ACCOUNTANCY

Valuation of Goodwill

Part 3: Capitalization Method and Final Summary

1. Concept of Capitalization Method

The Capitalization Method values goodwill by determining the amount of capital required to earn the current profits of the business, based on the Normal Rate of Return (NRR) in the industry. It essentially asks: "If we want to earn ₹X profit in this industry, how much capital should we normally have? If we are earning that profit with less capital, the difference is our Goodwill."

There are two distinct ways to apply this method:

• Capitalization of Average Profits Method
• Capitalization of Super Profits Method

Important Note: Theoretically, both capitalization sub-methods will yield the same value of goodwill if the base data (Average Profit and Capital Employed) remains consistent.

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2. Capitalization of Average Profit Method

Under this method, we calculate the "Capitalized Value" of the entire business and subtract the "Actual Capital Employed" (Net Assets) to find the goodwill.

The Formulas

Capitalized Value of Average Profit = (Average Adjusted Profit × 100) / Normal Rate of Return

Goodwill = Capitalized Value of Average Profit - Net Capital Employed Net Capital Employed = Total Assets (excluding goodwill & non-trade items) - Outside Liabilities

Numerical Demonstrations

Numerical 1: Capitalization of Average Profit (Easy)

Question: A firm earns an average profit of ₹ 60,000. The Normal Rate of Return is 10%. The Total Assets of the firm are ₹ 7,00,000 and Outside Liabilities are ₹ 2,20,000. Calculate Goodwill.

Solution:

1. Capitalized Value of Business: (60,000 × 100) / 10 = ₹ 6,00,000
2. Actual Capital Employed: 7,00,000 - 2,20,000 = ₹ 4,80,000
3. Goodwill: 6,00,000 - 4,80,000 = ₹ 1,20,000

Numerical 2: Capitalization of Average Profit (Very High Difficulty)

Question: From the following information, calculate goodwill.
• Average Profit of the firm: ₹ 2,40,000.
• Normal Rate of Return: 12%.
• Assets: ₹ 25,00,000 (Including ₹ 1,00,000 Non-Trade Investments and ₹ 50,000 Goodwill already in books).
• Liabilities: ₹ 6,00,000.
• Adjustments: Average profit was calculated after an abnormal gain of ₹ 20,000 and after charging ₹ 40,000 as annual management salary (previously ignored).

Solution:

Step 1: Calculate Adjusted Average Profit
Average Profit (Given): ₹ 2,40,000
Less: Abnormal Gain: (₹ 20,000)
Less: Management Salary: (₹ 40,000)
Adjusted Average Profit = ₹ 1,80,000

Step 2: Calculate Capitalized Value of Profit
(1,80,000 × 100) / 12 = ₹ 15,00,000

Step 3: Calculate Actual Capital Employed (Net Assets)
Total Assets: ₹ 25,00,000
Less: Non-Trade Investment: (₹ 1,00,000)
Less: Existing Goodwill: (₹ 50,000)
Less: Outside Liabilities: (₹ 6,00,000)
Net Assets = ₹ 17,50,000

Result Analysis:

In this specific scenario, Capitalized Value (₹15,00,000) is less than Actual Capital (₹17,50,000).
Goodwill = Nil. (The firm is earning less than the normal return on its actual investment).

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3. Capitalization of Super Profit Method

This method simply capitalizes the "Extra Profit" (Super Profit) earned by the firm. It is widely considered the fastest way to compute capitalization-based goodwill.

The Formula

Goodwill = (Super Profit × 100) / Normal Rate of Return Note: Super Profit = Adjusted Average Profit - Normal Profit

Numerical Demonstrations

Numerical 1: Capitalization of Super Profit (Easy)

Question: Super Profit of a firm is ₹ 20,000. The NRR is 10%. Calculate Goodwill.

Solution:

Goodwill = (20,000 × 100) / 10 = ₹ 2,00,000

Numerical 2: Master Problem (Difficulty: Very High)

Question: Average Profit of M/s ABC Traders: ₹ 3,00,000. Capital Employed: ₹ 18,00,000. NRR: 10%.
During 2023, the closing stock was undervalued by ₹ 20,000. There was an abnormal loss of ₹ 30,000 in 2022. The firm has a non-trade investment income of ₹ 10,000 included in the average profit. Calculate Goodwill by Capitalizing Super Profits.

Solution:

Adjustment Step	Calculation (₹)
Average Profit (Given)	3,00,000
(+) Undervaluation of Closing Stock	+20,000
(+) Abnormal Loss (2022) - Spread over average	+30,000
(-) Non-Trade Income	(10,000)
Adjusted Average Profit	3,40,000

1. Normal Profit: 18,00,000 × 10% = ₹ 1,80,000
2. Super Profit: 3,40,000 - 1,80,000 = ₹ 1,60,000
3. Goodwill: (1,60,000 × 100) / 10 = ₹ 16,00,000

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4. Summary Comparison of Methods

Method	Focus	Best Used When...
Average Profit	Past performance stability	Business is stable and future prospects are consistent with the past.
Super Profit	Extra earning capacity	Firm earns significantly more than industry competitors.
Capitalization	Investment value	Valuing the entire business as a financial asset or during mergers.

End of Series: Valuation of Goodwill

The valuation of goodwill is a blend of mathematical precision and professional judgment. While formulas provide the structure, the adjustments for abnormal items ensure that the valuation reflects the Future Maintainable Profits of the enterprise.

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