Valuation of Goodwill
Valuation of Goodwill
When a business is able to earn profits at a rate higher than that at When a business is able to earn profits at a rate higher than that at which a similar business earns, the former business is said to possess which a similar business earns, the former business is said to possess goodwill. Goodwill is, therefore, an invisible asset by the possession of goodwill. Goodwill is, therefore, an invisible asset by the possession of which a business can enjoy super earning. Since it is invisible the
which a business can enjoy super earning. Since it is invisible the goodwill is called an in tangible asset. But since its existence can be goodwill is called an in tangible asset. But since its existence can be felt through superior earning power it is a
felt through superior earning power it is a real asset.real asset.
There are several causes for which a business may have a goodwill and There are several causes for which a business may have a goodwill and some of them are:
some of them are:
(1)Possession of a large number of profitable contracts ; (2)Suitable (1)Possession of a large number of profitable contracts ; (2)Suitable nature of the business ; (3)Exclusive
nature of the business ; (3)Exclusive franchise ; (4)Protected valuablefranchise ; (4)Protected valuable patents and trademarks ; (5)Suitable location of
patents and trademarks ; (5)Suitable location of the business ;(6)Idealthe business ;(6)Ideal window dressing ; (7)Government patronage ;(8)Reputability,
window dressing ; (7)Government patronage ;(8)Reputability, respectability and reliability of the proprietor o
respectability and reliability of the proprietor or partners or trusteesr partners or trustees ; (9)Special ability and skill of the persons in management, etc.
; (9)Special ability and skill of the persons in management, etc. In case of transfer of business, sepa
In case of transfer of business, separation of the partners from theration of the partners from the business due to retirement, death, etc, assessment of the value
business due to retirement, death, etc, assessment of the value of theof the business for any reason, goodwill may have to be valued.
business for any reason, goodwill may have to be valued.
Methods of Valuation of Goodwill
Methods of Valuation of Goodwill
There are various methods for valuation of goodwill of a business of There are various methods for valuation of goodwill of a business of which the following are of common use:
which the following are of common use:
(1) Few years· Purchase of Average Profits Method:
(1) Few years· Purchase of Average Profits Method: Under thisUnder this method
method goodwill is goodwill is valued valued on the on the basis of basis of an an agreed nuagreed number mber of of years·years· purchase of the average maintainable profit. The word maintainable purchase of the average maintainable profit. The word maintainable
indicates several adjustments in respect of the factors which might indicates several adjustments in respect of the factors which might have influenced abnormally the profits of the years o
have influenced abnormally the profits of the years over which thever which the average is taken. If in any year there is an exceptional opportunity or average is taken. If in any year there is an exceptional opportunity or an exceptional expense or absence of
an exceptional expense or absence of expense, the profit for the yearexpense, the profit for the year has
has to be so adjusted to be so adjusted as to get it fras to get it free from suee from such exceptionalch exceptional influences.
influences.
Sometimes instead of the simple ave
Sometimes instead of the simple average of the adjusted profits asrage of the adjusted profits as discussed above, weighted average is taken into consideration. Weights discussed above, weighted average is taken into consideration. Weights are given to each years· profit on
are given to each years· profit on the consideration how each years·the consideration how each years· profit
profit is likely is likely to influence tto influence the future he future profit trenprofit trend.d.
(2) Super Profits Method:
(2) Super Profits Method: Under this method average super profit isUnder this method average super profit is ascertained. Goodwill is calculated at a few
ascertained. Goodwill is calculated at a few years· purchase of theyears· purchase of the super profit of the concern. The num
super profit of the concern. The number of years to be taken ber of years to be taken forfor consideration depends upon the nature of the business,
consideration depends upon the nature of the business, the steady orthe steady or fluctuating nature of the profit and also the
fluctuating nature of the profit and also the nature of goodwill.nature of goodwill.
First, ascertain the average capital employed during the year. For this First, ascertain the average capital employed during the year. For this purpose take the total of the closing real assets of the concern as purpose take the total of the closing real assets of the concern as revalued (excluding the non-trading assets and goodwill already revalued (excluding the non-trading assets and goodwill already appearing in the balance sheet unless
appearing in the balance sheet unless such goodwill represented thesuch goodwill represented the payment to the vendor).
payment to the vendor). In order to find out the ave
In order to find out the average capital employed it is necessary torage capital employed it is necessary to deduct from the above the current liabilities and 5
deduct from the above the current liabilities and 50% of the profits0% of the profits for the year after tax. The profit sho
for the year after tax. The profit should also be excluding non-tradinguld also be excluding non-trading income, if any. The average capital e
income, if any. The average capital employed in this way excludes themployed in this way excludes the long term loans, debentures and preference shares.
long term loans, debentures and preference shares.
The idea of capital employed is not suitable for the purpose of The idea of capital employed is not suitable for the purpose of
valuation of goodwill of an individual company where valuation is to be valuation of goodwill of an individual company where valuation is to be done to the advantage of the equity shareholders. In this case,
the above total assets we deduct
the above total assets we deduct the current liabilities, long termthe current liabilities, long term loans, preference capital, etc, also 50% o
loans, preference capital, etc, also 50% of the profit for the yearf the profit for the year
after excluding non-trading income and after charging interest on long after excluding non-trading income and after charging interest on long term loans and de
term loans and debentures, preference dividend, etc.bentures, preference dividend, etc.
The average capital employed is the mean of the opening and closing The average capital employed is the mean of the opening and closing capitals. As we have
capitals. As we have taken the closing net assets which includes thetaken the closing net assets which includes the profits for the year it is necessa
profits for the year it is necessary to deduct 50%of the profit inry to deduct 50%of the profit in order to get the capital at
order to get the capital at the middle of the year. If, however, thethe middle of the year. If, however, the closing net assets are after the payment o
closing net assets are after the payment of dividend or after settingf dividend or after setting aside a portion of the p
aside a portion of the profit to proposed dividend account, necessaryrofit to proposed dividend account, necessary adjustments must be done so
adjustments must be done so that the average capital ascertainedthat the average capital ascertained includes only 50%of the profit after
includes only 50%of the profit after tax.tax. Now we calculate the normal ave
Now we calculate the normal average annual trading profit after tax,rage annual trading profit after tax, but before charging interest on debentures and long term l
but before charging interest on debentures and long term loans andoans and also preference dividend. From this average profit reasonable
also preference dividend. From this average profit reasonable managerial remuneration should also be deducted. The profit as managerial remuneration should also be deducted. The profit as obtained after the above adjustments is to be
obtained after the above adjustments is to be compared with thecompared with the reasonable return on the average capital employed, calculated a
reasonable return on the average capital employed, calculated at thet the rate of return earned by similar businesses. If the
rate of return earned by similar businesses. If the former exceeds theformer exceeds the latter the balance represents the super profit.
latter the balance represents the super profit. A few years· purchase of the supe
A few years· purchase of the super profit is taken as the value r profit is taken as the value ofof goodwill.
goodwill.
(3) Annuity Method:
(3) Annuity Method: Under this method the basis is super profit. LetUnder this method the basis is super profit. Let us take an
us take an
example:-Suppose the super profit of a co
Suppose the super profit of a concern has been calculated at Rs.50000ncern has been calculated at Rs.50000 and it has been considered reasonable
and it has been considered reasonable that 5 years· purchase of thethat 5 years· purchase of the super profit approximates the value o
super profit approximates the value of goodwill. The contention behindf goodwill. The contention behind this is that, the purchaser of the business can expect to enjoy super this is that, the purchaser of the business can expect to enjoy super
profit of Rs.50000 per year for the
profit of Rs.50000 per year for the next 5 years. If this is next 5 years. If this is thethe contention it is not reasonable that he should pay Rs. (50000*5) or contention it is not reasonable that he should pay Rs. (50000*5) or Rs.250000. He should pay an amount which will give him an annuity of Rs.250000. He should pay an amount which will give him an annuity of Rs.50000 over the next 5 years at
Rs.50000 over the next 5 years at the current rate of interest. This isthe current rate of interest. This is what is known as the annuity method of valuation of goodwill. Once the what is known as the annuity method of valuation of goodwill. Once the super profit is ascertained, the present value and he
super profit is ascertained, the present value and hence the value ofnce the value of goodwill can be ascertained by the
goodwill can be ascertained by the following formula:-following
formula:-V=a/i[1-(1+i)^-n)] ,or, V=a/i[1-(1+i)^-n)] ,or, V=a/i[1-1/(1+i)^n] V=a/i[1-1/(1+i)^n] Where, Where,
V=the present value of the annuity o
V=the present value of the annuity or the value of goodwill inr the value of goodwill in this case
this case
a=the annuity or the annual super p
a=the annuity or the annual super profit in this caserofit in this case n=the number of years the annuity would be
n=the number of years the annuity would be enjoyedenjoyed i=the rate of interest per rupee per year
i=the rate of interest per rupee per year
(4)
(4) Capitalisation Capitalisation Method:-
Method:-(a) Capitalistion of Average Profit:
(a) Capitalistion of Average Profit: Under this method the averageUnder this method the average annual profit is to
annual profit is to be ascertained after providing for reasonablebe ascertained after providing for reasonable management remuneration. This profit should be capitalized at the management remuneration. This profit should be capitalized at the rate of reasonable return to find out the total value of business. Now rate of reasonable return to find out the total value of business. Now the value of goodwill will be the total value of business minus its net the value of goodwill will be the total value of business minus its net assets. If, however, the net assets is greater ther will
assets. If, however, the net assets is greater ther will be no goodwill,be no goodwill, rather there is badwill.
rather there is badwill.
(b) Capitilisation of Super Profit:
(b) Capitilisation of Super Profit: Under this method the averageUnder this method the average super profit is capitalised at a ce
super profit is capitalised at a certain rate of interest and thisrtain rate of interest and this capitalised amount becomes the value o
