12.Valuation of Goodwill & Shares

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390

Theory of valuation of goodwill and shares Meaning of goodwill: According to Spicer and Pegler goodwill is defined as, “goodwill is said to be that element rising from the reputation, connection or other advantages possessed by a business which enables it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business.” Thus goodwill is the value of the reputation of the concern, it consists the benefits a business enjoys in connection with its customer, employees and other third party. It is also said that, “goodwill is the present value of a firm’s anticipating excess earning.” Goodwill may be described as extra saleable value attaching to a prosperous business beyond the intrinsic worth of the net assets. Being of the nature of extra value or advantage, it is considered as an intangible asset like patents, trademarks and copyrights. It is not a fictitious asset. Factors determining the value of goodwill Various factors affecting the value of goodwill are as follows: 1. Nature of business. It means the prevailing competition, level of risk involved, govt. Regulations, nature of demands etc. If the existing business units are earning more than normal profits and have secured monopolistic position, they will be enjoying more goodwill. 2. Favourable location. It is very well known that certain cities or places are most suitable for particular industries, business having units falling under same areas can enjoy the goodwill by selling more products. It must be noted that goodwill arises in a particular locality only because shopping space is limited in relation to demand for it. 3. Capital requirements. Amount of capital required for a business is also influence the value of goodwill. The business requiring less capital can realise higher amount of goodwill than another business earning less profits with a huge amount of capital. 4. Life of the business. Time also increases the value of goodwill. Business running on profitable lines for the last many year enjoys more goodwill as compared to the recent started business.

SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 5. Trade name. A firm which possesses the necessary patents and trademarks for selling its products will have built up good reputation and enjoys goodwill. 6. Special contracts. Where a business is having special contracts in hand giving exceptional profits, the goodwill of the business will be much higher. 7. Managerial ability. The efficiency, skill and ability of the managerial personnel is also an important factor on which value of goodwill depends. The efficient management helps in increasing profits in the business which in turn, increases the value of goodwill. 8. Risk involved in the business. The value of goodwill is likely to be higher in the low risk business. On the contrary, if the business is purely of speculative nature and is very risky, the goodwill will have very little value. 9. Profit trends. When the last year’s records of the business shows the constantly increasing profits, it will lead to attract higher value for its goodwill. 10. Nature and extent of competition. The value of goodwill of a business is is greatly affected by the degree of competition. If the competition is negligible or if there is no competition, the value of goodwill will be more or vice-versa. 11. Quality of products. The business units which enjoys good commercial reputation for the quality of their products, they have a high value of goodwill. 12. Money market conditions. When easy money market conditions prevail, there would be more buyers willing to buy an established business and pay a higher price for the goodwill or vice-versa. 13. Types of customers. Commercial value of goodwill depends upon the types of customers. They may be classified according to the distinctive features viz. Cat, dog and rat. The valuation will depend upon the degree of attachment of business with personnel character of the owner. 14. Miscellaneous factors. Besides these above mentioned factors, the value of goodwill is also affected by employer-employee relation. Technical know-how possessed by the business, future prospects of the industry, research and development efforts, and govt. Policies etc. Need for value of goodwill. It depends on the form of business organisation. Sole traders: under the sole trade4rs form of business organisation the need for the valuation of goodwill may arise in the following circumstances: SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 a. When the business is sold. b. When a new person is admitted in the firm and the firm becomes a partnership firm. c. When the business is converted into a company. Partnership firm: Under the partnership form of business organisation the need for the valuation of goodwill may arise in the following circumstances: a. When a new partner is admitted to a partnership firm. b. When an existing partner retires or dies. c. When there exists any change in the profit sharing ratio of the existing partners. d. When whole of the partnership firm is sold out to any other firm or person. e. When a partnership firm is converted into a company. f. When there is a case of amalgamation of two firms. Companies: In case of a company, the need for valuation of goodwill may arise in the following circumstances: a. When there is a situation of amalgamation of two companies. b. When the business of the company is sold to another existing company. c. When one class of the shares is converted to another. d. When a company acquires the controlling interest in the company and becomes a holding company. e. When there arises a need for the valuation of the shares of the company. f. When shares of the company are not listed on the stock exchange and they have to be valued for taxation purposes.  Generally the goodwill is classified into two categories viz. 1. Purchased goodwill 2. Non purchased goodwill or raised goodwill

SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 Purchased goodwill: This type of goodwill arises only when a business enterprise is acquired by another business enterprise and the price paid is more than the net asset acquired, such goodwill is recognised by the accounting profession and is also shown in the balance sheet.

 Methods of valuation of goodwill 1. Arbitrary assessment method. The value of goodwill under this method is arrived at by mutual agreement b/w the vendor of a business and its buyer. The amount agreed to be payable for goodwill is the excess of purchase price over the net assets taken over. For example, A ltd. purchases the business of B ltd. and it is mutually agreed upon that A ltd. will pay to B ltd. a sum of Rs. 5,00,000 on account of goodwill. Although very simple, this me is not a reliable and scientific method based on a yardstick of performance of business. The value of goodwill being based on future maintenance profits, the earning capacity of business must be considered while valuing goodwill. If formation regarding earning capacity is not available, this method cannot be used. 2. Average profits method. Under this method, goodwill is valued as under: Goodwill = average profit X no. Of years of purchase In this case profit means future expected trading profit. For this purpose following adjustments are to be done: Balance of profit and loss Add: (i) all abnormal losses (if already debited) Like loss by fire or theft, loss on sale of Fixed assets. Less: (i) all abnormal incomes (if already credited) Like insurance claim income from lottery or speculation, profit on sale of fixed assets. (ii) Non-trading incomes, like (non-trade), rent from building let out

income

from

investment

(iii) normal expenses (if not already debited) SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 Adjusted trading profit Average profit may be calculated as (i) Simple averages Simple average = total profits of some years/no. Of years. Weighted profit = total of products of profits & weights/total of weights. Under this method, goodwill is valued on basis of an agreed no. Of year’s purchase of the average adjusted profit. The number of years selected depends upon the probable maintenance of past profit in future years. 3. Super profits methods. It is the excess of the average profits over the normal profits based on normal rate of return for representative firm in industry. For computation of super profit, the following three factors are required. A. Normal rate of return. B. Capital employed C. Normal profit Where capital employed = fixed assets + trade investments + current assets – debentures – current liabilities. Or Paid up equity and preference share capital + accumulated balance on capital reserves, general reserves and credit balance in profit and loss  revaluation profits or loss – fictitious assets – non assets. Goodwill under super average method Goodwill = super profit x no. Of years purchase Where super profit = average adjusted profit – normal profit Normal profit = capital employed x normal rate of return 4. Annuity method. Under this method the value of goodwill is calculated by finding the present worth of an annuity paying the super profit (per year) over the estimated period discounted at the appropriate rate of interest. Goodwill = super profits x value of an annuity.

SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 Mostly the value of annuity at the normal rate of profit and is same for number of years for which purchase of super profit method is to be applied is given. If in case of the value of annuity is not given the same is calculated by applying the formula r   1  1   100   Q r 100

Where

n

Q = present value of an annuity of re. 1 N = no. Of years. R = rate %v per annum.

5. Capitalisation method. There are two methods of calculation of goodwill under “capitalisation method”, viz. a. Capitalisation of average trading profit: under this method normal capital employed is be found out by capitalising average trading profit. Normal capital employed means the amount of capital must be invested in the same class of business to earn such average trading profit. But if actual capital employed is less than the normal capital employed, then such difference will be the goodwill of the firm. b. Capitalisation of super profit: in this case goodwill is calculated by capitalising the super profit at the normal rate of return. This method attempt to determine the amount of capital needed for earning super profit. Under this method, Goodwill = super profit x 100/normal rate of return.

Following are some of the main features of purchased goodwill: a. It arises only when there is a purchase of business from one party to another. b. It is reflected by the purchase transaction. c. Its cost could depend upon the future maintainable profits. d. It can be shown in the asset side of the balance sheet in the books of accounts at the end of the financial year. SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 Non-purchased goodwill: it is also known as “raised goodwill” being no cost is paid for acquiring this goodwill. This goodwill arises only when a business generates its own goodwill over a period of time. The value of raised goodwill depend upon the various factors such as favourable location life time of business, trade mark and patent right special contracts etc. The main features of such goodwill are: 1. It is internally generated. 2. No cost is placed for it. 3. It is not reflected by a purchase consideration. 4. It is not shown in the balance sheet. 5. Value of goodwill is based on the subjective judgement of the valuer. Goodwill can also be classified on some other basis which is known as “zoological classification” although this type of goodwill does not have any effect on the accounting treatment of goodwill in the books of accounts. The following are the types of goodwill under zoological classification: 1. Dog goodwill 2. Cat goodwill 3. Rat goodwill Dog goodwill: it arises when reputation of firm due to person instead of place. Like as the nature of dog who always follows its master wherever he goes. On the same way goodwill moves with movement of person. This type of goodwill can be seen in case of doctors, accountant, teachers and lawyers etc. Cat goodwill: This type of goodwill is attached with the place instead of persons. Same like the nature of cat, who always attach more with the house than the person living there in. In this type of goodwill, the owner of the business may change but customer will go to the same place. Rat goodwill: This type of goodwill not arises due to reticular place or person. Same as the nature of rat who has no attachment with place or person. There in this case it is difficult to ascertain that whether there is any goodwill of not.

SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390  Need for valuation of shares: Following are the circumstances, necessitating valuation of shares: 1. At the time of amalgamation and absorption. 2. When unquoted shares are to be bought or sold. 3. At the time of converting preference shares or debentures into equity shares. 4. Where a portion of shares is to be given by a member of proprietary company to another member as a member cannot sell it in the open market it become necessary to certify the fair price. 5. For the valuation of the assets of a finance or investment trust company. 6. At the time of assessment by the income tax authorities for the purpose of estate duty, capital gain, wealth tax and gift tax. 7. When the company is nationalised and the compensation is payable by the govt. 8. When a company acquires majority shares of another company for the purpose of acquiring a controlling interest in another company. 9. When shares are pledged as a security against loan 10. At the time of paying court fees. 11. When shares are purchased by the employees of a company to be kept by them during the tenure of their service. 12. At the time of purchase and sale of shares in private companies. 13. When partners hold shares of a company for ascertaining the amount to be distributed amongst them on dissolution of firm. 14. For satisfying dissentient shareholders in the case of reconstruction of a company under section 494. Factors affecting valuation of shares. 1. The basic or principle factor in the valuation of shares is the dividend yield that the investor expects to get as compared to the normal rate prevailing in the market in the same industry. 2. Growth prospects of the company. SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 3. Demand and supply of shares. 4. The nature of the business of the company concerned. 5. Dividend policy of the company and %age of dividend declared in the part. 6. Part performance of the company. 7. Govt. Policies in relation to company’s business. 8. Accumulated reserves of the company. 9. Economic climate 10. The income yielding capacity of the company. 11. Size of the business. 12. Net asset position of the company. 13. Availability of the ready market for future sale. 14. Management of the company. 15. Prospects of bonus or right issue. 16. Political factors prevalent peace and prosperity in the country and govt.’s attitude towards the industry.  Methods of valuation of shares. 1. Net assets method or intrinsic value or net worth method. As the name suggest, that the value of shares under this method is calculated by dividing the net assets of the business by no. Of equity shares. all the assets from the asset side of balance sheet are sum up than deduct the liabilities appearing on liabilities side also less any probable loss or expenses the value arrived is the amount available for equity shareholders. While calculating the value of net assets if it is necessary to understand that the non-trading assets like investments should also be included and all the assets should be taken in their market value. If the preference share capital appears in the balance sheet than the total amount of preference share capital and the payment of any type of dividend in arrears on them should also be deducted from the total value of assets:

SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 All assets

=XXX (at realisable value if any, otherwise

(except fictitious assets)

Book value)

All outside liabilities

= (-) xxx

Balance

=

Preference share capital

= (-) xxx

Any divided in arrears

= (-)

Net assets for equity shares

=

xxx

xxx

Value of per share = net assets for equity shares/ no. Of equity shares. Merits: 1. It is very simple and logical method for calculating the value of shares. 2. This method is mostly used by taxation authorities. 3. Present value of goodwill is also considered under this method. 4. As the net realisable value of assets is taken into consideration this is useful for company going liquidation. 5. Preference shares capital also given preferences or priority over equity and deducted from assets like other liability. Demerits: 1. This method is not suitable for growing company. 2. As goodwill is taken into consideration, it is difficult to calculate the value of goodwill. 3. This method leads to personal bias as the market price of the asset is to be quoted which is very difficult to ascertain. 4. This method is not a reliable one, as it includes the intangible asset such as goodwill, trade market. 2. Yield method or earning capacity or market value method. Under this method the value of the shares are calculated on the basis of its prospective earnings. Market value of assets and liabilities is not considered. SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 The value of shares is calculated by comparing the expected earnings of the company with normal rate of return on investments. This method is based on the philosophy that shareholders value the return which he received and not the earnings of the company. The calculation under this method is divided into three parts. a. Calculation of expected rate of return Profits available from dividend to equity/paid up equity share capital x 100 b. Value of equity shares : Expected rate of return/normal rate of return x paid up value of share. Profits available for dividend to equity shareholders is calculated as follows. There exists some items which should be deducted from profits of the company while calculating the expected profits available for equity shareholders viz. Amount for tax charges

-

Amount to be transferred to reserves

-

Amount transfer to debenture redemption fund

-

Preference dividend if any

-

The rest of the amount will be the expected profits available for equity shareholders Valuation of minority and majority holdings. Value of shares in case of majority holdings is ascertained by the method based Upon the expected rate of earnings where as in case of minority holdings the value of shares is better calculated by adopting expected rate of dividend rather than expected rate of dividend rather than expected rate of earnings, main reason being small investors generally interested in the dividend rather than the expected rate of earnings. Value of shares = possible rate of dividend/normal rate of dividend x paid up value of share Merits: a. This method is most reasonably accepted being this method is based upon comparison expected rate of return with normal rate of return. SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 b. This method is useful in case of minority holdings since they are interested in the profits earned by the company. c. It is best suited to a company which is a going concern. Demerits: a. It may have to face problems while selecting the normal rate of return. b. Major drawback is that it doesn’t take into consideration the value of net assets of the company. c. It is not suitable for the company which is going into losses for the past few years. d. The method contains various difficulties while application of this method. e. Predicting the future maintainable profits is quite difficult. 3. Fair value method. As we had already discussed the two methods of calculating the value of shares viz.  Net asset method  Yield earning method But both have some drawbacks say net asset method is not suitable where the company is having the phase of super profits where as yield earning method is not fit where the expansion plans are undertaken in the company. The formula applied to get the value of share is: fair value of shares= intrinsic value+ yield value/2 where intrinsic value is the value of share calculated by net asset method.  SUITABILITY This method of valuation of goodwill is suitable to apply under condition of availability of information. Various information is required for implementing the formula viz. Normal rate of return, value of all assets and outside liabilities etc. It is suitable where the market information related to normal rate of return is readily available. Value of all assets and outside liabilities is clearly mentioned so that the value of business could be easily ascertainable. Moreover the future maintainable profits of the company can be easily predicted on the basis of past data. SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 SUITABILITY Purchase of super profit method for calculating the value of goodwill can ne successfully applicable when the fair value of capital employed can be easily determined. The past information regarding the profit should be given so that it become easy to calculate the average profits. It is to be insured that the market information regarding the normal rate of return is reliable and readily available. Moreover the future maintainable profits of th company can also be estimated with reasonable level and which ensure the cent- % accuracy. Suitability Yield earning method is suitable where there exist no plans for the expansion of the business in near future nor there exists the chance for liquidation. All the information regarding the factors of future maintainable profits are easily available. It is also assured that the information regarding the past profits should also be available and there must not have long differences in the earnings, that the average profits is to be calculated. The market information regarding the prevailing normal rate of return is readily available. The information should be based upon the true facts and figures. 1. Net Assets Basics [Excluding the goodwill] All Assets [Excluding goodwill and factious assets] Less: all liabilities (including preference share capital. but excluding equity paid up capital and reserves & surplus) NET TANGIBLE assets Value per Equity share=Net Tangible Assets/no. Of Equity shares

[B] Net assets Basics [including goodwill] All Assets [Excluding fictitious assets] Less: All liabilities [including Preference share capital and reserves & surplus] Value per Equity Share=Net Assets/No. Of Equity Shares SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 2. Earnings capacity or yield basics or market value method (A) Valuation based on rate of return: (b) (I) valuation based on rate of dividend Value per Share= possible Rate of Dividend/Normal Rate of Dividend*paid-up Value per dividend Where, Possible Rate of Dividend=Total profits available for dividend/Equity paid up capital Calculations of total profits available for dividend; Profit after tax Less: transfer to reserve Transfer to debenture redemption fund Preference dividend Total profits available for equity dividend [a](II) Valuation Based on rate of Earning Value for share= possible earning rate/normal earning rate*paid up value per share Where possible rate of earning=actual profit earned/capital employed*100  Capital employed includes equity paid up capital +preference share capital + reserve and surplus +long term borrowing –fictitious assets.  Actual profit earned means profit after tax but before debenture interest and preference dividend. (B) Valuation based on price earning ratio(P/E ratio) Market value per share = price earning ratio x earning per share. Where, earning per share = profits available for equity shares/no. Of equity shares (C) Valuation based on productivity factor

SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390

ACCOUNTING SOLUTIONS SCO: 209, First Floor, Sector-36/D. Chandigarh (M): 0172-4670390-5017149, 9876149390 Productivity factor = average weighted adjustment profit (after tax)/average weighted net worth (i.e. shareholders fund) X 100 Maintainable profit = net worth on valuation date X productivity factor. Maintainable profit for equity shares = maintainable profit – transfer to reserve – dividend on preference shares. Capitalisation of maintainable profit for equity shares = Maintainable profit for equity shares X 100/normal rate of return Value for equity shares = capitalised value / no. Of equity shares 3. Dual basis as fair value method Value per share = (value per share on net assets basis + value per share on earning basis)/2

SCO: 209, F.F. Sector-36/D Chandigarh. 0172-4670390-5017149, 9876149390