CORPORATE ACCOUNTING B.COM II

VALUATION OF GOODWILL

A software company may have net assets (consisting primarily of miscellaneous equipment, and assuming no debt) valued at Rs 1crore, but the company's overall value (including brand, customers, intellectual capital) is valued at Rs 4 crore. Anybody buying that company would book Rs 4 crore in total assets acquired, comprising Rs1 crore physical assets, and Rs 3 crore in goodwill.

GOODWILL “Goodwill is nothing more than the probability that the old customer will resort to the old place.” -lord Eldon

When a man pays for goodwill, he pays for something which places him in the position of being able to earn more than he would be able to do by his own unaided efforts. Goodwill is, thus, present value of a firm’s anticipated super normal earnings.

FEATURES OF GOODWILL It is an intangible asset. It may be purchased or inherent in the business. It is capable of transfer from one person to another. Value of goodwill generally fluctuates from time to time. It can be sold only with entire business and not separately.

Elements of Goodwill Patents Franchises Customer lists Copyrights Organisation cost Special location advantage

FACTORS DETERMINING THE VALUE OF GOODWILL LOCATION ADVANTAGE CAPITAL REQUIRED SKILL OF MANAGEMENT TRADE NAME PROFIT TREND QUALITY SPECIAL CONTRACT

METHOD OF VALUING GOODWILL Arbitrary Assessment Capitalisation Method Purchase of Past Average Profit Super profit- (i)Purchase of Super Profit (ii)Annuity Method (iii)Capitalisation of Super Profit Method

ARBITRARY ASSESSMENT The valuation of goodwill is arrived at by making a valuation by one of the parties, vendor or purchaser to which the other agrees. If a company decide to purchase the business of another concern and it mutually agreed upon that the purchasing company will pay a specific amount for goodwill in lump sum. The amount so agreed upon is called an arbitrary assessment.

Example:- X ltd. Purchases the business of Y ltd. And it is mutually agreed upon that X ltd. Will pay to Y ltd. a sum of Rs. 1 lac on account of goodwill. This is the case of arbitrary assessment of valuation of goodwill.

CAPITALISATION METHOD Following are the main steps to be taken in computing by this method – a. ascertain the average net profit which it is expected will be earned in future. b. capitalize this net profit at the rate which is considered a suitable return on capital invested in a business of the type under consideration c. find the value of the net tangible assets used in the business (assets less outside liabilities) d. deduct the net tangible assets from the capitalized profit obtained and the difference is goodwill

Example; If the company desirous of selling its business has earned average profits of Rs. 1,80,000 and the net tangible assets of the vendor company was Rs. 15,00,000 and it was considered that a reasonable return on capital invested was 10% Capitalised Profits= 1,80,000 x 100 10 = 18,00,000 Net Tangible Assets = 15,00,000 Goodwill = Capitalised profit- Net Tangible Assets = Rs.3,00,000

Purchase of Past Average Profit This method of valuing goodwill is commonly met with in practice and probably is the on most generally understood. it is calculated on the following basis: 1.profit for an agreed number of year preceding valuation are averaged so as to arrive at the average annual profit earned during that period (average may be simple or weighted). 2. The goodwill is then estimated to be worth so many year purchase of such average profit .The number of year selected is presumed to bear relation to the number of years benefit to be derived from past association. The value of goodwill is calculated by multiplying the adjusted annual purchase profit by the number of year of purchase.

Goodwill = Average profits x Number of years purchase Example:- Average profit = 45000+ 40000+50000+ 47000+58000 = 48000 5 Goodwill = Average profits x No. of years purchase = Rs. 48000x3 =Rs. 144000

WEIGHTED AVERAGE PROFITS METHOD Goodwill = Weighted Average Profits x Number of Years Of Purchase Goodwill =20400X3= rs. 61200

SUPER PROFIT It is the excess of the average profit over the normal profit based on normal rate of return for representative firm in the industry for computation of super profit , the following three factor are required: Normal rate of return-This is the rate of profit or return which an investor expects on his investment. Capital employed –it may be calculated on the basis of assets side items or liabilities side items. capital employed=fixed assets +trade investment + current assets – debenture – current liabilities Normal profit – it is calculated by multiplying the normal rate of return with capital employed as the case may be.

PURCHASE OF SUPER PROFIT Super Profit = Average Profit - Normal Profit Goodwill = Super profit x No. Of Years Of Purchase

Goodwill=Super Profits x Number of Years Purchase. Super profits=Average Profits –Normal Profits. Normal profits=Capital Employed-Normal rate of return/100

EXAMPLE; X Ltd. is running its business with a capital of Rs. 20,00,000.on the basis of previous records , it is expected that the company will earn Rs. 5,00,000 in future. The normal rate of return is 15%. The super normal profits of X Ltd. Will be calculated as; Profits expected in future RS.5,00,000 LESS: Normal profits = [20,00,00 x15%] = Rs.3,00,000 Super profits = Rs.2,00,000 Goodwill= 2,00,000 x 5 =Rs.10,00,000

CAPITALISATION OF SUPER PROFIT METHOD Under this method, the value of goodwill is calculated by capitalizing the super profit at a normal rate of return. This method attempts to determine the amount of capital needed for earning super profit. Goodwill= Average Super Profit x 100 Normal Rate Of Return

EXAMPLE: If super profit is Rs EXAMPLE: If super profit is Rs. 45,000, the normal rate of profit is 15%, the value of goodwill as per capitalisation of super profit will be- Goodwill= Super profit x 100 Normal rate of return = 45000 x100 15

ANNUITY METHOD Under this method, the value of goodwill is calculated by finding the present worth of an annuity paying the super profit (per year) over the estimated period discounted at the appropriate rate of interest. The annuity method of calculation of goodwill is based on the present worth of an annuity of Re 1 for n years at r percent.

GOODWILL = SUPER Profit X ANNUITY VALUE

EXAMPLE; The amount of super profits amounts to Rs. 2,00,000.A reference to annuity table shows that Re.1 paid annually for 5 years at 10% rate of interest is equal to Rs.3.78 immediately. Hence Goodwill=Super profits x value of an annuity =2,00,000 x 3.78 =Rs. 7,56,000

CONCLUSION “Just as cement binds together the bricks and other building material into walls, similarly goodwill binds together or unites the other assets and aspects of the business into cohesive whole.”