Reconstitution of a Firm
TABLE OF CONTENTS
Q.1. What do you mean by Goodwill? What are the different methods
of calculating goodwill? Discuss every method with suitable examples.
(CBSE 1982,85,87,88,89,98; All India 1986,1990)
Answer: Goodwill is a thing which is not so easy to describe but in general
words good-name, reputation and wide business connection which helps the
business to earn more profits than the profit could be earned by a newly
started business. The monetary value of the advantage of earning more profits
is known as goodwill. Goodwill is an attractive force, which brings in customers
to old place of business. Goodwill is an intangible but valuable asset. In a
profitable concern it is not a fictitious asset.
Prof. Dicksee has defined goodwill as " 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."
According to J. O. Magee " The capacity of a business to earn profits in
future is basically what is meant by the term goodwill."
According to Lord Lindley " The term goodwill is generally used to
denote benefit arising from connections and reputation."
Lord Eldon has defined goodwill as " Goodwill is nothing more than the
probability, that the old customers will resort to the old place."
In the words of Lord Macnaghten, " Goodwill is a thing very easy to
describe, very difficult to define. It is the benefit and advantage of the
good name, reputation and connections of a business. It is the
attractive force, which brings in customers. It is one thing which
distinguishes an old established business from a new business at its
first start."
In the words of Dr. Canning, "Goodwill is the present value of a firms
anticipated excess earnings."
Methods of Valuation of Goodwill
The following are the methods of valuation of goodwill of a firm: -
i. Average Profit Method
ii. Weighted Average Profit Method
iii. Super Profit Method
iv. Capitalization of Average Profit Method
v. Capitalization of Super Profit Method
vi. Present Value of Super Profits Method
1. Average Profit Method: Under this method goodwill is calculated on the
basis of the average profit of previous years. The average profit is multiplied
by the number of years purchase.
Goodwill = Average Profit x Number of Years Purchase
Example: Calculate goodwill at twice the average profits of last four years
profits. The profits of the last four years were:
2001. Rs. 27,000
2002. Rs. 39,000
2003. Rs. 16,000 (Loss)
2004. Rs. 40,000
Solution: Total Profit for last four years = Rs. 27,000+ Rs. 39,000-Rs.
16,000+Rs. 40,000 = Rs. 80,000
Average Profit = Rs. 80,000/4 = Rs. 20,000.
Goodwill = Rs. 20,000 x 2 = Rs. 40,000.
2. Weighted Average Profit Method: This method is a modified version of
the average profit method. Under this method the respective number of
weights i.e. 1,2,3,4 multiplies profit of every year, in order to find out value
product and the total of products is then divided by the total of weights in
order to ascertain the weighted average profits.
Goodwill = Weighted Average Profits x No. of years Purchase
Weighted Average Profit = Total of Products of Profits/ Total of
Weights
Example: Calculate goodwill at twice the weighted average profits of last four
years profits. The profits of the last four years were:
2001. Rs. 37,000
2002. Rs. 29,000
2003. Rs. 26,000
2004. Rs. 40,000
Solution:
Profits Weight Product
Years
Rs. Rs.
2001 37,000 1 37,000
2002 29,000 2 58,000
2003 26,000 3 78,000
2004 40,000 4 1,60,000
Total 10 3,33,000
Weighted Average Profit = Rs. 3,33,000/10 = Rs. 33,300
Goodwill = Rs. 33,300 x 2 = Rs. 66,600
3. Super Profit Method: When the actual profit is more than the expected
profit or normal profit of a firm, it is called Super Profit. Under this method
goodwill is to be calculate of on the following manner:
Goodwill = Super Profit x Number of Years Purchase
Example: The books of a business showed that the capital employed on
January 1, 2001 was Rs. 4,50,000 and the profits for the last five years were
as follows: 2001-Rs. 40,000; 2002 -Rs. 50,000; 2003 - Rs. 60,000; 2004 -Rs.
70,000 and 2005 -Rs. 80,000.
You are required to find out the value of goodwill, based on three years
purchase of the super profit of the business given that the normal rate of
return is 10%.
Solution: Total Profit of last five years = Rs. 40,000 + Rs. 50,000 + Rs.
60,000 + Rs. 70,000 + Rs. 80,000 = Rs. 3,00,000
Average Profit = Rs. 3,00,000/5 =Rs. 60,000
Normal Profit = Rs. 4,50,000 x 10/100 = Rs. 45,000
Super Profit = Actual/Average Profit Normal Profit
Super Profit = Rs. 60,000 Rs. 45,000 = Rs. 15,000
Goodwill = Rs. 15,000 x 3 = Rs. 45,000.
4. Capitalization of Average Profit Method: Under this method goodwill is
difference between the total Capitalized value of the firm and the net assets of
the firm.
Goodwill = Capitalized Value the firm - Net Assets
Capitalized Value of the firm = Average Profit x 100/ Normal Rate of
Return
Net Assets = Total Assets External Liabilities
Example: A firm earns Rs. 65,000 as its average profits. The usual rate of
earning is 10%. The total assets of the firm amounted to Rs. 6,80,000 and
liabilities are Rs. 1,80,000. Calculate the value of goodwill.
Solution : Total Capitalized value of the firm = Rs. 65,000 x 100/10 = Rs.
6,50,000
Net Assets = Rs. 6,80,000 - Rs. 1,80,000 = Rs. 5,00,000
Goodwill = Total Capitalized value of the firm Net Assets
Goodwill = Rs. 6,50,000 - Rs. 5,00,000 = Rs. 1,50,000.
5. Capitalization of Super Profit Method:
a. Calculate Capitalized value of the firm
b. Calculate required profit on capital employed by using the following
formula:
Normal Profit = Capital Employed x Required Rate of Return/100
c. Calculate average profit
d. Calculate super profit
Goodwill = Super Profit x 100/Normal Rate of Return
Example: Verma Brothers earn a profit of Rs. 90,000 with a capital of Rs.
4,00,000. The normal rate of return in the business is 15%. Use Capitalization
of super profit method to value the goodwill.
Solution:
Normal Profit = Rs. 4,00,000 x 15/100 = Rs. 60,000
Super Profit = Rs. 90,000 - Rs. 60,000 = Rs. 30,000
Goodwill = Super Profit x 100/Normal Rate of Return
= Rs. 30,000 x 100/15 = Rs. 2,00,000
6. Present Value of Super Profit: Under this method, goodwill is
estimated as the present value of the future super profits. The
following steps are taken:
a. Calculate the future super profits for next years
b. Choose the required rate of return
c. Calculate present value factors
d. Multiply present value factors with future super profits
e. The sum of product of present value factors and super profits is the
value of goodwill.
Example: A firm has the forecasted profits for the coming 4 years as follows:
Profits
Years
Rs.
1 80,000
2 1,00,000
3 90,000
4 1,20,000
The total assets of the firm are Rs. 9,00,000 and outside liabilities are Rs.
3,00,000. The present value factors at 10% are as follows:
Present Value Factor
Years
1 .9279
2 .8029
3 .7056
4 .6978
Calculate the Value of goodwill.
Solution:
Net Assets = Total Assets Liabilities
= Rs. 9,00,000 Rs. 3,00,000
= Rs. 6,00,000
Normal Profit = 10/100 x Rs. 6,00,000 = Rs. 60,000
1 2 3 4
Years
Profits (Rs.) 80,000 1,00,000 90,000 1,20,000
Normal Profit 60,000 60,000 60,000 60,000
Super Profit 20,000 40,000 30,000 60,000
Present Value .9279 .8029 .7056 .6978
Factor
Present Value of 18,558 32,116 21,168 41,868
Super Profit
Goodwill = Rs. 18,558 + Rs. 32,116 + Rs. 21,168 + Rs. 41,868 = Rs.
1,13,710.
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