VALUATION OF GOODWILL
. Methods for Valuation of Goodwill:
Capitalisation Method
Super Profits Method
Annuity Method
Capitalization Method Steps:
o Future Maintainable Profits (FMP)
o Normal Rate of Return (NRR)
o Normal Capital Employed (NCE = FMP/NRR)
o Actual Capital Employed (ACE)
o Goodwill = NCE – ACE
Super Profits Method Steps:
o Average Capital Employed (Avg CE)
o NRR
o Normal Profits (NP = Avg CE x NRR)
o FMP
o Super Profits (SP = FMP – NP)
o Goodwill = SP x No of Years
Annuity Method Steps:
o SP
o Goodwill = SP x Annuity Factor
II. Capital Employed:
Liabilities Side Approach = Equity Share Capital + Reserves and Surplus – Non Trading Assets – Misc Expenditure (+/-) Adjustments in values of Assets or Liabilities
Assets Side Approach = Total Assets (Excld Misc Expenditure and Non Trading Assets) – Outside Liabilities – Preference Share Capital
Notes:
o Non Trading assets shall be excluded (Investments mentioned in the balance sheet shall be excluded, if nothing is mentioned assume it as non trading investments. If nothing is given regarding purchase date of investment it is assumed it is purchased at the beginning of the year.
o Asset must be taken at current cost. If nothing is mentioned take value given in the balance sheet.
o If we already have goodwill in balance sheet that shall be excluded.
o Proposed dividend is not an outside liability whereas preference dividend is an outside liability. (Appearing in Balance Sheet)
o Dividend Paid last year if there is no proposed dividend then the dividend paid shall be taken into consideration for capital employed.
o Sinking Fund is a part of Reserves and Surplus
o Workmen’s Compensation fund is a part of Shareholders fund.
o Preference shares are treated as cumulative and non-participating if nothing is mentioned
o Unclaimed dividend is considered as outside liability it is different from proposed dividend.
o If the profits for past and profits for future are given we have to take profits of future for FMP. And less weightage shall be allotted to future profits.
o Gratuity fund, workmen’s compensation fund is a outside liability.
o Capital Employed for Long term funds = Capital Employed as calculated above + Loans and Preference Share Capital
o Difference in Balance sheet is outside liability if it appears on liability side and assets if vice versa.
III. Average Capital Employed:
o If two balance sheets are given
= Closing Capital Employed + Opening Capital Employed
2
o If more than 2 years are given calculate first for two balance sheets then take consolidated average of all.
o If only one balance sheet is given then
= Closing Capital Employed – ½ of Current Year Profit
IV. Normal Rate of Return:
o Without taking any risk the return we get.
o Last year dividend paid % is given in the problem along with the closing market price then we have to calculate NRR as follows:
FV * Dividend Rate %
MP
o If average price is given instead of the market price then average dividend rate shall be used to calculate NRR
V. Future Maintainable Profits:
o Calculate average profits of past years which represent tomorrow (futures); if there is a trend in profits (it is better to take trend in profit % on sales if sales is also given) take weighted average, otherwise simple average.
o Only Net Operating Profit shall be taken into consideration i.e. profit available to Equity Shareholders.
o Only Profits of Normal Years shall be taken into consideration i.e. abnormal transactions shall be eliminated.
o We have to adjust future likely expenses / income / tax rate.
o If direct profits not given increase in general reserve balance can be taken as profit.
o If profits of past and profits for future are given we have to take profits of future for FMP and less weightage shall be given for more future.
VI. Leverage effect:
o If goodwill of Long Term Funds is lower than that of Shareholders fund then it is a favorable leverage effect.
General Notes:
o Any contention asked in problem regarding doubtful of goodwill try all methods for valuation of goodwill.
o If nothing is mentioned in the problem calculate super profits method.
o Capitalization method is more appropriate if capital is important factor. (i.e. Conversion of Pvt into public)
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