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THE PROBLEM OF CAPITAL budgeting is to decide which of the available investment opportunities a firm should accept and which it should reject. To make this decision rationally, the firm must have an objective. The objective which economists usually assume for a firm is profit maximization. In the traditional short-run theory of the firm, capital is fixed, and the firm seeks to maximize its dollar profits. In the long run the firm can either increase or reduce its investment. It will increase investment if investment brings more than the normal rate of return on invested capital; it will reduce investment if it brings less than the normal return on invested capital; and it will maintain investment if it earns the normal return. This is the same as profit maximization if we recognize that the normal rate of return on invested capital represents a cost rather than a profit. The simple rule of profit maximization can then be applied to any investment project: a project should be accepted only if it adds to the profits of the firm after all costs, including the cost of capital, have been met.In spite of this orientation of traditional theory, recent discussions of the capital-budgeting problem usually assume that the objective is to maximize either (a) the wealth of the owners of the firm or (b) the rate of return that the owners obtain on invested funds. Thus they suggest accepting investment projects which (a) increase the wealth of the owners of the firm or (b) yield a rate of return larger than the normal rate, since the owners would earn the normal rate if they invested elsewhere.The three criteria-profit maximization, wealth maximization, and * I am indebted to many people for helpful comments, criticisms, and suggestions. Special mention must go to Professors Fisher, Segall, Solomon, and Wellisz, although they should not be held in any way responsible for the egregious errors which may remain. 473

This paper develops balance sheets assuming that assets are future service potentials, or future cash flows. All balance sheet items are the present (discounted) values of future cash flows. All future flows, whether receipts or payments, including transactions with shareholders, are accounted for on the balance sheet. Balance sheets are constructed on the basis of (1) full knowledge of the future, and (2) knowledge only of past flows, assuming that investment projects have zero net present value. Capital gains (losses) are recorded when events demonstrate that projects have positive (negative) net present value.

DIRAN BODENHORNt I. INTRODUCTION AND SUMMARYTHE TRADITIONAL THEORY of the firm is based on the assumption that the firm acts in the stockholders' interests and that the stockholders are interested in profit, so that the objective of the firm is to maximize profit. There have been many theoretical discussions of the concept of profit but there is no consensus of opinion as to the precise definition of this theoretical construct.' Nevertheless the theory of the firm has been based on the assumption of profit maximization, and profit has been thought of (loosely) as the difference between the revenue received from the product sold and the payments made to the productive factors which together produced that product.This concept of profit has been difficult to apply to investment decisions, and wealth maximization and cash-flow concepts have been developed in connection with this problem. This paper presents a cash-flow concept of profit which is associated with the cash-flow theory of stock value. This concept of profit has three desirable properties which make it more useful than the traditional concept. (1) It can be used in decisionmaking within the firm since profit maximization is in the stockholders' interest.(2) The profit of the firm coincides with the stockholders' income in each time-period. (3) Past profit can be measured from market values so that it is an objective measure of performance.Net cash flows are defined in Section II as the cash flows between the firm and its stockholders. The value of the stock is then the present value of the future net cash flows. In Section III cash-flow profit is defined as the increase in the stock value plus the net cash flow of the period. If the expectations for the period are observed and those for the future are unchanged, a normal profit is made on the initial stock value (investment). If expectations change, pure profits arise.The cash-flow concept is then compared to the traditional concept. Section IV is concerned with the handling of depreciation, a concept which is not required in cash-flow analysis. It is shown that depreciation expenses understate capital costs unless implicit interest is charged on the book value of net worth. It follows in Section V that the traditional * The author is indebted to many friends for innumerable discussions of the concept of profit over many years. Professors Alan Batchelder and Robert Gallman have been particularly helpful in discussing the organization and content of this paper. t Professor of Economics, Ohio State University. 1. See, for example, Weston (10), and the references cited therein. (3), Dean (4), and Lorie and Savage (6). For further discussion and justification of cash-flow analysis, see Bodenhorn (2) and