On Optimal Replacement of Farm Tractors

Abstract

Two important parameters influencing replacement of farm tractors are (a) the tractor's remaining (terminal) market value and (b) income tax incentives. Peacock and Brake were among the first to estimate remaining value (RV) equations for tractors and other large farm machines. Remaining value equations are also presented in the Agricultural Engineers Yearbook and other recent publications. Chisholm modeled the effects of special income tax investment incentives on optimal replacement ages. Kay and Rister further examined and clarified the tax impacts of the United States. Bates, Rayner, and Custance extended previous studies by investigating the tax effects of inflation on optimal replacement ages. Each of these optimal replacement studies estimated replacement ages for tractors to be seven to fourteen years. This seems to be longer than ages actually used by many U.S. farm tractor owners. Kay and Rister (p. 358) list four possible reasons for the longer estimates: (a) misestimation of the repair-cost time pattern, (b) possible incorrect estimation of opportunity costs of tractor breakdowns, (c) owners' desires to replace with larger tractors, and (d) no consideration for replacing with technically improved machines. Kay and Rister assessed the potential impact of alternative repair and breakdown costs by generating alternative data. However, none of the studies examined the impact of using alternative RVs. Both the Kay-Rister study and the Bates-Rayner-Custance study relied upon the Peacock-Brake RV equation; Chisholm's study relied upon a single series of RV observations developed for Australian wheat farms in the 1960s. Also, each study reflected tax regulations existing in 1976 or earlier. With the passage of the Economic Recovery Tax Act of 1981 (ERTA-81), many changes were made to stimulate capital investment. Thus, the new tax law may cause more frequent replacement. The research reported in this paper examines the importance of RV forecasts in optimal replacement decisions. An original aspect of the research is the specification and estimation of a more generalized RV equation which includes more situation-specific explanatory variables than previous RV equations. Optimal tractor replacement decisions using forecasts from this generalized equation are compared to decisions based on three other RV equations. In addition, effects of the Economic Recovery Tax Act of 1981 on optimal replacement decisions are examined.