Valuation of Goodwill

Valuation-of-Goodwill

Meaning of Goodwill:

Goodwill means the reputation possessed 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 a business which enables to earn greater profits than the returns normally to be expected on the capital represented 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 itself since it is always attached to the 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 So, those business enterprises located in favourable localities will have more earning capacity and there 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 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 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 wherethe 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 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 a business concern in order to make it in an effective manner will increase reputation of the business and there 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
  1. 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
  2. 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
  3. Sources of capital: The business concern which is secured capital from the owners will have more goodwill than the business which is financed outsiders through debentures, 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 another business enterprise and the purchase price is more than the Net Assets. The following are the characteristics of purchased goodwill:
    1. Such a type of goodwill occurs on the account of a purchased transactions
    2. It arises when one business enterprise is purchased another
    3. It takes place only when the purchase price paid more than the net assets acquired
    4. Such purchased goodwill is reflected in the balance sheet
    5. While valuing purchased goodwill many factors are to be considered like nature of business, market conditions, past profits
  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 & The following are the characteristics of inherited goodwill or raised goodwill
    1. It is generated internally
    2. There is no cost placed on such type of goodwill
    3. Valuation of goodwill depends upon the subjective judgment made the valuer
    4. It is not shown in the balance sheet

Circumstances Necessitating Valuation of Goodwill

1. In case of Sole trading concerns

    1. When a sole trading concern is converted into a partnership firm
    2. When a sole trading concern is sold
    3. For tax purposes

2. In case of Partnership firm

  1. When there is a change in the profit sharing ratio of the partners
  2. On the admission of a new partner
  3. On the retirement of a partner
  4. On the death of a partner
  5. On amalgamation of partnership firm with another firm
  6. On dissolution of partnership firm
  7. On sale of partnership firm to a company

3. In case of joint stock companies

  1. On the conversion of private limited company into a public limited company
  2. On the amalgamation of two or more companies
  3. On the absorption of one company another
  4. On the external reconstruction of a company
  5. When shares are valued

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

Add: All losses and expenses not likely to occur in future (Abnormal losses)

Less: All profits and gains not likely to occur in future (Abnormal profits)

Add: All profits likely to occur in future (Normal Profits) Less: All expenses and losses likely to occur in future (Normal Losses and expenses)

Add: Over valuation of opening stock Less: Under valuation of opening stock Add: Under valuation of closing stock

Less: Over valuation of closing sock

Xxx Xxx

 

Xxx

 

Xxx Xxx

 

Xxx Xxx Xxx Xxx

Xxx Xxx

 

Xxx

 

Xxx Xxx

 

Xxx Xxx Xxx Xxx

Xxx Xxx

 

Xxx

 

Xxx Xxx

 

Xxx Xxx Xxx Xxx

Adjusted Profits xxx xxx xxx

Step 2: Calculation of Average Adjusted Profits:

  1. Simple average:

adjusted profit

  1. 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 a concern over and above the normal return on investments in that line of business. So in this method, goodwill is calculated 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

All Assets (Except goodwill, past accumulated losses and non-trading investments) at market values

Less: All Liabilities to outsiders at revised values

Less: Half of profits earned during the year

Xxx

 

Xxx Xxx

Average Capital Employed xxx

b.      Liability Approach Method

Equity share capital

Add: Preference Share capital Add: Reserves & Surplus

Add: profits on revaluation of assets and liabilities Less: Goodwill at book value

Less: Accumulated losses Less: Non trading investments

Less: Half of current year’s profit

Xxx Xxx Xxx Xxx Xxx Xxx Xxx

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

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 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.

  1. Following information is available for a business where profits for 3 years are
1998 1999 2000
50000 48000 52000

Profits of 1999 are reduced Rs.5000 due to stock destroyed 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.

 

  1. 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
  1. Closing stock of 1994 was overvalued 3600
  2. There was a managerial cost annually of Rs.7200 for the purpose of goodwill valuation
  3. On 1 September 1994 there was a major renewal of a lease of 9000 which was charged to revenue account

For goodwill calculation it is agreed to be capitalized subject to a depreciation of 10% p.a. W.D.V method. Books of accounts are closed on 31st December every year.

 

  1. X 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

Valuation of Shares

Valuation of shares refers to periodic updating the price of shares. A share is defined as “A share is a share in share capital of a company”. It is a proportionate part of the share capital and forms ownership in a company. The term valuation of shares also refers to the process of ascertaining the intrinsic value or the market value or the fair value of the shares of the company.

Circumstances necessitate the valuation of shares

  1. At the time of amalgamation or absorption for adjusting the rights of shareholder
  2. When a large block of shares is purchased so as to acquire controlling interest in a company
  3. When shares of one class are converted into shares of another class
  4. For wealth tax purpose
  5. For determining security margin, when shares are offered as a security for loans and advances
  6. For determining amount payable to the dissentient shareholders for the acquisition of their shares, when a company is sold to another company
  7. When company is taken over the government
  8. For the valuation of the assets of finance or investment companies

Factors for valuation of shares

  1. The nature of the business
  2. General economic conditions in the country
  3. Company’s earning capacity
  4. Political conditions in the country
  5. Capacity of management
  6. Goodwill of the business
  7. Progress of the company
  8. Nature of competition
  9. Reserves of the company
  10. Dividend declared the company in the past

Methods of valuation of shares

  1. Assets Backing Method, Net Assets Method, Balance Sheet Method, Intrinsic Value Method or Break-up Value Method
  2. Yield Method, Dividend Yield Method or Market Value on Dividend Yield Method
  3. Fair Value Method
  4. Earning Capacity Method or Market Value on Earning Capacity Method

Assets Backing Method or Intrinsic Value Method

In this method the value of equity shares of a company is calculated on the presumption that the company would be wound up. As it is assumed that the company would be wound up all its assets would be realized for the calculation of the value of shares at realizable or market value. From the value of all the assets, the total amount of all the liabilities payable to outsiders will be deducted. The balance is the value of net assets available for shareholders, then the total paid up preference share capital and arrears of preference dividend, if payable should be deducted.

The resulting balance is value of net assets available for equity shareholders.

Amount

Particulars

Goodwill Xxx
Land & Building Xxx
Plant & Machinery Xxx
Vehicles Xxx
Furniture & fixture Xxx
Patents & Trade marks Xxx
Investment Xxx
Prepaid expenses Xxx
Outstanding incomes Xxx
Stock Xxx
Debtors Xxx
Bills receivable Xxx
Cash in hand Xxx
Cash at bank Xxx
Less: Creditors Xxx
Bills payable Xxx
Bank overdraft Xxx
Outstanding expenses Xxx
Incomes received in advance Xxx
Workmen’s savings bank deposits Xxx
Provision for tax Xxx
Outstanding dividends Xxx
Outstanding debenture interest Xxx
Unclaimed dividend Xxx
Workmen’s compensation fund Xxx
Depreciation fund Xxx
Bank overdraft Xxx
Net assets available to shareholders Xxx
Less Arrears of preference dividend Xxx
Premium on redemption of preference shares Xxx
Preference share capital xxx
Net assets available to equity shareholders xxx

Intrinsic value of equity shares = Net assets available to equity shareholders

Number of Equity shares

Yield Method

This method, assumes that the company would continue to exist and would not dispose of its assets, the market values of assets and liabilities are not taken into account for calculation of the value of the shares. In this method, the profits available for equity dividend are taken into account while calculating the value of each equity shares. Step 1: Calculate the average profits

Step 2: Calculate the profits available for dividends after deducting provision for tax and various appropriations towards reserves

Step 3: calculate the profit available for equity dividends deducting the dividends payable to preference shareholders

Step 4: Calculate the capitalized profits

Capitalized profits = Profits available for equity dividends X 100 NRR

Step 5: Calculate the market value of each Equity shares Market Value per share = Capitalized Profits

Number of equity shares

 

Fair value per share = Intrinsic value + Market/yield value

2

Earning Capacity Method

Generally the rate of dividend declared a company is much less than the rate of its earning because of retention of accumulation of profits. Since the retained, accumulated or undistributed profits are likely to be distributed sooner or later to the shareholders in the form of bonus shares, it is appropriate that the market value of shares is based on the earnings of the company rather than the dividend declared the company.

Step 1: Calculation of rate of earnings

Firstly calculate the average profits then to the average profits add interest on debentures

Step 2: Calculation of Gross capital employed

Gross capital employed = Assets- liabilities to outsiders (Don’t deduct ½ of current years profit)

Step 3: Apply the following formula to get the percentage of earnings

= Total rate of earnings x 100 Capital employed

Step 4: Calculate market value of per share

Market value = % rate of earnings x paid up value of shares Normal rate of return

Problems:(Intrinsic Value method)

 

  1. From the following B/S calculate the value of equity shares under intensive method:-
LIABILITIES AMOUNT ASSETS AMOUNT
1000 8% preference 1,00,000 Land or Buildings 10,00,00
shares at ₨.100 each Plant & Machinery 1,50,000
30,000 equity shares 30,00,00 Furniture 1,50,000
at the ratio of 10 each Current Assets 2,50,000
Reserve fund 50,000 Preliminary expenses 20,000
10% debentures 10,00,00 Discounts on
Depreciation fund 10,00,00 debentures 5,000
Creditors 70,000 Profit/Loss A/c 45,000
7,20,000 7,20,000

The following information is to be considered:-

  • Debentures interest is due for 1 year
  • Current Assets includes Book debts of ₨.12,000 which are doubtful and no provision has been made:
  1. Following is the Balance sheet of a company as on 31/3/99.
LIABILITIES AMOUNT ASSETS AMOUNT
Equity shares at ₨.100 each 30,00,00 Land & Buildings 1,50,000
General reserve 50,000 Machinery 10,00,00
P/L A/c 25,000 Investments (market value
Creditors 40,000 40,000) 45,000
Provision for tax 20,000 Debtors 10,00,00
Provident fund 10,000 Stock 40,000
Cash 10,000
4,45,000 4,45,000

Additional information: Goodwill is to be taken at 50,000.

  • Depreciate machinery at the rate of 10% and lands & buildings is revealed at 1,80,000.
  • Provide 8% towards bad

Calculate the value of share Asset backing method.

OUNT ASSETS AMOUNT

 

  • Following is the Balance sheet of a company:



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