Valuation of Goodwill
Goodwill is an intangible asset.
Therefore it is very difficult to assess the value of it. Its value depends on
the seller & purchaser’s mutual agreement. There are different methods of
valuing goodwill. Some are discussed as below:
1.
Average Profit Method: This is a very simple method.
Goodwill is calculated on the basis of the no. of past years profits. Because
past profits indicate as to what profits are likely to accrue in the future.
Therefore past profits are averaged. Average of such profits is multiplied by
the agreed no. of years to find out the value of goodwill.
Value of Goodwill = Average Profit ×
Number of Years of Purchase
Some adjustment should be done while
calculating the average profit:
·
Abnormal
income of a year should be deducted out of the net profit of that year.
·
Abnormal
loss of a year should be added back to the net profit of that year.
·
Income
from investments should be deducted out of the net profit of that year.
Example: X
sold his business to Y. Calculate the value of goodwill taking into
consideration the following factors:
·
Goodwill
is valued at three years purchase of the average profits of the last four
years. Profits of the last four years were as : year 2011 – ₹40,000, year 2012
– ₹58,000, year 2013 – ₹53,000, year 2014 – ₹62,000.
·
Abnormal
loss of ₹2,000 due to theft has reduced the profits of the year 2011.
·
Profits
for the year 2012 include abnormal profit of ₹4,000.
·
A
speculative and lottery profit of ₹5,000 was received during the year 2013
which was included in that year’s profit.
·
Profits
of the year 2014 were reduced by ₹10,000 of the depreciation on such a
machinery which was destroyed by the fire during the year.
Solution:
Valuation of Goodwill
₹ ₹
Profit for 2011 40,000
Add: Abnormal Loss 2,000 42,000
Profit for 2012 58,000
Less: Abnormal Gain 4,000 54,000
Profit for 2013 53,000
Less: Abnormal Gain 5,000 48,000
Profit for 2014 62,000
Add: Abnormal Loss 10,000 72,000
Total Profit 2,16,000
Average
Profits = ₹ 2,16,000 / 4 = ₹
54,000
Goodwill
at 3 years purchase = ₹ 54,000 × 3 = ₹ 1,62,000
2.
Weighted Average Profit Method: It is considered better than the
simple average profit method because each year’s profit is assigned a weight
and highest weightage is given to the latest year. Then the each year’s profit
is multiplied by the weight assigned to it and the total of their product is
then divided by the total of weights in order to calculate the weighted average
profits. Then goodwill is calculated by multiplying the weighted average profit
obtained with the no. of year’s purchase agreed.
Weighted Average Profit=Total of
Products of Profits/Total of Weights
Goodwill = Weighted Average
Profit × No. of Year’s of Purchase
Example: The
profits earned by a firm during the last four years were as follows:
Year ended 31st March Profits (₹)
2009 80,000
2010 1,00,000
2011 1,10,000
2012 1,50,000
Calculate the value of goodwill on
the basis of 3 year’s purchase of weighted average profits. Weights to be used
1, 2, 3 and 4 respectively to the profits for 2009, 2010, 2011 and 2012.
Solution:
Valuation of Goodwill
Year ended 31st March Profits (₹) Weight Products
2009 80,000 1 80,000
2010 1,00,000 2 2,00,000
2011 1,10,000 3 3,30,000
2012 1,50,000 4 6,00,000
10 12,10,000
Weighted Average Profit = 12,10,000 /
10 = ₹ 1,21,000
Goodwill = ₹ 1,21,000 × 3 = ₹
3,63,000
This method is preferred when the profits over the past 4 or 5 years have
been continuously rising or falling.
3.
Super Profit Method: In this method goodwill is calculated
on the basis of super profits. Super profit is the profit which a firm earns
over normal profit. If it has no excess profit then it will have no goodwill.
Goodwill is calculated by multiplying the super profits by a reasonable no. of
years purchase.
Normal
Profit = Capital Invested × Normal Rate of Return/100
Super Profit
= Actual or Average Profit – Normal Profit
Goodwill =
Super Profit × No. of years purchase
Example: A partnership firm earned net profits during the last
four years as follows:
Year Profits
(₹)
1
56,000
2
64,000
3
60,000
4
62,000
The Capital investment in the firm throughout the
above mentioned period has been ₹ 3,00,000. Having regard to the risk involved,
15% is considered to be a fair return on capital. Calculate the value of
goodwill on the basis of 3 years’ purchase of average super profits earned
during the above mentioned 4 years.
Solution: Total Profits of four years=₹56,000+₹64,000+₹60,000+₹62,000
= ₹ 2,42,000
Average Profit = ₹ 2,42,000 / 4 = ₹ 60,500
Normal Profit = 3,00,000 × 15 / 100 = ₹ 45,000
Super profit = ₹ 60,500 – ₹ 45,000 = ₹ 15,500
Value of Goodwill = 15,500 × 3 = ₹ 46,500
Example: From the figures given below, calculate goodwill according to the capitalization of super profit method:
4. Capitalisation
of Average Profit Method: In this method, Goodwill is calculated by
deducting the actual capital employed from the capitalized value of average
profits. First we calculate average profits and then we capitalized it on the
basis of normal rate of return.
Capitalized value of
Average Profit=Average Profits×100/Normal Rate of Return
Capital Employed = Assets – Liabilities
Goodwill = Capitalized Value of Average Profits – Capital Employed
There will be no goodwill if the
actual capital employed in the business exceeds or equals the capitalized value
of average profits.
Example: The
average profit of a firm is ₹ 48,000. The total assets of the firm are ₹
8,00,000. Value of other liabilities is ₹ 5,00,000. Average rate of return in
the same business is 12%. Calculate the goodwill from capitalization of average
profits method.
Solution:
Capitalized value of Average profits=₹48,000×100/12=₹4,00,000
Capital employed = ₹ 8,00,000 – ₹ 5,00,000
= ₹ 3,00,000
Goodwill = ₹ 4,00,000 - ₹ 3,00,000 = ₹
1,00,000
5.
Capitalisation of Super Profit Method: In this method Goodwill is
calculated on the basis of super profits. We have to calculate the capital needed
for earning of super profits on the basis of normal rate of return. This capitalized
value of super profit is actually called the Goodwill.
Super Profit = Average Profit
– Normal Profit
Goodwill = Super Profit ×100
/ Normal Rate of Return
Example: From the figures given below, calculate goodwill according to the capitalization of super profit method:
(i)
Actual
Average Profits = ₹ 72,000
(ii)
Normal
Rate of Return = 10%
(iii)
Assets
= ₹ 9,70,000
(iv)
Liabilities
= ₹ 4,00,000
Solution:
Capital Employed = Assets – Liabilities
= ₹ 9,70,000 - ₹1,00,000 =₹ 5,70,000
Normal Profit=Capital Employed×Normal Rate of Return/100
= ₹ 5,70,000 × 10 /
100 = ₹ 57,000
Super Profit = Average Profit –
Normal Profit
= ₹ 72,000 - ₹ 57,000 = ₹
15,000
Goodwill = Super Profit×100/Normal Rate of Return
= ₹ 15,000×100/10 = ₹1,50,000
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