reduce its dividend per share before Caterpillar,

adversely affecting its stock price.

- 61 -

Debt Service Margin

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Cummins

Caterpillar

Cummins 1.40 3.22 1.77 4.94 5.12

Caterpillar 0.60 0.69 -1.13 0.69 1.30

2002 2003 2004 2005 2006

The debt service margin illustrates the firm’s ability to cover current maturities in

debt with cash provided from operations. The ratio is found by dividing the cash

flows from operations by the current installments due in long-term debt.

Cummins has been increasing their ratio by 3.8% from 2005 to 2006, from 4.94

to 5.12. Caterpillar only attained ratios of .69 and 1.3, but has grown the ratio by

87.87% in the same period. While Cummins’ ratio is not growing as quickly as

the industry’s is, they are leading the industry in debt coverage. Caterpillar is

providing only $1.30 in cash flows from operations for every dollar in current

maturities of debt, while Cummins is providing $5.12 from operations for every

dollar in installments due. Clearly management is doing a good job of debt

control and expansion of cash flows from operations. We believe that Cummins

will continue to grow their debt service margin slowly but will be able to sustain

attractive levels of coverage, and lead the industry.

- 62 -

Extended Ratio Analysis

The extended ratio analysis goes beyond the basic 14 ratios used to evaluate a

firm’s performance. We decided to further evaluate Cummins using ratios that

focus on more specific items we deem important to the valuation of the

company, to get a better grasp on management’s performance.

Dividend Payout Ratio

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

Cummins

Caterpillar

Cummins 60.98% 100.00% 15.14% 10.18% 9.23%

Caterpillar 0.18% 0.13% 0.04% 0.03% 0.03%

2002 2003 2004 2005 2006

The dividend payout ratio is found by dividing the amount of dividends paid by

net income. This ratio describes what percentage of net income is being paid to

shareholders. The payout ratio for Cummins has been considerably higher than

the industry average of .04% over the past three years, as compared to an

average of 11.52% in the same period. One reason that Caterpillar’s ratio has

remained basically flat and low since 2004 is that they have a more conservative

- 63 -

dividend policy and choose to retain most of their income in order to finance

further growth. Cummins has a more aggressive dividend policy and chooses to

pay out a higher percent of earnings to its shareholders. One reason for

Cummins’ higher payout rates is its tendency to issue common stock to finance

their asset growth as opposed to raising funds through debt. This falls in line

with management’s strategy of paying down previously owned debt and

maintaining a more reasonable debt to equity ratio. Paying out high yielding

dividends is attractive to investors, which in turn allows C.M.I. to easily raise

equity financing. It should also be noted that Cummins’s ratio has been declining

since 2004, but dividends paid per share of common stock have actually

increased. This is due to the fact that earnings growth is outpacing the declared

dividend growth rate. Therefore the percentage of net income used in paying out

cash dividends is declining.

Net Long-Term Asset Turnover Ratio

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

Cummins

Caterpillar

Cummins 2.05 2.10 2.59 3.34 3.82

Caterpillar 1.32 1.28 1.54 1.84 1.68

2002 2003 2004 2005 2006

- 64 -

Net long-term asset turnover is a way of measuring the amount of dollars in

sales produced from every dollar invested in long-term assets. Long-term assets

play an important role in this industry; Cummins needs to be able to produce an

acceptable turnover to keep capital investing in check. The average turnover

ratio for Cummins over the past five years was 2.78 and has been growing

during the same period at an impressive average of 17.24%. Compared to the

industry’s average turnover ratio and growth rate at 1.53 and 7.03%, Cummins

is setting the standards for Caterpillar to follow. As previously discussed in the

total asset turnover and ROA sections, Cummins has ingeniously been able to

increase sales from previous investments in capital rather than investing in new

assets to grow revenues, as Caterpillar has done. We believe that this is the

greatest competitive advantage that Cummins has over the industry, and that

they will continue to lead the industry in productivity and asset turnover.

PP&E Turnover Ratio

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

Cummins

Caterpillar

Cummins 4.49 4.67 5.12 6.37 7.22

Caterpillar 2.86 3.12 3.95 4.55 4.69

2002 2003 2004 2005 2006

- 65 -

The PP&E turnover is a measurement of the dollars in sales produced for every

dollar invested in PP&E. This is simply a narrow look at the turnover that the

company is experiencing from the PP&E portion of the fixed assets. We believe

that this ratio is significant because it is highlighted by management in the 10-K.

C.M.I. plans to focus on expanding PP&E minimally and grow sales from these

specific fixed assets by investing in already existing PP&E. This should allow

Cummins to generate the products needed to supply new demand in newly

entered markets without a drastic increase in fixed costs. Cummins averages a

PP&E turnover ratio of 5.57, outperforming the industry average ratio of 3.83.

However, as was the case in the total asset turnover section, Cummins’ 12.9%

growth rate of the PP&E turnover is slightly lower than Caterpillar’s average

growth of 13.5%. We believe that if Cummins is to continue to expand sales they

will have a tough time growing their PP&E ratio much more than they already

have. Instead of investing in improving PP&E, C.M.I. may have to start investing

in new PP&E. Even though the growth rate of the ratio has slowed, we believe

that the average ratio of 5.57 is impressive and can be maintained and improved

upon by the company at a slower rate of ratio growth.

- 66 -

EBITDA Margin

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Cummins

Caterpillar

Cummins 5.07% 4.99% 8.40% 11.02% 12.09%

Caterpillar 13.96% 14.35% 14.01% 14.95% 15.70%

2002 2003 2004 2005 2006

The EBITDA margin is a means of measuring profitability after compensating for

taxes, interest, depreciation and amortization. Over the period of 2004 to 2006,

Cummins has averaged a profitability margin of 10.51%, underperforming the

industry average of 15%. The industry has been growing the margin by an

average of 5.86%, while Cummins has been growing their margin at an average

of 20.44% per year since 2004. Cummins is underperforming the industry in

profit margins, but is outpacing the industry in its growth of profitability. While

Cummins is not yet at the desired level of earnings performance, we believe that

management has done a good job turning around and restructuring the

company. In our opinion, C.M.I. should attain or exceed the industry average

because of the rate at which profitability is growing.

- 67 -

SGR & IGR Analysis

IGR & SGR

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

IGR

SGR

IGR 0.66% 0.00% 4.55% 7.18% 8.69%

SGR 3.43% 0.00% 18.46% 23.65% 21.24%

2002 2003 2004 2005 2006

The sustainable growth rate (SGR) is the maximum rate of growth that a firm

can sustain without borrowing additional equity. The internal growth rate (IGR)

is the highest rate of growth that a firm can attain while keeping earnings and

financial policies the same. These ratios allow us to benchmark and asses

managements strategy for growing the firm. IGR is found by multiplying the ROA

by 1 less the dividend payout ratio, and SGR is found by multiplying the IGR by 1

plus the debt to equity ratio. These are Cummins’ ratios as follows.

SGR will always be either greater than or equal to IGR, and will increase or

decrease at the same rate. In the years 2002 and 2003, before the company

restructured, both ratios showed little ability for the firm to grow using the same

financial practices or without adding additional equity. There was a sharp

- 68 -

increase from 2003 to 2004, that illustrated a change in managements strategy

for growth. By looking back at the company’s previous five years of income

statements, we see that Cummins experienced an increase in net earnings of

600%, from 50 million in 2003, to 350 million in 2004, and continued to grow

earnings through 2006 at a new pace than in the previous periods. We believe

that the years prior to 2004 should be discounted when assessing growth,

because prior to 2004, Cummins was financially a different company than in the

later three years. By examining the ratios we believe that Cummins has potential

for attractive growth in the future by using the same financial policies during

2004 to 2006 and by keeping up the same rate of growth in earnings will reduce

the need to borrow additional equity to finance further growth.

Forecasting

We have evaluated the past trends and ratios of Cummins and the industry in

order to forecast the firm’s financial position and growth through 2016.

Since the fiscal year of 2000, Cummins has been working towards their strategy

to become a low cost provider and a participant in related high growth markets,

mainly in regards to developing countries. Between 2003 and 2004, there are

considerable differences in the five year growth trends concerning net earnings,

sales, and total assets to name some of the more forecast-able statement items.

This ‘blemish’ to the trend, gives us reason to discount the 2003 to 2004 period

as part of a restructuring time frame that will most likely not continue to produce

these abnormal increases on future financial statements. When including this

period of the company’s performance, the average of all five years data

constructs growth in some areas of the balance and income statements that is

not reasonably sustainable. For this reason, we have decided to use the period of

- 69 -

2005 to 2006 to forecast a more rational direction that we believe Cummins is

headed.

Total assets during the 2003 to 2004 period increased by more than 27%,

around 20% more than the growth attained over the 2005, 2006 period of

5.48% and 8.42%, that averages out to 6.95%. This more reasonable rate also

compares well with the asset growth rate of 5.97%, from 2002 to 2003. The

return on assets for the periods 2004, 2005 and 2006, are 5.36%, 8% and

9.58%, compared to returns of 1.4% and .79%, in the 2002, 2003 period. These

ratio results further strengthen our assumption that in the middle of the

observed period, from 2002 to 2006, Cummins changed their company’s

operations and strategies and are now operating at a drastically different level in

2005 and 2006 than in the previous years.

The 2004 statement of earnings also mirrors the changes made in 2003 and

2004. During this time frame earnings grew by 600%, an obviously irrational

number to include in our forecast of future earnings. Net sales jumped as well in

2004, increasing by 34% compared to an average growth rate of around 7% in

years prior to 2004, and then leveled off to an average of 16%, in 2005 and

2006.

We have found some explanations to validate our opinion that the 2003 to 2004

period was a restructuring phase of the company and should not be included in

the forecasting of future growth.

One of the company’s strategies in 2000, was to become a low cost leader in

their industry by implementing the ‘Six Sigma’ program. The sole purpose behind

the program is to make the company as a whole more productive and cost

effective allowing Cummins to earn more money on every dollar brought in by

sales. Six Sigma shows evidence that the strategy is working through an increase

- 70 -

in operating income of 234% and increases to net income of 600% in 2004,

while only stating an increase in net sales of 34% and an operating expense

ratio of 13.46%, and sales growth into 2005, 2006 averaging 16%, with a

declining operating expense ratio of 13.03% and 12.93%. One should also figure

in the high growth seen during this period in the capital industry, but the world

and domestic economic growth alone can not support this abnormal year of

2004. Increases of earnings at this level also can not be explained by mere cost

cutting programs even though Cummins has been effectively cutting operating

costs since 2003.

As previously mentioned, Cummins also planned to expand into related markets.

These related markets do not require drastic changes in the capital structure or

investments and demand existing products so that Cummins could utilize unused

capacity to supply these markets needs. Most of these new markets are located

in developing economies that have been experiencing high growth, such as

China and the Middle East. Through examining managements’ notes in the 2004

10-K report, we believe that the increase of total assets by 27% in 2004, is due

to a partnership that Cummins Captured in China with Dongfeng Auto, Inc. In

February of 2003, Cummins entered into an agreement with Dongfeng Auto and

attained a large market share as well as high growth in the booming Chinese and

Asian economies that explains the jump in sales in 2004 of 34% in sales and

increases in net income. Cummins had to contribute large amounts of capital to

this new partnership in order to supply the new related market. Between 2003

and 2004 this can be seen by examining the new issuance of common stock, for

financing the build up, as well as examining the increase of total assets by $1.4

billion, an increase of 27%. It is our belief that, after this large initial investment

in the Chinese market, management will not continue to grow assets at this

unsustainable rate, and will only continue to grow assets at a more reasonable

rate, as they did in 2005 and 2006 at 5.48% and 8.42%, in order to keep up

with these growing markets in developing economies. One fact that we are using

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to support this assumption is that capital expenditures have not deviated by

enough to suggest that the company is still attempting to expand at this rate.

Over the period from 2002 to 2006 capital expenditures have not deviated much

from year to year and average approximately 29%. This steady trend in the

increase of capital spending supports management’s statement that they are

keeping capital expenditures in check by focusing not on acquiring new plants

and machinery to support growth, as Cummins did prior to the year 2000, but

instead improving already existing facilities to support more productivity while

teaming up with partners to help grow at a more sustainable cost to the

company.

Through the extensive restructuring and strategy re-evaluations that the

company experienced in 2003 and 2004, we believe it is best not to incorporate

this time period into our forecasting of the company’s heading. We believe that

Cummins finished the ‘overhauling’ of their business strategy and investment

structure, during the period of 2003, 2004 and has been implementing the new

company structure and operating through the years 2005 and 2006, at a pattern

that is likely to continue. Therefore, we will be deriving most of our opinions and

assumptions from the last two years data instead of all five years.

Statement of Earnings

In trying to forecast the financial information for Cummins, we determined that

the best point of departure was to determine the sales growth. We found the

average growth rate of sales to be about 16.05% for the years 2005-2006. The

Industry average was about 10% growth in sales (MSN Money). We decided

long term sales growth would be about the average of 10%. We do not believe

that Cummins will be able to sustain this high growth rate through 2016,

because sales are starting to catch up to the industry average and it will be

harder to sustain more than the industry rate of 10% as the benchmark becomes

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larger and larger. The growth rate declined from 16.05% to 14.56% in 2005 and

2006, and we believe this trend in growth should continue to decline until

reaching the industry average. We continued to decline sales growth this decline

in sales growth each year by 1% until we reached the industry average of 10%.

With our forecast Cummins’ sales will reach approximately 20.02 billion in the

next five years, growing by 54.53% and 32.24 billion at a growth rate of almost

149% in ten years.

Through Cummins’ implementation of Six Sigma, they have been able to

decrease cost of goods sold as a proportion of sales by an average of 2% since

2003 when the program began to show improvements. In 2006 the decrease in

cost of goods sold began to taper off, so we continued that trend by decreasing

cost of goods sold by .05% each year for 5 years before leveling of at 74% of

sales. Caterpillar averaged a cost of goods sold as a percentage of sales of 72%

over the past two years, so our forecast was consistent with the industry

average.

We believe that Cummins has the ability to sustain operating expense at 13.7%

of sales. This was in part due to the fact that the Six Sigma program that they

implemented in 2000 included focusing on not only the manufacturing processes,

but the Selling General and Administrative related activates as well.

With the firms management focusing on productivity and cost control we believe

that earnings will sustain an average of 7.85% of sales through 2016.

With this assumption we forecast sales to more than double to 1.67 billion by

2011, and reach 2.7 billion in ten years, attaining a growth rate of 227%.

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CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS(in millions, except per share earnings)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Net sales 5,853 6,296 8,438 9,918 11,362 12953 14637 16393 18196 20016 22017 24219 26641 29305 32236Cost of sales 4,808 5,173 6,758 7,732 8,767 9844 11051 12295 13556 14812 16293 17922 19714 21686 23854

107Gross margin 1,045 1,123 1,680 2,186 2,595 3109 3586 4098 4640 5204 5725 6297 6927 7619 8381

Operating expenses and income

Selling and administrative expenses 736 830 1,015 1,145 1,283 1,424

Research and engineering expenses 201 200 241 278 321 330 Investee equity, royalty and other income (22) (70) (120) (131) (140)

Other operating expenses (income) (9) 5 Total operating expenses and income 906 960 1,136 1,292 1,469 1,775 2,005 2,246 2,493 2,742 3,016 3,318 3,650 4,015 4,416Operating earnings 139 163 544 894 1,126 1,334 1,581 1,852 2,147 2,462 2,708 2,979 3,277 3,605 3,965Interest income (12) (24) (47)Interest expense 61 90 111 109 96 149 168 189 209 230 253 279 306 337 371Other expenses (income) (18) 8 11 (1)Earnings before income taxes and minority interest 78 91 437 798 1,078 1,185 1,412 1,664 1,938 2,232 2,455 2,700 2,970 3,268 3,594

Provision (benefit) for income taxes (20) 27 56 216 324 324 366 410 455 500 550 605 666 733 806Minority interest in earnings of consolidated subsidiaries 16 14 26 32 44 39 44 49 55 60 66 73 80 88 97Net earnings 82 50 350 550 715 822 1,003 1,205 1,428 1,671 1,838 2,022 2,225 2,447 2,692

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CUMMINS INC. AND CONSOLIDATED SUBSIDIARIESCOMMON SIZED STATEMENTS OF EARNINGS

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20167.57% 34.02% 17.54% 14.56% 14.00% 13.00% 12.00% 11.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%

Net sales 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Cost of sales 82.15% 82.16% 80.09% 77.96% 77.16% 76.00% 75.50% 75.00% 74.50% 74.00% 74.00% 74.00% 74.00% 74.00% 74.00%Gross margin 17.85% 17.84% 19.91% 22.04% 22.84% 24.00% 24.50% 25.00% 25.50% 26.00% 26.00% 26.00% 26.00% 26.00% 26.00%Operating expenses and income avg 11.42% Selling and administrative expenses 12.57% 13.18% 12.03% 11.54% 11.29% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% Research and engineering expenses 3.43% 3.18% 2.86% 2.80% 2.83% 2.70% 2.70% 2.70% 2.70% 2.70% 2.70% 2.70% 2.70% 2.70% 2.70% Investee equity, royalty and other income -0.38% -1.11% -1.42% -1.32% -1.23% Other operating expenses (income) -0.15% 0.00% 0.00% 0.00% 0.04% Total operating expenses and income 15.48% 15.25% 13.46% 13.03% 12.93% 13.70% 13.70% 13.70% 13.70% 13.70% 13.70% 13.70% 13.70% 13.70% 13.70%Operating earnings 2.37% 2.59% 6.45% 9.01% 9.91% 10.30% 10.80% 11.30% 11.80% 12.30% 12.30% 12.30% 12.30% 12.30% 12.30%Interest income 0.00% 0.00% -0.14% -0.24% -0.41%Interest expense 1.04% 1.43% 1.32% 1.10% 0.84% 1.15% 1.15% 1.15% 1.15% 1.15% 1.15% 1.15% 1.15% 1.15% 1.15%Other expenses (income) 0.00% -0.29% 0.09% 0.11% -0.01%

Earnings before income taxes and minority interest 1.33% 1.45% 5.18% 8.05% 9.49% 9.15% 9.65% 10.15% 10.65% 11.15% 11.15% 11.15% 11.15% 11.15% 11.15%Provision (benefit) for income taxes -0.34% 0.43% 0.66% 2.18% 2.85% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50%Minority interest in earnings of consolidated subsidiaries 0.27% 0.22% 0.31% 0.32% 0.39% 0.30% 0.30% 0.30% 0.30% 0.30% 0.30% 0.30% 0.30% 0.30% 0.30%Net earnings 1.40% 0.79% 4.15% 5.55% 6.29% 6.35% 6.85% 7.35% 7.85% 8.35% 8.35% 8.35% 8.35% 8.35% 8.35%

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Balance Sheet

By forecasting the balance sheet we can understand and predict how the firm is

going to structure its self through debt, equity and assets to produce the

forecasted sales and earnings. We decided that the most accurate way to

forecast assets was through the use of the total asset turnover ratio. As

discussed previously, management has been and is implementing programs

concerning asset productivity, as shown through our evaluation of the asset

turnover ratio. Cummins was not increasing Assets in order to increase sales

after their restructuring period ended in 2003, but instead produced more sales

from previous investments through Six Sigma programs. We think that Cummins

will be able to further improve their asset turnover ratio through 2016, by 5.68%

per year. After assuming this growth in productivity we believe assets will grow

to 9.97 billion in five years at a growth rate of 23.89%, and will grow assets in

ten years by 51.37% to 12.19 billion. To find Current Assets, as well as current

liabilities, we determined that after taking an average of the past two years as a

percentage of total assets that Cummins would sustain the current relationship

between Current Assets/liabilities and Total Assets. We forecasted total liabilities

to continue to decrease as the firm has already shown in the previous five years.

We think that this is possible because management is using less debt every year

and more cash to finance company growth. We forecast Cummins to decrease

total liabilities by .5% per year, through the ten year period, reducing the debt to

equity ratio by 16.4% in five years and 26.8% in ten years. We predicted

shareholders’ equity through our assumption that the firm will continue with

management’s strategy to finance growth through retained earnings, by taking

the difference in total liabilities and total assets. Growth in shareholders’ equity

will bring the firm to approximately 4.72 and 6.18 billion, in five and ten years.

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CUMMINS INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED BALANCE SHEETS

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016ASSETSCurrent assets: Cash and cash equivilants 224 108 611 779 840 Marketable securities 74 87 79 61 95 Recievables, net 805 929 1,160 1,423 1,767 2,032 2,345 2,706 3,123 3,604 4,159 4,799 5,538 6,391 7,375 Inventories 641 733 1,016 1,174 1,393 1,523 1,664 1,816 1,980 2,157 2,350 2,560 2,789 3,038 3,310 Deffered income taxes 238 192 301 363 277 Prepaid exp and other current assets 81 106 116 116 Total current assets 1,982 2,130 3,273 3,916 4,488 4,832 4,994 5,019 5,272 5,487 5,711 5,945 6,188 6,441 6,704Long-term assets Property, plant and equipment, net 1,305 1,347 1,648 1,557 1,574 Investments in and advances to equity investees 264 339 286 278 345 Goodwill 343 344 355 358 356 Other intangible assets, net 96 92 93 100 128 Deffered income taxes 640 663 689 500 433 Other assets 207 211 183 176 141 Total Assets 4,837 5,126 6,527 6,885 7,465 8,053 8,610 9,125 9,585 9,977 10,384 10,809 11,251 11,711 12,189LIABILITIES AND SHAREHOLDERS' EQUITY 6.95% 0.08Current liabilities: Short-term borrowings 138 49 346 154 164 Accounts payable 427 557 823 904 1,104 Other accrued expenses 764 789 1,028 1,160 1,131 Total current liabilities 1,329 1,395 2,197 2,218 2,399 2,577 2,755 2,920 3,067 3,193 3,323 3,459 3,600 3,747 3,901Long-term liabilities Long-term debt 999 1,380 1,299 1,213 647 Pensions 438 439 466 396 367 Postretirement benefits other than pensions 575 577 570 554 523 Other liabilities and deffered revenue 563 263 386 415 473Total Non-Current Liabilities 2,575 2,659 2,721 2,578 2,010 2,020 2,030 2,040 2,051 2,061 2,071 2,081 2,092 2,102 2,113 Total liabilities 3,904 4,054 4,918 4,796 4,409 4,597 4,786 4,960 5,118 5,253 5,394 5,540 5,692 5,850 6,013Minority interest 92 123 208 225 254Shareholders' equity: issued authorized, 55.0 and 48.5 shares issued 121 121 121 121 137 Additional contributed capital 1,115 1,113 1,167 1,201 1,500 Retained earnings 569 569 866 1,360 2,009 Accumulated other comprehensive loss (964) (854) (753) (818) (844)

Total shareholders' equity 933 1,072 1,609 2,089 3,056 3,456 3,825 4,165 4,467 4,723 4,990 5,269 5,559 5,861 6,176Total liabilities and shareholders' equity 4,837 5,126 6,527 6,885 7,465 8,053 8,610 9,125 9,585 9,977 10,384 10,809 11,251 11,711 12,189

( in millions)

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CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES

COMMON SIZED BALANCE SHEET2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

ASSETSCurrent assets: Cash and cash equivilants 4.63% 2.11% 9.36% 11.31% 11.25% Marketable securities 1.53% 1.70% 1.21% 0.89% 1.27% Recievables, net 16.64% 18.12% 17.77% 20.67% 23.67% 25.23% 27.23% 29.65% 32.58% 36.12% 40.05% 44.40% 49.23% 54.58% 60.51% Inventories 13.25% 14.30% 15.57% 17.05% 18.66% 18.91% 19.32% 19.90% 20.66% 21.62% 22.63% 23.68% 24.79% 25.94% 27.15% Deffered income taxes 4.92% 3.75% 4.61% 5.27% 3.71%

Prepaid expenses and other current assets 0.00% 1.58% 1.62% 1.68% 1.55% Total current assets 40.98% 41.55% 50.15% 56.88% 60.12% 60.00% 58.00% 55.00% 55.00% 55.00% 55.00% 55.00% 55.00% 55.00% 55.00%Long-term assets Property, plant and equipment, net 26.98% 26.28% 25.25% 22.61% 21.09% Investments in and advances to equity investees 5.46% 6.61% 4.38% 4.04% 4.62% Goodwill 7.09% 6.71% 5.44% 5.20% 4.77% Other intangible assets, net 1.98% 1.79% 1.42% 1.45% 1.71% Deffered income taxes 13.23% 12.93% 10.56% 7.26% 5.80% Other assets 4.28% 4.12% 2.80% 2.56% 1.89% Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%LIABILITIES AND EQUITYCurrent liabilities: Short-term borrowings 2.85% 0.96% 5.30% 2.24% 2.20% Accounts payable 8.83% 10.87% 12.61% 13.13% 14.79% Other accrued expenses 15.79% 15.39% 15.75% 16.85% 15.15% Total current liabilities 27.48% 27.21% 33.66% 32.21% 32.14% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00%Long-term liabilities Long-term debt 20.65% 26.92% 19.90% 17.62% 8.67% Pensions 9.06% 8.56% 7.14% 5.75% 4.92%

Postretirement benefits other than pensions 11.89% 11.26% 8.73% 8.05% 7.01% Other liabilities and deffered revenue 11.64% 5.13% 5.91% 6.03% 6.34% Total liabilities 80.71% 79.09% 75.35% 69.66% 59.06% 57.09% 55.58% 54.36% 53.39% 52.66% 51.94% 51.26% 50.59% 49.95% 49.33%Minority interest 1.90% 2.40% 3.19% 3.27% 3.40%Shareholders' equity: issued authorized, 55.0 and 48.5 shares issued 2.50% 2.36% 1.85% 1.76% 1.84% Additional contributed capital 23.05% 21.71% 17.88% 17.44% 20.09% Retained earnings 11.76% 11.10% 13.27% 19.75% 26.91% Accumulated other comprehensive loss -19.93% -16.66% -11.54% -11.88% -11.31% Total shareholders' equity 19.29% 20.91% 24.65% 30.34% 40.94% 42.91% 44.42% 45.64% 46.61% 47.34% 48.06% 48.74% 49.41% 50.05% 50.67%

Total liabilities and shareholders' equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

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Cash Flows Statement

In order to forecast the Statement of Cash Flows, we took the average growth

rate from 2005 to 2006, which came out to 17%, and increased the annual

growth rate until we reached 17% and then continued to grow at that level. One

reason we took an average instead tying the growth to sales or income, is that

we think that management will be able to improve on cash from operating

activities to outpace growth in sales. We were able to forecast a limited number

of items on the Statement of Cash Flows. The Pension Expense was forecasted

by taking an average of the growth rate for the previous two years, which was

16.12%. Due to the growth rate leveling of in years 2005-2006, we kept this

growth rate constant. Depreciation was forecasted by increasing the growth rate

by .5% due to limited growth in assets. Cash flows from investing activities was

forecasted by taking the average of the past two years and extending it at 17%,

plus an additional 4% per year to compensate for maintenance on already

existing PP&E.

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(in millions)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Cash flows from operation activities

Net earnings 82 50 350 550 715 822 1,003 1,205 1,428 1,671 1,838 2,022 2,225 2,447 2,692 Adjustments to reconcile net earnings to net cash provided

by operating activities

Depreciation and amortization 219 223 272 295 296 297 299 300 302 303 305 307 308 310 311

Pension expense 21 61 89 103 120 139 162 188 218 253 294 342 397 461 535

Pension contributions (81) (118) (135) (151) (266)

Change in current assets and liabilities:

Receivables (87) (64) (163) (309) (301)

Inventories 46 (63) (204) (187) (158)

Other current assets (71) 4 (10) (9) (4)

Accounts payable 26 100 210 108 149

Accrued expenses 83 22 237 89 88

Changes in long-term liabilities (13) 88 23

Other, net 9 21 (6) (17) 45

Net cash provided by operating activities 193 160 615 760 840 933 1045 1181 1346 1548 1795 2100 2458 2875 3364

Cash flows from investing activities 17% avg

Capital expenses (90) (111) (151) (186) (249) 0.2333 0.3604 0.2318 0.3387

Investments in internal use software (20) (29) (33) (39) (52) Proceeds from disposals of property, plant and equipment 16 13 12 21 49

Net cash used in investing activities (152) (135) (181) (212) (277) -335.2 -405.6 -490.7 -593.8 -718.5 -869.3 -1052 -1273 -1540 -1864

Cash flows from financing activities 131 (145) 66 (372) (508)

CUMMINS INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS

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2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Cash flows from operation Net earnings 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Adjustments to reconcile net earnings to net cash provided by Depreciation and amortization 267.1% 446.0% 77.7% 53.6% 41.4% 36.2% 29.8% 24.9% 21.1% 18.2% 16.6% 15.2% 13.8% 12.7% 11.6% Pension expense 25.6% 122.0% 25.4% 18.7% 16.8% 17.0% 16.1% 15.6% 15.3% 15.2% 16.0% 16.9% 17.8% 18.8% 19.9% Pension contributions -98.8% -236.0% -38.6% -27.5% -37.2% Change in current assets and Receivables -106.1% -128.0% -46.6% -56.2% -42.1% Inventories 56.1% -126.0% -58.3% -34.0% -22.1% Other current assets -86.6% 8.0% -2.9% -1.6% -0.6% Accounts payable 31.7% 200.0% 60.0% 19.6% 20.8% Accrued expenses 101.2% 44.0% 67.7% 16.2% 12.3% Changes in long-term liabilities 0.0% 0.0% -3.7% 16.0% 3.2% Other, net 11.0% 42.0% -1.7% -3.1% 6.3%Net cash provided by operating activities 235.4% 319.8% 175.6% 138.2% 117.5% 113.5% 104.2% 98.0% 94.2% 92.6% 97.7% 103.9% 110.5% 117.5% 125.0%Cash flows from investing activitiesNet cash used in investing activities -185.4% -270.0% -51.7% -38.5% -38.7% -40.8% -40.4% -40.7% -41.6% -43.0% -47.3% -52.0% -57.2% -62.9% -69.2%Cash flows from financing activitiesNet cash (used in) provided by financing activities

CUMMINS INC. AND CONSOLIDATED SUBSIDIARIESCOMMON SIZED STATEMENTS OF CASH FLOWS

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Valuation Analysis

There are a variety of ways to value a company’s stock price to determine if the

stock’s market price is valued fairly, undervalued, or overpriced. The valuation

models employed below are deemed particularly insightful if deviations are 15%

or more between the intrinsic value we derive and the market price of the stock.

These valuation models, combined with subjective topics addressed in prior

sections, provide a comprehensive base for determining a company’s accurate

valuation. The Method of Comparables is used to gauge a company’s

performance and profitability relative to the industry it competes in. This method

is primarily employed for initial valuations. More valuation models are necessary

to gain a well-rounded understanding of the company’s stock price due to the

difference in results from each valuation model.

The other valuation models we use to most accurately determine Cummins

intrinsic value is the weighted average cost of capital, weighted average cost of

debt, and weighted average cost of equity. These are inputs are discounted

using present, historical, and estimated data. The discounted dividend model,

residual income, abnormal earnings growth, long-run residual income perpetuity,

and free cash flow model utilizes the cost of equity and debt. Aggregating the

results of these numerous valuation models provides us with a deep

understanding of the state of the company and enhances the accuracy of

Cummins share price. All of these models are based off theory and deviations in

each model’s accuracy are overcome by comprehensively analyzing the data.

More consideration is given to models that best represent the company’s method

of operations, and coupled with the rest of the valuation models, should

reasonably indicate the intrinsic value of Cummins.

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Method of Comparables Cummins Inc. Share

Price

Forward P/E 183.04

Trailing P/E 200.81

P/B 397.59

Price/Sales 241.28

PEG N/A

Price to EBITDA 17.07

Forward Price to Earnings (2007)

Forward P/E

PPS EPS P/E Industry average

CMI share price

CMI 145.21 14.2 10.23 183.04 CAT 67.03 5.2 12.89 12.89

To find the forward price to earnings, we found the industry average P/E and

then multiplied by the earnings per share to get the share price of Cummins. The

forward P/E of Cummins comes out to be 183.04, leading us to believe that the

firm’s stock is undervalued when compared to the observed price of 145.21. It is

difficult for us to put much trust in this model since the industry consists of only

Caterpillar and does not give us sufficient evidence of the firm’s actual value, but

rather is based upon what the market is willing to pay for the earnings per share

of the company. However, based upon this valuation Cummins is in good

position in its industry for the upcoming future.

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Trailing Price to Earnings (2006)

Trailing P/E

PPS EPS P/E Industry average

CMI share price

CMI 105.1 15.02 7 200.81 CAT 71.81 5.37 13.37 13.37

To find the trailing price to earnings, we divided the price per share by the

earnings per share to get the P/E. Then we took the average industry P/E and

multiplied by the earnings per share of Cummins. The trailing P/E for Cummins is

200.81, which tells us that Cummins is undervalued at the observed price of

105.10. Again this valuation depends on investor’s willingness to pay for earnings

per share as well as Caterpillar being the industry average. The model does

suggest that Cummins is in good position with the industry average.

Price to Book

Price to Book

PPS BPS P/B Industry average

CMI share price

CMI 145.21 63.01 2.3 397.59 CAT 67.03 10.62 6.31 6.31

To find the price to book, we took the price per share and divided by the book

value per share to get the industry average P/B. We then took the industry P/B

and multiplied by the book value per share of Cummins. The price to book states

that Cummins is valued at 397.59 compared to the observed price of 145.21,

implying that the firm is greatly undervalued. We do not believe this model to be

reliable in valuing the firm because of the difference in capital structures

between Cummins and the industry, Caterpillar. Cummins’ management focuses

on creating retained earnings to finance the growth of assets which creates a

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higher book value, where Caterpillar’s management relies on financing with debt

which lowers book value. These two firms are complete opposites when looking

at the shareholders’ equity portion of the balance sheet. For this reason this

valuation model is like comparing apples to oranges, and we will be discounting

these outcomes.

Price to Sales

Price to Sales

PPS SPS P/S Industry average

CMI share price

CMI 145.21 234.26 0.62 241.28 CAT 67.03 64.87 1.03 1.03

To find the price to sales, we found the sales of the firm and divided by the

number of shares outstanding to get the Sales per share. Then we divided the

price per share by the sales per share to find the industry average P/S. Cummins’

share price computes to 241.28 as opposed to the observed price of 145.21,

again implying that the firm is undervalued. We will also be discounting this

model because Caterpillar has many more shares outstanding than Cummins. If

Caterpillar’s sales were divided by the number of shares Cummins has in

circulation then the sales per share of Caterpillar would be 853.60, and Cummins

would be underperforming the industry substantially.

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Price Earnings Growth

Due to a negative earnings growth rates from both Caterpillar and Cummins,

PEG could not be calculated.

Price to EBITDA

Price to EBITDA

Calculated Multiples CMI share price

0.1053 0.0124 17.07 Formula data CMI CAT

PPS 145.21

67.03

EBITDA 1,379

5,414

The price to EBITDA valuation takes into account non-cash items. We found the

price to EBITDA by dividing the price per share by the EBITDA, which gave us a

multiple of the industry average. Then we multiplied the industry average by the

EBITDA for Cummins and got a share price of 17.07 that implies that Cummins is

severely overvalued at an observed price of 145.21. We believe that this model

does not evaluate Cummins well because of the heavily asset accumulation that

Cummins has.

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Cost of Capital

In order to value a company, an appropriate cost of capital must be determined.

The cost of capital consists of three elements: the Weighted Average Cost of

Capital (WACC), the Cost of Debt, and the Cost of Equity.

Cost of Debt

To find the cost of debt, we examined all of the liabilities that are disclosed in

the notes of the annual 10-K report. We then took the weighted average of the

different obligations and their corresponding interest rates as a percentage of

total liabilities. By adding all of the rates together we calculated a 7.13% total

cost of debt.

Cost of Equity

In order to determine the Cost of Equity, we used the capital asset pricing model

(CAPM), where the Cost of Equity is the sum of the Risk Free Rate (Rf) plus the

Systematic Risk (β) multiplied by the Market Risk Premium (which is the Risk

Free Rate (Rf) subtracted from the Expected Return on the Market Index (E(rm).

Ke = Rf + β[E(rm)-Rf]

Cummins Inc. Cost of Equity

11.89% = 4.5% + 1.48 * 5%

To determine the Risk Free Rate, we used monthly percentage data from the 3

month T-Bill. This was used due to the high correlation between Cummins Inc.

monthly returns and the returns from the S&P 500. Beta was calculated by

running a regression between Cummins Inc. monthly returns and the monthly

returns from the S&P 500. The adjusted R square was 32.47% which is

comparatively a high percentage. A Market Risk Premium was determined by

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taking the average of a historical percentage of 7% and current market studies

that show a lower Market Risk Premium of 3%. There is evidence that shows

that there has been a substantial decline in the Expected Market Risk Premium,

that the historical rate is not valid in the current market.

Weighted Average Cost of Capital (WACC)

The WACC is calculated by weighting the costs of debt and equity capital

according to their respective market values. Several variables are including the

WACC: the market value of debt (Vd), the market value of equity (Ve), the cost

of debt capital (Rd), the cost of equity capital (Ke), and the appropriate tax rate

(T). The WACC is then calculated by:

% Vd VeWACC= [Rd(1-T)] + (Ke)

Vd+Ve Vd+Ve

We used the book value of debt of 4409 (total liabilities), a market value of

equity of 7032 (the market value of shares multiplied by the number of

outstanding shares), and the appropriate tax rate of 35% (all numbers in

millions). The value of debt was taken from the most recent 10-k and the value

of equity we determined by analyzing current market conditions.

Cummins Inc. WACC

% 4409 70329.37%= [7.13%(1-35%)] + 11.89%

11441 11441

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Credit Analysis 2002 2003 2004 2005 2006Altman Z-Scores 1.592 1.631 1.983 2.492 2.884

The Altman Z- score is a weighted ratio based formula that incorporates several

financial statement items, to assess the credit risk of a firm. We can plug

historical data into the formula to see how the company is leveraged, and the

company’s ability to pay debt installments on principal as well as the interest on

their obligations. A Z-score greater than 2.7 implies that the firm has a low level

of risk to default on their debt, and a score of less than 1.8 signals that the firm

is at a higher risk of defaulting. A firm’s credit risk plays an important role in their

ability to raise capital through debt. If a company with little risk of default

(investment grade) wishes to raise capital through debt, their debt will trade at

par (the face value of the debt) or at a premium to par. This means that they

most likely will not have trouble reaching their goal amount. Conversely, if a high

credit risk (junk status) firm wishes to raise the same amount of debt as the

previous firm, their debt will trade at a discount to par. This means that they will

have to issue more debt than the investment grade firm to raise the same

amount of capital, making it more difficult to attain the financing needed. By

examining Cummins’ Z-scores from the past five years we can see that the firm

has been consistently decreasing their credit risk, from 1.592 in 2002, to 2.884 in

2006. We attribute this building of credit worthiness to management’s focus in

turning the capital structure of the company around in 2004. Cummins has

focused on financing growth through cash generated from operations while using

what is left over to pay down debt. Evidence can be found by looking at the past

financial statements that shows a dramatic decrease in debt to equity. The firm

crossed over into investment grade status in 2006 that will give them the ability

to issue debt to banks and pension funds increasing their ability to raise capital

with more ease. Management must keep and improve their investment status, or

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they will not be able to issue debt to banks and pension funds that are restricted

from any investments lower than investment grade. Since those entities are

responsible for investing in the majority of debt issuances, the credit risk

associated with Cummins could be vital to the company’s profitability and growth

in the future.

Discounted Dividends Model

Observed Price 144.99g

0 0.02 0.04 0.06 Undervalued0.09 35.10 45.12 63.17 105.29 Overvalued

0.119 24.75 29.75 37.30 49.960.129 22.33 26.43 32.37 41.750.139 20.32 23.74 28.53 35.760.149 18.62 21.51 25.45 31.17

Sensitivity Analysis

The discounted dividend model is a “traditional” finance model that calculates

the firm’s equity by taking the present value of forecasted dividends. For the

model we forecasted 10 years out with a terminal value (perpetuity) in year 11.

The model requires the use of forecasted future dividends and the estimated

cost of equity for the firm. We took the present value of the dividends for year

1-10 $9.61, the present value of the terminal value (with zero growth) $6.06 for

a value of equity of $24.69. We then took the estimated value at April 1, 2007

of $24.75. The Sensitivity Analysis was run by taking different costs of equity

and growth rates for the terminal value. The higher growth rates caused the

equity to spike, but still showed that Cummins Inc. stock price is overvalued.

The discounted dividends model is not applicable due to Cummins Inc. low

dividend payout ratio which has been decreasing from 15% down to about 9%.

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Free Cash Flow Model

g Observed Price

0 0.01 0.02 0.04

WACC 0.0937 $85.95 $96.84 $110.68 153.84 Undervalued

0.104 $65.36 $73.31 $83.16 112.09 Overvalued

0.114 $49.11 $55.11 $62.38 82.81

0.124 $35.64 $40.24 $45.72 $60.60

0.134 $24.31 $27.89 $32.10 $43.20

Sensitivity Analysis

$144.99

The Free Cash Flow Model is another “traditional” finance models. It uses

the forecasted free cash flows to the firm and discounts them back using the

weighted average cost of capitol (WACC). Free cash flows to the firm is

estimated by taking the cash from operations and adding the cash from investing

activities. The total present value of the free cash flows was $4158 and the

present value of the terminal cash flows was $4409 assuming no growth. The

value of the firm’s equity was $85.95. The Sensitivity Analysis allowed us to look

at what a different WACC and growth rates would do to the value of the firm’s

equity. In all variations of WACC and the growth rate, the firm is overvalued

except when the growth rate of 4% was used.

Residual Income (RI)

- 91 -

Sensitivity Analysisg Observed Price 144.99

0 -0.1 -0.2 -0.5Ke 0.09 186.48 156.45 147.13 138.13 Undervalued

0.119 123.33 114.92 111.79 108.46 Overvalued0.129 105.34 101.42 99.88 98.200.139 88.89 88.46 88.29 88.100.149 73.50 75.87 76.88 78.04

The Residual Income Model is found by finding the forecasted residual income of

the firm, and discounting it back using the estimated cost of equity. The current

book value of equity is added to the residual income for years 1-10, and then

added to the terminal value residual income. The book value of equity for the

end of 2006 (beginning of 2007) was $76.31, the residual income for years 1-10

was $28.34, and the terminal value (zero growth) was $18.36. This put the

firm’s value at $123.02. We then found the value at April 1, 2007 to be $123.33.

The Sensitivity Analysis was used to determine the effects of various

combinations of the cost of equity and growth rates. A negative growth rate was

used because in the long run, a positive terminal residual income cannot be

sustained. In all variations, the firm is overvalued unless a cost of equity of 9%

is used with a growth rate of less then -20%.

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Abnormal Earnings Growth

g Observed Price 0 0.02 0.03 0.05

Ke 0.09 $202.71 $206.48 $210.23 221.49 Undervalued0.1189 $113.34 $112.88 $112.57 111.68 Overvalued0.1289 $95.99 $95.34 $94.91 93.730.1389 $82.34 $81.66 $81.23 $80.070.1489 $71.37 $70.74 $70.35 $69.32

Sensitivity Analysis$144.99

The Abnormal Earnings Growth Model is used to value the firm’s equity by

discounting the firm’s increase in earnings each year. The earnings are then

invested in a Dividend Reinvestment Program (DRIP) at the estimated cost of

equity. The present value of the DRIP is added to the earnings per share, which

is the cumulative dividend earnings. Normal earnings are calculated by taking

last years earnings and multiplying by the estimated cost of equity. The

difference between the normal earnings and the cumulative dividend earnings is

the abnormal earnings growth. The abnormal earnings are then discounted back

to year one using the estimated cost of equity. To determine the intrinsic value

per share, the core earnings per share (2007) is added to the present value of

the abnormal earnings growth and the present value of the terminal year (year

11). The terminal value with the estimated cost of equity was negative, so we

chose a positive growth rate in our sensitivity analysis. In all of the various

combinations, the firm is overvalued. When we used a cost of equity that was

less than our estimated cost of equity, we were able to get a value that was

closer to the firm’s value. (If the cost of equity were in fact closer to 9%, a

negative growth rate would have been used which would have shown an intrinsic

value that was closer to the observed price)

- 93 -

Analyst Recommendation

Through a careful analysis of the five competitive forces, the industry that

Cummins Inc. operates, the competition that it faces as well as the immediate

threat of substitute products, we are able to see how Cummins Inc. has

remained the cost leader in the industry. Cummins Inc. is closely following these

key success factors that have helped them to produce a low cost, affordable

product while maintaining industry leading quality. Through overhaul in

management in 2003, Cummins has been able to go from a stagnant growth rate

in earnings to a high growth firm returning more earnings to the company to

finance investments, and not issuing debt while attempting to expand. This is

fundamental to the financial stability of the firm in the future, because the

extreme growth rates recorded over the past three years, after the

reconstruction period, most likely can not be sustained, putting the firm in better

position to handle slower sales growth as well as any economic downturns that

may arise. Through intrinsic valuation, we believe that Cummins Inc. is currently

overvalued. The main reason that we believe the market is overvaluing Cummins

Inc. is because of the abnormal growth rates attained in the 2004 to 2006

period, after management overhauled and implemented their new financial

strategies. These attractive growth rates may continue in the short-run, but we

believe, through the valuation models we have applied, that these high growth

rates can not be sustained. Our valuations price the future growth attainable

much less than what investors are willing to pay for them. We believe that the

observed market price of $144.99, is overvalued. Through our research and

analysis it is in our opinion that Cummins Inc. is currently overvalued and

presents a selling opportunity.

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APPENDIX

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Liquidity RatiosCurrent Ratio 1.49 1.53 1.49 1.77 1.87 1.88 1.81 1.72 1.72 1.72 1.72 1.72 1.72 1.72 1.72Quick Asset Ratio 0.83 0.81 0.84 1.02 1.13 0.79 0.85 0.93 1.02 1.13 1.25 1.39 1.54 1.71 1.89Efficiency RatiosInventory Turnover 7.50 7.06 6.65 6.59 6.29 6.46 6.64 6.77 6.85 6.87 6.93 7.00 7.07 7.14 7.21Days 48.66 51.72 54.87 55.42 58.00 56.47 54.96 53.91 53.31 53.16 52.64 52.14 51.63 51.14 50.64Receivables Turnover 7.27 6.78 7.27 6.97 6.43 6.37 6.24 6.06 5.83 5.55 5.29 5.05 4.81 4.59 4.37Days 50.20 53.86 50.18 52.37 56.76 57.26 58.48 60.25 62.64 65.72 68.94 72.33 75.88 79.60 83.51Working Capital Turnover 8.96 8.57 7.84 5.84 5.44 5.74 6.54 7.81 8.25 8.72 9.22 9.74 10.30 10.88 11.50Profitability Gross Profit Margin 17.9% 17.8% 19.9% 22.0% 22.8% 24.0% 24.5% 25.0% 25.5% 26.0% 26.0% 26.0% 26.0% 26.0% 26.0%Operating Expense Ratio 15.5% 15.2% 13.5% 13.0% 12.9% 13.7% 13.7% 13.7% 13.7% 13.7% 13.7% 13.7% 13.7% 13.7% 13.7%Net Profit Margin 1.4% 0.8% 4.1% 5.5% 6.3% 7.1% 8.0% 9.1% 10.3% 11.6% 13.1% 14.8% 16.7% 18.9% 21.4%Asset Turnover 1.21 1.23 1.29 1.44 1.52 1.61 1.70 1.80 1.90 2.01 2.12 2.24 2.37 2.50 2.64Return on Assets 1.7% 1.0% 5.4% 8.0% 9.6% 9.0% 8.5% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%Return on Equity 8.8% 4.7% 21.8% 26.3% 23.4% 23.8% 23.8% 23.8% 23.8% 23.8% 23.8% 23.8% 23.8% 23.8% 23.8%Capitol StructureDebt to Equity 4.18 3.78 3.06 2.30 1.44 1.33 1.25 1.19 1.15 1.11 1.08 1.05 1.02 1.00 0.97Times Interest Earned 2.28 2.01 4.94 8.32 12.23 8.96 9.39 9.83 10.26 10.70 10.70 10.70 10.70 10.70 10.70

Debt Service Margin 1.40 3.26 1.78 4.94 5.12 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

Financial Statement Ratio Analysis

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Value Weighted Cost of Equity 72 Month Summary Output

Regression Statistics Beta 1.4799914Multiple R 0.5780813 Adj. R Squa 32.47%R Square 0.3341779 Ke 0.0505787 5.06% annual measure 0.1188898Adj. R 0.3246662 Rf 0.0448903Standard Er 0.0805332 MRP 0.0038435 0.05 0.0525Observation 72

CoefficientsStandard Erro t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.0209325 0.0095112 2.200832 0.0310484 0.0019631 0.039902 0.0019631 0.039902X Variable 1 1.4799914 0.2496896 5.9273262 1.052E-07 0.9820013 1.9779815 0.9820013 1.9779815

60 Month Summary OutputRegression Statistics Beta 1.5722205

Multiple R 0.5580955 Adj. R Squa 29.96%R Square 0.3114706 Ke 0.0915028 9.15%Adj. R 0.2995994 Rf 0.043885Standard Er 0.0839981 MRP 0.030287Observation 60

CoefficientsStandard Erro t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.0190389 0.0109372 1.7407522 0.0870299 -0.002854 0.0409321 -0.002854 0.0409321X Variable 1 1.5722205 0.3069391 5.1222562 3.603E-06 0.9578152 2.1866258 0.9578152 2.1866258

48 Month Summary OutputRegression Statistics Beta 1.1334176

Multiple R 0.323834 Adj. R Squa 8.54%R Square 0.1048685 Ke 0.162324 16.23%Adj. R 0.0854091 Rf 0.0437458Standard Er 0.078872 MRP 0.1046201Observation 48

CoefficientsStandard Erro t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.0286745 0.0125958 2.2765119 0.0275153 0.0033205 0.0540285 0.0033205 0.0540285X Variable 1 1.1334176 0.4882384 2.3214429 0.0247468 0.1506446 2.1161905 0.1506446 2.1161905

36 Month Summary OutputRegression Statistics Beta 0.5124391

Multiple R 0.1526323 Adj. R Squa -0.54%R Square 0.0232966 Ke 0.0640343 6.40%Adj. R -0.00543 Rf 0.0448667Standard Er 0.0685174 MRP 0.0374047Observation 36

CoefficientsStandard Erro t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.0285839 0.0119091 2.4001631 0.0220094 0.0043816 0.0527862 0.0043816 0.0527862X Variable 1 0.5124391 0.5690333 0.9005431 0.374166 -0.643976 1.6688539 -0.643976 1.6688539

24 Month Summary OutputRegression Statistics Beta 0.8797089

Multiple R 0.2816152 Adj. R Squa 3.75%R Square 0.0793071 Ke 0.0792 7.92%Adj. R 0.0374574 Rf 0.0458625Standard Er 0.0594897 MRP 0.037896Observation 24

CoefficientsStandard Erro t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.0224605 0.0128764 1.7443203 0.0950606 -0.004243 0.0491645 -0.004243 0.0491645X Variable 1 0.8797089 0.6390413 1.3766073 0.1824834 -0.445582 2.2049994 -0.445582 2.2049994

- 96 -

Dividend Discount 1 2 3 4 5 6 7 8 9 102006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Termina

DPS 1.44 1.50 1.57 1.64 1.71 1.79 1.86 1.95 2.03 2.12 2.21PV Factor 0.8937 0.7988 0.7139 0.6380 0.5702 0.5096 0.4555 0.4071 0.3638 0.3252PV of Future Dividends 1.29 1.20 1.12 1.05 0.98 0.91 0.85 0.79 0.74 0.69

Total PV of Forecasted Future Dividends 9.61Continuing (Terminal) Value 18.63Present Value of Continuing Terminal Value 6.06

Esitmated Value per Share (12/31/06) 24.69FV Factor 1.0025 0.01022Esitmated Value per Share (04/01/07) 24.75 Observed Price 144.99Observed Value 144.99 gDiff -120.24 0 0.02 0.04 0.06 Undervalued

Ke 0.09 35.10 45.12 63.17 105.29 OvervaluedActual Price per share 144.99 0.119 24.75 29.75 37.30 49.96Cost of Equity 0.1189 0.129 22.33 26.43 32.37 41.75growth rate 0 0.139 20.32 23.74 28.53 35.76

0.149 18.62 21.51 25.45 31.17

Sensitivity Analysis

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Residual Income (RI) 1 2 3 4 5 6 7 8 9 10 Terminal

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Beginning BE (per share) 63.01 76.31 85.34 96.53 110.15 126.45 145.68 166.85 190.15 215.81 244.05Earnings Per Share 14.74 10.47 12.76 15.34 18.18 21.27 23.40 25.74 28.31 31.14 34.26Dividends per share 1.44 1.44 1.57 1.72 1.87 2.04 2.23 2.44 2.66 2.90 3.17Ending BE (per share) 76.31 85.34 96.53 110.15 126.45 145.68 166.85 190.15 215.81 244.05 275.14Ke 0.1189"Normal" Income 9.07 10.15 11.48 13.10 15.04 17.32 19.84 22.61 25.66 29.02(Change) 1.22 1.24 1.23 1.15 -0.16 -0.18 -0.20 -0.22 -0.24Residual Income (RI) 1.40 2.61 3.86 5.08 6.24 6.08 5.90 5.70 5.48 5.24 5.24Discount Factor 0.92 0.84 0.77 0.70 0.65 0.59 0.54 0.50 0.45 0.42Present Value of RI 1.28 2.19 2.97 3.58 4.03 3.59 3.20 2.83 2.49 2.18

BV Equity (per share) 2006 76.31Total PV of RI (end 2006) 28.34Continuation (Terminal) Value 44.08PV of Terminal Value (end 2006) 18.36Estimated Value (2006) 123.02 Sensitivity AnalysisFV Factor 1.0025 0.01022 g Observed Price 144.99Esitmated Value per Share (04/01/07) 123.33 0 -0.1 -0.2 -0.5

Ke 0.09 186.48 156.45 147.13 138.13 UndervaluedActual Price per share 144.99 0.119 123.33 114.92 111.79 108.46 OvervaluedGrowth 0 0.129 105.34 101.42 99.88 98.20Ke 0.1189 0.139 88.89 88.46 88.29 88.10

0.149 73.50 75.87 76.88 78.04

- 98 -

Free Cash Flow 1 2 3 4 5 6 7 8 9 10 Terminal

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Cash Flow from Operations 840 933 1045 1181 1346 1548 1795 2100 2458 2875 3364Cash Provided (Used) by Investing Activities -335 -406 -491 -594 -718 -869 -1052 -1273 -1540 -1864

Free Cash Flow (to firm) 505 527 554 587 627 678 743 828 917 1,012 1,012

discount rate (9.37% WACC) 0.914 0.836 0.764 0.699 0.639 0.584 0.534 0.488 0.447 0.408Present Value of Free Cash Flows 462 441 423 410 401 396 397 404 410 413Total Present Value of Annual Cash Flows 4,158

Continuing (Terminal) Value 10,798PV of Continuing (Terminal) Value 4,409 g Observed Price Value of the Firm (end of 2006) 8,567 0 0.01 0.02 0.04Preferred Stock $4,409 WACC 0.0937 $85.95 $96.84 $110.68 153.84 UndervaluedValue of Equity (end of 2006) 4,158 0.104 $65.36 $73.31 $83.16 112.09 OvervaluedEstimated Value per Share 85.73 0.114 $49.11 $55.11 $62.38 82.81FV Factor 1.0025 0.01022 0.124 $35.64 $40.24 $45.72 $60.60Esitmated Value per Share (04/01/07) 85.95 0.134 $24.31 $27.89 $32.10 $43.20

Actual Price per share $144.99

WACC 0.0937

terminal growth 0.00

Sensitivity Analysis

$144.99

- 99 -

AEG 1 2 3 4 5 6 7 8 9 10 Termina2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

EPS 15.02 10.47 12.76 15.34 18.18 21.27 23.40 25.74 28.31 31.14 34.26DPS 1.44 1.44 1.57 1.72 1.87 2.04 2.23 2.44 2.66 2.90 3.17DPS invested at 11.89% (Drip) 0.17 0.17 0.19 0.20 0.22 0.24 0.27 0.29 0.32 0.34Cum-Dividend Earnings 10.64 12.93 15.52 18.38 21.49 23.64 26.00 28.60 31.46 34.60Normal Earnings 16.81 11.71 14.28 17.16 20.34 23.80 26.18 28.80 31.68 34.85

Abnormal Earning Growth (AEG) -6.17 1.22 1.24 1.23 1.15 -0.16 -0.18 -0.20 -0.22 -0.24 -0.24PV Factor 0.89 0.80 0.71 0.64 0.57 0.51 0.46 0.41 0.36PV of AEG 1.09 0.99 0.87 0.74 -0.09 -0.09 -0.09 -0.09 -0.09 -0.09

Core EPS 10.47 -0.746Total PV of AEG 3.25PV of Terminal Value -0.27Total Average EPS Perp (t+1) 13.44Capitalization Rate (perpetuity) 0.1226

Intrinsic Value Per Share 109.64FV Factor 1.0025 0.01Esitmated Value per Share (04/01/07) 109.92Actual Price per share 144.99Ke 0.1189 g Observed Price g 0 0 0.02 0.03 0.05

Ke 0.09 $148.81 $151.96 $154.33 162.6 Overvalued0.1189 $109.92 $109.47 $109.17 108.31 Undervalued0.1289 $100.93 $100.24 $99.79 98.540.1389 $93.29 $92.52 $92.03 $90.710.1489 $86.68 $85.92 $85.44 $84.19

Sensitivity Analysis$144.99

- 100 -

References:

1. Yahoo Finance: http://finance.yahoo.com

2. MSN Money:http://money.msn.com

3. Cummins Corporate Website: http://www.cummins.com

4. Caterpillar Corporate Website: http://www.cat.com

5. Securities and Exchange Commission Website: http://www.sec.gov

6. Palepu, Healy and Bernard, Business Analysis and Valuation (Ohio: Thomson- Southwestern, 3rd Edition, 2004)

7. St. Louis Federal Reserve: http://research.stlouisfed.org/fred2/categories/22