Sneha.docx

TOPIC GOODWILL VALUATION

SUBMITTED BY: Sneha Ajay Nair ROLL NO: TAF18018 CLSS BACOLER OF COMMERCE (ACCOUNTING AND FINANCE) SEMESTER 6 SUBMITTEDT TO: UNIVERSITY MUMBAI PROJECT GUIDE: PROF: MR GHANSHYAM LAKHANI S. I. C. E. SOCIETY’ S DEGREE COLLECE OF ARTS, SCIENCE AND COMMERCE JAMBHUL PHATA, CHIKHLOLI AMBERNATH (WEST) MUMBAI - 400 064

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DECLARATION

I MS. SNEHA AJAY NAIR ROLL NO: TAF 18018 of S. I. C. E. SOCIETY’ S DEGREE COLLECE OF ARTS, SCIENCE AND COMMERCE BACHELOR OF COMMERCE (ACCOUNTING AND FIANANCE) (semester6) as complete project “VALUATION OF SHARES AND GOODWILL FOR BUSINESS VALUATION” in the academic year 2018-19 .This information submitted is original and true to the best of my knowledge.

DATE: SIGNATURE OF STUDENT

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Certifite This is to certify that Ms/Mrs. SNEHA AJAY NAIR has worked and duly completed her/his Project Work for the degree of Bachelor in Commerce (Accounting & Finance) under the Faculty of Commerce in the subject of ________________________________________ and her/his project is entitled, “VALUATION OF SHARES AND GOODWILL FOR BUSSINESS VALUATION ” under my supervision. I further certify that the entire work has been done by the learner under my guidance and that no part of it has been submitted previously for any Degree or Diploma of any University. It is her/ his own work and facts reported by her/his personal findings and investigations.

Name and Signature of Guiding Teacher

Project co -ordinate: College seal Date of submission:

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Declaration of learner I the undersigned Miss / Mr. SNEHA AJAY NAIR here by, declare that the work embodied in this project work titled “VALUATION OF SHARES AND GOODWILL FOR BUSSINESS VALUATION”, forms my own contribution to the research work carried out under the guidance of ________________________________ is a result of my own research work and has not been previously submitted to any other University for any other Degree/ Diploma to this or any other University. Wherever reference has been made to previous works of others, it has been clearly indicated as such and included in the bibliography. I, here by further declare that all information of this document has been obtained and presented in accordance with academic rules and ethical conduct.

Name and Signature Of the student

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ACKNOWLEDGEMENT I would like to thank the University of Mumbai in my college forgiving me this opportunity for taking such a challenging project, which has enhanced my knowledge about “VALUATION OF SHARES AND GOODWILL FOR BUSSINESS VALUATION” I express my sincere gratitude the principal, course ordinate Guide PROF. GHANSHYAM LAKHANI and our librarian and other teachers for their constant support and helping for completing the project . I am also grateful to my friend for giving support in my project .Lastly , I would like to thank each and every person who helped me in completing the project especially my parents . ‘ NO ENDEAVOUR ACHIEVES SSUCESS WITHOUT THE ADVICE & COOPERATION OF OTHER “

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Executive summary Reputation, image, prestige, and goodwill are concepts used by different disciplines, e.g., economics, marketing, sociology, and accounting, to denote the general standing of organizations among their counterparts. In this paper, the various concepts are reviewed and compared in terms of semantics, organizational cost, determinants, and implications, among others. An interdisciplinary, multiconstituency framework of organizational standing is developed, and research propositions are delineated. The valuation of goodwill assumed even grayer important whit the advent of the corporate intangible fixed assets 1 April 2002, which in many cases enables a newly incorporated business to claim a tax deduction on the amortization of goodwill. In most valuation analyses, goodwill includes concepts from both the income definition. Financial advisers sometimes identify and value goodwill collectively as the total intangible value of a business entity .in this

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Index Chapter No. 1

Title of the Chapter Introduction What is valuation Need of valuation goodwill Definition Some definition of goodwill Meaning of goodwill

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Calculation of goodwill This reputation will depend on Need of valuation of goodwill Key factor affecting of goodwill Accounting of goodwill Feature of goodwill Types of good will ( a ) purchase goodwill ( b ) non purchase \inherent goodwill Factor affecting of goodwill Important of goodwill Method of goodwill

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INTRODUCTION A firms’ reputation of generally assessed by Goodwill earned by the firm during its tenure. The Goodwill has been defined by many, but no one has given a crystal clear definition.” Goodwill” is generally used in business world, to access the value of a firm. It an intangible, invaluable asset. A business, which has earned a good reputation during its tenure, gets credit of “Goodwill”. The people are started trusting in the products or services of that firm. It is a common notion that if a firm is a profitable one it is valued high and in turn attracts goodwill. Now we can say that the reputation of a firm coupled with its going profitability represents “Goodwill”. But goodwill can be realized and quantified in money’s worth when the firm is disposed off. Valuation of shares is the process of knowing the value of company shares. Share valuation is done based on quantitative techniques and share value will vary depending on the market demand and supply. The share price of the listed companies which are traded publicly can be known easily. But private companies whose shares are not publicly traded, valuation of shares is really important and challenging. Every asset, financial as well as real, has a value. The key to successfully investing in and managing these assets lies in understanding not only what the value is, but the sources of the value. Every asset can be valued, but some assets are easier to value than others, and the details of valuation will vary from case to case. Thus, valuing of a real estate property will require different information and follow a different format than valuing a publicly traded stock. What is surprising; however, is not the difference in techniques across assets, but the degree of similarity in the basic principles of valuation. There is uncertainty associated with valuation. Often that uncertainty comes from the asset being valued, though the valuation model may add to that uncertainty.

What is valuation? A valuation is an estimate of how much a business, property, antique or any asset is worth. If you have a business and seek funding from investors, they will need to know how much your enterprise is worth. This is achieved through a valuation – an estimate of your company’s overall worth. Many different techniques may be used to determine something’s value. An expert who is making a valuation of a company will look at its management, its capital structure, the market value of its assets, and its outlook (prospect of future earnings). In the world of business and finance, items that are typically valued are financial assets, such as stocks, options, commercial enterprises, patents, or trademarks. Valuations may also be carried out on liabilities, such as the bonds issued by a company. 8

Here are 5 benefits of getting a business valuation. 1. Better Knowledge of Company Assets It is significantly important to obtain an accurate business valuation assessment. Estimates are not acceptable as it is a generalization. Specific numbers need to be gained from valuation processes so that business owners can obtain proper insurance coverage, know how much to reinvest into the company, and how much to sell your company for so that you still make a profit.

2. Understanding of Company Resale Value If you are contemplating selling your company, knowing its true value is necessary. This process should be started far before the business goes up for sale on the open market because you will have an opportunity to take more time to increase the company's value to achieve a higher selling price. As a business owner, you should know what your company's valuation is. You also need to be aware of what your company's resale value really is in order to negotiate a higher selling price. Use black and white statistics, provided by a valuation firm, to solidify your stance on the higher selling price. A. Neumann & Associates, LLC CEO Achim Neumann said, "We are approached by business owners to have the value of their business determined two to four years prior to its contemplated sale."

3. Obtain a True Company Value You may have a general idea of what your business is worth, based upon simple data such as stock market value, total asset value and company bank account balances. But, there is much more to business valuations than those simple factors. Work with a reputable valuations company to ensure that the correct numbers are provided. Knowing the true value of your company is often a deciding factor if selling the business becomes a possibility. It also helps to show company income and valuation growth over the course of the previous five years. Potential buyers like to see that a company has seen regular, consistent growth as it ages.

4. Better During Mergers/Acquisitions If a major company asks about purchasing your company, you have to be able to show them what the value is as a whole, what its asset withholdings are, how it has grown, 9

and how it can continue to grow. Major corporations will attempt to acquire your business or merge with it for as little money as possible. When you know what your business valuation really is, you are able to negotiate your way to the appraised valuation numbers provided by a well-known and reputable valuation determination service. If you are offered less for your company than it is shown to be worth, reject the deal or offer to enter negotiation mediation. It will help both sides come to a comfortable agreement.

5. Access to More Investors When you seek additional investors to fund company growth or save it from financial disaster, the investor is going to want to see a full company valuation report. You should also provide potential investors with a valuation projection based upon their provided funding. Investors like to see where their money is going and how it is going to provide them with a return on the investment. You are more likely to gain the attention of a potential investor when they can see that their funds will carry the company to the next level, increase its value, and put more money back into their own products.

shares Putting your money into shares can seem daunting if you’re a newcomer to stockmarket investing. This essential introduction to shares lays bare the basics to help you understand exactly what’s involved. Buying company shares can be exciting. As a shareholder, you will have a stake in the company you’ve invested in and you have a right to vote supporting or criticising directors’ decisions. If the company performs well, you should receive an income in the form of dividend payouts. And, over time, there is the potential for further returns from the growth in the share’s value though, of course, they could fall in value. Here’s what you need to know about investing in shares.

What are shares? Companies issue shares as a means to raise money. This may be to finance company expansion, a new development, or to move into overseas markets. When you buy shares, you effectively become a part owner of the company. The bigger the investment you make, the bigger your stake will be in the company.

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In the world of business and finance, items that are typically valued are financial assets, such as stocks, options, commercial enterprises, patents, or trademarks. Valuations may also be carried out on liabilities, such as the bonds issued by a company.

Here are 5 benefits of shares:1.

Shares go up in price, and also down. If you buy shares at a high price and the market falls, you may lose money. But if you buy more shares and the price goes up, you’ll make money on the share market.

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‘Get rich slow’ should be the share investor’s motto. Shares have an excellent long-term track record of generating wealth. If you choose your shares wisely, they’ll build your wealth better than almost any other asset — if you invest for the long term.

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Shares are a risky investment. Because shares generally produce a better return than other assets, they carry more risk, mainly because they’re more volatile in price. Using shares as a short-term gamble can give some big wins, but this strategy is fraught with danger.

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Shares provide the best return on investment. You take an added risk by holding shares because they provide better returns than other investments. Investment is about creating wealth first, and then using that wealth to fund your retirement. You need the capital gains that shares can bring.

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Shares need time to increase in value. With enough time and diversification (buying a range of shares spread across the economy), you’re unlikely to lose on the share market. If you’re impatient, and you’re not well diversified, you can easily lose money in shares.

The shares which can be issued by a company, are of two types:1. Preference Shares 2. Equity Shares.

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1. Preference Shares: The Preference Shares are those which have some preferential rights over the other types of shares. A share to be preference share, must have two preferential rights (a) They have a preferential right to be paid dividend during the life-time of the company. (b) They have a preferential right to the return of capital when the Company goes into liquidation.

Features of a Preference Share: 1. It has preferential rights to dividends at a fixed rate. 2. It has cumulative rights to dividends. 3. It has preferential rights to assets of the company in the case of liquidation. 4. It is redeemable after the expiry of a period of ten years from the date of its issue. 5. It can be purchased or sold in a stock exchange at a price above or below its face value. 6. It has no voting power. 7. It may or may not be converted into equity share(s).

The Preference Shares are of the following types: (a) Cumulative Preference Shares: The dividend payable on these shares goes on accumulating till it is fully paid off. If dividend at the fixed rate cannot be paid in any year due to inadequate profits, arrears of dividends will accumulate and will have to be paid out of profits of future years. The arrears of dividend shall be paid before anything is paid out of profits to the holders of any other class of shares. This type of shareholders have a right to claim a fixed percentage as dividend every year. Preference shares are always cumulative unless otherwise stated.

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(b) Non-Cumulative Preference Shares: These shares get preference in the matter of payment of dividend at a fixed rate in any year, only if there is any profit available for distribution in that year. The right to claim dividend will lapse if there are no sufficient profits in a particular year. Shareholders cannot claim arrears of dividends of any year out of the profits of the subsequent years. That is, if the dividend is not paid, it cannot be carried forward.

(c) Participating Preference Shares: These shares are not only entitled to a fixed rate of dividend, but also to a share in the surplus profits which remain after the claims of the equity shareholders. This type of right should be expressly provided in the Article of Association.

(d) Non-Participating Preference Shares: The holders of these shares are entitled to a fixed dividend and not in the surplus profits. If the Articles and Memorandum are silent and there is no clear provision in the terms of issue of these shares, all preference shares are deemed to be non-participating preference shares.

(e) Convertible Preference Shares: The holders of these shares have a right to get their preference shares converted into equity shares within a certain period.

(f) Non-Convertible Preference Shares: When a share cannot be converted into equity share then it is said to be non-convertible preference share.

(g) Redeemable Preference Shares: Ordinarily, the amounts paid on the shares are not redeemable (refundable) except when the company goes into liquidation. If a company is authorised by its Articles of Association, it may issue redeemable preference shares. Such shares are issued for a fixed term, and they are paid off after the expiry of the term.

(h) Irredeemable Preference Shares: Share, which cannot be redeemed during the life time of the company is known as irredeemable preference share.

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2. Equity Shares: Equity shares, with reference to any company limited by shares, are those which are not preference shares [(Sec. 85(2)]. Equity shares are also known as Ordinary Shares. These types of shares do not enjoy any preferential rights. Generally, rate of dividend is not fixed on equity shares. The rate of dividend may vary from year to year, depends upon the profits of the company. If profits are insufficient, equity shareholders may not get any dividend at all. On the other hand, they usually stand to receive a relatively higher return in the years of prosperity when the business is good and profits are large. The rate of dividend is determined by the Directors of the company.

Features of an Equity Share: 1. It is a part of the capital of the company. 2. It can be purchased or sold in a stock exchange. 3. It has no cumulative rights to dividends. 4. It can vote in the election of directors. 5. It can take part in the making of certain important company decisions. 6. It can participate in the profits of the company. 7. It can purchase a proportionate part of future share issues (i.e., rights issue). 8. It has the right to share in assets upon liquidation. 9. On winding up, the shareholders will receive surplus, after all obligations are met.

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GOODWILL Goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rate of profits. The implication of the term over and above is that there is always a certain normal rate of profits earned by similar firms in the same locality. The excess profit earned by a firm may be due to its location advantage, better customer service, possession of a unique patent right, personal reputation of the partner or for similar other reasons. G is for genial, a pleasing personality. O is for openness, it's refreshing! D is for dashing, the romantic you! W is for willing, to go the extra mile I is for intuitive, others should trust your instincts L is for lucky, who is more? L is for life, that you live so well. Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill. 15

What is goodwill ? In accounting, goodwill is an intangible asset associated with a business combination. Goodwill is recorded when a company acquires (purchases) another company and the purchase price is greater than 1) the fair value of the identifiable tangible and intangible assets acquired, minus 2) the liabilities that were assumed.

Outside of accounting, goodwill might be referring to some value that has been built up within a company as a result of delivering amazing customer service, unique management, teamwork, etc. However, this goodwill is unrelated to a business combination and cannot be recorded or reported on the company's balance sheet.

Benefit of goodwill It is the benefit and advantage of good name, reputation and connection of a business. It is the attractive force which brings in more customers. ... “Goodwill is a nebulous term for that part of the value of an asset or business arising from factors and directly associated with the assets or business as such.

Definition Valuation A valuation is the process of determining the fair market value of a company in a notional context, meaning that the valuation is a) time specific, b) there is no negotiation, and c) there is no exposure to the open market. Valuations are highly subjective calculations that aim to determine the fair market value of a company. There are many common situations when valuations are required, including business reorganizations, expropriations, employee share or stock option plans (ESOPs), mergers and acquisitions (M&A), and shareholder disputes.

Shares A unit of ownership that represents an equal proportion of a company's capital. It entitles its holder (the shareholder) to an equal claim on the company's profits and an equal obligation for the company's debts and losses. Two major types of shares are (1) ordinary shares (common stock), which entitle the shareholder to share in the earnings of the company as and when they occur, and to vote at the company's annual general meetings and other official meetings, and (2) preference shares (preferred stock) which entitle the shareholder to a fixed income 16

(interest) but generally do not give him or her voting rights.

Goodwill Goodwill is a long-term (or noncurrent) asset categorized as an intangible asset. Goodwill arises when a company acquires another entire business. The amount of goodwill is the cost to purchase the business minus the fair market value of the tangible assets, the intangible assets that can be identified, and the liabilities obtained in the purchase. The amount in the Goodwill account will be adjusted to a smaller amount if there is impairment in the value of the acquired company as of a balance sheet date. (Private companies may opt to amortize goodwill generally over a 10-year period and thereby minimize the cost and complexity involved with testing for impairment.)

CHARACTERISTIC OF GOODWILL a) It is a valuable asset. b) It contribution to the earning of excess profit. c) Its valve is liable to constant fluctuation d) Its value is only realized when a business is sold or transferred. e) There can be effect of personal ability for valuation of goodwill.. Meaning : Goodwill in the world of business refers to the established reputation of a company as a quantifiable asset and calculated as part of its total value when it is taken over or sold. It is the vague and somewhat subjective excess value of a commercial enterprise or asset over its net worth. It is a vital component for increasing a company’s customer base and retaining existing clients. It also attracts investors and encourages stakeholders to forgive you if you make a mistake. Share is a single unit of ownership in a company or financial asset. It is essentially an exchangeable piece of value of a company which can fluctuate up or down, depending on several different market factors. Companies divide capital into shares as a means of raising capital. Shares are also known as stocks.

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Valuation is an estimate of how much a business, property, antique or any asset is worth. If you have a business and seek funding from investors, they will need to know how much your enterprise is worth. This is achieved through a valuation – an estimate of the your company’s overall worth

Calculating goodwill In order to calculate goodwill, the fair market value of identifiable assets and liabilities of the company acquired is deducted from the purchase price. For instance, if company A acquired 100% of company B, but paid more than the net market value of company B, goodwill occurs. In order to calculate goodwill, it is necessary to have a list of all of company B's assets and liabilities at fair market value. Fair market value Accounts Receivable $10 Inventory $5 Accounts payable $6 ------------------------Total Net assets = $10 + $5 - $6 = $9

In order to acquire company B, company A paid $20. Hence, goodwill would be $11 ($20 - $9). The journal entry in the books of company A to record the acquisition of company B would be:

DR Goodwill $11 DR Accounts Receivable $10 DR Inventory $5 CR Accounts Payable $6 CR Cash

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This reputation will depend on : (a)The personal reputation of the owner and \or management; (b) It is the value of the reputation of a firm in respect of profits in future over and above the normal expected profits. (C) The value of goodwill depends on the mutual agreement between the purchaser and the seller. (d) There are a few accounting methods available to determine the quantum of goodwill.

 Need of valuation of goodwill :

1. 2. 3. 4. 5. 6. 7.

Generally goodwill may be valued at the time of disposal of business of the firm. But in many cases the goodwill may be valued to find out value of the firm. In case of proprietorship business it will be valued at the time of disposal of business, in case of firm it may be calculated at the time of addition, resignation and disposal of firm. Now in case of companies the need for valuation of goodwill arises in the following circumstances; In case of Amalgamation of company; In case of takeover of one company by another or sold of business of one company; In case of a company wants to write off or reduce debit balance in its profit and loss account; In case of a company wants to exercise controlling interest in other company; In case of valuation of shares of an Unlisted Company; In case of conversion of shares from one class to another class; In case of company’s management has been taken over by Government and some other events in which valuation of Goodwill held.

 Factors affecting of goodwill and valuation 19

The following important factors which affect the value of goodwill, i.e., (1) Location, (2) Time, (3) Nature of Business, (4) Capital Required (5)Trend of Profit, (6) Efficiency of Management, and (7) Others. 1. Location Factor: If the firm is centrally located or located in a very prominent place, it can attract, more customers resulting in an increase in turnover. Therefore, location factor should always be considered while ascertaining the value of goodwill. 2. Time Factor: Time dimension is another factor which influences the value of goodwill. The comparatively old firm will enjoy more commercial reputation than the other one since the old one is better known to its customers although both of them may have the same location advantages. 3 Nature of Business: (i) The nature of goods; (ii) Risk involved; (iii) Monopolistic nature of business; 4 Capitals Required: More buyers may be interested to purchase a business which requires comparatively small amount of capital but rate of earning profit is high and, consequently, raise the value of goodwill. On the contrary, for a business which requires large amount, of capital but the rate of earning profit is comparatively less, no buyer will be interested to have the business and, hence, goodwill of the said firm is pulled down. 20

5. Trend of Profit: Value of goodwill may also be affected due to the fluctuation in the amount of profit (i.e. on the basis of rate of return). If the trend of profit is always rising, no doubt value of goodwill will be high, and vice versa. 6. Efficiency of Management: The efficient management may also help to increase the value of goodwill by increasing profits through proper planned production, distribution and services. Therefore, in order to ascertain the value of goodwill, it must be noted that such efficiency in management must not be stopped.

7. Other Factors: (i) Condition of the money market; (ii) Possibility of competition; (iii) Government policy; and

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Accounting for goodwill : 1

Recognize the difference between tangible and intangible assets. Goodwill is considered an intangible asset. Unlike tangible assets, which are physical assets such as property, machinery, or vehicles, an intangible asset is an asset that cannot be touched. These would traditionally include things like brand names, copyrights, patents, or trademarks.[1] 

From an accounting perspective, both tangible and intangible assets are recorded on the balance sheet, since both types of assets have value.

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Calculate the book value of a company. Understanding goodwill requires an understanding of book value. Book value is the tangible assets of a business minus its liabilities (also known as its debt and its intangible assets). It is called book value because this is the value of the business that is being carried on the balance sheet.[2] 

For example, assume there is a business with tangible assets of $2 million, intangible assets of $500 thousand, and liabilities of $1 million. This would mean the book value is equal to $1 million ($2 million of tangible assets minus $1 million of liabilities).

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The value of business's assets are equal to the cost that was originally paid for them.

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Note that the book value of the business is not necessarily equal to the market value (also known as fair value) of the business, or what the market would be willing 23

to pay. For example, the above business has a book value of $1 million, but the market may be willing to pay $3 million.

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Learn the definition of goodwill. When a business is purchased, goodwill is equal to the amount the purchase price is above the book value of the business.[3] 

For example, pretend Company A wants to buy Company B for $1 million. Assume the book value of Company B is $500,000. Since goodwill is equal to the amount the purchase exceeds the book value, the goodwill in this case would equal $500,000.

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Goodwill can exist for many reasons. A business may be willing to pay more than the book value because the business in question may have great profit margins, exceptional future profit growth prospects, or a major competitive advantage.

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Feature of goodwill The following are the feature of goodwill: 1 Goodwill is an intangible assets .it is non-visible but it is not a fictitious asset. 2 It cannot be separated from the business and the fore cannot be sold like other identifiable and separable assets, without disposing off the business as a whole 3 the value of goodwill has no relation to the amount invested or cost incurred in order to build it: 4 Valuation of goodwill is subjective and is highly dependent on the judgment of the valuer. 5 Goodwill is subject to fluctuations. The value of goodwill many fluctuate widely according to internal and external factors of business.

Types of goodwill Goodwill is generally of two types:

a) Purchased goodwill; and b) Non-Purchased or Inherent goodwill.

Purchased Goodwill: Purchased goodwill arises when a business concern is purchased and the purchase consideration paid exceeds the fair value of the separable net assets acquired. The purchased goodwill is shown on the assets side of the Balance sheet. Para 36 of AS-10 ‘Accounting for fixed assets’ states that only purchased goodwill should be recognized in the books of accounts.

Non-Purchased or Inherent goodwill. Inherent goodwill is the value of the business in excess of the fair value of its separable net assets. It is referred to as internally generated goodwill and it arises over a period of time due to the good reputation of a business. The value of goodwill may be positive or negative. Positive goodwill arises when the value of the business as a 25

whole is more than the fair value of its net assets. It is negative when the value of the business is less than the value of its net assets.

Factor Affecting Goodwill The important factors that give rise to goodwill are as follows: 1.

The profitability of company is past and expected profit in future will affects value of Goodwill; 2. Capital Employed to earn profit; 3. The yield from business as expected by the investors; 4. The longevity of existence of business concern; 5. Market share of products of entity; 6. Quality of services rendered; 7. The edge of concern over its competitions in the market; 8. Relationship between management and staffs; 9. Location of business enterprise; 10. Brand position and efforts taken to establish brand of the concern; 11. Technical innovation, modern technology, patents, etc,; 12. Tax Planning; 13. Relationship with Government, Local Bodies; 14. There are some other factors affecting the value of Goodwill.

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Importance of goodwill Investors understand the importance of goodwill and what it builds with customers. If your company has a positive reputation as a result of the goodwill it has built, it will increase its value. ... Actively take the time to search out ways to build goodwill with

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Just as a good reputation is vital for the social standing of a person, goodwill is vital to the long-term success of any business. Some of the ways in which business goodwill affects a business are mentioned below. Goodwill in a business increases the number of return customers and recommendations based on their pleasant experiences.

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A Well-established business goodwill increases the chances of loan sanctions from a bank and the interest of potential investors.

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It strengthens the business networks, opens new avenues and creates opportunities for expansion in business.

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In case of a blunder or mistake, people are more forgiving to a business based on the goodwill it garners, much like the mistakes of an individual with a 'good name' will be given the benefit of doubt.

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In any business, goodwill provides ammunition against resistance and sabotage.

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The equity value and the accounting value of a business are greatly affected by the goodwill of that business.

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As mentioned in the beginning of this article, goodwill is one of the major intangible assets of any business. Greater the goodwill of a business, greater the value of its intangible assets and thus, greater the acquisition price in a takeover.

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Methods of valuing goodwill (7 methods) 1. Years’ Purchase of Average Profit Method 2. Years’ Purchase of Weighted Average Method: 3. Capitalization Method: 4. Annuity Method: 5. Super-Profit Method: 6. Capitalizations of Super-Profit Method: 7. Sliding Scale Valuation Method:

In this article, we will look at how to value goodwill which has no market scale available to measure it. It differs from business to business and region to region. 1. Years’ Purchase of Average Profit Method: Under this method, average profit of the last few years is multiplied by one or more number of years in order to ascertain the value of goodwill of the firm. How many years’ profit should be taken for calculating average and the said average should be multiplied by how many number of years — both depend on the opinions of the parties concerned. The average profit which is multiplied by the number of years for ascertaining the value of goodwill is known as Years Purchase. It is also called Purchase of Past Profit Method or Average Profit Basis Method. 28

Profit Basis Method:

Value of Goodwill = Average Profit x Years’ Purchase Illustration 1: Majumdar & Co. decides to purchase the business of Banerjee & Co. on 31.12.2003. Profits of Banerjee & Co. for the last 6 years were: 1998 Rs. 10,000; 1999 Rs. 8,000; 2000 Rs. 12,000; 2001 Rs. 16,000, 2002 Rs. 25,000 and 2003 Rs. 31,000. The following additional information about Banerjee & Co. were also supplied: (a) A casual income of Rs. 3,000 was included in the profit of 2000 which can never be expected in future. (b) Profit of 2001 was reduced by Rs. 1,000 as a result of an extraordinary loss by fire. (c) After acquisition of the business, Majumdar & Co. has to pay insurance premium amounting to Rs. 1,000 which was not paid by Banerjee & Co. (d) S. Majumdar, the proprietor of Majumdar & Co., was employed in a firm at a monthly salary of Rs. 1,000 p.m. The business of Banerjee & Co. was managed by a salaried manager who was paid a monthly salary of Rs. 4,000. Now, Mr. Majumdar decides to manage the firm after replacing the manager. Compute the value of Goodwill on the basis of 3 years’ purchase of the average profit for the last 4 years.

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2. Years’ Purchase of Weighted Average Method: This method is the modified version of Years’ Purchase of Average Profit Method. Under this method, each and every year’s profit should be multiplied by the respective number of weights, e.g. 1, 2, 3 etc., in order to find out the value of product which is again to be divided by the total number of weights for ascertaining the weighted average profit. Therefore, the weighted average profit is multiplied by the years’ purchase in order to ascertain the value of goodwill. This method is particularly applicable where the trend of profit is rising.

Value of Goodwill = Weighted Average Profit x Years Purchase

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Illustration 2: XYZ Co. Ltd. intends to purchase the business of ABC Co. Ltd. Goodwill for this purpose is agreed to be valued at 3 years’ purchase of the weighted average profits of the past four years. The appropriate weights to be used: 1998 — 1; 1999 — 2; 2000 — 3; 2001-4. The profits for these years were:

The following information were available: (a) On 1.9.1999 a major repair was made in respect of a Plant at a cost of Rs. 8,000 and this was charged to revenue. The said sum is agreed to be capitalized for Goodwill calculation subject to adjustment of depreciation of 10% p.a. on Diminishing Balance Method. (b) The Closing Stock for the year 2000 was overvalued by Rs. 3,000. (c) To cover the Management cost an annual charge of Rs. 10,000 should be made for the purpose of Goodwill valuation. You are asked to compute the value of Goodwill of the company.

3. Capitalisation Method: Under this method, the value of the entire business is determined on the basis of normal profit. Goodwill is taken as the diffe

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race between the Value of the Business minus Net Tangible Assets. Under this method, the following steps should be taken into consideration for ascertaining the amount of goodwill: (i) Expected Average Net Profit should be ascertained; ii) Capitalized value of profit is to be calculated on the basis of normal rate of return; (iii) Net Tangible Assets (i.e. Total Tangible Assets – Current Liabilities) should also be calculated; (iv) To deduct (iii) from (ii) in order to ascertain the value of Goodwill. Capitalized Value of Profit = Profit (Adjusted)/Normal Rate of Return x 100

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Value of Goodwill = Capitalized Value of Profit – Net Tangible Assets Illustration 3: The following is the Balance Sheet of P. Ltd. as at 31.12.2009:

The profits of the past four years (before providing for taxation) were:

Compute the value of Goodwill of the company assuming that the normal rate of return for this type of company is 10%. Income Tax is payable @ 50% on the above profits.

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Illustration 4: From the following Balance Sheet and other necessary information of P. Ltd. for the year ended 31.12.2001, compute the value of Goodwill by the application of Capitalisation Method:

The company commenced operation in 1997 with a paid-up capital of Rs. 2, 00,000. Profits earned before providing for taxation have been: 1997 — Rs. 90,000; 1998 — Rs. 95,000; 1999 — Rs. 1, 05,000; 2000 — Rs. 80,000; 2001 — Rs. 1, 10,000. Assume that Income-Tax @ 50% has been payable on these profits. Dividends have been distributed from the profits of the first three years @ 10% and for those of the next two years @ 15% on the Paid-up Capital. 34

Value of Goodwill = Capitalized Value of Profit – Net Tangible Assets Illustration 3: The following is the Balance Sheet of P. Ltd. as at 31.12.2009:

The profits of the past four years (before providing for taxation) were: 2006 — Rs. 20,000; 2007 — Rs. 30,000; 2008 — Rs. 36,000 and 2009 — Rs. 40,000. Compute the value of Goodwill of the company assuming that the normal rate of return for this type of company is 10%. Income Tax is payable @ 50% on the above profits.

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Illustration 4: From the following Balance Sheet and other necessary information of P. Ltd. for the year ended 31.12.2001, compute the value of Goodwill by the application of Capitalisation Method:

The company commenced operation in 1997 with a paid-up capital of Rs. 2, 00,000. Profits earned before providing for taxation have been: 1997 — Rs. 90,000; 1998 — Rs. 95,000; 1999 — Rs. 1, 05,000; 2000 — Rs. 80,000; 2001 — Rs. 1, 10,000.

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Assume that Income-Tax @ 50% has been payable on these profits. Dividends have been distributed from the profits of the first three years @ 10% and for those of the next two years @ 15% on the Paid-up Capital.

4. Annuity Method:

Under this method, Super-profit (excess of a ctual profit over normal profit) is being considered as the value of annuity over a certain number of years and, for this purpose, compound interest is calculated at a certain respective percentage. The present value of the said annuity will be the value of goodwill.

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Value of Goodwill, V=

Where V = Present value of Annuity a = Annual Super Profit n = Number of Years I = Rate of Interest Illustration 5: From the following particulars, compute the value of goodwill under Annuity Method: Super-Profit Rs. 10,000 Number of years over which Super-Profit is to be paid 5 Rate Per cent p.a. 5% Computation of Goodwill:

5. Super-Profit Method: Super-profit represents the difference between the average profit earned by the business and the normal profit (on the basis of normal rate of return for representative firms in the industry) i.e., the firm’s anticipated excess earnings. As such, if there is no anticipated excess earning over normal earnings, there will be no goodwill. 38

This method for calculating goodwill depends on: (i) Normal rate of return of the representative firms; (ii) Value of capital employed/Average capital employed; and (iii) Estimated future profit, i.e. the average profit of the last few years. Super-Profit = Average Profit (Adjusted) – Normal Profit Value of Goodwill = Super-Profit x Years’ Purchase The students should remember that the number of years’ purchase of goodwill differs from firm to firm and industry to industry. One or two years’ purchase should be taken into consideration if the retiring partner of a business was the main source of success. It should also be remembered that three to five years’ purchase is usually taken. Of course, a large number of years’ purchase may be considered if the super-profit itself is found to be large. If there is a declining trend in super-profit, one or two years’ purchase may be considered. The following steps should carefully be followed for calculating the value of Goodwill under Super- Profit Method: (a) Ascertain the amount of Capital Employed/Average Capital Employed; (b) Ascertain the amount of Normal Profit (i.e. Percentage of Normal Rate of Return on Capital/Average Capital Employed); (c) Ascertain the Actual Maintainable Profit; (d) Ascertain the difference between Actual Maintainable Profit minus Normal Profit. If Actual Maintainable Profit is more than the Normal Profit, the excess is called Super-Profit and, in the opposite case, this is no Super-Profit;

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(e) Value of Goodwill = Super-Profit x Year’s Purchase. Illustration 6: From the following information, compute the Goodwill of the firm XYZ Co. Ltd. on the basis of four years’ purchase of the average Super-Profit on a 10% yield basis:

As per the Articles of Association of this private company, its Directors have declared and paid dividends to its members in the month of December each year out of the profit of the related year. The cost of the Goodwill to the company was Rs. 5, 00,000. Capital employed at the beginning of the year 2006 was Rs. 19, 30,000 including the cost of Goodwill and balance in Profit and Loss Account at the same time was Rs. 60,000.

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Value of Goodwill will be four years’ purchase of Average Super-Profit, i.e. Rs. 4,75,833 x 4 = Rs. 19,03,332, or, say, Rs. 19,00,000. 6. Capitalization of Super-Profit Method: Under the method, we are to consider super-profit in place of ordinary profit against the normal rate of return. The same is calculated as: Value of Goodwill = Super-Profit/Normal Rates of Returns x 100

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Illustration 7: X Ltd. presented the following information: Normal Rate of Return @ 10% Capital Employed Rs. 3, 00,000 Profits for last 5 years are Rs. 20,000; Rs. 25,000; Rs. 45,000; Rs. 30,000 and Rs. 50,000 Compute the value of goodwill.

7. Sliding Scale Valuation Method: Under this method, the distribution of profit which is related to super-profit may vary from year to year. In other words, in order to find out the value of goodwill, sliding scale valuation may be considered relating to super-pr8fits of an enterprise.

Illustration 8: 42

Compute the value of Goodwill on the basis of Sliding Scale Method. Amount of Super-Profit estimated at Rs. 12,000. Sliding Scale: First Rs, 6,000 for 3 years’ purchase Next Rs. 4,000 for 2 years’ purchase Balance Rs. 2,000 for 1 year’s purchase

Hidden Goodwill When the value of goodwill is not given at the time of admission of a new partner, it has to be derived from the arrangement of the capital and the profit sharing ratio and is known as hidden goodwill. For example, A and B are partners sharing profits equally with capitals of Rs.50,000 each. They admitted C as a new partner for one-third share in the profit. C brings in Rs.60,000 as his capital. Based on the amount brought in by C and his share in profit, the total capital of the newly constituted firm works out to be Rs.1,80,000 (Rs. 60,000 × 3). But the actual total capital of A, B and C is Rs.1,60,000 (50,000 + 50,000+ 60,000). Hence, it can be said that the difference is on account of goodwill,i.e., Rs.20,000 (1,80,000 – 1,60,000).

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Solved Example for You Q: M/s Mehta and sons earn an average profit of rupees 60,000 with a capital of rupees 4,00,000. The normal rate of return in the business is 10%. Using capitalization of super profits method, calculate the value the goodwill of the firm. Solution: Goodwill = Super profits × 100/ Normal Rate of Return = 20,000 × 100/10 = 2, 00,000. Working notes: (i). Normal Profit = Capital employed * Normal Rate of Return/100 = 4, 00,000 × 10/100 = 40,000 (ii) Super Profit = Average Profit – Normal Profit = 60,000 – 40,000 = 20,000

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FMP Method Of Valuation No of years purchase method The future maintainable profit determined above indicates the expected future income of the business per year. Such income may continue for a number of years in future .the actual value goodwill is thus calculated as Future maintainable profit *No of year’s

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