There are three methods of valuation of goodwill of the firm,1. Average Profits Method2. Super Profits Method3. Capitalization Method1. Average Profits Method:Under this method goodwill is calculated on the basis of the average of some agreed number of past years. The average is then multiplied by the agreed number of years. This is the simplest and the most commonly used method of the valuation of goodwill.Goodwill = Average Profits X Number of years of PurchaseBefore calculating the average profits the following adjustments should be made in the profits of the firm:a. Any abnormal profits should be deducted from the net profits of that year.b. Any abnormal loss should be added back to the net profits of that year.c. Non-operating incomes eg. Income from investments etc should be deducted from the net profits of that year.Now we will explain this method with the help of a simple example.A Ltd agreed to buy the business of B Ltd. For that purpose Goodwill is to be valued at three years purchase of Average Profits of last five years. The profits of B Ltd. for the last five years are:u00a0u00a0u00a0u00a0u00a0u00a0 Yearu00a0u00a0u00a0u00a0u00a0u00a0u00a0 Profit/Loss ($)u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2005u00a0u00a0u00a0u00a0u00a0u00a0u00a0 10,000,000u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2006u00a0u00a0u00a0u00a0u00a0u00a0u00a0 12,250,000u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2007u00a0u00a0u00a0u00a0u00a0u00a0u00a0 7,450,000u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2008u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2,450,000 (Loss)u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2009u00a0u00a0u00a0u00a0u00a0u00a0u00a0 12,400,000u00a0u00a0u00a0 Following additional information is available:1. In the year 2023 the company suffered a loss of $1,000,500 due to fire in the factory.2. In the year 2023 the company earned an income from investments outside the business $ 4,500,250.Solution:Total profits earned in the past five years= 10,000,000 + 12,250,000 + 7,450,000 u2023 2,450,000 + 12,400,000 = $ 39,650,000Total Profits after adjustments = $ 39,650,000 + $ 1,000,500 u2023 $ 4,500,250=$ 36,150,250Average Profits= $ 36,150,250u00f75=$ 7,230,050Goodwill = $ 7,230,050u00d73=$ 21,690,150Thus A Ltd would pay $21,690,150 as the price of Goodwill earned by B Ltd.2. Super profits method:Super Profits are the profits earned above the normal profits. Under this method Goodwill is calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits. For example if the normal rate of return in a particular type of business is 20% and your investment in the business is $1,000,000 then your normal profits should be $ 200,000. But if you earned a net profit of $ 230,000 then this excess of profits earned over the normal profits i.e. $ 230,000 u2023 $ 200,000= Rs.30, 00 are your super profits. For calculating Goodwill, Super Profits are multiplied by the agreed number of years of purchase.Steps for calculating Goodwill under this method are given below:i) Normal Profits = Capital Invested X Normal rate of return/100ii) Super Profits = Actual Profits u2023 Normal Profitsiii) Goodwill = Super Profits x No. of years purchasedFor example, the capital employed as shown by the books of ABC Ltd is $ 50,000,000. And the normal rate of return is 10 %. Goodwill is to be calculated on the basis of 3 years purchase of super profits of the last four years. Profits for the last four years are:u00a0u00a0u00a0u00a0u00a0u00a0 Yearu00a0u00a0u00a0u00a0u00a0u00a0u00a0 Profit/Loss ($)u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2005u00a0u00a0u00a0u00a0u00a0u00a0u00a0 10,000,000u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2006u00a0u00a0u00a0u00a0u00a0u00a0u00a0 12,250,000u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2007u00a0u00a0u00a0u00a0u00a0u00a0u00a0 7,450,000u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0u00a0 2008u00a0u00a0u00a0u00a0u00a0u00a0u00a0 5,400,000u00a0u00a0u00a0 Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 = $35,100,000Average Profits = 35,100,000 / 4 = $ 8,775,000Normal Profits = 50,000,000 X 10/100 = $ 5,000,000Super Profits = Average/ Actual Profits u2212 Normal Profits = 8,775,000 u2212 5,000,000 = $ 3,775,000Goodwill = 3,775,000 u00d7 3 = $ 11,325,000u00a03. Capitalization Method:There are two ways of calculating Goodwill under this method:(i) Capitalization of Average Profits Method(ii) Capitalization of Super Profits Method(i) Capitalization of Average Profits Method:Under this method we calculate the average profits and then assess the capital needed for earning such average profits on the basis of normal rate of return. Such capital is called capitalized value of average profits. The formula is:-Capitalized Value of Average Profits = Average Profits X (100 / Normal Rate of Return)Capital Employed = Assets u2023 LiabilitiesGoodwill = Capitalized Value of Average Profits u2023 Capital EmployedFor example a firm earns $40,000 as its average profits. The normal rate of return is 10%. Total assets of the firm are $1,000,000 and its total external liabilities are $ 500,000. To calculate the amount of goodwill:Total capitalized value of the firm = 40,000 u00d7 100/10 = 400,000Capital Employed = 1,000,000 u2212 500,000 = 500,000Goodwill = 500,000 u2212 400,000 = 100,000u00a0(ii)Capitalization of Super Profits:Under this method first of all we calculate the Super Profits and then calculate the capital needed for earning such super profits on the basis of normal rate of return. This Capital is the value of our Goodwill. The formula is:-Goodwill = Super Profits X (100/ Normal Rate of Return)For example ABC Ltd earns a profit of $ 50,000 by employing a capital of $ 200,000, the normal rate of return of a firm is 20%. To calculate Goodwill:Normal Profits = 200,000 u2212 20/100 =$ 40,000Super profits = 50,000 u2212 40,000 = $10,000Goodwill = 10,000 u00d7 100 / 20 = $50,000
