No accurate formula can be laid down for the measurement of the value of goodwill. The value of goodwill depends upon the nature of a particular business and the circumstances connected with it.
Various methods are advocated for the valuation of goodwill. In many cases the method adopted is a purely arbitrary one and is often governed by the custom of the particular trade in which the business is engaged. The more usual bases of valuation are as follows:
1. Average profits method
The average profits of given number of vast years multiplied by an agreed number is considered to be the value of goodwill. Thus three years purchase of average profits of the last few years is commonly spoken of as the basis upon which goodwill is to be valued. The average profit of a given number of past years is multiplied by an agreed number of years to arrive at the value of goodwill. This method is purely arbitrary and will frequently produce a figure for goodwill out of all proportions to its true value.
2. Super profits method
Super profits of a business are the profits which can be expected In the future over and above those necessary to pay a fair return upon the capital invested in the business, having regard to the risk involved in that particular business and a fair remuneration for the services of the partners who work therein. Super profit is the excess of actual profits over normal profits. The normal profits are calculated by multiplying the average capital employed with the rate of general expectation. The super profit thus calculated is multiplied by an agreed figure to find out the value of goodwill.
3. Capitalization method
In this method, the whole value of business is calculated by capitalization the average or actual profits by the following formula:
Actual profits x 100
Normal rate of return
The net assets of the firm are deducted from the value of business as calculated above to find out the value of goodwill.
Suppose a firm earns a net profit of 7,500 annually and the firm normally earns a profit of 10 %, the total value of the firm will be Rs. 75,000 i.e. Rs. 7,500 x = Rs, 75,000. If, however, the net tangible assets of the business amount to Rs. 50,000, the goodwill be valued at Rs. 75,000 — Rs. 50,000 i.e. Rs. 25,000. However, there will be no goodwill if the net tangible assets exceed or equal the total value of the business.
This method of valuation of goodwill involves the following steps:
(1) Find out the average profits.
(ii) Capitalize the average profits on the basis of the normal rate of return; this will give total value of business.
(Iii) Compute the actual capital employed by deducting the outside liabilities form total assets (excluding goodwill)
(iv) Compute the value of goodwill by deducting net assets from the total value of business.
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