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What is goodwill ?

In accounting, goodwill is an intangible asset associated with a business


combination. Goodwill is recorded when a company acquires (purchases) another company
and the purchase price is greater than the combination or net of 1) the fair value of the
identifiable tangible and intangible assets acquired, and 2) the liabilities that were assumed.
Goodwill is reported on the balance sheet as a noncurrent asset. Since 2001, U.S. companies
are no longer required to amortize the recorded amount of goodwill. However, the amount of
goodwill is subject to a goodwill impairment test at least once per year.
Outside of accounting, goodwill could refer to some value that has been developed within a
company as a result of delivering amazing customer service, unique management, teamwork,
etc. This goodwill, which is unrelated to a business combination, is not recorded or reported
on the company's balance sheet.

A word about goodwill :

Practice goodwill is generally the most subjective and variable asset in


valuing a medical practice. Valuing the intangible assets and goodwill of a medical practice
can be a contentious issue.
Hospitals dont want to pay anything for goodwill. If a younger physician takes the place of
a senior physician, it is assumed that the younger physician wont be able to earn what a
seasoned, more established senior physician earns, Kropiewnicki says. A hospital buys a
practice because they want the physician, for example, a surgeon because the hospital wants
to make sure there are enough surgeons to meet patient needs in the hospitals catchment
area.
With the expected proliferation of ACOs established by hospitals, purchases of physician
practices by hospitals may increase dramatically, so that there will be enough physicians to
take care of all the patients contracted to the ACO, Kropiewnicki adds.

If the practice or related entity owns the office building, a commercial real-estate appraiser
normally appraises the structure. If the office is leased, the leasehold may have a value
depending upon the number of years remaining, amount paid for rent compared to going
market rent, and the ability to renew the lease, DeMuth explains.
Office location and profitability are also important, according to Kropiewnicki. If a practice
is in the middle of nowhere, rural versus suburban Pennsylvania or New Jersey, then the rural
practice will almost certainly be worth less than the suburban practice, all else being equal,
he says. Also, profitability is a major factor, so if you have two practices in the same
geographic area each grossing $1 million, and one physician is making $300,000 and the
other physician is netting out $500,000, a buyer should be willing to pay more for the more
profitable practice.
While there are numerous factors which could affect it, the value of goodwill is generally
dependent upon the ability of the purchaser to be able to earn a superior return from the
practice compared with what could normally be expected to be earned by physicians in the
specialties represented in the practice, DeMuth says.
The Health Care Group publishes the Goodwill Registry, a large database of healthcare
practice transactions from all over the country and source of actual goodwill values paid. It
lists goodwill as a percentage of a practices gross income and has other financial information
about the practices reported to them by specialty.
When buying a home, comparables existyou can compare homes in different
neighborhoods, Kropiewnicki says. No neighborhood level comparables exist like that
when it comes to medical practices. The Goodwill Registry comes closest to providing
healthcare practice comparables, but on a wider geographic scale.
Although its usually inappropriate to solely apply rules-of-thumb in valuing medical
practices, especially goodwill and intangible assets, the Goodwill Registry can be used to
support or confirm the valuation results achieved using other valuation methods.
Even when using a database of sales data, significant thought needs to go into understanding
similarities and differences in published data, such as the Goodwill Registry. Some data is
based on matrimonial disputes, some are arms-length sales, some are based on internal sales
transactions which may have other, tax driven components to them. Failure to fully take these
issues into account is likely to lead to erroneous conclusions, Glusman says.

Goodwill:
Definition and Valuation of Goodwill
Definition:
A business builds up some reputation after it has continued for some time. If
the reputation is good, the firm will come to acquire a fixed clientele in the sense that a
number of customers will automatically make their purchases from the firm. This is a very
valuable asset even if one cannot touch or see it. The asset is intangible but not fictitious. This
asset is known as goodwill and may be defined as the value of the reputation of a firm. Its
tangible effect is extra profit which firms not possessing equal reputation do not earn.

This reputation will depend on:


(a) The personal reputation of the owners and/or management;
(b) The reputation of the goods dealt in or the quality of the service rendered;
(c) The peculiar advantage of the site of the business;
(d) The peculiar advantage available to it as regards sales or supplies of materials; and
(e) The patents, copyrights or trademarks owned by the firm, (but often a separate value is put
on these).
Those who purchase goodwill will acquire the name of the firm and also the site, the patents
and trademarks, etc., and existing contracts. All the factors named above result in extra profits
and hence goodwill will arise only when the business is profitable.
A business running into losses will have, generally, no goodwill. What has to be particularly
remembered is that it is the expectation of profits in future that makes goodwill a valuable
asset. A firm which has made good profits by virtue of an exceptionally favourable contract,
that is not to be renewed, cannot expect to get much for its goodwill.

Valuation of Goodwill:

Three methods are in use:

(a) Average Profits Basis:


In this method, the profits of the past few years are averaged and adjusted for
any change that is expected to occur in the near future. The adjusted average is multiplied by
a certain number (say, 2 or 3 or 5) as agreed. It is expressed, for example, as 3 years purchase
of five years average profits. If, for example, the profits for the last five years have been Rs
80,000, Rs 90,000, Rs 70,000 Rs 85,000 and Rs 1, 00,000; the average yearly profit comes to

If, goodwill is to be valued at 3 years purchase of average profits for. 5 years, goodwill will
be Rs 85,000 x 3 = Rs 2, 55,000.

(b) Super Profits Basis :

In every industry, there is a rate which is considered to be the normal rate at


which profits are expected to the earned on capital employed. If a firm is able to earn more
than the normal expected profit, the excess is called super profits which can be attributed to
the special advantages of firm.
Suppose, the capital of the firm is Rs 4, 00,000 and that 15% is reasonable
return in the industry. The reasonable or normal profits are Rs 60,000. If the average profits
are Rs 85,000, the super profits in this case come to Rs 25,000. Super Profits multiplied by
the number of years purchase agreed upon gives goodwill. In the example given above, if
goodwill is to be calculated at 3 years purchase, the goodwill is ` 75,000 i.e. Rs 25,000 x 3.
(c) Capitalisation Method:
In this method, the value of the whole business is found out by the formula,

Then, from this figure, the net assets (excluding goodwill) of the firm are deducted and the
remainder is goodwill. In the example given above, the value of the whole business is

or 15, 66,667. Net


4, 00,000. Hence,
5,66,667Rs 4,00,000.

assets (excluding goodwill) or capital is Rs


the goodwill is Rs 1, 66,667 i.e. Rs

The necessity for the valuation of goodwill in a firm arises in the following cases:
(a) When the profit-sharing ratio amongst the partners is changed;
(b) When a new partner is admitted;
(c) When a partner retires or dies; and
(d) When the business is sold;
In the last case, obviously, the value of goodwill will be a matter for negotiation between the
firm and the intending purchaser.
Accounting Treatment of Goodwill :
Because of the provisions of the Accounting Standard 10 on Accounting for Fixed Assets,
accounting treatment of goodwill has undergone a fundamental change.
Consider extract of the Accounting Standard which runs as follows :
Goodwill should be recorded in the books only when some consideration in money or
moneys worth has been paid for it. Whenever a business is acquired for a price (payable in
cash or in shares or otherwise) which is in excess of the value of net assets of the business
taken over, the excess should be termed as goodwill.
It means that goodwill can appear in the books only when it has been paid for. When a
business is acquired and the consideration paid for it exceeds the fair amount paid for net
assets other than goodwill, such excess can be recorded as goodwill.
Suppose, P and Q are equal partners in a firm. They take over the business of XY (Pvt.) Ltd.
for Rs 20, 00,000 payable in cash.
On the date of the takeover, the abridged balance sheet of the private company is as
follows:

The firm takes over all the assets and liabilities at book values except that machinery is
valued by an expert at Rs 8, 94,000 and a provision for bad debts @2% is created against
debtors.
The journal entries in the books of the partnership firm will be as follows:

A firm cannot raise a goodwill account for internally generated goodwill although it may be
sure that if it sells its business, it will be able to get a certain sum of money for its goodwill.

In this connection, paragraphs 35, 36 and 37 of Accounting Standard 26 on Intangible Assets


(issued in 2002) are noteworthy.
These paragraphs run as follows:
35. Internally generated goodwill should not be recognized as an asset:
36. In some cases, expenditure is incurred to generate future economic benefits, but it does
not result in the creation of an intangible asset that meets the recognition criteria in this
statement. Such expenditure is often described as contributing to internally generated
goodwill. Internally generated goodwill is not recognized as asset because it is not an
identifiable resource controlled by the enterprise that can be measured reliably at cost.
37. Difference between the market value of an enterprise and the carrying amount of its
identifiable net assets at any point of time may be due to a range of factors that affect the
value of the enterprise. However, such differences cannot be considered to represent the cost
of intangible assets controlled by the enterprise.
The effect of the abovementioned provisions is that the question of raising goodwill account
on a change in profit sharing ratio among partners, admission of a new partner or retirement
of a partner or death of a partner does not arise any longer. However, in any one of the
abovementioned cases, the partners may agree upon a value of internally generated goodwill
and an appropriate adjustment entry involving the capital accounts of the concerned partners
may be passed.
Change in the Profit-sharing Ratio :
If partners decide to share profits in future in a ratio different from the one hitherto, the
gaining partner must compensate the losing partner unless otherwise agreed upon. The
compensation is the value of goodwill represented by the gain because the change in profitsharing ratio means that one partner is purchasing from another partner a share of the profits
previously belonging to the latter. Suppose, A and B, are partners sharing profits in the ratio
of 3: 1 respectively. It is decided that in future both will be equal partners; it means that A is
selling to B 1/4th share of profits.
Therefore, B will pay to A an amount equal to one-fourth of the total value of goodwill. In
concrete terms, suppose, the profit is Rs 60,000, previously A would get Rs 45,000 and B
would get Rs 15,000. After the change in the profit-sharing ratio, each would get Rs 30,000
A, therefore, loses annually Rs 15,000 and B gains Rs 15,000. If the goodwill is valued at Rs
1, 50,000, B must pay A one-fourth of Rs 1, 50,000 viz., Rs 37,500.
Illustration 1:

A, B and C are partners who were sharing profits in the ratio of 6:5:2 respectively. On 1st
April, 2010, they, agree to become equal partners. The value of firms goodwill is agreed
upon to be Rs 78,000. Pass the necessary adjustment entry.

Methods of valuation of Goodwill :


There are three methods of valuation of goodwill of the firm;
1. Average Profits Method
2. Super Profits Method
3. Capitalisation Method

1. Average Profits Method:


Under this metod 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 Puchase
Before calculating the average profits the following adjustments should be made in the profits
of the firm:
a. Any abnormal profits shoulld be deducted from the net profits of that year.
b. Any abnormal loss should be added back to the nat 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:
Year

Profit/Loss ($)

2005

10,000,000

2006

12,250,000

2007

7,450,000

2008

2,450,000 (Loss)

2009

12,400,000

Following additional information is available:


1. In the year 2008 the company suffered a loss of $1,000,500 due to fire in the factory.
2. In the year 2009 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 2,450,000 + 12,400,000 = $ 39,650,000
Total Profits after adjustments = $ 39,650,000 + $ 1,000,500 $ 4,500,250=$ 36,150,250
Average Profits= $ 36,150,2505=$ 7,230,050
Goodwill = $ 7,230,0503=$ 21,690,150
Thus 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 examplle 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 $ 200,000= Rs.30,000 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/100
ii) Super Profits = Actual Profits Normal Profits
iii) Goodwill = Super Profits x No. of years purchased

For 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 puchase of super profits of the last four years. Profits for the last four years are:
Year

Profit/Loss ($)

2005

10,000,000

2006

12,250,000

2007

7,450,000

2008

5,400,000

Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 =
$35,100,000
Average Profits = 35,100,000 / 4 = $ 8,775,000
Normal Profits = 50,000,000 X 10/100 = $ 5,000,000
Super Profits = Average/ Actual Profits Normal Profits = 8,775,000 5,000,000 = $
3,775,000
Goodwill = 3,775,000 3 = $ 11,325,000

3. Capitalisation Method:
There are two ways of calculating Goodwill under this method:
(i) Capitalisation of Average Profits Method
(ii) Capitalisation of Super Profits Method
(i) Capitalisation 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 capitalised value of average profits. The formula is:Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)

Capital Employed = Assets Liabilities


Goodwill = Capitalised Value of Average Profits Capital Employed
For 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 = 40,000 100/10 = 400,000
Capital Employed = 1,000,000 500,000 = 500,000
Goodwill = 500,000 400,000 = 100,000

(ii) Capitalisation 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:Goddwill = 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 20/100 =$ 40,000
Super profits = 50,000 40,000 = $10,000
Goodwill = 10,000 100 / 20 = $50,000

Accounting Procedure for Valuation of Goodwill (4 Methods) :


The valuation of goodwill depends upon assumptions
made by the valued. Methods to be adopted in valuation of goodwill would
depend on circumstances of each case and is often based on the customs
of the trade.
The various methods that can be adopted for valuation of goodwill are follows:

1. Average Profit Method


2. Super Profit Method
3. Capitalization Method
4. Annuity Method.
1. Average Profit Method:
Under this method the value of Goodwill is calculated by multiplying the Average Future
profit by a certain number of years purchase.
Goodwill = Future maintainable profit after tax x No. of years purchase
The first step under this method is the calculation of average profit based on past few years
profit. Past profit are adjusted in respect of any abnormal items of profit or loss which may
affect future profit. Average profit may be based on simple average or weighted average.
If profits are constant, equal weight-age may be given in calculating the average profits i.e.,
simple average may be calculated. However, if the trend shows increasing or decreasing
profit, it is necessary to give more weight-age to the profits of recent years.
Number of years purchase:
After calculating future maintainable average profits, the next step is to determine the number
of years purchase. The number of years of purchase is determined with reference to the
probability of new business to catch up with an existing business. It will differ from industry
to industry and from firm to firm. Normally the number of years ranges between 3 to 5.
Steps Involved under Average Profits Method:
(i) Calculate past profits before tax.

(ii) Calculate future-maintainable profit before tax after making past adjustments.
(iii) Calculate Average Past adjusted Profits (taking simple average or weighted average as
applicable).
(iv) Multiply Future Maintainable Profits by number of years purchase.
Value of Goodwill = Future Maintainable Profits x No. of years purchase.
Illustration 1:
X Ltd. agreed to purchase business of a sole trader. For that purpose, goodwill is to be valued
at 3 years purchase of average profits of last 5 years.

Illustration 2:
Y Ltd. proposed to purchase business carried on by Mr. A. Goodwill for this purpose is
agreed to be valued at 3 years purchase of the weighted average profits of the past four
years.
The profit for these years and respective weights to be assigned are as follows:

On a scrutiny of the accounts, the following matters are revealed:


(a) On 1st September, 2012 a major repair was made in respect of plant incurring Rs. 6,000
which was charged to revenue, the said sum is agreed to be capitalized for goodwill
calculation subject to adjustment of depreciation of 10% p.a. on reducing balance method.
(b) The closing stock for the year 2011 was over valued by Rs. 2,400; and
(c) To cover management cost an annual charge of Rs. 4,000 should be made for the purpose
of goodwill valuation.
Required:
Compute the value of goodwill of the firm.

Solution:
Before calculating goodwill, it is necessary to compute adjusted profit on the basis of
information given.

2.
Super Profit Method:
Super profit is the excess of estimated future maintainable profits over normal profits. An
enterprise may possess some advantages which enable it to earn extra profits over and above
the normal profit that would be earned if the capital of the business was invested in some
other business with similar risks. The goodwill under this method is ascertained by
multiplying the super profits by certain number of years purchase.

Steps Involved in Calculating Goodwill under Super Profit Method:


Step 1: Calculate capital employed (it is the aggregate of Shareholders equity and long
term debt or fixed assets and net current assets).
Step 2: Calculate Normal Profits by multiplying capital employed with normal rate of
return.
Step 3: Calculate average maintainable profit.
Step 4: Calculate Super Profit as follows:
Super Profit = Average maintainable profits Normal Profits.
Step 5: Calculate goodwill by multiplying super profit by number of years purchase.
Illustration 3:
From the following information calculate the value of goodwill on the
basis of 3 years purchase of super profits of the business calculated on the average profit
of the last four years (simple average and weighted average):
(i) Capital employed Rs. 50,000
(ii) Trading profit (after tax):
2010 Rs. 12,200;
2011 Rs. 15,000;
2012 Rs. 2,000 (loss); and
2013 Rs. 21,000
(iii) Rate of interest expected from capital having regard to the risk involved is 10%.
(iv) Remuneration from alternative employment of the proprietor (if not engaged in
business) Rs. 3,600 p.a.

3. Capitalization Method:
Goodwill under this method can be calculated by capitalizing average normal profit or
capitalizing super profits.
(i) Capitalisation of Average Profit Method:
Under this method goodwill is ascertained by deducting Actual Capital
Employed (i.e., Net Assets as on the valuation date) from the capitalised value of the average
profits on the basis of normal rate of Return (also known as value of the firm or capitalised
value of business)

Goodwill = Capitalised Value Net Assets of Business


Steps involved in calculating goodwill as per capitalisation of Average Profits Method:
Step 1: Calculate Average future maintainable profits
Step 2: Calculate Capitalised value of business on the basis of Average Profits

Step 3: Calculate the value of Net Assets on the valuation date


Net Assets = All Assets (other than goodwill, fictitious assets and non-trade investments) at
their current values Outsiders Liabilities
Step 4: Calculate Goodwill
Goodwill = Capitalised Value Net assets of business.
Illustration 5:
From the following calculate the value of goodwill according to capitalisation of Average
Profits Method:

(ii) Capitalisation of Super Profit Method :


The goodwill under this method is ascertained by capitalizing the super profits on the basis of
normal rate of return. This method assesses the capital needed for earning the super profit.
The value of goodwill is computed as follows:

Illustration 6:
Balance Sheet of X Ltd. on 31st March, 2013 was as under:

4. Annuity Method :
Under this method, goodwill is calculated by taking average super profit as the value of an
annuity over a certain number of years. The present value of this annuity is computed by
discounting at the given rate of interest (normal rate of return). This discounted present value
of the annuity is the value of goodwill. The value of annuity for Rupee 1 can be known by
reference to the annuity tables.
If the value of annuity is not given, it can be calculated with the help of following
formula:

Illustration 7:
The net profit of a company after providing for taxation for the past five years
is:

The net tangible assets in the business are Rs. 4, 00,000 on which the normal rate of
return is expected to be 10%. It is also expected that the company will be able to
maintain its super profits for next five years. Calculate the value of goodwill of the
business on the basis of an annuity of super profits, taking present value of an
annuity of Rs. 1 for five years at 10% interest is Rs. 3.78.

Defination of Shares :
A unit of ownership that represents an equal proportion of a company's capital.
It entitles its holder (the shareholder) to an equal claim on the company's profits and an
equal obligation for the company's debts and losses.
Two major types of shares are :
(1) ordinary shares (common stock), which entitle the shareholder to share in the earnings of
the company as and when they occur, and to vote at the company's annual general
meetings and other official meetings, and
(2) preference shares (preferred stock) which entitle the shareholder to a fixed
periodic income (interest) but generally do not give him or her voting rights. See also stock.

Concept And Meaning Of Valuation Of Shares :


The value of every share is printed in front of the shares. Such a value
is called as par value or face value of shares. The face value is assigned by the
promoters of joint stock company and is given in the memorandum of association. Except the
face value, it has also get market value on stock exchange market which may be differ from
face value. The market value of a share is determined by the demand and supply. Such a
value is affected by the action and opinions of investors and their fear, guess, investment
policy etc. Hence, the market price does not reflect the true value of shares and requires a
proper valuation of shares. Specially, in the case of private limited company the shares of
such a company are not freely purchased and sold to the public. In that case, the valuation
becomes absolutely necessary.
The value of shares can be determined in different ways. It can be valued either by taking the
earning of a company or net assets that comprise the company. The choice is governed by the
reasons for investment.

Methods of Valuation of Shares (5 Methods) :


Let us make in-depth study of the five methods of valuation of shares, i.e., (1) Asset
Backing Method, (2) Yield-Basis Method, (3) Fair Value Method, (4) Return on
Capital Employed Method, and (5) Price-Earning Ratio Method.
A. Asset-Backing Method:
Since the valuation is made on the basis of the assets of the company, it is known as
Asset-Basis or Asset- Backing Method. At the same time, the shares are valued on
the basis of real internal value of the assets of the company and that is why the
method is also termed Intrinsic Value Method or Real Value Basis Method.
This method may be made either:
(i) On a going/continuing concern basis; and
(ii) Break-up value basis.
In the case of former, the utility of the assets is to be considered for the purpose of
arriving at the value of the assets, but, in the case of the latter, the realizable value of
the assets is to be taken. Under this method, value of the net assets of the company
is to be determined first.
Thereafter, the net assets are to be divided by the number of shares in order to rind
out the value of each share. At the same time, value of goodwill (at its market value),
investment (non-trading assets) are to be added to net assets. Similarly, if there are
any preference shares, those are also to be deducted with their arrear dividends
from the net assets.
However, this following step should carefully be followed while calculating Net Assets
or the Funds Available for Equity Shareholders:
(a) Ascertain the total market value of fixed assets and current assets;
(b) Compute the value of goodwill (as per the required method);
(c) Ascertain the total market value of non-trading assets (like investment) which are
to be added;
(d) All fictitious assets (viz, Preliminary Expenses, Discount on issue of
Shares/Debentures, Debit-Balance of P&L A/c etc.) must be excluded;
(e) Deduct the total amount of Current Liabilities, Amount of Debentures with arrear
interest, if any, Preference Share Capital with arrear dividend, if any.

(f) The balance left is called the Net Assets or Funds Available for Equity
Shareholders.
The following chart will make the above principle clear:

Alternatively:
Net Assets = Share Capital + Reserves and Surplus Revaluation Loss on
Revaluation
Applicability of the Method:
(i) The permanent investors determine the value of shares under this method at the
time of purchasing the shares;
(ii) The method is particularly applicable when the shares are valued at the time of
Amalgamation, Absorption and Liquidation of companies; and
(iii) This method is also applicable when shares are acquired for control motives.
Illustration 1:
From the following Balance Sheet of Sweetex Ltd. you are asked to-ascertain the
value of each Equity Share of the company:

For the purpose of valuing the shares of the company, the assets were revalued as:
Goodwill Rs. 50,000; Land and Building at cost plus 50%, Plant and Machinery Rs.
1, 00,000; Investments at book values; Stock Rs. 80,000 and Debtors at book value,
less 10%.

Intrinsic Value of each share = Funds available for Equity Shares/Total Number of
Shares
Intrinsic Value of shares = Rs. 3, 30,000/20,000
= Rs. 16.50.
Intrinsic Value of Shares on the Basis of Valuation of Goodwill

Illustration 2:
X Ltd. presented the following Balance Sheet as on 31st March 2010:

Additional Information:
(a) Land and Building and Plant and Machinery were revalued at Rs. 15, 00,000 and
Rs. 2, 28,000, respectively.
(b) Investments were valued at market value.
(c) Stock to be taken at Rs. 80,000 and Debtors subject to a deduction @ 10% for
bad debts.
(d) Net profit (before Tax) for the last five years were: Rs. 50,000; Rs. 70,000; Rs.
80,000; Rs. 1, 00,000 and Rs. 1, 25,000.
(e) Managerial Remuneration Rs. 8,000 to be charged against profit for every year.
(f) Normal Rates of Return 10%.
(g) Goodwill to be valued at 5 years purchase of Super-Profit.
(h) Rate of tax 50%.
Ascertain the Intrinsic Value of Shares.

Intrinsic Value of Share and Ratio of Exchange of Shares:


Illustration 3:

The following Balance Sheets were presented by X Ltd. and Y Ltd. as on 31st
Dec. 2008:

Solution:
(a) Calculation of Intrinsic Value of Shares:

(b) Calculation of Ratio of Exchange:


It can be calculated by two ways:
(i) Ascertain the L.C.M. of the intrinsic value of shares and the same is divided by the
intrinsic values in order to get the ratio of exchange.
We know, L.C.M. of 20 and 10 is 20.
Thus, one share of X Ltd. is equal to two shares of Y Ltd. since value of X Ltd.s
share is Rs. 20 and that of Y Ltd.s is Rs. 10.
So, we can say, the ratio of exchange is 1 share of X Ltd. is equal to 2 shares of Y
Ltd.
(ii) Alternatively:
Net assets of Y Ltd. should be divided by the intrinsic value of X Ltd. in order to
calculate the number of shares to be issued on the basis of which they said ratio can
be ascertained.

Thus, the ratio of exchange is 5,000 shares of X Ltd. for 10,000 shares of Y Ltd. i.e.,
the ratio is 1 : 2 or 1 share of X Ltd. is equal to 2 shares of Y Ltd.

B. Yield-Basis Method:
Yield is the effective rate of return on investments which is
invested by the investors. It is always expressed in terms of percentage. Since the
valuation of shares is made on the basis of Yield, it is called Yield-Basis Method. For
example, an investor purchases one share of Rs. 100 (face value and paid-up value)
at Rs. 150 from a Stock Exchange on which he receives a return (dividend) @ 20%.
(dividend) @ 20%.

Under Yield-Basis method, valuation of shares is made on;


(i) Profit Basis;
(ii) Dividend Basis.
(i)

Profit Basis:
Under this method, at first, profit should be ascertained on the basis of past
average profit; thereafter, capitalized value of profit is to be determined on the
basis of normal rate of return, and, the same (capitalized value of profit) is divided
by the number of shares in order to find out the value of each share.

The following procedure may be adopted:

Illustration 4:

Two companies, A Ltd. and B. Ltd., are found to be exactly similar as to their
assets, reserves and liabilities except that their share capital structures are
different:
The share capital of A. Ltd. is Rs. 11,00,000, divided into 1,000, 6% Preference
Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each.
The share capital of B. Ltd. is also Rs. 11,00,000, divided into 1,000, 6% Preference
Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each. .
The fair yield in respect of the Equity Shares of this type of companies is ascertained
at 8%.
The profits of the two companies for 2009 are found to be Rs. 1, 10,000 and Rs. 1,
50,000, respectively.
Calculate the value of the Equity Shares of each of these two companies on
31.12.2009 on the basis of this information only. Ignore taxation.

Illustration 5:
From the following information of J. Adams Co. Ltd. compute the value of its
equity share by capitalisation of earning method:

It is the usual practice of the company to transfer Rs. 30,000 every year to General
Reserve. Assume rate of Taxation is at 50% and the rate of normal earnings at
12.5%.

Show workings also.

(ii) Dividend Basis:


Valuation of shares may be made either (a) on the basis of total amount of
dividend, or (b) on the basis of percentage or rate of dividend:

Whether Profit Basis or Dividend Basis method is followed for ascertaining the value
of shares depends on the shares that are held by the respective shareholders. In
other words, the shareholders holding minimum number of shares (i.e., minority
holding) may determine the value of his shares on dividend basis since he has to
satisfy himself having the rate of dividend which is recommended by the Board of
Directors, i.e., he has no such power to control the affairs of the company.
On the contrary, the shareholders holding maximum number of shares (i.e., majority
holding) has got more controlling rights over the affairs of the company including the
recommendation for the rate of divided among others. Under the circumstances,
valuation of shares should be made on profit basis. In short, Profit Basis should be
followed in the case of Majority Holding, and Dividend Basis should be followed in
the case of Minority Holding.
The same principle may be represented in the following form:

Note:
Yield-Basis Method may also be termed as:
Market Value Method; Profit Basis/Income Basis Method;
Earning Capacity Method etc.
Value of share under yield basis:

Illustration 6:
On December 31, 2009 the Balance Sheet of MA KALI Ltd. disclosed the following
position:

Illustration 7:
Calculate the value of each Equity Share from the following information:

C. Fair Value Method:


There are some accountants who do not prefer to use Intrinsic
Value or Yield Value for ascertaining the correct value of shares. They, however,
prescribe the Fair Value Method which is the mean of Intrinsic Value Method end
Yield Value Method. The same provides a better indication about the value of shares
than the earlier two methods.

Illustration 8:
The following is the Balance Sheet of X Co. Ltd. as on 31.12.2009:

Ascertain the value of each equity share under Fair Value Method on the basis
of the information given:

Assets are revalued as:


Building Rs. 3, 20,000, Plant Rs. 1, 80,000, Stock Rs. 45,000 and Debtors Rs.
36,000. Average Profit of the company is Rs. 1, 20,000 and 12% of profit is
transferred to General Reserve, Rate of taxation being 50%. Normal dividend
expected on equity shares is 8% whereas fair return on capital employed is 10%.
Goodwill may be valued at 3 years purchase of super-profit.

D. Return on Capital Employed Method:


Under this method, valuation of share is made on the basis of
rate of a return (after tax) on capital employed. Rates of return are taken on the basis
of predetermined/expected rates of return which an investor may expect on the
investments. After ascertaining this expected earnings, we are to determine the
capital sum for such a return.
Thus, we are to follow the following procedure one by one:
(a) Ascertain the expected (maintainable) profit (after adjustments, if any);
(b) Ascertain the normal rate of return on capital employed for a similar business;
(c) At last, on the basis of expected rate of return, capitalize the (maintainable) profit.
Illustration 9:
Ascertain the value of each equity share under Return on Capital Employed
Method from the following particulars:

E.

Price-Earnings Ratio Method:


We know that it is the ratio which relates the market price of the share to earning per
equity share.
It is calculated as:

Illustration 10:
Compute the value per share and valuation of the business from the following
particulars:

Need For Valuation Of Shares :


The following are the circumstances where need for the valuation of shares arises:
1. Where companies amalgamate or are similarly reconstructed, it may be necessary to arrive
at the value of shares hold by the members of the company being absorbed or taken over.
2. Where shares are hold jointly by the partners in a company and partnership firm dissolved,
it becomes necessary to value of shares.

3. Where a portion of the shares is to be given by a member of proprietary company to


another member as the member cannot sell it in the open market, it becomes necessary to
certify the fair price of these shares by an auditor.
4. When a loan advanced on the security of shares, it becomes necessary to know the value of
shares on the basis of which loan has been advanced.
5. When shares are given in a company as gift it may be necessary for the purpose of
assessing gift tax, to place a value on the shares.
6. When preference shares or debentures are converted into equity share it becomes necessary
to value the equity shares for ascertaining the number of equity shares required to be issued
for debentures or preference shares which are to be converted.
7. When equity shareholders are to be compensated on the acquisition of their shares by the
government under a scheme of nationalization then it is necessary to value the equity shares.

Conclusion :

Bibliography / References :

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