CHAPTER- 3

VALUATION OF GOODWILL

Meaning of goodwill - is the extra value attached to the business over and above the intrinsic
value of its net assets. In other words, it is the value of reputation or good name of the
business.

Definition - according to Prof Dicksee, “when a man pays for goodwill, he pays for
something which puts him in a position of being able to earn more than he would be able to
do by his own unaided efforts”

TYPES OF GOODWILL -

Dog Goodwill:

Since dogs are attached to one person, customers that are attached like that lead to personal
goodwill which is not transferable.

Cat Goodwill:

Since cats prefer the person of the old home, similarly such customers give rise to Local
Goodwill.

Rat Goodwill:

The other variety of customer has attachment neither to the person nor to the place which in
other words is known as Fugitive Goodwill.  

FEATURES OF GOODWILL -

1. Goodwill is an intangible asset/ can't be seen or touched

2. Goodwill is a real asset but not a fictitious asset
3. Goodwill always exists with business but it cannot exist by itself.
4. Goodwill is subject to fluctuations

Factors determining the value of goodwill –

1. Location factors - favourable location influences the earning capacity of the business
and enhances its goodwill.
2. Time factors - A long established business enjoys better goodwill than a new
business.
3. Nature of business - The nature of goods dealt with, the risk attached, the competition
involved, the privileges enjoyed by the firm etc determine the value of goodwill.
4. Efficiency of management  - Of a firm contributes to his/her profits and
consequently, the goodwill of such a firm will be more.
5. Past profits of a business - A business which has been earning more profits in the past
is likely to earn more profits in the future also
6. Stability of a business - A stable business enjoys more goodwill than an unstable one.

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 7. Future prospects of a business - The better the future prospects of a business the more
the goodwill and vice versa.
8. Other factors - General economic conditions, Political stability, government policies,
money market conditions, trade cycles etc are other factors influencing the value of
goodwill.

CALCULATION OF GOODWILL –

Value of goodwill = Adjusted average profits X Number of years of purchase

METHODS OF CALCULATING GOODWILL –

1. ARBITRARY METHOD:
Under this method, the goodwill is valued/ decided by the purchaser and seller of the business
orally or after coming to a uniform opinion. This method is followed to avoid taxation. This
method is illegal. (no problems)

2. PURCHASE OF PAST PROFITS METHOD:

Under this method, the value of goodwill is decided by finding out average profits of several
years and then the average profits are multiplied by no. of years of purchase. (problems)

3. AVERAGE PROFIT METHOD -

Under this method, the value of goodwill is calculated by multiplying the adjusted average
annual profits by the number of years of purchase.

Value of goodwill = Adjusted average annual profits X Number of years of purchase

a. Simple average profit method - When there is a fluctuation in the profits , simple
average profit method should be followed. This can be calculated by using the
following formulae :

Adjusted Average Profits (simple average) = Total adjusted profits of all given years  
                                                                                     Number of years
    b) Weighted average profit method - when the weights for each year are given in the
problem or when the profits are following an increasing or decreasing trend, weighted
average profit should be calculated. Using the following formula :

Weighted Adjusted Average Profits = Total product

                                                           Total weights

4. SUPER PROFIT METHOD -

Goodwill can be attached to a business only if it is earning above normal profits or super-
profits. Excess profit known as super-profit is the difference between the average profit
earned by the business and the normal profit based on the normal rate of return. Basic
information required to calculate this is -

A. The estimated average future profits of the firm (ascertained as already explained)
B. The normal rate of return on investment and
C. The fair value of average capital employed in the business.

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Normal rate of return refers to the rate of earnings which investors in general expect on their
investments in a particular type of industry. It varies depending upon general factors like the
bank rate , general economic conditions, political stability, etc and specific factors like period
of investment.  
 
5. CAPITALISATION METHOD

a . Capitalisation of average profits

Step 1 - calculation of adjusted average profits :

The adjusted profits of the business can be found out in the same manner as in the case of
average profits method.

Step 2 - Calculation of total value of the business :

The total value of the business can be found out with the help of the following formula:

Total value of the business = Adjusted average profits X 100

                                               Normal rate of return

Step 3 - Calculation of Goodwill:

The goodwill can be ascertained by deducting the net assets of the business (i.e., assets minus
liabilities) or capital employed from the total value of the business.

b. Capitalisation of Super profits

Under this method, the value of goodwill can be ascertained directly by capitalising its super
profits on the basis of Normal rate of return with the help of the following formula

Goodwill =  Super profits           X 100

                 Normal rate of return

ANNUITY METHOD -
The goodwill of a concern is ascertained by taking into account the present value of an
annuity for a certain number of years at a certain rate of interest. The super profits of the
business is multiplied by the present value of the rupee ascertained from the annuity tables.  

Goodwill of the firm = Super profits X Annuity value

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Valuation Of Goodwill – Problems
Problems based on Past Year’s Profits –

1. The profits of a limited company for past 6 years are as follows –

2001 30,000 2004 35,000

2002 35,000 2005 45,000
2003 25,000 2006 40,000

Calculate the value of Goodwill of the company if it is based on 3 years purchase of

the average profits of the 6 years.

2. The results of a limited company are given below for 5 years –

2001 28,000
2002 35,000
2003 15,000( loss)
2004 12,000( loss)
2005 27,000
Calculate the value of goodwill of the company if it is based on 4 years of the past 5 years
profits.

Capitalization Method

Simple Average Profit Method –

Steps to follow-

a. Calculate the average profits

b. Calculate the total value of the business i.e Average Profits /NRR
c. Calculate goodwill where-
Goodwill =(Total value of Business – Net worth) X No. of years of purchase

3. The net profits of a company for past 5 years are as follows –

2003 40,000
2004 45,000
2005 47,000
2006 40,000
2007 48,000

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The capital employed in the business is Rs. 4,00,000 on which a reasonable rate of return of
10% is expected. Calculate the value of goodwill on the basis of capitalization of simple
average profits method, if it is based on 3 years purchase.

When there are losses

4. The net result of a company for past 6 years are as follows –

2002 80,000 2005 1,05,000

2003 85,000 2006 1,15,000
2004 (30,000) 2007 1,25,000

The capital employed into the business is Rs. 2,50,000 on which a reasonable rate of return is
expected @12%. Calculate the value of goodwill of the company by capitalization of simple
average profit method if it is based on 4 years purchase.

5. The profits/losses of a company for the past 5 years are as follows –

2003 1,00,000
2004 1,20,000
2005 (40,000)
2006 (50,000)
2007 1,20,000

The networth of the business is Rs. 80,000 on which a reasonable rate of 14% is expected.
Calculate the value of goodwill of the company by capitalization of Simple average profit
method if it is based on 3 years purchase.

Capitalization Method – Adjusted Average Profit Method

Steps-

a. Find out the known values /given values in the problem

b. Calculate the adjusted average profits
c. Calculate the total value of business , where –

Total value of business = Adjusted Average profits

NRR

d. Calculate goodwill , where –

Goodwill = (Total value of Business – Networth) X No.
of years of Purchase

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 6. Y Co. Ltd is desirous of selling its business to another company .It has earned an
average profit of Rs. 1,60,000 p.a and the same amount of profit is likely to be earned
in the future also except that –
a. Director’s fees of Rs.12,000/- p.a will not be payable by the purchasing company
to the directors in future because the existing board of directors can manage the
new business themselves .
b. Rent of Rs. 28,000 p.a will not be payable by the purchasing company and is also
not to be incurred in the future as it has its own building .
c. The net assets of the company other than goodwill was estimated to be Rs.
18,00,000 /- and NRR in similar business is assumed to be 10% p.a .
Calculate the value of goodwill if it is based on 3 years purchase of the adjusted
average profits of the company .

7. ‘A’ company Ltd is interested to sell its business to S Company at capitalized value .
Average past profit of the company is Rs. 2,20,000 and the profits are likely to be
earned in a similar trend in future also except –
a. 3 directors salaries of Rs.20,000 each p.a will not be payable by S Co. ltd because
they themselves can manage the business .
b. A rent of Rs.5,000/- p.m is not to be payable by S Ltd as it has its own building .
c. The net valuation of ‘A’ company other than goodwill was estimated to be Rs.
21,00,000 and the NRR is 8% p.a .

Calculate the goodwill of A Ltd Company if it is based on 2 years purchase on the adjusted
average profits of the company .

Super Profits Method

Steps-

a. Calculate the adjusted average Profits

b. Calculate the average capital employed , where ,
Average Capital Employed= Net Worth -1/2 of Current years profit
c. Calculate Normal profits , where ,
Normal Profits= Average Capital Employed X NRR
d. Calculate the super profits , where,
Super Profits = Adjusted Average Profits – Normal Profits
e. Calculate Goodwill , where ,
Goodwill = Super Profits X Number of years of purchase

8. From the following particulars relating to relating to Mr. Vishwanath , calculate the
value of goodwill on the basis of 2 years purchase of super profits by taking into
consideration the average profits of the past 5 years .

Given data Rs.

Fixed Assets 6,50,000
Debtors 80,000

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 Stock 65,000
Other Current Assets 35,000
Creditors 20,000
Other Current Liabilities 1,00,000

The NRR in similar industries is 12% . The profits for the last 5 years are as follows –

Year Profit
1 1,60,000
2 1,55,000
3 1,40,000
4 1,50,000
5 1,60,000 (CY)

9. From the following information calculate the value of goodwill under super profits
method.

Average Capital Employed 6,00,000

Net Profits of the company for last 3 years before paying 50,000 p.a
manager’s remuneration

1 1,60,000
2 1,80,000
3 1,70,000

The NRR in similar industries is 12% . The total assets of the firm at a revised value
amounted to Rs. 7,50,000 and total liabilities amounted to Rs. 40,000 . Calculate the
value of goodwill at 3 years purchase .

10. The net profits of the business concern (after providing taxation @ 30%) for the past 5
years are as follows –

Year Profit
1 80,000
2 92,000
3 85,000
4 1,05,000
5 1,18,000

The average capital employed in a similar business is Rs. 8,00,000 and NRR is 10%.

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Calculate the value of goodwill on the basis of 5 years purchase of super profits . Also
calculate goodwill under capitalization of super profits method .

11. The adjusted average profits of the company for the last 4 years are calculated to be
Rs.20,000 , after adjusting the average managerial remuneration of Rs.5,000 p.a .
The NRR in similar industries is assumed to be 10% , the net capital invested into the
business is Rs. 80,000 /- . Calculate the value of goodwill on the basis of 3 years
purchase of super profits . Also calculate goodwill under capitalization of super
profits methods .

12. ( When Balance Sheet is given)

The B/S of Suman Company as on 31 Dec 2005

Liabilities Rs. Assets Rs.

Equity Share Capital (Rs. 5,00,000 Fixed Assets 4,00,000
10 per share )
General Reserve 2,00,000 Investments 1,00,000
P/L A/c 1,00,000 Current Assets 4,00,000
Current Liabilities 1,00,000

9,00,000 9,00,000

The net profit of the company after providing the taxation @ 30% for the past 3 years
are as follows –

2003 1,30,000
2004 1,25,000
2005 1,50,000

Goodwill is to be calculated at 4 years purchase of the average profits . The NRR is

15 % . The Current Assets revised value is Rs. 4,20,000. Ascertain the value of
goodwill under super profits method and capitalization of super profits method .

# Annuity Method

13. The net profits of a limited company after providing for taxation @ 20% for the past
5 years are as follows –

1 40,000
2 42,000
3 38,000
4 45,000
5 55,000

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The capital employed in the business is Rs. 4,00,000/- on which a reasonable rate of return of
10 % is expected . It is assumed that the company will earn super profits for next 5 years .

Calculate the value of goodwill on the basis of 6 years purchase of super profits taking into
account the present value of Re. 1 for 5 years @ 10% interest @ Rs. 3.78/-.

14. The net profits of a company before providing for taxation @ 25% for the past 5
years are as follows –

1 80,000
2 1,20,000
3 1,40,000
4 1,60,000
5 1,80,000
The capital employed in the business is Rs. 6,00,000 on which a reasonable rate of return of
10 % is expected . It is assumed that the company will earn super profits for the next 5 years .
Calculate the value of goodwill of the company on the basis of 4 years purchase of super
profits taking into a/c the present value of Re. 1 for 5 years @ 10% interest being Rs. 3.78/-.

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