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Valuation of Goodwill

Valuation of Goodwill

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how to value goodwill
how to value goodwill

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Published by: abhi_cool7864757 on Mar 24, 2010
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02/06/2013

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Valuation of Goodwill
When a business is able to earn profits at a rate higher than that atwhich a similar business earns, the former business is said to possessgoodwill. Goodwill is, therefore, an invisible asset by the possession ofwhich a business can enjoy super earning. Since it is invisible thegoodwill is called an in tangible asset. But since its existence can befelt through superior earning power it is a real asset.There are several causes for which a business may have a goodwill andsome of them are:(1)Possession of a large number of profitable contracts ; (2)Suitablenature of the business ; (3)Exclusive franchise ; (4)Protected valuablepatents and trademarks ; (5)Suitable location of the business ;(6)Idealwindow dressing ; (7)Government patronage ;(8)Reputability,respectability and reliability of the proprietor or partners or trustees; (9)Special ability and skill of the persons in management, etc.In case of transfer of business, separation of the partners from thebusiness due to retirement, death, etc, assessment of the value of thebusiness 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 ofwhich the following are of common use:
(1) Few years· Purchase of Average Profits Method:
Under thismethod goodwill is valued on the basis of an agreed number of years·purchase of the average maintainable profit. The word maintainable
 
indicates several adjustments in respect of the factors which mighthave influenced abnormally the profits of the years over which theaverage is taken. If in any year there is an exceptional opportunity oran exceptional expense or absence of expense, the profit for the yearhas to be so adjusted as to get it free from such exceptionalinfluences.Sometimes instead of the simple average of the adjusted profits asdiscussed above, weighted average is taken into consideration. Weightsare given to each years· profit on the consideration how each years·profit is likely to influence the future profit trend.
(2) Super Profits Method:
Under this method average super profit isascertained. Goodwill is calculated at a few years· purchase of thesuper profit of the concern. The number of years to be taken forconsideration depends upon the nature of the business, the steady orfluctuating nature of the profit and also the nature of goodwill.First, ascertain the average capital employed during the year. For thispurpose take the total of the closing real assets of the concern asrevalued (excluding the non-trading assets and goodwill alreadyappearing in the balance sheet unless such goodwill represented thepayment to the vendor).In order to find out the average capital employed it is necessary todeduct from the above the current liabilities and 50% of the profitsfor the year after tax. The profit should also be excluding non-tradingincome, if any. The average capital employed in this way excludes thelong term loans, debentures and preference shares.The idea of capital employed is not suitable for the purpose ofvaluation of goodwill of an individual company where valuation is to bedone to the advantage of the equity shareholders. In this case, from
 
the above total assets we deduct the current liabilities, long termloans, preference capital, etc, also 50% of the profit for the yearafter excluding non-trading income and after charging interest on longterm loans and debentures, preference dividend, etc.The average capital employed is the mean of the opening and closingcapitals. As we have taken the closing net assets which includes theprofits for the year it is necessary to deduct 50%of the profit inorder to get the capital at the middle of the year. If, however, theclosing net assets are after the payment of dividend or after settingaside a portion of the profit to proposed dividend account, necessaryadjustments must be done so that the average capital ascertainedincludes only 50%of the profit after tax.Now we calculate the normal average annual trading profit after tax,but before charging interest on debentures and long term loans andalso preference dividend. From this average profit reasonablemanagerial remuneration should also be deducted. The profit asobtained after the above adjustments is to be compared with thereasonable return on the average capital employed, calculated at therate of return earned by similar businesses. If the former exceeds thelatter the balance represents the super profit.A few years· purchase of the super profit is taken as the value ofgoodwill.
(3) Annuity Method:
Under this method the basis is super profit. Letus take an example:-Suppose the super profit of a concern has been calculated at Rs.50000and it has been considered reasonable that 5 years· purchase of thesuper profit approximates the value of goodwill. The contention behindthis is that, the purchaser of the business can expect to enjoy super

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