Calculating Goodwill by Capitalisation Method

The question requires us to calculate the value of goodwill for a business using the Capitalisation method. This method assesses goodwill by comparing the capital required to earn the average profits at the normal rate of return with the actual capital employed in the business.

Understanding the Given Information

• Average Profit earned by the business: ₹2,50,000
• Total Assets of the firm: ₹25,00,000
• External Liabilities of the firm: ₹4,50,000
• Normal Rate of Return in a similar business: 10%

Steps for Calculation using Capitalisation of Average Profits Method

The Capitalisation of Average Profits method involves the following steps:

1. Calculate the Net Assets (Capital Employed) of the business.
2. Calculate the Capitalised Value of the business based on the average profit and the normal rate of return.
3. Calculate Goodwill by subtracting the Net Assets from the Capitalised Value.

Step 1: Calculate Net Assets (Capital Employed)

Net Assets are calculated as the difference between Total Assets and External Liabilities.

Formula: $\text{Net Assets} = \text{Total Assets} - \text{External Liabilities}$

Calculation:

$\text{Net Assets} = ₹25,00,000 - ₹4,50,000$

$\text{Net Assets} = ₹20,50,000$

Step 2: Calculate Capitalised Value of the Business

The Capitalised Value of the business is the amount of capital required to earn the average profit if invested at the normal rate of return.

Formula: $\text{Capitalised Value} = \frac{\text{Average Profit}}{\text{Normal Rate of Return}}$

Normal Rate of Return = 10% = $\frac{10}{100} = 0.10$

Calculation:

$\text{Capitalised Value} = \frac{₹2,50,000}{0.10}$

$\text{Capitalised Value} = ₹25,00,000$

Step 3: Calculate Goodwill

Goodwill is the excess of the Capitalised Value of the business over its actual Net Assets (Capital Employed).

Formula: $\text{Goodwill} = \text{Capitalised Value} - \text{Net Assets}$

Calculation:

$\text{Goodwill} = ₹25,00,000 - ₹20,50,000$

$\text{Goodwill} = ₹4,50,000$

Alternative Method: Capitalisation of Super Profits

Goodwill can also be calculated using the Capitalisation of Super Profits method. Super Profit is the excess of Average Profit over Normal Profit.

Steps:

1. Calculate Net Assets (Capital Employed) - already done: ₹20,50,000.
2. Calculate Normal Profit.
3. Calculate Super Profit.
4. Calculate Goodwill by capitalising Super Profit.

Step 2 Alt: Calculate Normal Profit

Normal Profit is the profit expected from the capital employed at the normal rate of return.

Formula: $\text{Normal Profit} = \text{Net Assets} \times \text{Normal Rate of Return}$

Calculation:

$\text{Normal Profit} = ₹20,50,000 \times 0.10$

$\text{Normal Profit} = ₹2,05,000$

Step 3 Alt: Calculate Super Profit

Formula: $\text{Super Profit} = \text{Average Profit} - \text{Normal Profit}$

Calculation:

$\text{Super Profit} = ₹2,50,000 - ₹2,05,000$

$\text{Super Profit} = ₹45,000$

Step 4 Alt: Calculate Goodwill by Capitalising Super Profit

Formula: $\text{Goodwill} = \frac{\text{Super Profit}}{\text{Normal Rate of Return}}$

Calculation:

$\text{Goodwill} = \frac{₹45,000}{0.10}$

$\text{Goodwill} = ₹4,50,000$

Both methods give the same goodwill value of ₹4,50,000.

Summary of Calculation

The calculated value of Goodwill by the Capitalisation method is ₹4,50,000.

Revision Table: Goodwill Calculation Methods

Additional Information: Concepts in Goodwill Valuation

Understanding the terms used in goodwill valuation is crucial:

• Average Profit: The average profit earned by the business over a specified number of past years. It can be simple average or weighted average.
• Normal Rate of Return (NRR): The rate of return that businesses in the same industry and with similar risks usually earn on their capital employed.
• Normal Profit: The profit that the business is expected to earn on its capital employed at the normal rate of return.
• Super Profit: The profit earned by the business over and above the normal profit. It represents the extra earning capacity due to factors like good reputation, location, management, etc.
• Capital Employed (Net Assets): The total capital invested in the business. It is calculated as Total Assets minus External Liabilities. Sometimes, it can also be calculated as Shareholders' Funds plus Long-term Loans.
• Capitalised Value: The value of the entire business calculated by capitalising the average profit at the normal rate of return. It is the theoretical capital needed to earn the average profit at the market rate.