Valuation of Goodwill

Valuation of Goodwill When a business is able to earn profits at a rate higher than that at which a similar business earns, the former business is said to possess goodwill. Goodwill is, therefore, an invisible asset by the possession of which a business can enjoy super earning. Since it is invisible the goodwill is called an in tangible asset. But since its existence can be felt through superior earning power it is a real asset. There are several causes for which a business may have a goodwill and some of them are: (1)Possession of a large number of profitable contracts ; (2)Suitable nature of the business ; (3)Exclusive franchise ; (4)Protected valuable patents and trademarks ; (5)Suitable location of the business ;(6)Ideal window dressing ; (7)Government patronage ;(8)Reputability, respectability and reliability of the proprietor or o r partners or trustees ; (9)Special ability and skill of the persons in management, etc. In case of transfer of business, separation sepa ration of the partners from the business due to retirement, death, etc, assessment of the value of the business for any reason, goodwill may have to be valued.

Methods of Valuation of Goodwill There are various methods for valuation of goodwill of a business of which the following are of common use: (1) Few years· Purchase of Average Profits Method: Under this method goodwill is valued on the basis of an agreed number number of years· purchase of the average maintainable profit. The word maintainable

indicates several adjustments in respect of the factors which might have influenced abnormally the profits of the years over o ver which the average is taken. If in any year there is an exceptional opportunity or an exceptional expense or absence of expense, the profit for the year has to be so adjusted as to get it free free from such such exceptional influences. Sometimes instead of the simple average ave rage of the adjusted profits as discussed above, weighted average is taken into consideration. Weights are given to each years· profit on the consideration how each years· profit is likely to influence the the future profit trend. trend. (2) Super Profits Method: Under this method average super profit is ascertained. Goodwill is calculated at a few years· purchase of the super profit of the concern. The number num ber of years to be taken for consideration depends upon the nature of the business, the steady or fluctuating nature of the profit and also the nature of goodwill. First, ascertain the average capital employed during the year. For this purpose take the total of the closing real assets of the concern as revalued (excluding the non-trading assets and goodwill already appearing in the balance sheet unless such goodwill represented the payment to the vendor). In order to find out the average ave rage capital employed it is necessary to deduct from the above the current liabilities and 50% 5 0% of the profits for the year after tax. The profit should sho uld also be excluding non-trading income, if any. The average capital employed e mployed in this way excludes the long term loans, debentures and preference shares. The idea of capital employed is not suitable for the purpose of valuation of goodwill of an individual company where valuation is to be done to the advantage of the equity shareholders. In this case, from

the above total assets we deduct the current liabilities, long term loans, preference capital, etc, also 50% of o f the profit for the year after excluding non-trading income and after charging interest on long term loans and debentures, de bentures, preference dividend, etc. The average capital employed is the mean of the opening and closing capitals. As we have taken the closing net assets which includes the profits for the year it is necessary necessa ry to deduct 50%of the profit in order to get the capital at the middle of the year. If, however, the closing net assets are after the payment of o f dividend or after setting aside a portion of the pprofit rofit to proposed dividend account, necessary adjustments must be done so that the average capital ascertained includes only 50%of the profit after tax. Now we calculate the normal average ave rage annual trading profit after tax, but before charging interest on debentures and long term loans l oans and also preference dividend. From this average profit reasonable managerial remuneration should also be deducted. The profit as obtained after the above adjustments is to be compared with the reasonable return on the average capital employed, calculated at a t the rate of return earned by similar businesses. If the former exceeds the latter the balance represents the super profit. A few years· purchase of the super supe r profit is taken as the value of goodwill. (3) Annuity Method: Under this method the basis is super profit. Let us take an example:Suppose the super profit of a concern co ncern has been calculated at Rs.50000 and it has been considered reasonable that 5 years· purchase of the super profit approximates the value of o f goodwill. The contention behind this is that, the purchaser of the business can expect to enjoy super

profit of Rs.50000 per year for the next 5 years. If this is the contention it is not reasonable that he should pay Rs. (50000*5) or Rs.250000. He should pay an amount which will give him an annuity of Rs.50000 over the next 5 years at the current rate of interest. This is what is known as the annuity method of valuation of goodwill. Once the super profit is ascertained, the present value and hence he nce the value of goodwill can be ascertained by the following formula:V=a/i[1-(1+i)^-n)] ,or, V=a/i[1-1/(1+i)^n] Where, V=the present value of the annuity or o r the value of goodwill in this case a=the annuity or the annual super profit p rofit in this case n=the number of years the annuity would be enjoyed i=the rate of interest per rupee per year (4) Capitalisation Method:(a) Capitalistion of Average Profit: Under this method the average annual profit is to be ascertained after providing for reasonable management remuneration. This profit should be capitalized at the rate of reasonable return to find out the total value of business. Now the value of goodwill will be the total value of business minus its net assets. If, however, the net assets is greater ther will be no goodwill, rather there is badwill. (b) Capitilisation of Super Profit: Under this method the average super profit is capitalised at a certain ce rtain rate of interest and this capitalised amount becomes the value of o f goodwill.