Question

Explain various methods of valuation of goodwill.

Explain any one method of goodwill valuation.

Answer 1

The following are the various methods of valuation of goodwill.

1. Average Profit Method: Under this method, goodwill is calculated on the average basis of the profits of past few years. The formula for calculating goodwill is:

Goodwill = Average Profit × No. of Years Purchase

Average Profit = `"Total Profit of Past Given Years"/"Number of Years"`

Number of years of purchase implies the number of years for which the firm expects to earn the same amount of profits.

Steps to calculate goodwill by Average Profit Method:

1. Ascertain the total profit of past years.
2. Add all abnormal losses, like loss by fire, theft, etc.
3. Add all normal income, if not added previously.
4. Less all non-business incomes and all abnormal gains and incomes like speculation, lottery, etc.
5. Less all normal expenses, if not deducted previously.
6. Calculate average profit by dividing the total profit ascertained in Step 5 by the number of years.
7. Multiply the average profit by the number of year’s purchases to calculate the value of goodwill.

Example: The profits for last 5 years are 1,00,000, 3,00,000, (2,00,000), 5,00,000, 8,00,000.

Calculate goodwill on the basis of 4 years of purchases:

Average Profit = `[1,00,000 + 3,00,000 + 5,00,000 + 8,00,000 - 2,00,000]/5`

= `[15,00,000]/5`

= Rs. 3,00,000

Goodwill = 3,00,000 × 4 years = Rs. 12,00,000

2. Weight Average Method: It is a modified version of the Average Profit Method. Under this method, the weights are assigned for each year’s profit. Highest weights are assigned to the recent year’s profit and lower weights are assigned to the past year’s profits. The products of the profits and the weights are added and divided by the total weights to calculate Weighted Average Profits. The formula for calculating goodwill by this method is:

Weighted Average Profit = `"Total products of profits"/"Total of weights"`

Goodwill = Weighted Average Profit × Number of Years Purchase

Steps to calculate goodwill by the Weighted Average Method:

1. Assign the highest weights to the recent year’s profit and lower weights to the past year’s profits, like 4, 3, 2, 1.
2. Multiply the weights with its corresponding year’s profits.
3. Calculate the total of the products.
4. Divide the total of the product by the total of the weights in order to calculate Weighted Average Profit.
5. Multiply the Weighted Average Profit by the number of years purchased.

Example: The profits for the last 5 years are Rs. 1,00,000, Rs. 3,00,000, Rs. (2,00,000), Rs. 5,00,000, Rs. 8,00,000.

Calculate goodwill on the basis of 4 years of purchases:

Profit/Loss (Rs.)	Weights	Product (Rs.)
1,00,000	1	1,00,000 × 1 = 1,00,000
3,00,000	2	3,00,000 × 2 = 6,00,000
(2,00,000)	3	(2,00,000) × 3 = (6,00,000)
5,00,000	4	5,00,000 × 4  = 20,00,000
8,00,000	5	8,00,000 × 5  = 40,00,000
Total	15	Rs. 61,00,000

Weighted Average Profit = `(61,00,000)/15` = Rs. 4,06,666.67

Goodwill = 4,06,666.67 × 4 = Rs. 16,26,668

3. Super Profit Method: Under this method, goodwill is calculated on the basis of excess profit earned by a firm over the normal profit earned by its counterparts in the same industry. The excess profit over the normal profit is termed as Super Normal Profit.

Steps to calculate goodwill by Super Profit Method:

1. Calculate Average Profit
2. Calculate Average Capital Employed as:
   Average Capital Empolyed = `"Opening Capital Employed" + "Closing Capital Employed"/2`
3. Calculate Normal Profit by the formula:
   Normal Profit = `"Average Capital empolyed" xx "Normal Rate of Return"/100`
4. Calculate Super Normal Profit by the formula:
   Super Normal Profit = Average Profit – Normal Profit
5. Multiply the Super Normal Profit by the Number of Years Purchase to calculate goodwill.

4. Capitalisation Method: Under this method, goodwill is calculated by the following two methods:

1. By capitalisation of Average Profit.
2. By capitalisation of Super Profit.

a) Capitalisation of Average Profit:

1. Calculate Average Profit
2. Calculate Capitalised value of Average Profit by the following formula:
   Capitalised value of Average Profit = `"Average Profit" xx 100/"Normal Rate of Return"`
3. Ascertain Actual Capital Employed
4. Deduct Actual Capital Employed from Capitalised Average Profit to calculate goodwill.
   Goodwill = Capitalised Average Profit – Actual Capital Employed

b) Capitalisation of Super Profit:

1. Calculate the Capital Employed
2. Calculate Normal Profit by the following formula:
   Normal Profit = `"Average Capital Employed" × "Normal Rate of Return"/100`
3. Calculate Average Profit
4. Calculate Super Normal Profit by the following formula:
   Super Normal Profit = Average Profit – Normal Profit
5. Calculate goodwill by the following formula:
   Goodwill = `"Super Profit" xx 100/"Normal Rate Return"`