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Valuation of Goodwill

Meaning of Goodwill: Goodwill means the reputation possessed by a business enterprise or the attractive force which
brings customers. In other words, it is an intangible asset compounded from various factors such as good management,
customer acceptance, good location, quality and profitability of a product etc.

Definition: According to Spicer and Pegler Goodwill may be that element arising from the reputation, connection or
other advantages possessed by a business which enables to earn greater profits than the returns normally to be
expected on the capital represented by the net tangible assets employed in the business

Characteristics of Goodwill

1. Goodwill is an intangible asset which does not have any physical existence, which cannot be seen or touched
2. Goodwill can be sold with the entire business
3. Goodwill is valued only if it is capable of being transferred from one person to another
4. The value of goodwill be based on subjective judgment of the valuer
5. Goodwill cannot have an exact cost, since its value fluctuates from time to time
6. Goodwill cannot exist by itself since it is always attached to the business. So, goodwill is born with the business,
lives with the business and dies with the business
7. It does not become obsolete. It does not suffer depreciation. However, it is subject to fluctuation

Factors determining value of goodwill

The following are different factors which are to be considered in valuing goodwill:

1. Location Factor: Favourable location of the business influences the earning capacity of the business. So, those
business enterprises located in favourable localities will have more earning capacity and there by more
goodwill
2. Earning Capacity: A person buying a business is concerned with that business to see that whether it will be
maintaining its profits in future. If the profits are equal to return on ordinary investments without any payment
of premium no business man will purchase such type of business. Therefore, the earning capacity of business
with more future profits will have more goodwill.
3. Nature of goods: Profits depends upon the nature of goods. If a business deals in those goods which are of
daily use profits are likely to be constant. The more constant profits, the more would be the goodwill and vice-
versa
4. Nature of competition: Competition in the market is another important factor which determines the value of
goodwill. In case of monopolistic enterprises there will be more goodwill as compared to those business
enterprises with more competition
5. Efficiency of Management: Managerial efficiency also contributes to higher profits whereby the earning
capacity of business increases. Consequently, goodwill of such firms would be more
6. Past Profits: A business which is earning more profits in the past is likely to earn more profits. In future
consequently value of goodwill of such firms will be more
7. Money Market Conditions: The value of goodwill also depends upon the money market conditions prevailing
in the economy. If the market conditions are good it will increase the value of goodwill and tight money market
conditions decreases the value of goodwill
8. Profit contracts: If a business concern, has large number of profitable contracts like long term contracts for
supply of goods then it can continue to earn more and more profits and will have more goodwill
9. Effective Publicity: The publicity undertaken by a business concern in order to make it in an effective manner
will increase reputation of the business and there by increases the value of goodwill
10. Future Prospects: A business which enjoys more stability in the long run will have more growth and good
future prospects and hence enjoys more goodwill and vice-versa
11. Risk Involved: The nature of risks involved in a business is also considered while valuing goodwill. A business
which is relatively free from risks enjoys more goodwill than the business which is risky
12. Efficiency of employees: Employees efficiency also contributes in the valuation of goodwill. Skilled and
efficient employees of an enterprise will contribute more profits which in turn increases the value of goodwill
13. Sources of capital: The business concern which is secured capital from the owners will have more goodwill
than the business which is financed by outsiders through debentures, loans. Since in case of outside financing
profits are less due to interest on the borrowings

Types of goodwill:

Goodwill can be

1. Purchased Goodwill: It is a goodwill which arises when a business enterprise is purchased by another business
enterprise and the purchase price is more than the Net Assets. The following are the characteristics of
purchased goodwill:
a. Such a type of goodwill occurs on the account of a purchased transactions
b. It arises when one business enterprise is purchased by another
c. It takes place only when the purchase price paid more than the net assets acquired
d. Such purchased goodwill is reflected in the balance sheet
e. While valuing purchased goodwill many factors are to be considered like nature of business, market
conditions, past profits etc.
2. Non Purchased Goodwill: It is a goodwill which arises when a business generates its own goodwill over a
period of time which depends upon various factors such as location, sales, public image, efficient
management, quality, products & Services. The following are the characteristics of inherited goodwill or raised
goodwill
a. It is generated internally
b. There is no cost placed on such type of goodwill
c. Valuation of goodwill depends upon the subjective judgment made by the valuer
d. It is not shown in the balance sheet

Circumstances Necessitating Valuation of Goodwill


1. In case of Sole trading concerns
a. When a sole trading concern is converted into a partnership firm
b. When a sole trading concern is sold
c. For tax purposes
2. In case of Partnership firm
a. When there is a change in the profit sharing ratio of the partners
b. On the admission of a new partner
c. On the retirement of a partner
d. On the death of a partner
e. On amalgamation of partnership firm with another firm
f. On dissolution of partnership firm
g. On sale of partnership firm to a company
3. In case of joint stock companies
a. On the conversion of private limited company into a public limited company
b. On the amalgamation of two or more companies
c. On the absorption of one company by another
d. On the external reconstruction of a company
e. When shares are valued
f. For tax purpose
Methods of Valuation of Goodwill

1. Average Profit Method


2. Super Profits Method
3. Capitalization Method
4. Annuity Method

Average Profit Method

Under this method certain number of years purchase (times) of the average adjusted annual profits of a given number
of past years is taken as the value of the goodwill of a business. Average profits are those profits which consider the
profits of a given number of years which are adjusted for extraordinary, abnormal incomes and expenses and are then
taken the average on the basis of simple or weighted average.

Calculation of Goodwill

Step 1 Calculation of adjusted profits

Particulars I Year II Year III Year


Profits as given Xxx Xxx Xxx
Add: All losses and expenses not likely to occur in future Xxx Xxx Xxx
(Abnormal losses)
Less: All profits and gains not likely to occur in future Xxx Xxx Xxx
(Abnormal profits)
Add: All profits likely to occur in future (Normal Profits) Xxx Xxx Xxx
Less: All expenses and losses likely to occur in future Xxx Xxx Xxx
(Normal Losses and expenses)
Add: Over valuation of opening stock Xxx Xxx Xxx
Less: Under valuation of opening stock Xxx Xxx Xxx
Add: Under valuation of closing stock Xxx Xxx Xxx
Less: Over valuation of closing sock Xxx Xxx Xxx
Adjusted Profits xxx xxx xxx
Step 2: Calculation of Average Adjusted Profits:

a. Simple average:
Average Adjusted Profits = Total Adjusted profits
No. of Years
b. Weighted Average:
Average Adjusted Profits = Total Product
Total weights

Step 3: Calculation of Goodwill


Goodwill = Average Adjusted Annual Profits x No. of years of purchase
Super Profit Method

Super profit means excess of actual average annual profits earned by a concern over and above the normal return on
investments in that line of business. So in this method, goodwill is calculated by estimating the average capital
employed and super profits are multiplied with the given number of years of purchase.

Calculation of Goodwill

Step 1: Calculation of Adjusted Annual Profits


Step 2: Calculation of Average Adjusted Annual Profits
Step 3: Calculation of Capital Employed

a. Asset Approach Method


All Assets (Except goodwill, past accumulated losses and non-trading investments) at Xxx
market values
Less: All Liabilities to outsiders at revised values Xxx
Less: Half of profits earned during the year Xxx
Average Capital Employed xxx

b. Liability Approach Method


Equity share capital Xxx
Add: Preference Share capital Xxx
Add: Reserves & Surplus Xxx
Add: profits on revaluation of assets and liabilities Xxx
Less: Goodwill at book value Xxx
Less: Accumulated losses Xxx
Less: Non trading investments Xxx
Less: Half of current years profit xxx
Average Capital Employed xxx
Step 4: Calculation of Normal Profits
Normal Profits = Average Capital Employed x Normal rate of return
Step 5: Calculation of super profits
Super profits = Average Adjusted Profits Normal Profits (Step 2 Step 4)
Step 6: Calculation of Goodwill
Goodwill= Super Profits x No. of Years of Purchase

Capitalization Method

In this method the total value of business consisting of Net assets of the firm (Assets Liabilities) is capitalized by the
actual adjusted annual profits on the basis of normal return expected. Capitalization can be made on the basis of
average profits or super profits and thus goodwill is estimated.

Calculation of Goodwill

1. Capitalization of Average Profits


Step 1: Calculation of Adjusted Annual Profits
Step 2: Calculation of Average Adjusted Annual Profits
Step 3: Calculation of Total value of Business
Total value of business = Average Adjusted Annual Profits
Normal Rate of Return (N.R.R)
Step 4: Calculation of Goodwill
Goodwill = Total value of business Net Assets where Net Assets= Capital Employed

2. Capitalization of Super Profits


All Step 1 to Step 5 are same as calculated in super profit method
Step 6: Goodwill = Super Profits
Normal Rate of Return (N.R.R)

Annuity Method
In this method goodwill is ascertained by taking into account the present value of annuity for a certain number
of years at certain rate of interest. So goodwill is estimated by taking super profits of the business multiplying
with the present value of the rupee ascertained from the annuity table

Calculation of Goodwill
Step 1 to step 5 are same as calculated in super profit method
Step 6: Goodwill = Super profits x Annuity value

Problems
Average Profit Method
1. X Co. decided to purchase a business. Profits for the last four years are given below
1993 1994 1995 1996
20000 25000 24000 23000
The business was looked after by a manager whose remuneration comes to Rs.3000 p.a. Find the amount
of goodwill on the basis of 3 years of purchase for the last four years profit.

2. Following information is available for a business where profits for 3 years are
1998 1999 2000
50000 48000 52000
Profits of 1999 are reduced by Rs.5000 due to stock destroyed by fire. Profits for 1998 include a non-
recurring income of Rs.3000. Profits for the year 2000 include income on investments Rs.2000 which are
non-trading stock was not insured and it is thought wise to insure the stock and insurance premium is
estimated at Rs.500 p.a. Remuneration to proprietor is Rs.10000 p.a. Value goodwill on the basis of 2 years
of purchase.

3. Anil proposed to purchase a business of Mr. Arvind. Goodwill for this purpose is agreed to be valued at 3
years purchase of the weighted average profits of past 4 years
The weights are 1, 2, 3 and 4 respectively. The profits for 4 years are
1993 1994 1995 1996
30300 31200 36000 45000
a. Closing stock of 1994 was overvalued by Rs.3600
b. There was a managerial cost annually of Rs.7200 for the purpose of goodwill valuation
c. On 1 September 1994 there was a major renewal of a lease of Rs.9000 which was charged to revenue
account
For goodwill calculation it is agreed to be capitalized subject to a depreciation of 10% p.a. by W.D.V
method. Books of accounts are closed on 31st December every year.

4. X Ltd. purchased the business of Y Ltd. Goodwill for this purpose is agreed to be valued at 3 years purchase
of the weighted average profits of past 4 years
The assigned weights are 2,3,4,1 respectively. Profits for 4 years are as follows:
1998 1999 2000 2001
101000 124000 100000 150000
On verification the following matters revealed
On 1.1.2000 a major repair was made in respect of the plant and machinery incurring Rs.30000. This
amount was charged to revenue account and hence agreed to be capitalized for the purpose of goodwill
there is a subjection of depreciation at the rate of 10% p.a. on diminishing balance method. Closing stock
for the year 1999 was overvalued by 12000. Opening stock for the year 2001 was undervalued by Rs.2000.
There was a managerial cost of Rs.24000.

5. Arun purchased a business from Balan on 1.4.93 profits earned by Balan for the preceeding years ending
December 31
1990 1991 1992
50000 60000 54000
It was found out that for the year 1990 included a non-recurring item of Rs.2000 and the profits for the
year 1992 was reduced by Rs.3000 due to abnormal loss on account of small fire in the shop. The
properties of the business were not insured in the past. But it was thought prudent to insure the properties
in future and the premium was expected to be Rs.500 p.a. Arun at the time of purchase was employed as
a manager in X LTd. at a monthly salary of Rs.1000. He wants to replace the manager who is presently paid
a salary of Rs.750 p.m. The goodwill is estimated at 2 years purchase of average profit. Calculate the value
the goodwill.

Super Profit Method


1. From the following information calculate goodwill on the basis of 3 years purchase of super profits of past 4
years profits
1998 1999 2000 2001
120000 130000 140000 150000
Given fixed assets Rs.800000, current assets Rs.80000, current liabilities Rs.160000. Normal Rate of Return
15%. Managerial remuneration if employed elsewhere Rs.10000 p.a.

2. Following is the Balance Sheet of a trader as on 30/6/96


Liabilities Amount Assets Amount
Equity share capital 228000 Land & Buildings 80000
Preference capital 100000 Plant & Machinery 50000
General reserve 400000 Furniture 50000
P/L A/c 40000 Stock in trade 4080
Debenture 50000 Debtors 40000
Sundry creditors 20000 Cash in hand 100000
Bills Payable 6080 Cash at bank 100000
Non Trading investments 20000
Preliminary expenses 20000
Underwriting commission 20000
484080 484080
Following are the net profits from
1993 1994 1995 1996
64000 52000 86000 120000
Net profits include income from non-trading investments Rs.4000 p.a. standard rate of return on capital
employed is 8%. Calculate the amount of goodwill at 3 years purchase of average super profits of 4 years.

3. Balance sheet of X Co. Ltd. as on 31.3.2000 is as under


Liabilities Amount Assets Amount
8% 5000 preference Goodwill 10000
shares of Rs.10 each 50000 Fixed assets 180000
Investments (5% Govt. Bonds) 20000
10000 equity shares 100000 Current assets 100000
of Rs.10 each Preliminary expenses 10000
Reserves Discount on issue of debentures 5000
(including provision 100000
for tax 10000) 50000
8% debentures 25000
creditors
325000 325000
The average profits of the company after deducting interest on debentures and tax is Rs.31000. market value
of the machine included in fixed assets is Rs.5000 more. Expected rate of return is 10%. Calculate goodwill at
5 times of super profits.

4. Balances sheet as on 31.12.96


Liabilities Amount Assets Amount
10000 Equity shares Land & Buildings 84000
of Rs.10 each 100000 Plant & Machinery 60000
P/L A/c 20000 Furniture 5000
Debentures 15000 5% Govt. Loan 10000
Trade Creditors 20000 Stock 12000
Provision for Tax 9000 Book Debts 6000
Proposed Dividends 15000 Cash 2000
179000 179000
Profits after charging depreciation and tax for the following years are given:
1992 1993 1994 1995 1996
17000 19000 18000 20000 19000
On 31.12.96 land & building was revalued at Rs.95000, Plant & machinery at Rs.71000, Furniture at Rs.4000.
Normal rate of return is expected at 10%. Value goodwill at 5 years purchase.

5. Following is the Balance Sheet of a limited company as on 31.12.96


Liabilities Amount Assets Amount
50000 Equity shares Land & Building 300000
at Rs.10 each 500000 Plant & Machinery 500000
General reserve 200000 Stock 500000
P/L A/c 50000 Debtors 300000
5% Debentures 500000 Cash at Bank 100000
Trade Creditors 450000

1700000 1700000
Present value of Plant & machinery is Rs.800000. Profits for the last 3 years after charging depreciation and
tax are 1994 Rs.101000, 1995 Rs.100000, 1996 Rs.222000. Reasonable rate of return is 8% goodwill is assumed
that it will be purchased as per the number of years of profits

6. Balance sheet on 31.3.99


Liabilities Amount Assets Amount
30000 Equity shares Goodwill at cost 30000
of Rs.10 each 300000 Land & building at cost 175000
Reserves 60000 Plant & machinery at cost 90000
Creditors 71000 Stock 115000
Provision for tax 55000 Book debts 98000
P/L A/c 26000 Less Reserve 3000 95000
Cash at bank 7000
512000 512000
Sufficient provision has to be made in the accounts for income tax and rate of income tax may be taken at
50%. Reasonable rate of return on capital employed 12%. Goodwill to be calculated at 3 years purchase
7. The results at the end of each accounting year is given below
2001 2002 2003 2004
15000 18000 25000 30000
The total assets of the business according to last years balance sheet is Rs.250000 which includes land and
building Rs.50000 (market value Rs.60000) plant and machinery Rs.98000, investments (5% Govt. Loan)
Rs.20000, current assets Rs.80000, establishment expenses Rs.2000. liabilities include depreciation fund for
land & building Rs.5000 and plant and machinery Rs.8000 other liabilities (excluding owners funds) Rs.50000
average rate of return expected is 10% calculate the value of goodwill at 3 years purchase of super profits.
8. The average profits of a business for the last 3 years amounted to Rs.220000 but on adjustments of certain
items being carried out for the purpose of valuation of goodwill amounted to Rs.230000. 7 1/ 2 % represented
a fair commercial return on average capital employed. The book value of capital employed came to be
Rs.1345000, but on proper valuation capital usefully employed was ascertained to be Rs.1150000. valuating
the goodwill on the basis of 5 years super profits you are required to fix the final value of goodwill.
Capitalization Method & Problems on All methods
1. The profits of a company for 5 Years are
1996 1997 1998 1999 2000
40000 45000 49000 40000 48000
Capital employed in the business is Rs.400000. on which the rate of return is 10%. Calculate goodwill under
capitalization of average profits and super profits.
2. Balance sheet given below
Liabilities H Ltd. G Ltd. Assets H Ltd. G Ltd.
Equity shares at Land & Buildings 100000 50000
Rs.10 each 500000 250000 Plant & Machinery 100000 50000
General reserve 200000 20000 Furniture 150000 -----
P/L A/c 100000 30000 Vehicles 50000 -----
Creditors 50000 ---- Investments (6% Govt. 100000 -----
Bank overdraft 50000 ---- Promissory notes)
Stock 150000 100000
Debtors 150000 50000
Cash 100000 25000
Bank ----- 25000
900000 300000 900000 300000
Net Profits after tax
Years H Ltd. G Ltd.
1996 130000 45000
1997 125000 40000
1998 150000 56000
Goodwill for the purpose of amalgamation will be taken at 4 years purchase on the basis of 15% normal profits
on capital employed. Ascertain Goodwill under (a) Average Profit method (b) Super profit method (c)
capitalization of Average profit method (d) Capitalization of super profit method.

3. Balance sheet of a company is given below for the year ending 31.12.04
Liabilities Amount Assets Amount
2500 Equity shares at Goodwill 25000
Rs.100 each 250000 Land & Buildings 100000
P/L Appropriation A/c 60000 Plant & Machinery 110000
Bank overdraft 80500 Stock in trade 150000
Sundry Creditors 48000 Book Debts 102000
Provision for Tax 42500 Less Provision 6000 96000
481000 481000
The company started its operations in 1996 with a paid up capital of Rs.250000 profits earned before providing
for tax and the rate of dividends distributed are given as under
Year Profits Rate of dividend
2000 60000 8%
2001 75000 10%
2002 85000 12%
2003 95000 15%
2004 85000 15%
You may assume that income tax at 50 paise in a rupee has been payable in these profits. Find the value of
goodwill under (a) Average profit method (b) Super profit method (c) Capitalization of average profit
method (d) capitalization of super profits method

4. From the following information prepare a statement showing capital employed, average capital employed and
goodwill on the basis of 5 years purchase of average super profits.
Liabilities Amount Assets Amount
20000 equity shares Goodwill 30000
of Rs.10 each 200000 Fixed assets 350000
1000 9% preference Non trading investments (6% Govt. Loan) 45000
shares at the rate of Current assets 200000
Rs.100 each 100000 Commission on selling shares 10000
Reserves and Discount on issue of debentures 15000
provision 200000
(Provision for tax
Rs.20000)
10% debentures 90000
creditors 60000
650000 650000
The current market value of plant included in fixed assets is 15000 more. The average profit of the company
(after deducting interest on debentures and govt. Taxes) is Rs.68000. expected rate of return is 10% rate of
depreciation on fixed assets is 10%. Assume that, taxation is already provided, value of fixed assets in the
balance sheet is after deducting depreciation.

Annuity Method & Problems on All methods

1. X Ltd. agreed to purchase the business of a sole trader for the profits during the year
1998 1999 2000 2001
40400 60000 50000 49600
The closing stock for the year 31.12.99 was overvalued by Rs.4800. in order to cover management and
annual charges Rs.4800 was to be made. On 1 September 2000 a major renewal of plant and machinery
lease was uncured for rs.12000 which was charged to revenue expenditure and it was agreed to be
capitalized, subject to depreciation on its original cost at the rate of 10% p.a. Normal rate of return is 5%
and the value of annuity per 1 Re. at the rate of 10% for 5 years is Rs.3.78. Calculate goodwill under average
profit method, super profit method, capitalization of average and super profits method, annuity method.
Liabilities Amount Assets Amount
5000 shares at the rate of Rs.100 Goodwill 125000
each 500000 Land & building
Reserve Fund 150000 Less Dep. 144000
Workmans compensations fund 25000 Plant & Machinery
Workmens profit sharing fund 45000 Less Dep. 200000
Profit & loss A/c 150000 Trading investments 330000
Creditors 230000 (for replacement of
Other liabilities 100000 machinery)
Debtors 100000
Stock 200000
Bank balance 75000
Preliminary exp. 26000
1200000 1200000

2. Following is the Balance sheet of a company as on 30/9/97


Liabilities Amount Assets Amount
Capital 164000 Land & building 36000
General reserve 40000 Plant & machinery 54000
creditors 38040 Investments 30000
Stock 26850
Bank 75990
debtors 19200
242040 242040
The following were the net profits for the year ended 30.9.95 Rs.32280, 30.9.96 Rs.36870, 30.9.97
Rs.43350. The above amounts include income from investments Rs.1800 p.a. you are required to value
goodwill at 2 years purchase of the weighted super profits of 3 years taking into account the fact that
standard rate of return in such type of business is 10%

3. Mr. X invested a sum of Rs.200000 in his own business. The annual profits of his business are Rs.45000
which includes a sum of Rs.10000 received as compensation of a part of his premises. As an alternative to
his engagement in his business, he could have invested the money in a long term deposit with bank earning
a normal rate of interest of 10% and also could engage himself in employment getting annual salary of
Rs.7200. Considering 2% as compensation for the risks involved in the business. Calculate goodwill of his
business on capitalization super profits at normal rate of interest.

4. From the following information calculate the value of goodwill on the basis of 3 years purchase of super
profits of the business. Sundry assets of the firm are Rs.2250800, current liabilities Rs.93625, average
capital employed in the business is Rs.1800000, rate of interest expected from capital for the risk involved
is 10%. Net trading profits of the firm for the past 3 years are Rs.322800, Rs.272100, Rs.337500;
remuneration to the partners for their services is Rs.36000 p.a.