Chapter 3-Valuation of Goodwill

Meaning:

Goodwill is the extra value attached to the business over and above the intrinsic
value of its net assets. In other words, it is the value of reputation or good name of
the business.

Definition

According to Prof.Dicksee,”when a man pays for goodwill, he pays for something

which puts him in a position of being able to earn more than he would be able to do
his own unaided efforts.

Features of Goodwill

1. Goodwill is an intangible asset

2. Goodwill is a real asset but not a fictitious asset

3. Goodwill always exist with business but it cannot exist by itself

4. Goodwill is subject to fluctuation

Factors determining the value of Goodwill

1. Location factors

2. Time factor

3. Nature of Business

4. Efficiency of management

5. Past profits of a business

6. Stability of a business

7. Future prospects of a business

8. other factors

“DON’T LIMIT YOUR CHALLENGES CHALLEGE YOUR LIMITS”

Circumstances when it may be necessary to value goodwill.

1. In case a sole trading concern

a. When STC is sold

b. When STC is converted to partnership firm or JSC

c. When ST C is amalgamated with another STC

2. In case of partnership Firm

a. On Admission of new partner

b. On retirement of a partner

c. On death of a partner

d. On Amalgamation of partnership firm

e. On sale of PF

3. In case of Joint stock company

a. On the amalgamation of two or more companies

b. on absorption of one company by another company

c. On the external reconstruction of a company

d. For purpose of valuation of shares.

Methods of valuation of goodwill

1. Average profits method: Value of goodwill is calculated by multiplying the

adjusted average annual profits by the number of year of purchase

“IF IT DOESN’T CHALLEGE YOU IT WON’T CHANGE YOU”

Step 1:

Calculation of adjusted profits or adjusted future profits or maintainable profits

Proforma of calculation of adjusted profits:

Particulars Amount(Rs)
Profit xxx
Add; All expenses and losses not likely
to occur or incur in future. xxx
For Example: Extra ordinary salary of a
person, loss from fire or theft, capital
expenditure etc.
xxx
Add: All profits likely to come in the
future
Eg: Profit due to new line of business
xxx
Less: All expenses and losses expected
to occur in future
For example salary of director,staff to be
oppointed,insurance,depreciation etc xxx

Less: Profit not likely to recur.

Adjusted Profits xxxx
Step 2

Calculation of adjusted average profits:

a. Simple average: When there is fluctuation in the profits

SAP=Total adjusted profits of all the given years

Number of years

b. Weighted Adjusted average profits:

WAAP=Total products

Total Weights

“SPEAK LESS YOU KNOW HAVE MORE THAN YOU SHOW”

Step 3

Calculation of Goodwill

Value of Goodwill=Adjusted Average profits x Number of Years of purchase.

Problems:

Simple Average profits method:

1. Mr. Sanjay has been doing business, intends to sell his business on 1-12-
2010.From the following particulars ascertain the amount of goodwill based on 3
year purchase of average profits of last 4 years.

The adjusted profit of last four year after making all adjustment is RS.100, 000

2. Mr. Juniad has been doing business, intends to sell his business on 1-12-
2015.From the following particulars ascertain the amount of Goodwill based on
3years purchase of average profits of last 4 years.

The profits during 4 years were as follows:

2012-200,000, 2013=240,000, 2014=300,000, 2015=360,000.

At the time of acquisition of business, the buyer was employed as a manager of

similar business on a salary of Rs.6, 000 per month. The profits of 2015 include
income from investment of Rs.20, 000. The profits of 2012 were reduced by Rs.60,
000 being loss on speculation. Similarly, in 2014 profits were reduced by Rs 100,000
due to loss from betting

3. Ramesh purchased a business from Suresh from 1-4-2001.Profits earned by

Suresh for the preceding years were 31-3-1999-500,000, 31-3-2000-600,000, and
31-3-2001-540,000. It was found that the profits for the year 1999 included a
nonrecurring income of Rs.20,000 and profits for the year 2001 was reduced by
30,000 due to an abnormal loss on account of a small fire in the shop. The properties
of the business were not insured in the past, but it was thought prudent to insure the
property in future at premium of Rs.5, 000 P.a. Ramesh at the time if purchase of a
business was employee as manager of an identical business concern at a monthly
salary of Rs.10, 000. He intends to replace the manager of business who is drawing
a salary of Rs.7500 pm. The goodwill is estimated at 2years purchase of average
profits. Calculate goodwill.

Weighted Average profits method:

1. Giri ltd. proposed to purchase the business carried on by Mr. Srinivas. Goodwill
for this purpose is agreed to be valued at 3 years purchase of the weighted average
profits of the past 4 years, the appropriate weights to be used are:

1998 1, 1999 2, 2000 3, 2001 4

The profits for the years are:

1998- Rs.101, 000

1999-Rs.124, 000

2000-Rs.100, 000

2001-Rs.150, 000

On a scrutiny of the accounts the following matters are revealed:

a) On 1st January, 2000 a major repair was made in respect of plant incurring
Rs.30, 000 which amount was charged to revenue. The said sum is agreed to be
capitalized for goodwill. Calculation subject adjustment of depreciation of 10% p.a
on reducing balance method.

b) The closing stock for the year 1999 was overvalued by 12,000

c) To cover management cost an annual charge of Rs. 24, 000 should be made for
the purpose of goodwill valuation

Compute the value of goodwill of the firm.

2. ABC ltd. purchased the business of XYZ ltd. Calculate goodwill on the basis of 3
year purchase of weighted average for 4 years. The appropriate weight are: 2001-1,
2002-2.5, 2003-3.8, and 2004-4.2.

The profits for these years were RS.40, 500, RS.46, 500, Rs.60, 000 and Rs.75,
000 respectively. On scrutiny of accounts, the following aspects were revealed.
1. The company purchased new furniture on 30th June 2004 which was entered in
purchase day book. The value of furniture was Rs.10, 000. For the purpose of
goodwill the error has to be rectified and depreciation would be provided at 10%
under WDV

2. The opening stock of the year 2003 was undervalued by Rs.2, 500

3. Anticipated additional expenses in administration is Rs.5, 000

Capitalization method

Goodwill under this method is ascertained by deducting the actual capital employed
from capitalization value of the business. Under this method, the value of whole
business is determined by applying normal rate of return.

Two methods,

a) Capitalization of average profit.

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.

Step 1:
Calculation of average profits

Step 2:
Calculation of Total value of the business
=adjusted average profit ×100
Normal rate of return

Step 3:
Calculation of goodwill:
Goodwill=Total value of the business-Capital employed or Asset-liabilities

“DON’T WISH IT WAS EASIER, WISH YOU WERE BETTER”

B) Capitalization of super profits

Under this method, we calculate the super profits and then assess the
capital needed for earning such super profits on the basis of normal rate of
return.

Goodwill= Super profits × 100

Normal rate of return

Problems (Capitalization of adjusted average profits)

1. The net profits of the company for the past 5 years are 1996-40,000, 1997-45,000,
1998-47,000, 1999-40,000 and 2000-48,000. The capital employed in the business
is Rs.40, 000. On which a reasonable rate of return of 10% is expected. Calculate
the goodwill of the company under the capitalization of the average profits method.

2.A company desirous of selling its business to another company has earned an
average past profit of Rs.16,000 per annum and the same amount of profit is likely
to be earned in the future also, except that

A) Directors fees of Rs.12, 000 per annum charged against such profits will not be
payable by the purchasing company whose existing board can manage the new
business also.

b) Rent of Rs.28, 000 per annum which had been paid by the vendor company will
not be incurred in the future since the purchasing company owns its own premises
and the necessary accommodation can be provided.

The net assets, other than goodwill, were Rs.18, 00,000 and it was considered that a
reasonable return on investment in this type of business would be 10%

“THERE IS NO ELEVATOR TO SUCESSS FIND STAIRS”

Super profit method

Super profit: Difference between average profits and normal profits

Step 1

Calculation of adjusted average profits

Step 2

Calculation of average capital employed

Asset based approach

Assets (other than non trading assets, goodwill and past deferred expenses and
losses) X XX

Less: Liabilities to outsiders at revised values, if any

XXX

Capital employed at the end of the year XXX

Less: Half of the profits earned during the year XXX

Average capital employed for the year XXX

Liability based approach:

ADD: Equity share capital xxx

Preference share capital xxx

Reserves and profits xxx

Profits on revaluation of assets and liabilities xxx

Less: Good will (Book value) xxx

Losses and past expenses not yet written off xxx

Loss on revaluation xxx

Less: Half of the profits earned during the year xxx

Average capital employed xxx

Step 3

Calculation of Normal profits

Normal profit=Average Capital employed ×Normal rate of return

Step 4

Calculation of super profits

Adjusted average profits xxx

Less: Normal profits xxx

Super profits xxx

Step 5:

Calculation of goodwill

Goodwill = super profits X number of years of purchase

Problems:

1. From the following particulars relating to the business of Ashwini. Compute the
value of goodwill on the basis of three years purchase of super profits taking average
of last four years.

Fixed assets Rs.80, 000

Current assets Rs.80, 000

Current liabilities Rs.160, 000

Normal rate of return 15%

Managerial remuneration if employed elsewhere Rs.10, 000p.a

Profits for the last four years were Rs.120, 000, Rs.140, 000, Rs.130, 000 and
150,000 respectively.

2.The net profit of a business after providing for the past five years are Rs.80,000,
Rs.92,000, Rs.85,000, Rs.103,000 and 118,000. The capital employed in the
business is Rs.800, 000.The normal rate of return expected in this type of business
is 10%. It is expected that the company will be able to maintain its super profits for
the next 5 years. Calculate the value of goodwill on the basis of

a. 5 years purchase of super profit method

b. Capitalizations of super profit method.

3. Following is the balance sheet of shared ltd for the year ended 31st march 2002

Liabilities Amount(RS) Assets Amount

Share capital: Fixed assets
10,000 shares of Building 100,000
Rs.10 each 100,000 Machinery 50,000
Current assets:
Reserves Debtors 50,000
&surplus: Stock 40,000
P/L a/c 90,000 Cash 60,000
10000 70,000
P/L for 2001-02 40,000
80000 40,000
7% debentures
Current liabilities
Creditors
300,000 300,000

Normal rate of return on average capital employed is 10%. Find out the value of
goodwill on the basis of 2 years purchase of super profits. Buildings are revalued at
150,000 and machinery at Rs.40, 000. All others assets are worth their book values.
4. Balance sheet of standard ltd.as on 31-3-2006 is as under:

Liabilities Amount Assets Amount

Share capital Fixed assets 10,00,000
10,00 Equity Stock 350,000
shares if Rs.100 10,00,000 Debtors 450,000
each Cash and Bank 200,000
6,000 15% 600,000
preference shares 80,000
of Rs 100 each 160,000
General reserve 160,000
P/L account
Sundry creditor
20,00,000 20,00,000

The profits of the company (before providing for taxation at 38.5%) and the rate of
dividend declared in respect of the past 5 financial years are as under.

Financial year Profits Rate of dividend

2001-02 270,000 8%
2002-03 310,000 10%
2003-04 340,000 12%
2004-05 330,000 15%
2005-06 360,000 15%

You are required to find out the value of goodwill at 5 years purchase of the super
profits of the company

Annuity method
Under this method, the goodwill of a concern is ascertained by taking into account
the present value of an annuity for certain number of years at a certain rate of interest.
The super profits of the business is multiplied by the present value of Rupee
ascertained from the annuity tables.

The value of the goodwill of the business can be calculated as follows.

Goodwill of the firm=Super profits x Annuity value

Problem

1. The net profits of a company after providing for taxation, for the past 5 years are:

RS.40, 000, Rs.42, 000, Rs.45, 000 and Rs.47, 000

The capital employed in the business is Rs.400, 000 on which a reasonable rate of
return of 10% is expected

It is expected that the co. will be able to maintain its super profits for the next five
years.

Calculate the value of the goodwill of business on the basis of

a. Annuity of super profits, taking the present value of an annuity of 1 Re for 5 year
at 10% interest is 3.38

b. Capitalizations of super profit method

c. 5 years purchase of super profit method

“YOUR MIND IS EVERYTHINNG, WHAT YOU THINK YOU BECOME”