Methods of Valuation of Goodwill

The following are the methods of valuation of goodwill of a firm: - #
1. Average Profit Method
2. Weighted Average Profit Method
3. Super Profit Method
4. Capitalization of Average Profit Method
5. Capitalization of Super Profit Method
6. Present Value of Super Profits
Method 1. Average Profit Method: Under this method goodwill is calculated on the basis of the average profit of previous years. The average profit is multiplied by the number of year's purchase. Goodwill = Average Profit x Number of Years Purchase Example: Calculate goodwill at twice the average profits of last four years' profits. The profits of the last four years were: # # Rs. 27,000 # Rs. 39,000 # Rs. 16,000 (Loss) # Rs. 40,000 Solution: Total Profit for last four years = Rs. 27,000+ Rs. 39,000-Rs. 16,000+Rs. 40,000 = Rs. 80,000 Average Profit = Rs. 80,000/4 = Rs. 20,000. Goodwill = Rs. 20,000 x 2 = Rs. 40,000.
Method 2. Weighted Average Profit Method: This method is a modified version of the average profit method. Under this method the respective number of weights i.e. 1,2,3,4 multiplies profit of every year, in order to find out value product and the total of products is then divided by the total of weights in order to ascertain the weighted average profits. Goodwill = Weighted Average Profits x No. of years Purchase Weighted Average Profit = Total of Products of Profits/ Total of Weights Example: Calculate goodwill at twice the weighted average profits of last four years' profits. The profits of the last four years were:
2001. Rs. 37,000
2002. Rs. 29,000
2003. Rs. 26,000
2004. Rs. 40,000
Solution:
Years Profits Rs. Weight Product Rs.
2001 37,000 1 37,000
2002 29,000 2 58,000
2003 26,000 3 78,000
2004 40,000 4 160,000
Total 10 333,000
Weighted Average Profit = Rs. 333,000/10 = Rs. 33,300 Goodwill = Rs. 33,300 x 2 = Rs. 66,600
Method 3. Super Profit Method: When the actual profit is more than the expected profit or normal profit of a firm, it is called 'Super Profit.' Under this method goodwill is to be calculate of on the following manner: Goodwill = Super Profit x Number of Years Purchase Example: The books of a business showed that the capital employed on January 1, 2001 was Rs. 4,50,000 and the profits for the last five years were as follows: 2001-Rs. 40,000; 2002 -Rs. 50,000; 2003 - Rs. 60,000; 2004 -Rs. 70,000 and 2005 -Rs. 80,000. You are required to find out the value of goodwill, based on three years' purchase of the super profit of the business given that the normal rate of return is 10%. Solution: Total Profit of last five years = Rs. 40,000 + Rs. 50,000 + Rs. 60,000 + Rs. 70,000 + Rs. 80,000 = Rs. 300,000 Average Profit = Rs. 300,000/5 =Rs. 60,000 Normal Profit = Rs. 450,000 x 10/100 = Rs. 45,000 Super Profit = Actual/Average Profit - Normal Profit Super Profit = Rs. 60,000 - Rs. 45,000 = Rs. 15,000 Goodwill = Rs. 15,000 x 3 = Rs. 45,000.
Method 4. Capitalization of Average Profit Method: Under this method goodwill is difference between the total Capitalized value of the firm and the net assets of the firm. Goodwill = Capitalized Value the firm - Net Assets Capitalized Value of the firm = Average Profit x 100/ Normal Rate of Return Net Assets = Total Assets - External Liabilities Example: A firm earns Rs. 65,000 as its average profits. The usual rate of earning is 10%. The total assets of the firm amounted to Rs. 680,000 and liabilities are Rs. 180,000. Calculate the value of goodwill. Solution : Total Capitalized value of the firm = Rs. 65,000 x 100/10 = Rs. 650,000 Net Assets = Rs. 680,000 - Rs. 180,000 = Rs. 500,000 Goodwill = Total Capitalized value of the firm - Net Assets Goodwill = Rs. 650,000 - Rs. 500,000 = Rs. 150,000.
Method 5. Capitalization of Super Profit Method: # # Calculate Capitalized value of the firm # Calculate required profit on capital employed by using the following formula: Normal Profit = Capital Employed x Required Rate of Return/100 # # Calculate average profit # Calculate super profit Goodwill = Super Profit x 100/Normal Rate of Return Example: Verma Brothers earn a profit of Rs. 90,000 with a capital of Rs. 4,00,000. The normal rate of return in the business is 15%. Use Capitalization of super profit method to value the goodwill. Solution: Normal Profit = Rs. 4,00,000 x 15/100 = Rs. 60,000 Super Profit = Rs. 90,000 - Rs. 60,000 = Rs. 30,000 Goodwill = Super Profit x 100/Normal Rate of Return = Rs. 30,000 x 100/15 = Rs. 200,000
Method 6. Present Value of Super Profit: Under this method, goodwill is estimated as the present value of the future super profits. The following steps are taken: # # Calculate the future super profits for next years # Choose the required rate of return # Calculate present value factors # Multiply present value factors with future super profits # The sum of product of present value factors and super profits is the value of goodwill. Example: A firm has the forecasted profits for the coming 4 years as follows:
Years Profits Rs.
1 80,000
2 100,000
3 90,000
4 120,000
The total assets of the firm are Rs. 900,000 and outside liabilities are Rs. 300,000. The present value factors at 10% are as follows:
Years Present Value Factor
1 .9279
2 .8029
3 .7056
4 .6978
Calculate the Value of goodwill. Solution: Net Assets = Total Assets - Liabilities = Rs. 900,000 - Rs. 300,000 = Rs. 600,000
Normal Profit = 10/100 x Rs. 600,000 = Rs. 60,000
Years
1
2
3
4
Profits (Rs.)
80,000
100,000
90,000
120,000
Normal Profit
60,000
60,000
60,000
60,000
Super Profit
20,000
40,000
30,000
60,000
Present Value Factor
0.9279
0.8029
0.7056
0.6978
Present Value of Super Profit
18,558
32,116
21,168
41,868
Goodwill = Rs. 18,558 + Rs. 32,116 + Rs. 21,168 + Rs. 41,868 = Rs. 113,710.