Introduction, 472. — Origin of the theory, 474. — Definition of risk, 476. — The investment model, 479. — Two theoretical objections to the theory, 481. — Evidence on the theory, 483. — Examination of sample data, 486. — Further research, 490.

In the neo-classical theory of a firm's investment, the objective of the firm is to maximize its value. Its value is a function of its future income and its future income is a function of its investment. As Lutz and Lutz [8] admirably demonstrated in their standard work on the subject, given the behavior postulate and these two functions, the investment and value of a firm may be determined. Unfortunately, however, the numerous models they constructed assume the future is known with certainty and with minor qualifications that the firm can freely lend or borrow at a given rate of interest. These conditions are not realized in fact, the data of their models cannot be observed, and the models stand as elegant intellectual exercises of limited usefulness.1 A consequence is that the literature concerned with testable propositions on the investment and the valuation of the firm makes little or no reference to the neo-classical theory. Further, empirical theories of investment, for example, those discussed in Meyer and Kuh [ io], refer to the valuation of the firm only in passing, and theories of valuation such as Durand [1] make no reference to the investment of the firm. Only the normative literature, including in a sense Modigliani and Miller [ii] relates the investment and value of a firm, but this literature continues to provide little empirical information on the investment and financing that maximize the value of a firm. The purpose of this paper is to present a theory of the investment and valuation of a corporation analogous to the neo-classical theory without the assumptions that the future is certain and that funds are freely available at a given rate of interest. Specifically, the initial statement is that the value of a firm is a function of its expected future income. The future income is then represented by a function of the corporation's investment to obtain an expression in which a share's price is the dependent variable, the investment function provides the independent variables, and the parameters represent the corporation's cost of capital. In general structure the model parallels those of neo-classical theory, and similarly it may be solved to find the investment that maximizes the value of the firm. The difference is that the variables are observable and the parameters may be estimated from sample data. The model is developed under restrictive assumptions with respect to the financing policies of corporations and the form of the return on investment function. These assumptions are irritating from a theoretical point of view, but they are of limited material significance as will be evidenced by the empirical results to be presented. Work currently under way and to be reported later, however, will make the model considerably more general. The theory will be tested here as a valuation model and not as an investment model. That is, the ability of the model to explain the differences in price among common stocks will be tested, and it will be seen that under a variety of considerations the model performs better than previous efforts in this direction. By the statement that the theory will not be tested as an investment model, I mean that no attempt will be made to establish whether or not the investment of the corporation is determined by the objective of maximizing its value. Under the functional form of the stock price model established, a corporation's cost of capital is an increasing function of the rate of * The research reported here was supported by a grant from the Sloan Research Fund, School of Industrial Management, Massachusetts Institute of Technology, and the computations were carried out at the Computation Center, M.I.T. Discussions with Professors Chow, Kuh, and Solow and comments by Professor Modigliani on an earlier draft of this paper have been of considerable assistance to the writer. The advice of Ramesh Gangolli on problems of statistical inference was most helpful. I am especially indebted to Henry Y. Wan, Jr., for his unflagging energy and painstaking care in collecting the data and programming the computations. 'In the last half of their book the Lutzes withdraw the assumption that the future is certain, but this material is largely a well written distillation of the qualitative statements contained in textbooks on finance.

The article presents the set of rules for determining transfer prices that can serve as a feasible and efficient instrument for the decentralized administration of a socialist economy. The problems of bureaucracy in the management of a socialist economy are if anything more acute than the problems of a large firm in a capitalist economy. The classical solution to the decentralized administration of a socialist economy was stated most clearly by O. Lange. Lange proposed a socialist economy in which firm managers exploited their monopoly power to influence prices might be more or less efficient than a centralized economy. The article examines the so-called accounting and economic theories on the relation between cost and production and establishes the role each plays in the administration of a firm. It presents a model of cost behavior which results is the foundation for the transfer price system. It finally describes how cost, price and production are determined under the system and examines the consequences of the system for the allocation and utilization of resources.

The article focuses on a criterion for choice among alternative accounting principles, argue the merits of the criterion, and suggest how it may be used. In other words it does not present the results of research on accounting principles, it only proposes a method for carrying out the research. Many accountants are more interested in establishing accounting principles than in considering how one goes about doing so. In fact, some accountants merely state "correct" principles with little or no effort at substantiating their correctness. Confining to questions of research methodology, the author may therefore call for some justification. This justification will be provided by beginning with a review of an important recent effort at establishing the principles of accounting that should be used as a basis for financial statements. In 1959 the American Institute of Certified Public Accountants created an Accounting Principles Board, which would be the sole group within the Institute having authority to make or authorize pronouncements on accounting principles.

Accounting theory in the measurement of an economic entity's income and wealth involves the discovery and in some sense the verification of principles or rules which will make the practice of accounting in the actual tasks of measurement more effective. The importance of the task and the inherent fascination of the subject have combined to make this among the most intensively discussed topics in accounting. In fact, some consider it the subject of accounting theory, and refer to the theory underlying the measurement of income and wealth. Broadly speaking, economics is concerned with explaining and predicting the behavior that man engages in to satisfy his material wants, and the behavior or characteristics of physical objects as instruments for the satisfaction of these wants. Topics of interest include such diverse phenomena as the price and output of a commodity, the functioning of trade unions, the impact of seniority and business pension plans on the mobility of workers, the dividend policy of corporations, and the conditions which favor change in the technology of production.

The author of this article reviews the thesis that the last-in-first-out (LIFO) method of inventory valuation and an accounting system designed to provide management with internal data for control and decision compliment each other. He elaborates the LIFO theory, illustrating it with quotations. He then enumerates with examples, the data required by a manufacturing enterprise with a heterogeneous inventory under any variant to find its LIFO inventory and cost of goods sold. He considers the problems faced by a first-in-first-out (FIFO) firm while demonstrating that periodic reports derived from a standard cost system compliments LIFO, whereas they conflict with FIFO. He examines the question of whether a firm should price on a FIFO or a current cost basis as prices are subject to frequent changes. He discusses the ability of the purchasing department to buy at the right prices as an important factor of the success of the firm and the conditions under which a firm can be said to be speculating on a commodity.

When accounts are kept on a historical cost basis, the opening balances of the deferred cost accounts are valued at prices prevailing in prior periods. Insofar as these opening balances remain deferred, the dosing balances of these balance sheet accounts do not reflect current cost. Insofar as these balances are expensed to revenue, the related income statement accounts also do not reflect current cost. The capital gains created by the adjustments to the deferred cost accounts are carried to a statement of capital gains, and the conventional income statement is appropriately renamed the operating income statement. Also, the retained earnings account is replaced with two accounts, one of the retained earnings from operations and the other the aggregate capital gain. The operating income and the capital gains of a period are carried to their respective net worth accounts. The above adjustments result in an operating statement in which revenue and all charges to revenue are measured in current dollars. This statement allows the analysis of performance in that all items are valued in the prices of the same period, and this period is the current period. On the other hand, the valuation income statement dearly presents the gain or loss in the legal unit of account due to the change in prices of assets carried forward from the prior period. The balance sheet offers the same advantages for analysis as the operating income statement in that real assets are valued at their current cost, and monetary assets and liabilities are valued at the actual amounts involved. The balance sheet is not a mix of historical and current cost valued in the purchasing power dollars of a prior period. The current cost accounts provide two significant measures of real profit. Total monetary income, which includes capital gains as well as operating income, is the difference between the opening and the closing net worth.