Valuation of Goodwill

What is Goodwill ? It is generally observed that an old and established firm is in a position to earn a higher amount of profit as compared to a new firm inspite of all other things such as investment, location, quality of goods etc. remaining the same. This is because over a period of time a firm establishes its reputation on account of which not only do the old customers continue to patronize the firm but they also bring in new customers.

Meaning of Goodwill This enables the firm to earn excess profits as compared to the new firm. According to Institute of Chartered Accountants of India, Goodwill is an intangible asset arising from trade name or reputation of an enterprise.

Need for Valuation of Goodwill When the business of a company s taken over by some other company, i.e. in case of absorption and amalgamation. When the business of the company is taken over by the government. When a person wants to purchase a large number of shares of a company with a view to acquire control over the management.

Factors affecting value of goodwill Profitability Normal rate of return Capital employed

Methods of Valuation of Goodwill Average Profit Method Weighted Average profit Method Super profit method Capitalization of profit method Annuity Method

Average Profit Method In this method, past profits of a number of years are taken into consideration for calculating goodwill. Such profits are totaled up (amount of loss if any are deducted) and their average value is found out by dividing total profits of past few years.

Average Profit Method Average Profit = Total profits of past years less loss if any Number of Years

Weighted Average Profit Method This method is a modified version of the simple average method. Under this method, each year’s profit is multiplied by the respective number of weights i.e. 1,2,3,4 etc. in order to find out value of product and the total products is then divided by the total of weights in order to ascertain the weighted average profit.

Super Profit Method Under this method Goodwill is calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits. For example if the normal rate of return in a particular type of business is 20% and your investment in the business is Rs.10 lakhs then your normal profits should be Rs.2 lakh. But if you earned a net profit of Rs. 2,30,000 then Rs.2,30,000 - Rs.2,00,000= Rs.30,000 are your super profits.

Super Profit Method For calculating Goodwill Super Profits are multiplied by the number of years of purchase. For calculating Goodwill:- i) Normal Profits = Capital Invested X Normal rate of return/100 ii) Super Profits = Actual Profits - Normal Profits iii) Goodwill = Super Profits x No. of years purchased

Calculation of Capital Employed Capital Employed= Fixed Assets+ Current Assets – All outside liabilities

Capitalization of Profit Method Under capitalization of profit method, capital value of business profit is to be found out. Capital value means to find out the capital needed for earning an annual/ average/ super profit and on the basis of this goodwill is valued.

Capitalization of Profit Method There are two ways of calculating Goodwill under this method: (i) Capitalisation of Average Profits Method (ii) Capitalisation of Super Profits Method

(i) Average Profits Method: Under this method we calculate the average profits and then assess the capital needed for earning such average profits on the basis of normal rate of return. Such capital is called capitalised value of average profits. The formula is:- Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return) Capital Employed = Assets - Liabilities Goodwill = Capitalised Value of Average Profits - Capital Employed

(ii) Capitalisation of Super Profits: As the name itself suggests this method tries to assess the capital needed for earning the super profit, This capital is known as goodwill. Goodwill =100 X Super Profit Normal rate of return

Annuity Method If the present value of annuity is less than Re.1, then Goodwill= Super Profit Present Value of annuity If the present value of annuity is less than Re.1then Goodwill= Super Profit X Present Value of annuity