Methods of valuation of goodwill

Following are the methods generally followed to value goodwill:

1. Average profit method
Under this method, goodwill is calculated as certain years of purchase of average
profits of the past few years. The number of years of purchase is generally
determined on the basis of the average period a new business will take in order
to bring it to the current state of the existing business. It may also be determined
on the basis of the number of years for which the past average profit will be
earned in future.
While computing the average profit, in addition to rectification of errors, the
following adjustments are to be made:
Adjusted profit = Actual profit + Past expenses not required in the future – Past
revenues not likely to be earned in the future + Additional income expected in the
future – Additional expenses expected to be paid in the future
The average profit may be either simple average profit or weighted average
profit.
(a) Simple average profit method
Under this method, goodwill is calculated by multiplying the average profits by a
certain number of years of purchase. Simple average profit is calculated by adding
the adjusted profits of certain number of years by dividing the total number of
such years.
Goodwill = Average profit × Number of years of purchase
Average profit = Total profit / Number of years
Illustration 1
The following are the profits of a firm in the last five years:
2014: ₹ 4,000; 2015: ₹ 3,000; 2016: ₹ 5,000; 2017: ₹ 4,500 and 2018: ₹ 3,500
Calculate the value of goodwill at 3 years purchase of average profits of five years.
Solution
Goodwill = Average profit × Number of years of purchase
Goodwill = Average profit × Number of years of purchase
= 4,000 × 3 = ₹ 12,000

Illustration 2
The profits and losses of a firm for the last four years were as follows:
2015: ₹ 15,000; 2016: ₹ 17,000; 2017: ₹ 6,000 (Loss); 2018: ₹ 14,000
You are required to calculate the amount of goodwill on the basis of 5 years purchase
of average profits of the last 4 years.
Solution
Goodwill = Average profit × Number of years of purchase
Average profit = Total profit / Number of years
Goodwill = Average profit × Number of years of purchase
= 10,000 × 5 = ₹ 50,000
Illustration 3
A partnership firm has decided to value its goodwill for the purpose of settling a retiring partner.
The profits of that firm for the last four years were as follows:
2015: ₹ 40,000; 2016: ₹ 50,000; 2017: ₹ 48,000 and 2018: ₹ 46,000
The business was looked after by a partner. No remuneration was paid to him. The fair
remuneration of the partner valued at comes to ₹ 6,000 per annum.
Find out the value of goodwill, if it is valued on the basis of three years purchase of the average
profits of the last four years.
Solution
Goodwill = Average profit × Number of years of purchase
= 40,000 × 3 = ₹ 1,20,000

Illustration 4
From the following information relating to Arul enterprises, calculate the value of goodwill on the
basis of 2 years purchase of the average profits of 3 years.
a) Profits for the years ending 31st December 2016, 2017 and 2018 were ₹ 46,000, ₹ 44,000
and ₹ 50,000 respectively.
b) A non-recurring income of ₹ 5,000 is included in the profits of the year 2016.
c) The closing stock of the year 2017 was overvalued by ₹ 10,000.
Solution
Calculation of adjusted profit
Tutorial note: Over valuation of closing stock in 2017 will result in over valuation of opening stock
in 2018
Goodwill = Average profit × Number of years of purchase = 45,000 × 2 = ₹ 90,000
 Illustration 5
The following particulars are available in respect of a business carried on by a
partnership firm:
a) Profits earned: 2016: ₹ 30,000; 2017: ₹ 29,000 and 2018: ₹ 32,000.
b) Profit of 2016 includes a non-recurring income of ₹ 3,000.
c) Profit of 2017 is reduced by ₹ 2,000 due to stock destroyed by fire.
d) The stock is not insured. But, it is decided to insure the stock in future. The
insurance premium is estimated at ₹ 5,600 per annum.
You are required to calculate the value of goodwill on the basis of 2 years purchase of
average profits of the last three years.
Solution
(a) Calculation of adjusted profit
Goodwill = Average profit × Number of years of purchase
= 24,400 × 2
= ₹ 48,800
(b) Weighted average profit method
Under this method, goodwill is calculated by multiplying the weighted average profit by a certain
number of years of purchase.
Goodwill = Weighted average profit × Number of years of purchase
In this method, weights are assigned to each year’s profit. Weighted profit is ascertained by
multiplying the weights assigned with the respective year’s profit. The sum of the weighted
profits is divided by the sum of weights assigned to determine the weighted average profit.
Weighted average profit = Total of weighted profits / Total of weights

This method is used when the profits show an increasing or decreasing trend. More weight is
generally given to the profits of the recent years.
Illustration 6
For the purpose of admitting a new partner, a firm has decided to value its goodwill at 3 years purchase of the average profit of the last 4 years using weighted average method. Profits of the past 4 years and the respective weights are as follows:

Compute the value of goodwill.

Solution
Calculation of weighted average profit

Goodwill = Weighted average profit × Number of years of purchase

= 24,800 × 3 = ₹ 74,400
2. Super profit methods
Under these methods, super profit is the base for calculation of the value of goodwill. Super
profit is the excess of average profit over the normal profit of a business.
Super profit = Average profit – Normal profit
Average profit is calculated by dividing the total of adjusted actual profits of certain number of
years by the total number of such years. Normal profit is the profit earned by the similar business
firms under normal conditions.
Normal profit = Capital employed × Normal rate of return
Capital employed = Fixed assets + Current assets – Current liabilities
Normal rate of return = It is the rate at which profit is earned by similar business entities in the
industry under normal circumstances.
(a) Purchase of super profit method
Under this method, goodwill is calculated by multiplying the super profit by a certain number of
years of purchase.
Goodwill = Super profit × Number of years of purchase

Illustration 7
From the following information, calculate the value of goodwill based on 3 years purchase of
super profit
i. Capital employed: ₹ 2,00,000
ii. Normal rate of return: 15%
iii. Average profit of the business: ₹ 42,000
Solution
Normal profit = Capital employed × Normal rate of return
= 2,00,000 × 15% = ₹ 30,000
Super profit = Average profit – Normal profit
= 42,000 – 30,000
= ₹ 12,000
Goodwill = Super profit × Number of years of purchase
= 12,000 × 3
= ₹ 36,000
Illustration 8
Calculate the value of goodwill at 5 years purchase of super profit from the following information:
(a) Capital employed: ₹ 1,20,000
(b) Normal rate of profit: 20%
(c) Net profit for 5 years:
2014: ₹ 30,000; 2015: ₹ 32,000; 2016: ₹ 35,000; 2017: ₹ 37,000 and 2018: ₹ 40,000
(d) Fair remuneration to the partners ₹ 2,800 per annum.

Solution (p.t.o)
Normal profit = Capital employed × Normal rate of return
= 1,20,000 × 20%
= ₹ 24,000
Super profit = Average profit – Normal profit
= 32,000 – 24,000
= ₹ 8,000
Goodwill = Super profit × Number of years of purchase
= 8,000 × 5
= ₹ 40,000
(b) Annuity method
Under this method, value of goodwill is calculated by multiplying the super profit with the
present value of annuity.
Goodwill = Super profit × Present value annuity factor
Present value annuity factor is the present value of annuity of rupee one at a given time. It
can be found out from annuity table or by using formula.
illustration 9
From the following information, compute the value of goodwill as per annuity method:
(a) Capital employed: ₹ 50,000
(b) Normal rate of return: 10%
(c) Profits of the years 2016, 2017 and 2018 were ₹ 13,000, ₹ 15,000 and ₹ 17,000
respectively.
The present value of annuity of ₹ 1 for 3 years at 10% is ₹ 2. 4868.
Solution
Average profit = Total profit / Number of years
= 13,000 + 15,000 + 17,000 / 3
= 45,000/3
= ₹ 15,000
Normal profit = Capital employed × Normal rate of return = 50,000 × 10% = ₹ 5,000
Super profit = Average profit – Normal profit = 15,000 – 5,000
= ₹ 10,000
Goodwill = Super profit × Value of annuity = 10,000 × 2.4868 = ₹ 24,868
c. Capitalisation of super profit method
Under this method, value of goodwill is calculated by capitalising the super profit at normal rate
of return, that is, goodwill is the capitalised value of super profit.
Goodwill = [ Super profit / Normal rate of return ] × 100

Illustration 10
From the following information, compute the value of goodwill by capitalising super profit:
a) Capital employed is ₹ 4,00,000
b) Normal rate of return is 10%
c) Profit for 2016: ₹ 62,000; 2017: ₹ 61,000 and 2018: ₹ 63,000
Solution
Average profit = Total profit/Number of years
= [62,000 + 61,000 + 63,000] /3
= ₹ 62,000
Normal profit = Capital employed × Normal rate of return
= 4,00,000 × 10%
= ₹ 40,000
Super profit = Average profit – Normal profit
= 62,000 – 40,000
= ₹ 22,000
Goodwill = Super profit/Normal rate of return x 100
= 22,000/10 x 100
= ₹ 2,20,000
3. Capitalisation method
Under this method, goodwill is the excess of capitalised value of
average profit of the business over the actual capital employed
in the business.
Goodwill = Total capitalised value of the business – Actual capital
employed
The total capitalised value of the business is calculated by
capitalising the average profits on the basis of the normal rate of
return.
Capitalised value of the business = [ Average profit / Normal rate
of return ] x 100
Actual capital employed = Fixed assets (excluding goodwill) +
Current assets – Current liabilities
Illustration 11
From the following information, find out the value of goodwill by
capitalisation method:
(a) Average profit = ₹ 60,000
(b) Normal rate of return = 10%
(c) Capital employed = ₹ 4,50,000
Solution
Total capitalised value of the average profit = [ Average profit / Normal rate of
return ] x 100
= 60,000 / 10 = x 100
Goodwill = Total capitalised value of the average profit – Capital employed
= 6,00,000 – 4,50,000
= ₹ 1,50,000