UNIT - 3

VALUATION OF GOODWILL
Goodwill of a business means reputation, fame or image of the
business in the market.
Goodwill is the name and fame of a business which is expressed
in monetary terms.
“A man pays for goodwill for something which places him in the
position of being able to earn more money than he would be able to
do by his own unaided efforts.
“The goodwill is the benefit and advantage of good name,
reputation and connection of a business. It is the attractive force
which brings in customers”.
“Goodwill is nothing more than the probability that the old
customers will resort to the old place”
CHARACTERISTICS OF GOODWILL
(a)It is an intangible asset. It is always attached to the business. It
cannot exist on its own.
(b) It doesn’t become obsolete, not suffer from depreciation
but it is subject to fluctuations because of internal and external
circumstances.
(c)It can be realized independently, but can be realized along with
other assets at the time of liquidation of the business.
(d) It represents non-physical value over and above the
physical assets.
(e)The assessment of the value of the goodwill is highly
dependent on the subjective judgment of the valuer.
 COMPONENTS OF GOODWILL
1. Technical know how of the business
2. Advantage of copy rights or patents enjoyed by the business
3. Advantage of location of the business
4. Advantage of secret process and formula
5. Licenses
6. Franchisies
7. Efficiency of the management
8. Superior earnings power.
9. Special advantage of long term contract etc.
FACTORS AFFECTING GOODWILL
1. Proper use of capital
2. Efficient Management
3. Past Profits
4. Nature of the goods
5. Monopolised Business
6. Age of the business
7. Long term contracts
8. Nature of capital
9. Superiority or specialty of the product .
10. Trends of Profit
11. Other Factors
a. Political protection
b. Favorable Government policy
c. Minimum capital oriented business units
d. Favorable Industrial policy
e. Attitude of Employees, customers, suppliers etc.
TYPES OF GOODWILL :
Goodwill is generally of two types, They are
(a) Purchased Goodwill
(b) Non-purchased Goodwill.
Purchased Goodwill :
The concept of Purchased goodwill will come into picture only
when one business purchases another business and the purchase
consideration paid is more than the value of the net tangible assets
received. It can never be in case of new business except by purchase.
Following are the important features of purchased goodwill:
1. It arises only on acquisition or purchase of a business.
2. It is demonstrated by a purchase transaction.
3. It is recognized in financial statements.
4. It is depends upon the purchaser’s perception towards future
profits.
Non-Purchased Goodwill :
1. It is internally generated
2. Valuation depends on the subjective judgment of the valuer.
3. It is not demonstrated by a purchase price.
4. It is never recognized in financial statements.
Need for valuation of Goodwill :
I. In case of Sole Trading concern
 When a sole trading concern is converted into a
partnership
 When a sole trading concern is sold.
II. In case of Partnership Firm :
 When there is a change in the profit sharing ratio
  In case of admission of a new partner
 On the retirement of a partner
 On the death of a partner
 On the amalgamation of partnership firm with other firms
 On the dissolution of partnership firm
 On the sale of a partnership firm into a joint stock
company.
III. In case of Joint Stock Company.
 Conversion of private company into a public company.
 On the amalgamation of two or more joint stock
company
 On the absorption of one company by another
company
 On the external reconstruction of a company
 For the valuation shares.
 When the government takes over the business of
another company.
 Valuation is done for taxation purpose.
 When one class of share is converted into another.
METHODS OF VALUATION OF GOODWILL :
1. Average Profits method/Simple profit method.
2. Weighted Average Profit.
3. Super profit method
4. Capitalization method.
(a)Capitalization of Average Profit
(b) Capitalization of super profits
5. Annuity Method.
Average Profits Method :
Under this method the value of goodwill is ascertained by
multiplying the adjusted average annual profits with certain number
of years purchase.
 Goodwill = Adjusted Average Annual Profits X Number of years
purchase.
Weighted Average method :
This method is used when any weights are given for each year
otherwise, profits are showing a trend of either increasing or
decreasing. This can be calculated by using the following formula :
Weighted Adjusted Average profit = Total Product
Total weights
Super Profit method :
Super profit is the excess of actual profit over the normal profit
of the business. A common method of valuation of goodwill is the
super profit method. A business may possess some distinctive
advantages which help to make additional profits over and above the
amount which would be earned if the capital of the business was
invested in another place with similar risks. This additional or extra
profit generally called as super profits which will be valued of the
few year’ purchase of super profit.
Steps to be followed :
1. Calculation of capital employed
2. Calculation of Average capital employed
3. Calculation of Average adjusted profit
4. Calculation of Super profit
5. Calcuation of Goodwill.

Capitalization Method : Under this method goodwill is valued

by capitalizing the future maintainable average profits by
applying the normal rate or return. In capitalization method, t is
estimated that , the amount of capital will be required for
 earning an exact amount or profit at the normal rate of return.
There are two methods to find out the value of goodwill.
(a) Capitalization of super profit : Super Profit x 100
Normal Rate of Return

(b) Capitalization of average profit Super Profit (Future

Maintainable profit)x100
Normal Rate of Return
ANNUITY METHOD :
When a purchaser purchases a business, he pays some amount
for goodwill along with the amount for the net assets of the business.
At the time of purchase of business, the purchaser thinks that the
amount paid for goodwill would be recouped by him during the
coming three of four years in the form of super profit.

Methods of Valuation of Goodwill

There are four methods of valuation of goodwill, which are as
follows:
1. Average Profits method/Simple profit method.
2. Weighted Average Profit.
3. Super profit method
4. Capitalized method.
5. Annuity method.
Proforma and Calculation of Average Profits Method
Average Profits Method:
Particulars Amount Amount
Annual Profits xxxxxx
Add: Expenses not likely to occur future:
a. Stock destroyed by fire xxxxxx
b. Loss due to fire/theft xxxxxx
Less: a. Interest on investments xxxxxx
b. Non-recurring incomes xxxxxx xxxxxx
xxxxxx
Less : a. Managerial renuneration, if any Xxxxxx
b. Over-valuation of closing stock xxxxxx xxxxxx
Adjusted Annual Profits xxxxxx
Adjusted Annual Profits xxxxxx

Problem No. 1 Ascertain the goodwill on the basis of 3 years purchase the
average profits of the 1ast 4 years. Were Rs. 20,000, Rs.34,000 Rs. 30,000
and Rs. 36,000 respectively.

Average Profit = Total Profit___

Number of Years

Average Profit = 20,000 + 34,000 + 30,000 + 36,000 = 30,000

04 years

Goodwill = Average Profit x Years purchase x 90,000

30,000 x 3

ACTIVITY: Siddanth Co. Ltd. decided to purchase a business. Its profits

for the last 4 years were 2014 -Rs. 40,000, 2015 Rs. 48,000. 2016 Rs.
50,000, 2017 Rs. 46,000. Find out the amount of goodwill, if it is valued
on the basis of 3 years purchase of the average profits for the last 4 years.

2. The following particulars are available in respect of the business carried

on by Mr. Sanjay.
(a) Profits earned in 2008 – Rs. 50,000 in – 2009 Rs. 48,000 and in 2010
Rs. 52,000.
(b) Profits of 2009 is reduced by Rs. 5,000 due to stock destroyed by fire and
Profits of 2008 included a non-recurring income of Rs. 3,000
© Profits of 2010ninclude Rs. 2,000 income on investment.
(d) The stock is not insured and it is thought prudent to insure stock in future.
The insurance premium is estimated at Rs. 500 p.a.
(e) Fair remuneration to the proprietor if employed else where is Rs. 10,000
p.a.

Compute the value of goodwill on the basis of 2 years purchase of average

profits of last 3 years.

Calculation of Adjusted Profit

Particulars Years
2008 2009 2010
Net Profits 50,000 48,000 52,000
Add: Expenses not likely to occur in future
stock destroyed by fire -5000
Less : Non-operating Incomes 3,000 2,000
Less : Expenses to be incurred in future
Insurance on stock 500 500 500
Less : A managerial remuneration, if any 10,000 10,000 10,000
Adjusted Profit 36,500 42,500 39,500

Average Profit = Total Profit

No. of Years

Average Profit = 36,500 + 42,500 + 39,500 = 39,500

03 years
Goodwill = Average Profit x Years Purchase
= 39,500 x 3 = 79,000

WEIGHTED AVERAGE METHOD

This method is used when any weights are given for each year
otherwise, profits are showing a trend of either increasing or decreasing.
This can be calculated by using the following formula:

Weighted Adjusted Average Profit = Total Product

Total weights

Note: If weights are not mentioned in the problem, in such a case first
year weight will be 1, second years weight will 2, third years weight will
be 3 and so on with the highest weight to the most recent year.
Problem No. 1 ABC Ltd., is planning to purchase the business from a
firm. For this purpose, it is agreed to be valued at 2 years purchase of the
weighted average profits.

The appropriate weights and profits for the past 04 years are as
follows:

Year Weight Profits (In Lakhs)

2009 1 100
2010 2 125
2011 3 150
2012 4 200

Compute the value of the goodwill.

Calculation of Weighted Average Profit

Year Profit Weight Product – [Link]
2009 100 1 100
2010 125 2 250
2011 150 3 450
2012 200 4 800

10 1600

Average Profit = Total Product

Total Weight
= 1600 = 160
10
Goodwill at 2 years purchase = 160 x 2 = 320 Lakhs.

Super Profit method :

Super profit is the excess of actual profit over the normal profit
of the business. A common method of valuation of goodwill is the
super profit method. A business may possess some distinctive
advantages which help to make additional profits over and above the
amount which would be earned if the capital of the business was
invested in another place with similar risks. This additional or extra
profit generally called as super profits which will be valued of the
few year’ purchase of super profit.
Steps to be followed :
6. Calculation of capital employed
7. Calculation of Average capital employed
8. Calculation of Average adjusted profit
9. Calculation of Super profit
10. Calculation of Goodwill.

Illustration No. 1. Following is the Balance Sheet of Chandra Ltd., as on

31-03-2020.
Liabilities Rs. Assets Rs.
Share Capital 30,00,000 Fixed Assets 20,00,000
Reserves & Surplus 7,50,000 Current Assets 25,00,000
Creditors 12,50,000 Investments 5,00,000
50,00,000 50,00,000

The investments are 8% Government Bonds. The net profit after taxation
for the past 4 years were Rs. 7,85,000, Rs. 8,45,000, Rs. 8,50,000 and
Rs. 8,60,000 respectively. Normal rate of return on average capital
employed is 20%. Calculate goodwill at 3 years purchase of super profits.

Solution:

Total Value of Assets

Fixed Assets Rs. 20,00,000
Current Assets Rs. 25,00,000
------------------ 45,00,000
Less : Creditors 12,50,000
-------------
32,50,000
Less ½ of C.Y’s profit
8,60,000 - 40,000 (Int. on investment at 8%
0f 5,00,000)

= 8,20,000 /2 4,10,000
-------------
28,40,000
Average capital employed

Average Profit = 33,40,000 = 8,35,000

4

Adjusted Average Profit = 8,35,000-40,000 = 7,95,000

Super Profits
Adjusted average profit 7,95,000

Less : Normal Profits 28,40,000 20/100 5,68,000

-----------
Super Profit 2,27,000

Goodwill = Super Profit x Year’s Purchase

2,27,000 x 3 6.81,000

Goodwill = Rs. 6,81,000

Illustration No. 2 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 8,00,000

Current Assets 80,000
Current liabilities 1,60,000
Normal Rate of Return = 15%

Managerial remuneration if employed elsewere Rs. 10,000 p.a. Profit of

the last four years were Rs. 1,20,000, Rs. 1,30,000, Rs. 1,40,000 and
Rs. 1,50,000 respectively.

Solution:
Capital employed
Fixed Assets 8,00,000
Current Assets 80,000
-----------
8,80,000
Less Current liabilities 1,60,000
-----------
Capital employed 7,20,000
 Less ½ of current years profit 70,000
(1,50,000-10,000 x ½)
-----------
Average capital employed 6,50,000

Normal Profit = Averaged capital employed x Normal rate of return

= 6,50,000 x 15/100 x 97,500

Average Profit = Total Profits

No. of years.

= 1,20,000 + 1,30,000 + 1,40,000 + 1,50,000 = 1,35,000

4

Average Profits 1,35,000

Less Managerial remuneration 10,000
----------
Adjusted Average Profits 1,25,000
Less : Normal Profits 97,500
Super Profits
Adjusted average profits 1,25,000
Less : Normal Profits 97,500
---------
Super Profits 27,500

Goodwill = Super Profits x No. of years purchase

= 27,500 x 3 = 82,500

Goodwill Rs. 82,500.

Capitalization Method:

Illustration No. 1 Sri Ram has invested a sum of Rs. 3,00,000 in his own
business which is a very profitable one. The amount profit earned from
his business is 6,000 which included a sum of Rs. 10,000 received as
compensation for acquisition of part of his business.

The money could have been invested in deposits for a period of 5

years at 10% interest and himself could earn Rs. 7,200 per annum in
alternative employment considering 2% as fair compensation for the risk
involved in the business.
 Calculate the value of goodwill of his business on capitalization of
super profits at normal rate of return of 12%.