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The valuation of the Goodwill of a sole proprietorship is done when the business is being sold, but in
case of a partnership firm and a joint stock company goodwill can be sold to some another business
entity without selling the whole business. Hence when you are going to sell the goodwill of your
business, you should be assured of the value of your goodwill at that particular time.
In case of a Partnership firm, there is a need for the valuation of Goodwill of the Firm in the
following cases:
6) In case of valuation of shares of the company for taxation purposes, if stock exchange quotations
are not available.
3. Capitalisation Method
Before calculating the average profits the following adjustments should be made in the profits of the
firm:
a. Any abnormal profits shoulld be deducted from the net profits of that year.
b. Any abnormal loss should be added back to the nat profits of that year.
c. Non operating incomes eg. income from investments etc should be deducted from the net profits
of that year.
Now we will explain this method with the help of a simple example.
A Ltd agreed to buy the business of B Ltd. For that purpose Goodwill is to be valued at three years
purchase of Average Profits of last five years. The profits of B Ltd. for the last five years are:
1. In the year 2008 the company suffered a loss of $1,000,500 due to fire in the factory.
2. In the year 2009 the company earned an income from investments outside the business $
4,500,250.
Solution:
Total profits earned in the past five years= 10,000,000 + 12,250,000 + 7,450,000 2,450,000 +
12,400,000 = $ 39,650,000
Thus A Ltd would pay $21,690,150 as the price of Goodwill earned by B Ltd.
2. Super profits method:
Super Profits are the profits earned above the normal profits. Under this method Goodwill is
calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits. For
examplle if the normal rate of return in a particular type of business is 20% and your investment in
the business is $1,000,000 then your normal profits should be $ 200,000. But if you earned a net
profit of $ 230,000 then this excess of profits earned over the normal profits i.e. $ 230,000 $
200,000= Rs.30,000 are your super profits. For calculating Goodwill, Super Profits are multiplied by
the agreed number of years of purchase.
Steps for calculating Goodwill under this method are given below:
For example, the capital employed as shown by the books of ABC Ltd is $ 50,000,000. And the
normal rate of return is 10 %. Goodwill is to be calculated on the basis of 3 years puchase of super
profits of the last four years. Profits for the last four years are:
Super Profits = Average/ Actual Profits Normal Profits = 8,775,000 5,000,000 = $ 3,775,000
3. Capitalisation Method:
Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)
For example a firm earns $40,000 as its average profits. The normal rate of rteturn is 10%. Total
assets of the firm are $1,000,000 and its total external liabilities are $ 500,000. To calculate the
amount of goodwill:
Under this method first of all we calculate the Super Profits and then calculate the capital needed for
earning such super profits on the basis of normal rate of return. This Capital is the value of our
Goodwill . The formula is:-
For example ABC Ltd earns a profit of $ 50,000 by employing a capital of $ 200,000, The normal rate
of return of a firm is 20%. To calculate Goodwill:
The various methods that can be adopted for valuation of goodwill are
follows:
1. Average Profit Method
ADVERTISEMENTS:
3. Capitalization Method
4. Annuity Method.
ADVERTISEMENTS:
The first step under this method is the calculation of average profit based on
past few years profit. Past profit are adjusted in respect of any abnormal
items of profit or loss which may affect future profit. Average profit may be
based on simple average or weighted average.
ADVERTISEMENTS:
ADVERTISEMENTS:
Illustration 1:
X Ltd. agreed to purchase business of a sole trader. For that purpose,
goodwill is to be valued at 3 years purchase of average profits of last 5 years.
Illustration 2:
Y Ltd. proposed to purchase business carried on by Mr. A. Goodwill for this
purpose is agreed to be valued at 3 years purchase of the weighted average
profits of the past four years.
The profit for these years and respective weights to be assigned are as
follows:
(b) The closing stock for the year 2011 was over valued by Rs. 2,400; and
(c) To cover management cost an annual charge of Rs. 4,000 should be made
for the purpose of goodwill valuation.
Required:
Compute the value of goodwill of the firm.
Solution:
Before calculating goodwill, it is necessary to compute adjusted profit on the
basis of information given.
Illustration 3:
From the following information calculate the value of goodwill on the
basis of 3 years purchase of super profits of the business calculated on
the average profit of the last four years (simple average and weighted
average):
(i) Capital employed Rs. 50,000
(iii) Rate of interest expected from capital having regard to the risk involved is
10%.
3. Capitalization Method:
Goodwill under this method can be calculated by capitalizing average normal
profit or capitalizing super profits.
(i) Capitalisation of Average Profit Method:
Under this method goodwill is ascertained by deducting Actual Capital
Employed (i.e., Net Assets as on the valuation date) from the capitalised value
of the average profits on the basis of normal rate of Return (also known as
value of the firm or capitalised value of business)
Net Assets = All Assets (other than goodwill, fictitious assets and non-trade
investments) at their current values Outsiders Liabilities
Illustration 5:
From the following calculate the value of goodwill according to
capitalisation of Average Profits Method:
(ii) Capitalisation of Super Profit Method:
The goodwill under this method is ascertained by capitalizing the super profits
on the basis of normal rate of return. This method assesses the capital
needed for earning the super profit.
Illustration 6:
Balance Sheet of X Ltd. on 31st March, 2013 was as under:
4. Annuity Method:
Under this method, goodwill is calculated by taking average super profit as the
value of an annuity over a certain number of years. The present value of this
annuity is computed by discounting at the given rate of interest (normal rate of
return). This discounted present value of the annuity is the value of goodwill.
The value of annuity for Rupee 1 can be known by reference to the annuity
tables.
If the value of annuity is not given, it can be calculated with the help of
following formula:
Illustration 7:
The net profit of a company after providing for taxation for the past five
years is:
The net tangible assets in the business are Rs. 4, 00,000 on which the normal
rate of return is expected to be 10%. It is also expected that the company will
be able to maintain its super profits for next five years. Calculate the value of
goodwill of the business on the basis of an annuity of super profits, taking
present value of an annuity of Rs. 1 for five years at 10% interest is Rs. 3.78.