Thank you, thank you! It works!
It took me a bit of work to discover I have to set Soundflower as audio output only for the app I am recording (not in Mac's System Preferences), and input for Captivate. But the sound is now excellent in the Captivate slide.
What I have not figured out yet (and which I need) is how to HEAR the app I am recording, while I am recoridng the demo in Captivate, and still have the sound routed into Captivate. I mean -- it is very difficult to demo an audio application while you cannot HEAR it!
(I can't believe I have to install a separate utility to make Captivate do what it should do naturally. Adobe, why don't you do a better job with Mac software?)
There is another utility freely available on the net called "Line in".
Using this you can route the app audio to soundflower as well as hear the same in system speakers simultaneously.
I noticed a bit of a lag between the recorded audio and the "re-routed" audio from Line-in but only if I continued to use it for a long time.