VALUATION OF GOODWILL

Submitted To: Mam, Mrs. Nisha Aggarwal

GOODWILL CONSISTS OF THE ADVANTAGES A BUSINESS HAS IN CONNECTION WITH ITS CUSTOMERS, EMPLOYEES AND OUTSIDE PARTIES WITH WHOM IT HAS TO CONTACT. THAT IS WHY IT WAS DEFINED AS THE PROBABILITY THAT THE OLD CUSTOMERS WILL RESORT TO THE OLD PLACE. THUS, TO DETERMINE THE NATURE OF GOODWILL IN A PARTICULAR CASE, IT IS NECESSARY TO CONSIDER THE TYPE OF BUSINESS AND THE TYPE OF CUSTOMERS WHICH SUCH A BUSINESS IS INHERENTLY LIKELY TO ATTRACT AS WELL AS SURROUNDING CIRCUMSTANCES OF EACH CASE.

Goodwill is sometimes described as a momentum or a push that keeps the business going without further effort like the momentum of a body that continues its motion against a retarding force till it comes to rest gradually. When a man pays for goodwill, he pays for something which places him in the position of being able to earn more than he would be able to do by his own unaided efforts.

Goodwill is thus present value of a firms anticipated super normal earnings. The term

super normal earnings, means the excess of earnings attributable to operating tangible and intangible assets over the normal rate of return.

ACCORDING TO KOHLER: Goodwill is the current value of expected future income in excess of a normal return on investment in net tangible assets. Whatever be the nature of goodwill, one thing is definite about it. It is treated as an intangible asset in accounts. One of the basic characteristic features of assets is that they help in earning profit for the business. As a result, every asset is said to have productivity. Thus, goodwill is, like any other asset, a store of prospective revenue.

FEATURES OF GOODWILL
A.

Goodwill can be sold only with the entire business or it

cannot be sold in part or in isolation except on admission or retirement of a partner when new partner compensate the old partners or the retiring partner gives up his rights in favour of remaining partners.
B.

Goodwill is valuable only if it is capable of being transferred from one person to another. If it cannot be

C. D.

E.

transferred then there will be no value of goodwill. Goodwill represents a non-physical value over and above the physical assets. Goodwill cannot have an exact cost as its value fluctuates from time to time due to internal or external factors which ultimately affect the fortune of the company. The value of goodwill is based on subjective judgement of the valuer.

TYPES OF GOODWILL
PURCHASED

a business enterprise is acquired by another business enterprise and the price paid is more than the net assets acquired. THE MAIN FEATURES OF SUCH GOODWILL ARE: It arises only on purchase of business. It is reflected by purchase transaction. Its cost could depend upon the future maintainable profits. It can be shown in the balance sheet.

GOODWILL: It arises only when

 NON-PURCHASED

when a business generates its own goodwill over a period of time due to various factors such as location,good management,sales policies etc. THE MAIN FEATURES OF SUCH GOODWILL ARE: It is internally generated. No cost can be placed on it. Value of goodwill is based on the subjective judgement of the valuer. It is not reflected by purchase consideration. It is not shown in the balance sheet.

GOODWILL: It arises only

CLASSES OF GOODWILL
According to rowland, there are four principal classes of goodwill,viz.,

Local, arising from the situation of traders premises e.g.,

a retail shopkeeper in a busy market centre;

The personal reputation, of the individual, arising

through his skill,influence and personality, as in the case of professional man.

The reputation of the goods sold, arising from the

high standard of quality of the goods sold themselves.
absolute or partial monoply.

The absence of competition, or the existence of an

RECORDING OF GOODWILL
The following are the circumstances when goodwill is valued and recorded:
i.

ii.

a)

In case of partnership where there is a change in the profit sharing ratio on admission, death and retirement of a partner or when two firms are amalgamated, the value of goodwill is to be calculated. In case of a joint stock company, the need for valuation of goodwill may arise in the following cases: When the business of the company is to be sold to another company or when the company is to be amalgamated with another company.

RECORDING OF GOODWILL
b)

c)

d)
e) f)

When the stock exchange quotations not being available, shares have to be valued for taxation purposes-gift tax, etc. When a large block of shares has to be bought and sold as to enable the buyer to exercise control over the company concerned. When the company has previously written off goodwill and wants to write it back. When the company is being taken over by another company. Goodwill is frequently to be brought into account upon consolidation of the assets and liabilities of a holding company and its subsidiaries.

FACTORS TO BE CONSIDERED IN THE VALUATION OF GOODWILL

The most important consideration is earning capacity of the business. Earning capacity of the business depends upon the following factors:

Nature of goods. Monopolised business. Trade name. Risk involved. Favourable location and site. Possession of trademarks, patents and copyrights. Skill to management. Future competition. Profit trends. Money market conditions. Capital required.

Goodwill can be said to have value only when it can be transferred for valuable considerations. Thus, personal knowledge and skill as possessed by a doctor cannot be transferred and sold and goodwill of such a person made up wholly of such a factor will have no commercial value. A prospective buyer of a business will be very much concerned with the possible future taxation liability. Buyer of the goodwill expects to recoup what he has paid for goodwill out of the future profits. The future profits are likely to be reduced materially by taxation and the buyer will not be ready to pay any large amount for goodwill, other things being equal.

METHODS OF VALUING GOODWILL

By

an arbitrary assessment. By capitalisation of expected net profits or earnings (or capitalisation method). By certain number of years purchase of past average profits or earnings. By super profits or earnings. This includes:

purchase of super profit. Annuity method. Capitalisation of super profit method.

Arbitrary assessment: This method can be used only

a) b)

c)

when information relating to earning capacity is available. If this information is not available because of non-availability of the profit immediately prior to sale or if the profits are abnormal or unreliable then such profits cannot be used as a guide to super profits. Capitalisation method: The following are the main steps to be taken in computing goodwill by this method:Ascertain the average net profit which it is expected will be earned in future; Capitalise this net profit at the rate which is considered a suitable return on capital invested in a business of the type under consideration; Find the value of the net tangible assets used in the business, i.e., assets less outside liabilities. (here outside liabilities will also include preference capital) and

d)

While making an estimate of future maintainable profit on the basis of past profits, the following points are kept in mind:

Deduct the net tangible assets as per (c) from the capitalised profit obtained in (b) and the difference is goodwill.

Interest on debentures and depreciation on all fixed assets and non-trading investments should be excluded. Provision for taxation should be made. Preference dividend should be deducted. If the profits of the past 4 or 5 years have been increasing or decreasing in a significant manner, it will be better to give more importance to the profits of the last year and least importance to the profits of the first year. This can be taken care of by taking weighted average profit by assigning weights as 1,2,3,4 and 5 to the profits of 1st year, 2nd year, 3rd year, 4th year and 5th year respectively. This practice is not to be followed if there is consistent decline of profits.

ILLUSTRATION 1
A company desirous of selling its business to another company has earned an average profit in the past of Rs.1,50,000 per annum. It is considered that such average profit fairly represents the profit likely to be earned, in the future, except that: Directors fees Rs.10,000 charged against such profit will not be payable by the purchasing company whose existing board can easily cope with the additional administrative work at present fees payable to the directors. Rent at Rs.20,000 p.a. which had been paid by the vendor company will not be charge in the future, since the purchasing company owns its own premises and can supply the accommodation necessary for the staff and the equipment of the vendor company. The value of the net tangible assets of the vendor company at the proposed date of the sale was Rs.15,00,000 and it was considered that a reasonable return on capital invested, for this type of commodity, was 10%.

a)

b)

ILLUSTRATION 1
The profit of the vendor company would in no way be affected by the sale of its business to the purchasing company and goodwill existed and was to be paid for on the basis that the vendor company was a continuing enterprise. Calculate the value of goodwill by capitalisation of expected future net profits. SOLUTION: CALCULATION OF VALUE OF GOODWILL
Average net profit Add: Non-recurring charges for: Directors fees Rent Estimated future maintainable profit Future profit capitalised at 10% i.e., Rs.1,80,000*100 10 Capitalised profit Less: Net tangible assets Goodwill 1,50,000 Rs. 10,000 20,000

30,000 1,80,000

18,00,000 18,00,000 15,00,000 3,00,000

ILLUSTRATION 2
Ascertain the value of goodwill of P.Co. Ltd. Carrying on business as retail traders from the following information according to capitalisation method: BALANCE SHEET as on 31st December, 2007
Liabilities
Paid-up capital: 2,500 Shares of Rs.100 each Profit and loss account Bank Overdraft Sundry Creditors Provision for Taxation

Rs.

Assets

Rs.
25,000 1,10,000
1,00,000 1,50,000 90,000 4,75,000

Goodwill 2,50,000 Land and Building at cost Plant and Machinery at cost less Depreciation 56,650 Stock at cost 58,350 Book Debts less Provision for 90,500 Doubtful Debts 19,500 4,75,000

The company commenced operations in 2003 with a paid up capital as aforesaid of Rs.2,50,000. The profits earned, before providing for taxation, have been as: 2003 Rs.61,000 ; 2004 Rs.64,000 ; 2005 Rs.71,500 ; 2006 Rs.78,000 and 2007 Rs.85,000. You may assume that income-tax at the rate of 50% has been payable on these profits. The average dividend paid by the company for the four years is 10% which is taken as reasonable return expected on the capital invested in the business.

SOLUTION

Profit for 5 years(Rs.61,000+Rs.64,000+Rs.71,500+Rs.78,000+ Rs.85,000) = 3,59,500 Less: 50% income-tax 1,79,750 1,79,750 Average profit (Rs. 1,79,750 /5) 35,950 Future profits capitalised at 10%= Rs.35,950*100 10 3,59,500 Total Assets = Rs. 4,75,000 Less: Goodwill Rs. 25,000 Less: Liabilities (Rs.58,350+ Rs.90,500+ Rs.19,500) Rs. 1,68,350 Rs. 1,93,350 Net Tangible Assets Rs. 2,81,650 Capitalised Profit 3,59,500 Less: Net Tangible Assets 2,81,650 Goodwill 77,850