Unit 4

VALUATION OF SHARES

4.1 Meaning of Goodwill

Goodwill is an intangible but not fictitious assets which means it has some realisable value. From the accountants’ point of view goodwill, in the sense of attracting custom, has little significance unless it has a saleable value. To the accountant, therefore, goodwill may be said to be that element arising from the reputation, connection, or other advantages possessed by a business which enables it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business. In considering the return normally to be expected, regard must be had to the nature of the business, the risks involved, fair management remuneration and any other relevant circumstances.

The goodwill possessed by a firm may be due, inter alia, to the following:

1. The location of the business premises, the nature of the firm’s products or the reputation of its service.
2. The possession of favourable contracts, complete or partial monopoly, etc.
3. The personal reputation of the promoters.
4. The possession of efficient and contented employees.
5. The possession of trademarks, patents or a well-known business name.
6. The continuance of advertising campaigns.
7. The maintenance of the quality of the firm’s product and development of the business with changing conditions

The need for evaluating goodwill may arise in the following cases:

1. When the business or when the company is to be sold to another company or when the company is to be amalgamated with another company;
2. When, stock exchange quotations not being available, shares have to be valued for taxation purposes, gift tax, etc.;
3. When a large block of shares, so as to enable the holder to exercise control over the company concerned, has to be bought or sold; and
4. When the company has previously written off goodwill and wants its write back. In valuation of goodwill, consideration of the following factors will have a bearing:

(a)  Nature of the industry, its history and the risks to which it is subject to.

(b)  Prospects of the industry in the future.

(c)  The company’s history — its past performance and its record of past profits and dividends.

(d)  The basis of valuation of asset of the company and their value.

(e)  The ratio of liabilities to capital.

(f)   The nature of management and the chance for its continuation.

(g)  Capital structure or gearing.

(h)  Size, location and reputation of the company’s products.

(i)   The incidence of taxation.

(j)   The number of shareholders.

(k)  Yield on shares of companies engaged in the same industry, which are listed in the Stock Exchanges.

(l)   Composition of purchasers of the products of the company.

(m)  Size of block of shares offered for sale since large blocks very few buyers would be available and that has a depressing effect on the valuation. Question of control, however, may become important, when large blocks of shares are involved.

(n)  The major factor of valuation of goodwill is the profits of the company. One who pays for goodwill looks to the future profit. The profits that are expected to be earned in future are extremely important for valuation of goodwill. The following are the important factors that have a bearing on future profits:

(i)     Personal skill in management

(ii)     Nature of business

(iii)     Favourable location

(iv)     Access to supplies

(v)     Patents and trademarks protection

(vi)     Exceptionally favourable contracts.

(vii)     Capital requirements and arrangement of capital.

(o)  Estimation of the profits expected to be earned by the firm and the amount  of  capital employed to earn such profits, are to be computed carefully.

(p)  Market reputation which the company and its management enjoys.

(q)  Returns expected by investors in the industry to which the firm or company belongs.

4.2 Concept of Goodwill

When one company buys another company, the purchasing company may pay more for the acquired company than the fair market value of its net identifiable assets (tangible assets plus identifiable intangibles, net of any liabilities assumed by the purchaser). The amount by which the purchase  price  exceeds  the  fair  value  of  the  net  identifiable  assets  is  recorded  as an  asset  of the acquiring company. Although sometimes reported on the balance sheet with a descriptive title such as “excess of acquisition cost over net assets acquired”, the amount is customarily called goodwill.

Goodwill arises only part of a purchase transaction. In most cases, this is a transaction in which one company acquires all the assets of another company for some consideration other than an exchange of common stock. The buying company is willing to pay more than the fair value of the identifiable assets because the acquired company has a strong management team, a favourable reputation in the marketplace, superior production methods, or other unidentifiable intangibles.

The acquisition cost of the identifiable assets acquired is their fair market value at the time of acquisition. Usually, these values are determined by appraisal, but in some cases, the net book value of these assets is accepted as being their fair value. If there is evidence that the fair market value differs from net book value, either higher or lower, the market value governs.

Q1) Company X acquires all the assets of company Y, giving Company Y Rs 15 lakh cash. Company Y has cash Rs 50,000 accounts receivable that are believed to have a realisable value of Rs 60,000, and other identifiable assets that are estimated to have a current market value of Rs 11 lakhs.

Solution:

This extra amount of Rs 2,90,000 paid over an above, Net worth Rs 12,10,000 is goodwill, which is  a capital loss for purchasing company and to be shown on assets side of Balance Sheet. This entire amount will be written off against revenue profit, i.e., Profit and Loss Account over period of time.

4.3 Methods of Valuing Goodwill

There are basically two Methods of valuing goodwill: (a) Simple/Average profit method and (b) Super profit method.

(a) Simple/Average Profit Method: Goodwill is generally valued on the basis of a certain number of years’ purchase of the average business profits of the past few years. While calculating average profits for the purposes of valuation of goodwill, certain adjustments are made. Some of the adjustments are as follows:

Trading Profit/Business Profit/Recurring Profit/Normal Profit (of Past Year)

Calculation of Average profit:

(a)      Simple Average Profit =

(b)      Weighted Average profit:

Total profit of (past years)

Total number of past years

Total product

Total of weight Notes: If past profits are in increasing trend, then calculate Average Profit by weighted average method or otherwise simple average method.

Calculation of F.M.P. (Future Maintainable Profit):

(i)    All actual expenses and losses not likely to occur in the future are added back to profits.

(ii)    All actual expenses and losses not likely to occur in the future are added back to profits.

(iii)    All profits likely to come in the future are added.

After adjusting profit in the light of future possibilities, average profit are estimated and then the value of goodwill is estimated. If goodwill is to be valued at 3 years’ purchase of the average profits which come to Rs 50,000, the goodwill will be Rs 1,50,000, i.e., 3 × Rs 50,000.

This method is a simple one and has nothing to recommend since goodwill is attached to profits over and above what one can earn by starting a new business and not to total profits.

It ignores the amount of capital employed for earning the profit. However, it is usual to adopt this method for valuing the goodwill of the practice of a professional person such as a chartered accountant or a doctor.

Calculation of Capital Employed and Average Capital Employed

Average Capital Employed = Opening Capital Employed + Closing Capital Employed

= Closing Capital Employed – ½ of Current Years’ Profit+ Current Years’ Dividend

(b) Super Profit Method: The future maintainable profits of the firm are compared with the normal profits for the firm. Normal earnings of a business can be judged only in the light of normal rate of earning and the capital employed in the business. Hence, this method of valuing goodwill  would require the following information:

(i)    A normal rate of return for representative firms in the industry.

(ii)    The fair value of capital employed.

The normal rate of earning is that rate of return which investors in general expect on their investments in the particular type of industry. Normal rate of return depends upon the risk attached to the investment, bank rate, market, need, inflation and the period of investment.

Normal Rate of Returns (NRR)

It is the rate at which profit is earned by normal business under normal circumstances or from similar course of business. Normal Rate of Returns means rate of profit on capital employed which is normally earned by others in a similar type of business. It will always be given in the problem in form of percentage.

Or NRR = Rate of Risk + Rate of Returns or Dividend per Share x 100

               Market price per Share

As the capital employed may be expressed as aggregate of share capital and reserves less the amount of non-trading assets such as investments. The capital employed may also be ascertained by adding up the present values of trading assets and deducting all liabilities. Super profit is the simple difference between future maintainable operating profit and normal profit.

Q2) Rishi Computers Ltd. gives you the following summarised balance sheet as at 31st December, 2009:

The company earned a profit of Rs 18,00,000 before tax in 2009. The capital work-in-progress represents additional plant equal to the capacity of the present plant; if immediately operational, there being no difficulty in sales. With effect from 1st January, 2010, two additional Works Managers are being appointed at Rs 1,00,000 p.a. Ascertain the future maintainable profit and the capital employed, assuming the present replacement cost of fixed assets is Rs 1,00,00,000 and the annual rate of depreciation is 10% on original cost.

Solution:

Normal profit: Suppose investors are satisfied with a 180% return, in the above example, the normal profit will be Rs 11,34,000, i.e., 18% of Rs 63 lakhs.

The followings are some items which generally require adjustment in arriving at the average of the past earnings:

1. Exclusion of material non-recurring items such as loss of exceptional nature through strikes, fires, floods and theft, etc., profit or loss of any isolated transaction not being part of the business of the company.
2. Exclusion of income and profits and losses from non-trading assets.
3. Exclusion of any capital profit or loss or receipt or expense included in the profit & loss account.
4. Adjustments for any matters suggested by notes, appended to the accounts or by qualifications in the Auditor’s Report, such as provision for taxation and gratuities, bad debts, under provision or over provision for depreciation, inconsistency in valuation of stock, etc.
5. Depreciation is an important item that calls for careful review. The value may adopt book depreciation provided he is satisfied that the tale was realistic and the method was suitable for the nature of the company and they were consistently applied from year to year. But imbalances do arise in cases where consistently written down value method was in use and heavy expenditure in the recent past has been made in rehabilitating or expanding fixed assets, since the depreciation charges would be unfairly heavy and would prejudice the seller. Under such circumstances, it would be desirable to readjust depreciation suitably as to bring a more equitable charge in the profits meant for averaging.

Another important factor comes up for consideration in averaging past profits and that is the  trend of profits earned. It is imperative that estimation of maintainable profits be based on the only available record i.e., the record of past earnings, but indiscrete use of past results may lead to an entirely fallacious and unrealistic result.

Where the profits of a company are widely fluctuating from year to year, an average fails to aid future projection. In such cases, a study of the whole history of the company and of earnings of a fairly long period may be necessary. If the profits of a company do not show a regular trend upward or downward, an average of the cycle can usefully be employed for projection of future earnings.

In some companies, profits may record a distinct rising or falling trend from year; in these circumstances, a simple average fails to consider a significant factor, namely, trend in earnings.

The shares of a company which record a clear upward trend of past profits would certainly be more valuable than those of a company whose trend of past earnings indicates a downtrend. In such cases, a weighted average giving more weight to the recent years than to the past, is appropriate. A simple way of weighing is to multiply the profits by the respective number of the years arranged chronologically so that the largest weight is associated with the most recent past year and the least for the remotest.

Future Profitability Projections: Project is more a matter of intelligent guesswork since it is essentially an estimation of what will happen in the risky and uncertain future. The average profit earned by a company in the past could be normally taken as the average profit that would be maintainable by it in the future, if the future is considered basically as a continuation of the past. If future performance is viewed as departing significantly from the past,  then appropriate adjustments will be called for before accepting the past average profit as the future maintainable profit of the company.

There are three methods of calculating goodwill based on super profit. The methods and formulae are as follows:

Purchase of Super Profit Method

Goodwill as per this method is: Super profit multiplied by a certain number of years. Under this method, an important point to note is that the number of years of purchase as goodwill will differ from industry to industry and from firm to firm. Theoretically, the number of years is to be determined with reference to the probability of a new business catching up with an old business. Suppose it is estimated that in two years’ time, a business, if started now will be earning about the same profits as an old business is earning now, goodwill will be equivalent to two times the super profits. In the example given above, goodwill will be Rs 12.12 1akhs, i.e., Rs 6.06 1akhs × 2 years.

Annuity Method of Super Profit

Goodwill, in this case, is the discounted value of the total amount calculated as per purchase method. The idea behind super profits methods is that the amount paid for goodwill will be recouped during the coming few years. But in this case, there is a heavy loss of interest. Hence, properly speaking what should be paid now is only the present value of super profits paid annually at the proper rate of interest. Tables show that the present value 18% of Re. 1 received annually two years is 1.566. In the above example, the value of goodwill under this method will be 1.3 × Rs 6.06 1akhs or Rs 9.49 lakhs.

Capitalization of Super Profit Method

This method tries to find out the amount of capital needed for earning the super profit.

The formula is Super Profit x 100

                                         NRR

In above example, Goodwill will be = 6.06 lakhs x 100

                                                                               18

      = Rs. 33.67 lakhs

 Given in the Problems

1. Information of old firms assets and liabilities.
2. Information regarding past or profit.
3. Adjustment valuation of goodwill.

Required to Prepare

Valuation of goodwill by different methods.

Steps, Method and Formula for Calculation of Goodwill

1. Goodwill by purchase of average profit method: Steps:

(a)   Find out average trading profit.

(b)  Find out the number of year purchase (it will always be given in problem).

(c)   Goodwill: Number of year purchase × Average trading profit.

2.     Goodwill by purchase of future maintainable profit method: Steps:

(d)  Find out future maintainable profit.

(e)   Number of year purchase (given in problem).

(f)    Goodwill: No of years purchase × Future maintainable profit.

3.     Goodwill by capitalisation of future maintainable profit method: Steps:

1. Find out future maintainable profit.
2. Find out capitalised value of future maintainable profit.

Capitalisation Value of Future Maintainable Profit = FMP x 100

                                                                                                                   NRR

c.      Calculate capital employed.

d.     Goodwill = Capitalised Value of E.M.P. – Capital Employed

4.     Goodwill by purchase of super profit method: Steps:

(g)  Find out average trading profit.

(h)   Find out future maintainable profit.

(i)    Find out capital employed.

(j)     Find out Normal Rate of Return (always given in the problem in terms of %).

(k)  Find out number of year purchase (given in the problem).

(l)    Find out normal profit:= (Capital Employed x NRR) / 100

(m) Find out super profit:

Super Profit = Future Maintainable Profit – Normal Profit

(n)   Goodwill = Number of year purchase × Super Profit.

5.     Goodwill by capitalisation super profit method: Steps:

 Calculate super profit as discussed above.

Goodwill = Annuity Rate × Super Profit

Notes: Annuity Rate will always be given in the problem.

4.4 Valuation of Shares

In the cases of shares quoted in the recognised Stock Exchanges, the prices quoted in the Stock Exchanges are generally taken as the basis of valuation of those shares. However, the Stock Exchange prices are determined generally on the demand-supply position of the shares and on business cycle. The London Stock Exchange opines that the Stock Exchange may be linked to a scientific recording instrument which registers not its own actions and options but the actions and options of private institutional investors all over the country/world. These actions and options are the result of fear, guesswork, intelligent or otherwise, good or bad investment  policy  and many other considerations. The quotations what result definitely do not represent valuation of a company by reference to its assets and its earning potential. Therefore, the accountants are called upon to value the shares by following the other methods.

The value of share of a company depends on so many factors such as:

1. Nature of business.
2. Economic policies of the Government.
3. Demand and supply of shares.
4. Rate of dividend paid.
5. Yield of other related shares in the Stock Exchange, etc.
6. Net worth of the company.
7. Earning capacity.
8. Quoted price of the shares in the stock market.
9. Profits made over a number of years.
10. Dividend paid on the shares over a number of years.
11. Prospects of growth, enhanced earning per share, etc.

4.5 Need and Purpose of Valuation of Shares

The need for valuation of shares may be felt by any company in the following circumstances:

1. For assessment of Wealth Tax, Estate Duty, Gift Tax, etc.
2. Amalgamations, absorptions, etc.
3. For converting one class of shares to another class.
4. Advancing loans on the security of shares.
5. Compensating the shareholders on acquisition of shares by the Government under a scheme   of nationalization.
6. Acquisition of interest of dissenting shareholder under the reconstruction scheme, etc.

4.6 Factors Influencing Valuation

The valuation of shares of a company is based, inter alia, on the following factors:

1. Current stock market price of the shares.
2. Profits earned and dividend paid over the years:
3. Availability of reserves and future prospects of the company.
4. Realisable value of the net assets of the company.
5. Current and deferred liabilities for the company.
6. Age and status of plant and machinery of the company.
7. Net worth of the company.
8. Record of efficiency, integrity and honesty of Board of Directors and other managerial personnel of the company.
9. Quality of top and middle management of the company and their professional competence.
10. Record of performance of the company in financial terms.

4.7 Methods of Valuation of Shares

Certain methods have come to be recognised for valuation of shares of a company, viz., (1) Open market price, (2) Stock exchange quotation, (3) Net assets basis, (4) Earnings per share method, (5)Yield or return method, (6) Net worth method, (7) Break-up value, etc.

Intrinsic Value Method

This method is also called as Assets Backing Method, Real Value  Method,  Balance  Sheet Method or Break-up Value Method. Under this method, the net assets of the company including goodwill and non-trading assets are divided by the number of shares issued to arrive at the value of each share.

If the market value of the assets  is available,  the same  is to be considered  and in  the absence  of such information, the book values of the assets shall be taken  as  the  market  value.  While arriving at the net assets, the fictitious assets such as preliminary expenses, the debit balance in the Profit and Loss A/c should not be considered. The liabilities payable to the third parties and to the preference shareholders is to be deducted from the total asset to arrive at the net assets. The funds relating to equity shareholders such as General Reserve, Profit and Loss Account, Balance of Debenture Redemption Fund, Dividend  Equalization  Reserve,  Contingency  Reserve,  etc  should not be deducted.

Q3) From the information given below and the balance sheet of Cipla Limited on 31st December, 2009, find the value of shares by Intrinsic value method.

Balance Sheet

Building is now worth of Rs 3,50,000 and the Preferential shareholders are having preference as to capital and dividend.

Solution:

Value of Equity Shares = Net assets available for Equity share holders

      No of Equity Shares

    =13,30,000

           4,000

    = Rs 332.5

Intrinsic value of each equity share= Rs 332.50

Yield Method

The valuation of shares under the Yield Method may be done under two categories:

1. Return on capital employed method: This method is applied for the purpose of valuation of the shares of majority shareholding. A big investor is more interested in what the company earns and not simply in what the company distributes. Even if the company does not distribute 100% of its earning among its shareholders, it, as a matter of fact, strengthens the financial position of the company. The value of the share under this method is calculated by the formula:

Return on C.E=        Return of C.E                  x  paid up value of shares

                               Normal Rate of Return

Valuation on the basis of dividend: This method is more suitable for valuation of small

block of shares. The method of calculation is:

Expected Rate of Dividend x paid up value per share

Normal rate of Dividend

Normal Rate of Dividend Method

Q4) The following particulars are available in respect of Good luck Limited:

(a)  Capital 450, 60% preference shares of Rs 100 each fully paid and 4,500 equity shares of Rs 10 each fully paid.

(b)  External liabilities: Rs 7,500.

(c)  Reserves and Surplus Rs 35,000.

(d)  The average expected profit (after taxation) earned by the company Rs 8,500.

(e)  The normal profit earned on the market value of equity shares (full paid) of the same type of companies is 9%.

(f)   10% of the profit after tax is transferred to reserves.

Calculate the intrinsic value per equity share and value per equity share according to dividend yield basis.

Assume that out of total assets, assets worth of Rs 350 are fictitious.

Solution:

Intrinsic Value of Shares = Net Assets available for Equity Shareholders

                 Number of Equity Shares

 = 48,150/4,500

 = 10.70

Rate of Dividend = 4,950 x 10

    45,000

 = 11%

Value of Equity Shares =        Rate of Dividend                 x  paid up value of shares

                                                       Normal Rate of Return

    =11/9 x 10 = 12.22

Q5) The capital structure of company as on 31st March, 2009 was as under:

The company on an average earns a profit of Rs 4,00,000 annually before deduction of interest on Debentures and Income Tax, which works out to 45%. The normal return on equity shares on companies similarly placed is 15% provided:

(a)  The profit after tax covered the fixed interest and fixed dividends at least four times.

(b)  Equity capital and reserves are 150% of debentures and preference capital.

(c)  Yield on shares is calculated at 60% of profits distributed and 5% on undistributed profits.

The company is regularly paying an equity dividend of 18%. Ascertain the value of equity share of the company.

Solution:

Evaluation of Conditions given in the question:

(a)  Profit after tax whether covers fixed interest and fixed dividend at least four times. Profit after tax = 4,00,000 – 1,58,400 = 2,41,600

Fixed interest and fixed dividend interest:

Interest      48,000

Fixed dividend (11% of 3,30,000)   33,000

81,000

Fixed interest and fixed dividend interest= 2,41,600/81,000 = 2.9827 times

Fixed interest and dividend coverage is 2.98 times only and is less than the prescribed 4 times.

(b)  Whether equity capital and reserves are of 150% of preference share capital and debentures.

 Ratio =

8,00,000 x 100 = 114.28%

7,00,000

Ratio is less than the Prescribed Ratio of 150%.

(c)  Yield on Profit:

Yield Rate = 57,530/5,00,000 =11.506%

Value of Equity Shares =        Possible Yield Rate               x  paid up value of shares

           Expected Yield Rate

= 11.506/16 x 100

 = Rs 71.91

Q6) From the following information of Dell Ltd., calculate the value of share by yield basis.

Balance Sheet as on 3/12/09

Land and Building to be valued at Rs 90,000. The company’s earnings were as follows:

The company paid managerial remuneration of Rs 6,000 per annum but it will become Rs 10,000 in future. There has been no change in capital employed. The company paid dividend of Rs 9 per share  and it will maintain the same in future. The company proposed to build up  a plant  rehabilitation reserve at 15% of profit after tax. Dividend rate in this type of company is fluctuating and the asset backing of the equity share is about 1½ times. The equity share with an average dividend of 8% sold at par.

Solution:

Average Maintainable Profits:

Weighted Average Profit= 4,80,000/10= 48,000

Average Backing per Equity Share:

Asset Backing = 1,60,000/80,000= 2 times

Capitalisation Factor= 100/7= 14.226

Value of equity share = Profit available for Equity share holders x Cap Factor

         Number of Equity Shares

    = 15,100/800 x 14.286

    = 269.64

Fair Value of a Share

The fair value of a share is the average of the value obtained by the  net asset method and the  yield method.

Fair Value = Intrinsic Value + Yield Value

         2

Q7) The following is the Balance Sheet of M/s. Mahendra Ltd., as at 31-3-2013.

The Turnover, Net Profit and Dividend paid on Equity shares of the last 3 years ended 31st  March, 2012 are as given below:

Calculate the fair value of Equity Shares of the company, assuming that the fair return in investment in the company doing similar business is 12%.

Solution:

M/s. Mahindra Ltd.

Intrinsic Value =

=

Profit Available to Equity Shareholders

Number of Equity Shares

4,40,000

30,000

= Rs 14.67.

Yield Value:

Average Net Profit =

3,05,000 + 4,50,000 + 5,60,000

3

= 13,15,000

3

= Rs 4,38,333.

Average Profit of Earning = 4,06,383/3,00,000 x 100 = 135.44%

Value of Equity Share =         Average Rate of Return               x  paid up value of shares

                  Normal Rate of Return

   = 135.44/12 x 100

   = Rs 112.87(Earning Basis)

Value of Equity Share =         Average Rate of Dividend               x  paid up value of shares

                  Normal Rate of Return

   = (15+15+18)/3  x  10

    12

   = Rs 13.33

Q8) On 31st March, 2012, the Balance Sheet of Gomati Ltd. was as follows.

The Net profits of the company after providing for tax were as follows:

On 31st March, 2012, Land and Building were valued at Rs 3,75,000 and Plant and Machinery were valued at Rs 2,25,000. Normal rate of return can be considered at 8%. Goodwill is to be valued at  3 years purchase of super profits based on average profit of last 5 years.

Find the intrinsic value of fully paid and partly paid equity shares Consider closing capital employed as average capital employed.

Solution:

Gomati Ltd.

Valuation of Goodwill

Step 1: Calculation of Average Profit

= 1,72,500 +1,50,000 + 1,87,500 + 1,80,000 + 1,35,000

5

= 1,65,000

Step 2: Calculation of Capital Employed

Step 3: Calculation of Normal Profit

Normal Profit = 17,80,000 × 8% = 1,42,400

Step 4: Calculation of Super Profit

Super Profit = 1,65,000 – 1,42,400 = 22,600

Step 5: Calculation of Goodwill

Goodwill = 22,600× 3 = 67,800

Valuation of Shares

Step 1: Net Assets available to Equity Shareholders

Step 2: Value per Share

Value per Share=18,49,800/15,000= 123.32

Totally paid-up share value = 123.32 – 30 = 103.32.

Q9) The following particulars of Amber Ltd. as on 31st March, 2012 are available:

7.   Average Profit after Tax (for last three years) Rs 5,85,000

8.   20% of profit after tax is transferred to General Reserve every year

9.   Fictitious Assets Rs 80,000

10.   Normal Rate of Return is 10%

Considering the above information, compute the value of equity share by:

1. Assets Backing method
2. Yield method
3. Fair value method (ignore goodwill)

Solution:

Valuation of Shares

Q10) The Balance Sheet of Sagar Ltd. as on 31st March, 2011 was as follows:

The net profit of the company after deducting all working charges and providing depreciation and taxation were as under:

On 31st March, 2011, Building was valued at Rs 500 lakhs and Machinery at Rs 300 lakhs. The other assets and liabilities have been correctly valued. In view of the nature of business, it is assumed that 10% is a reasonable return on tangible capital. Consider closing capital as average capital employed and simple average for computing average profit.

You are required to determine:

(a)  Value of Goodwill on the basis of 5 year’s purchase of super profits.

(b)  Intrinsic value of Equity Share.

Solution:

Sagar Ltd.

(a) Valuation of Goodwill by Super Profit Method

1. Average Capital Employed

2. Normal Rate of Return 10%

3. Normal Profit = A.C.E. × N.R.R. = 1376 × 10% = 137.60

4. Future Maintainable Profit

Average Profit = 932/5 = 186.40

5. Super Profit = F.M.P. – Normal Profit = 186.40 – 137.60 = 48.80

6. Goodwill = Number of years purchase × Super Profit = 5 × 48.80 = 244.00

Intrinsic Value of Equity Share

1. Net Assets available to Equity Shareholders

2. Intrinsic value per Equity Share

 = Net Assets Available to Equity Shareholder / No of Equity Shares

 = 1,620/100 = 16.20

Q11) The Balance Sheet of Adesh Ltd. as on 31st March, 2008 is given as under:

Balance Sheet as on 31st March, 2008

The after tax profits during the immediately past 5 years were as follows:

(a)  The loss of 2003-04 was due to strained industrial relations relations, which has since improved satisfactorily.

(b)  The market price of equity shares at present is Rs 130 per share.

(c)  The profit for 2007-08 was calculated after debiting the Profit & Loss A/c with Rs 50 lakhs for MD’s remuneration. In future, it will be Rs 6 lakhs for which necessary formalities have been completed.

(d)  A tender submitted in 2006-07 has been accepted and the annual additional earnings for the contract is going to be Rs 80 lakhs for the next 5 years with an annual growth 5%. For this purpose, new machinery worth Rs 100 lakhs would be needed and it will be acquired by  issuing paid-up shares.

The following revaluation have been agreed upon:

 Buildings Rs 220 lakhs

 Inventory Rs 350 lakhs

 Debtors Rs165lakhs

You are required to calculate:

(a)  Goodwill, if any on the basis of 5 year’s purchase of average annual super profits.

(b)  Valuation of equity shares on Asset Backing Method (Net Assets Method).

(c)  Valuation of equity shares on earnings basis when normal earnings in similar kind of business is 16%.

(d)  Valuation of equity shares on yield basis.

Solution:

Working

(a) Calculation of Capital Employed

(b)                   Normal Rate of Return

 Average Dividend = 18+20+22+15/4 = 85/4 = 21.25%

 NRR= Dividend/ Market Price x 100

         = 21.25/130 x 100 = 16%

(c)  Normal Profit of Average Capital Employed= 16% of 692.5 lakhs

            = 110.8 lakhs

(d)    Future Maintainable Profit= 68+133+120+135 = 456 lakhs

Average Profit= 456/4 = 114 lakhs

Annual Average Profit before Tax= 114/70 x 100 = 162.85 lakhs

 Add: Increase in Earnings     80.00 lakhs

 Less: Increase in MD’s remuneration (10.00) lakhs

 232.85 lakhs

                 Less: Tax @ 30%  (69.85) lakhs

 FMP  163.00 lakhs

Super Profit = F.M.P. – Net Profit

= 163 lakhs – 110.8 lakhs

= 52.2 lakhs

(a)  Goodwill = 5 × Super Profit

= 5 × 52.2 lakhs

=   Rs 261 lakhs

(b) Value Per Share

Net Tangible Assets 692.50 lakhs

Add: Goodwill 261.00 lakhs

953.50 lakhs

Less: Preference Capital 100.00 lakhs

Net Assets 853.50 lakhs

Number of shares = 40 lakhs

Value per Share= Net Assets/ No of Shares = 853.50/40 = Rs 21.34

(c)  Value per share on basis of earnings= ARR/NRR x paid up value per share

ARR = Avg Profit/C.E x 100

   = 163/692.32 x 100 = 23.53%

Value per share = 23.53/16 x 10 = Rs 14.70

(d) Yield Value = Dividend per share/Normal rate x 100

= 2.5/16 x 100 = 15.62%

Or Alternatively

Workings:

Calculation of Capital Employed:

Total Assets 985 lakhs

Less: Liabilities 335 lakhs

650 lakhs

Less: 1/2 of Retained Earnings = 25  12.50 lakhs

637.50 lakhs

Average rate of dividend =21.25%

N.R.R= 16%

Normal Profit = 16% of 637.50 = Rs 102 lakh

Average Profit before Tax= 114/70 x 100 = 162.85%

Say 163 lakhs

Less: Normal Profit 102 lakhs

Super Profit 61 lakhs

(a)  Goodwill = 5 × Selling Price = 5 × 61 = 305 lakhs.

(b)  Value of Equity Share of Net Asset Basis:

Net Assets 760 lakhs

Add: Goodwill 305 lakhs

1065 lakhs

Less: Profit Capital 100 lakhs

Net Assets  965 lakhs

Value of Share= 965/40 = Rs 24.125 lakhs

(c)  Value of Equity shares on earning basis = 135-10 (Pref Div) x 10

                400

 = 125/400 x 10 = Rs 31.25

Value per share = 31.25/16 x 10 = Rs 19.53

OR

=                               135-10                           x 100

    Capital+ R&S-Deferred Revenue Exp

= 125/515 x 100 = Rs 24.27

Value per share= 24.57/16 x 10 = Rs 13.28

(d)  Yield Basis = Average Yield/16 x 10

  = 21.25/16 x 10 = Rs 13.28

References

1. Corporate Accounting by B.B.Dam

2. Corporate Accounting by K.R.Das