Reconstitution of a Firm

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Q.1. What do you mean by Goodwill? What are the different methods of calculating goodwill? Discuss every method with suitable examples. (CBSE 1982,85,87,88,89,98; All India 1986,1990)

Answer: Goodwill is a thing which is not so easy to describe but in general words good-name, reputation and wide business connection which helps the business to earn more profits than the profit could be earned by a newly started business. The monetary value of the advantage of earning more profits is known as goodwill. Goodwill is an attractive force, which brings in customers to old place of business. Goodwill is an intangible but valuable asset. In a profitable concern it is not a fictitious asset.

Prof. Dicksee has defined goodwill as " When a man pays for goodwill, he pays for something which places him in the position of being able to earn more than he would be able to do by his own unaided efforts."

According to J. O. Magee " The capacity of a business to earn profits in future is basically what is meant by the term goodwill."

According to Lord Lindley " The term goodwill is generally used to denote benefit arising from connections and reputation."

Lord Eldon has defined goodwill as " Goodwill is nothing more than the probability, that the old customers will resort to the old place."

In the words of Lord Macnaghten, " Goodwill is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connections of a business. It is the attractive force, which brings in customers. It is one thing which distinguishes an old established business from a new business at its first start."

In the words of Dr. Canning, "Goodwill is the present value of a firm’s anticipated excess earnings."

Methods of Valuation of Goodwill

The following are the methods of valuation of goodwill of a firm: -

  1. Average Profit Method
  2. Weighted Average Profit Method
  3. Super Profit Method
  4. Capitalization of Average Profit Method
  5. Capitalization of Super Profit Method
  6. Present Value of Super Profits Method

1. Average Profit Method: Under this method goodwill is calculated on the basis of the average profit of previous years. The average profit is multiplied by the number of year’s purchase.

Goodwill = Average Profit x Number of Years Purchase

Example: Calculate goodwill at twice the average profits of last four years’ profits. The profits of the last four years were:

  1. Rs. 27,000
  2. Rs. 39,000
  3. Rs. 16,000 (Loss)
  4. Rs. 40,000

Solution: Total Profit for last four years = Rs. 27,000+ Rs. 39,000-Rs. 16,000+Rs. 40,000 = Rs. 80,000

Average Profit = Rs. 80,000/4 = Rs. 20,000.

Goodwill = Rs. 20,000 x 2 = Rs. 40,000.

2. Weighted Average Profit Method: This method is a modified version of the average profit method. Under this method the respective number of weights i.e. 1,2,3,4 multiplies profit of every year, in order to find out value product and the total of products is then divided by the total of weights in order to ascertain the weighted average profits.

Goodwill = Weighted Average Profits x No. of years Purchase

Weighted Average Profit = Total of Products of Profits/ Total of Weights

Example: Calculate goodwill at twice the weighted average profits of last four years’ profits. The profits of the last four years were:

2001. Rs. 37,000
2002. Rs. 29,000
2003. Rs. 26,000
2004. Rs. 40,000

Solution:

Years

Profits

Rs.

Weight

Product

Rs.

2001

37,000

1

37,000

2002

29,000

2

58,000

2003

26,000

3

78,000

2004

40,000

4

1,60,000

Total

 

10

3,33,000

Weighted Average Profit = Rs. 3,33,000/10 = Rs. 33,300

Goodwill = Rs. 33,300 x 2 = Rs. 66,600

 




3. Super Profit Method:
When the actual profit is more than the expected profit or normal profit of a firm, it is called ‘Super Profit.’ Under this method goodwill is to be calculate of on the following manner:

Goodwill = Super Profit x Number of Years Purchase

Example: The books of a business showed that the capital employed on January 1, 2001 was Rs. 4,50,000 and the profits for the last five years were as follows: 2001-Rs. 40,000; 2002 -Rs. 50,000; 2003 - Rs. 60,000; 2004 -Rs. 70,000 and 2005 -Rs. 80,000.

You are required to find out the value of goodwill, based on three years’ purchase of the super profit of the business given that the normal rate of return is 10%.

Solution: Total Profit of last five years = Rs. 40,000 + Rs. 50,000 + Rs. 60,000 + Rs. 70,000 + Rs. 80,000 = Rs. 3,00,000

Average Profit = Rs. 3,00,000/5 =Rs. 60,000

Normal Profit = Rs. 4,50,000 x 10/100 = Rs. 45,000

Super Profit = Actual/Average Profit – Normal Profit

Super Profit = Rs. 60,000 – Rs. 45,000 = Rs. 15,000

Goodwill = Rs. 15,000 x 3 = Rs. 45,000.

4. Capitalization of Average Profit Method: Under this method goodwill is difference between the total Capitalized value of the firm and the net assets of the firm.

Goodwill = Capitalized Value the firm – Net Assets

Capitalized Value of the firm = Average Profit x 100/ Normal Rate of Return

Net Assets = Total Assets – External Liabilities

Example: A firm earns Rs. 65,000 as its average profits. The usual rate of earning is 10%. The total assets of the firm amounted to Rs. 6,80,000 and liabilities are Rs. 1,80,000. Calculate the value of goodwill.

Solution : Total Capitalized value of the firm = Rs. 65,000 x 100/10 = Rs. 6,50,000

Net Assets = Rs. 6,80,000 – Rs. 1,80,000 = Rs. 5,00,000

Goodwill = Total Capitalized value of the firm – Net Assets

Goodwill = Rs. 6,50,000 – Rs. 5,00,000 = Rs. 1,50,000.

5. Capitalization of Super Profit Method:

  1. Calculate Capitalized value of the firm
  2. Calculate required profit on capital employed by using the following formula:
  3. Normal Profit = Capital Employed x Required Rate of Return/100

  4. Calculate average profit
  5. Calculate super profit

Goodwill = Super Profit x 100/Normal Rate of Return

Example: Verma Brothers earn a profit of Rs. 90,000 with a capital of Rs. 4,00,000. The normal rate of return in the business is 15%. Use Capitalization of super profit method to value the goodwill.

Solution:

Normal Profit = Rs. 4,00,000 x 15/100 = Rs. 60,000

Super Profit = Rs. 90,000 – Rs. 60,000 = Rs. 30,000

Goodwill = Super Profit x 100/Normal Rate of Return

= Rs. 30,000 x 100/15 = Rs. 2,00,000

6. Present Value of Super Profit: Under this method, goodwill is estimated as the present value of the future super profits. The following steps are taken:

  1. Calculate the future super profits for next years
  2. Choose the required rate of return
  3. Calculate present value factors
  4. Multiply present value factors with future super profits
  5. The sum of product of present value factors and super profits is the value of goodwill.

Example: A firm has the forecasted profits for the coming 4 years as follows:

Years

Profits

Rs.

1

80,000

2

1,00,000

3

90,000

4

1,20,000

The total assets of the firm are Rs. 9,00,000 and outside liabilities are Rs. 3,00,000. The present value factors at 10% are as follows:

Years

Present Value Factor

1

.9279

2

.8029

3

.7056

4

.6978

Calculate the Value of goodwill.

Solution:

Net Assets = Total Assets – Liabilities

= Rs. 9,00,000 – Rs. 3,00,000

= Rs. 6,00,000

Normal Profit = 10/100 x Rs. 6,00,000 = Rs. 60,000

Years

1

2

3

4

Profits (Rs.)

80,000

1,00,000

90,000

1,20,000

Normal Profit

60,000

60,000

60,000

60,000

Super Profit

20,000

40,000

30,000

60,000

Present Value Factor

.9279

.8029

.7056

.6978

Present Value of Super Profit

18,558

32,116

21,168

41,868

Goodwill = Rs. 18,558 + Rs. 32,116 + Rs. 21,168 + Rs. 41,868 = Rs. 1,13,710.


 

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