Valuation of Goodwill
Goodwill is an important part of the business. It creates worth of the business. It is an intangible
asset of the business. It creates from profit of the business. When we sale our business,
amalgamation, merger, acquisition and in case of reconstruction of business etc. need arise of
valuation of goodwill. It cannot directly calculated therefore, we may use following methods to find
out the value of Goodwill.
| Valuation of Goodwill Methods | |
| SL NO. | Name of the Method |
| 1. | Average profit method |
| 2. | Super Profits Method |
| 3. | Annuity method |
| 4. | Capitalization of average profits method |
| 5. | Capitalization of super profit method |
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Valuation of Goodwill – Methods Explanation.
- Average profit method
We can find out valuation of goodwill by average profit method. This method is widely used for the
valuation of Goodwill. It has four steps. Each step is important. Therefore, we have to calculate very carefully.
Step – 1 –Computation of past profit before tax (PPBT)
| S.No. | Particular | Amount |
| A | Closing balance of P/L account | XXXXX |
| B | Add1) Goodwill w/o……………………………………………..XXX2) Interim dividend……………………………………………XXX3) Proposed .Preference .dividend……………………………XXX4) Proposed Equity dividend…………………………………XXX 5) Dividend distribution tax…………………………………..XXX 6) Transfer to Reserve……………………………………..…XXX |
XXXXX |
| C | Less : Opening balance of P/L account | XXXXX |
| D | PAT (A+B-C) (Profit after Tax PAT) | XXXXX |
| E | Add : Tax at actual rate (PAT/T*(1-T) | XXXXX |
| F | Profit before Tax (D+E) | XXXXX |
Step – 2 –Computation of past adjusted profit before tax (PAPBT)
| S. No. | Particular | Amount |
| A | Profit before Tax from step – 1 | XXXXX |
| B | Add:i. Abnormal loss …………………………………………..XXXXii. Capital expenditure charged on Revenue account…….…XXXXiii. Over valuation of opening stock…………………….…..XXXXiv. Income of previous year not credited…………………….XXXX |
XXXXX |
| C | Less:i. Abnormal profit…………………………………………XXXXii. Income from non trade investment………………………XXXXiii. Depreciation charged on above assets……………………XXXXiv. Capital receipts charged on Revenue account……………XXXX v. Over valuation of Closing stock…………………………..XXXX vi. Revenue expenditure of previous year not charged………XXXX |
XXXXX |
| D | PAPBT(A+B-C) | XXXXX |
Step – 3 –Computation of future maintainable profit (FMP)
| S. No. | Particular` | Amount |
| A | Past adjusted profit before tax (PAPBT) calculated in step – 2 | XXXXX |
| B | Add :1. Income not earned in the past but likely to be earn in future2. Expenditure incurred in the past but not likely to be incurred inFuture | XXXXX |
| C | Less :1. Income earned in the past but not likely to be earn in future2. Expenditure not incurred in the past but likely to be incurred inFuture | XXXXX |
| D | Future maintainable profit before tax (A+B-C) | XXXXX |
| E | Tax likely at future rate | XXXXX |
| F | Future maintainable profit after tax (D-E) | XXXXX |
Step – 4 –Valuation of Goodwill
Goodwill = Future maintainable profit X number of year of purchase.
2. Super profits method
Super profit method also used in the valuation of Goodwill. This method used when the business
man assumed that a new business will not able to generate excess profit during the first few years of
its operations. It has five steps. Each have been mentioned below :
Step – 1 –Computation of average capital employed
Average capital employed cannot find out without capital employed. Therefore, first we have to
calculate capital employed. It may calculated by long term fund approach and shareholder’s fund
approach.
Average capital employed
Where only one year’s Assets and Liabilities are given:
| S. No. | Particulars | Amount |
| A | Closing capital employed calculated above | XXXXX |
| B | Dividend & Dividend tax paid at the end of current year | XXXXX |
| C | Adjusted closing capital employed (A+B) | XXXXX |
| D | Half of {current year adjusted profit before tax + income from non trade investments – tax} | XXXXX |
| E | Average capital employed (C – D) | XXXXX |
Where more than one year Assets and Liabilities is are given:
| S. No. | Particulars | Amount |
| A | Closing capital employed calculated above | XXXXX |
| B | Dividend & Dividend tax paid at the end of current year | XXXXX |
| C | Adjusted closing capital employed (A+B) | XXXXX |
| D | Opening capital employed | XXXXX |
| E | Average capital employed (C +D/2) | XXXXX |
Step – 2 –Computation of normal profit
Normal profit = Avg. capital employed (calculated in step -1) X normal rate of return
Step – 3 –Computation of future maintainable profit (FMP)
Computation of future maintainable profit will remain same as calculated in average profit method.
Step – 4 –Computation of Super profit
Super profit = Normal profit – future maintainable profit
Step – 5 –Computation of Goodwill
Goodwill = Super profit X number of year purchase.
Leverage effect: Normally shareholder’s fund approach used for the leverage effect. Leverage
effect arises due to use of borrowed fund carrying rate of interest lower than the rate of return on
investment.
Leverage effect = value of Goodwill on the basis of Shareholder’s approach – value of Goodwill
on the basis of long term fund approach.
3. Annuity method
Under annuity method time value of money considered. Following steps used for the calculation of
Goodwill under annuity method:
Step – 1: Future super profit = Avg. profit – normal profit
Step – 2: compute present value of all super profits.
Step – 3: Goodwill = sum of all present value of super profit calculated in step -2.
4. Capitalization of super profit method
Goodwill under this method is ascertained by capitalizing the super profit profits on the basis of
normal rate of return. Following steps uses to find out the value of Goodwill.
Step – 1: Compute Super profits (according to steps given under super profits method)
Step – 2: Goodwill = Super profits x 100/ Normal rate of return.
Capitalization of super profit method is used if in the no. of years purchase of profits is not given.
5. Capitalization of average profits method
Step –1: Compute average Future Maintainable Profits (according to steps given under average
Profits Method).
Step – 2: Compute the capitalized Value of Average profits as under:
Capitalized Value = Average Future Maintainable Profits x 100/ Normal Rate of Return
Step – 3: Compute the value of Net Assets as on the date of valuation of goodwill as under: Net
Assets = all assets (other than goodwill, fictitious assets and non- trade investments) at their current
values less Outsiders Liabilities.
Step – 4: Goodwill = Capitalized Value – Net Assets
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