A CASH‐FLOW CONCEPT OF PROFIT*

Abstract

THE 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