UNIT 4
Valuation of goodwill
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.
The following reasons arises the need for evaluating goodwill
Goodwill is the excess of purchase price over share of net assets (fair value). Goodwill is an intangible assets, it is a reputation of a company. Goodwill = purchase price – FV of net assets acquired as on date of purchase.
Definition
An intangible asset that arises as a result of the acquisition of one company by another for a premium value. The value of a company’s brand name, solid customer base, good customer relations and any patents or proprietary technology represents goodwill.
Types of valuing goodwill
Steps
Calculation of Average profit:
(a) Simple Average Profit = Total profit of (past years)/ Total number of past years
(b) Weighted average profits
Trading Profit (a) | Weight (b) | Product (a × b) | ||
2007 2008 2009 | xx xx xx | 1 2 3 | xx xx xx | |
6 | xxx | |||
Weighted Average Profit = Total product / Total of weight
For example 1– the profits of the company for the last three years are as follows
Year | Profits |
2008 | 20000 |
2009 | 20000 |
2010 | 35000 |
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Solution
The average profits of the company are = (20000+20000+35000)/3 = 25000
Example 2 – Xltd agreed to purchase a business. For that purchase, goodwill id to be valued at 3 years’ purchase of average profits of last 5 years
Profits for these years are: Years Profits (Rs) I 24,000 II 20,000 III 22,000 IV 26,000 V 24,000 Solution: Average profit = Rs 24,000 + 20,000 + 22,000 + 26,00 + 24,000 / 5 = 1,16,005 / 5 = 23,200 Goodwill = 3 year’s purchase average profit of last 5 years = Rs 23,200 × 3 = Rs 69,600
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Example 3 - calculated weighted average profit
Year | Profit | Weights |
2010 2011 2012 2013 | 15,400 17,600 23,400 24,620 | 1 2 3 4 |
Solution
Calculation of Average Profit
Years | Trading Profit (a) | Weight (b) | Product (a × b) | |
2010 2011 2012 2013 Sum total | 15,400 17,600 23,400 24,620 | 1 2 3 4 | 15,400 35,200 70,200 98,480 | |
- | 10 | 2,19,280 | ||
Weighted Average Profit = Rs 2,19,280 / 10
= Rs 21,928
Goodwill = 3 year’s purchase of weighted average profit
= Rs 21,928 × 3
= Rs 65,784
2. Super profit method - Super profit is the excess of estimated future maintainable profits over normal profits. The goodwill under this method is ascertained by multiplying the super profits by certain number of year’s purchase.
Steps
Example – the capital employed as shown by the books of ABC LTD is 50,000,000. And the normal rate of return is 10%. Goodwill is to be calculated on the basis of three years purchase of super profits of the last four years. Profits of last four years are:
Year | Profit |
2005 | 10,000,000 |
2006 | 12,250,000 |
2007 | 7,450,000 |
2008 | 5,400,000 |
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Solution
Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 = 35,100,000 Average Profits = 35,100,000 / 4 = $ 8,775,000
Normal Profits = 50,00,000 x 10/100 = 5,000,000 Super Profits = Average/ Actual Profits – Normal Profits = 8,775,000 – 5,000,000 = 3,775,000 Goodwill = 3,775,000 × 3 = 11,325,000 |
3. Capitalized method - Goodwill under this method can be calculated by capitalizing average normal profit or capitalizing super profits.
Goodwill = Capitalised Value – Net Assets of Business
Steps
Capitalised Value = Average Future maintainable profits x 100 / Normal Rate of Return
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Goodwill = Capitalised Value – Net assets of business.
b. Capitalization of super profit method - The goodwill under this method is ascertained by capitalizing the super profits on the basis of normal rate of return. This method assesses the capital needed for earning the super profit.
Goodwill = Average Annual Super Profits x 100 / Normal Rate of Return |
Example
Balance Sheet of Mr. X as on 31st Dec. 2004 was as under:
Capital Creditors Bills Payable | 2,50,000 80,000 20,000
| Land Machinery Furniture Stock Cash at Bank | 1,80,000 1,10,000 2,000 8,000 50,000 |
3,50,000 | 3,50,000 |
The profit of the business for the five years ending 31st Dec. 2004 are:
Rs.
2000 40,000
2001 42,000
2002 45,000
2003 50,000
2004 53,000
The assets are revalued as under:
Land 1,94,000
Machinery 1,18,000
Furniture 1,000
The reasonable return on capital invested is 10% p.a.
Assume that normal management remuneration is Rs. 6,000.
Find out Goodwill by Capitalisation Method.
Solution
(a) Average profit = Total profits of 5 years / 5 = 2,30,000 ÷ 5 = 46,000 Less: Remuneration = 6,000 Average Profit 40,000 Calculation of normal capital by capitalization of average profit 40,000 x 100 / 10 = Rs. 4,00,000 Rs. Land 1,94,000 Machinery 1,18,000 Furniture 1,000 Stock 8,000 Cash 50,000 Total Assets 3,71,000
Less: Liabilities Creditors 80,000 B/P 20,000 1,00,000 Net assets (capital employed) 2,71,000
Goodwill = Normal Capital – Actual Capital Employed = Rs. 4,00,000 – 2,71,000 = Rs. 1,29,000 (b) Capitalisation of super profit: Average Profit Rs. 40,000 Less: Normal profit: 10% on Rs. 2,71,000 Rs. 27,100 Super Profit: 12,900 Goodwill = Rs. 12,900 x 100/10 = Rs. 1,29,000
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4. Annuity method - goodwill is calculated under this method by taking average super profit as the value of an annuity over a certain number of years. The present value of this annuity is computed by discounting at the given rate of interest (normal rate of return). This discounted present value of the annuity is the value of goodwill.
Steps
Example -
The net profit of a company after providing for taxation for the past five years is:
Year 2010 2011 2012 2013 | Profit (Rs) 50,000 30,000 70,000 80,000 |
The net tangible assets in the business are Rs. 4, 00,000 on which the normal rate of return is expected to be 10%. It is also expected that the company will be able to maintain its super profits for next five years. Calculate the value of goodwill of the business on the basis of an annuity of super profits, taking present value of an annuity of Rs. 1 for five years at 10% interest is Rs. 3.78.
Solution
Calculation of Average Profits Year Profit (Rs) 2009 40,000 2010 50,000 2011 30,000 2012 70,000 2013 80,000 Total 2,70,000 Average Profit = 2,70,000 / 5 = Rs. 54,000
Calculation of Super Profit Particulars Profit (Rs) Average Profit 54,000 Less: Normal Profit (10% of 4,00,000) 40,000 Super Profit 14,000 Value of Goodwill = Super Profit x Value of an Annuity = Rs. 14,000 x 3.78 = Rs. 52,920
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Key takeaways –
Valuation of shares
Valuation of shares is the process of knowing the value of company’s shares. Normally, the value of shares is ascertained from the market price quoted on the stock exchange. Shares of limited company are required to be valued on many occasions such as –
Methods of valuation of shares
- Goodwill must be properly valued
- The fixed assets should be taken at their realized value
- Provision of bad debts, depreciation, etc must be considered
- Floating assets should be taken at market value
- All unrecorded assets and liabilities should be considered.
Thus the value of net asset is:
Total of realisable value of assets – Total of external liabilities = Net Assets (Intrinsic value of asset)
Total Value of Equity shares = Net Assets – Preference share capital
Value of one Equity share = Net Assets – Preference share capital/Number of Equity shares
Example – the following information is available from Tina ltd as on 31st march 2009
Capital: 1,000, 5% Preference Shares of Rs. 100 each fully paid Rs. 1,00,000 2,000 Equity Shares of Rs. 100 each fully paid Rs. 2,00,000 Reserve and Surplus Rs. 2,00,000 6% Debentures Rs. 1,00,000 Current Liabilities Rs. 1,00,000
Assets: Fixed Assets Rs. 4,00,000 Current Assets Rs. 3,00,000 |
For the purpose of valuation of shares, fixed assets and current assets are to be depreciated by 10%; interest on debentures are due for 6 months; preference dividend is also due for the year. Neither of these have been provided for in the balance sheet. Calculate value of equity under net asset method
Solution
Net Assets Available To Equity Shareholders: Rs Assets Fixed assets (400000 – 10% of 400000) 360000 Current assets (300000 – 10% of 300000) 270000 Value of Assets 630000 Less: Liabilities Current Liabilities 100000 6% Debentures 100000 Add: Interest Outstanding (Rs. 100000*6/100*6/12) 3000 203000
5% Preference Share Capital 100000 Add: Arrear Dividend (Rs 100000 * 5%) 5000 105000 308000
Net Assets available to Equity Shareholders 322000 No. of equity shares 2000
Value of each share under Net Assets Method: Value per share = Net Assets available to Equity Shareholders / No. of Equity Shares = Rs. 3,22,000/ 2,000 = Rs. 161
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2. Yield method - the emphasis is given to the yield that an investor expects from his investment, under this method. The yield means return that an investor gets out of his holdings—dividend, bonus shares, right issue. Yield is the effective rate of return on investments which is invested by the investors. It is always expressed in terms of percentage. Under Yield-Basis method, valuation of shares is made on;
Profit basis - Under this method, firstly, profit are determined on the basis of past average profit; thereafter, capitalized value of profit is to be ascertained on the basis of normal rate of return, and, the same (capitalized value of profit) is divided by the number of shares in order to find out the value of each share.
Capitalised Value of Profit = Profit1 / Normal rate of Return x 100 Value of each equity share = Capitalised Value of Profit / Number of Shares Or, Value of each equity share = Profit / Normal rate of Return x Number of Equity Shares x 100
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Examples –
Two companies, A Ltd. and B. Ltd., are found to be exactly similar as to their assets, reserves and liabilities except that their share capital structures are different:
The share capital of A. Ltd. is Rs. 11,00,000, divided into 1,000, 6% Preference Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each.
The share capital of B. Ltd. is also Rs. 11,00,000, divided into 1,000, 6% Preference Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each. .
The fair yield in respect of the Equity Shares of this type of companies is ascertained at 8%.
The profits of the two companies for 2009 are found to be Rs. 1, 10,000 and Rs. 1, 50,000, respectively.
Calculate the value of the Equity Shares of each of these two companies on 31.12.2009 on the basis of this information only.
Solution
Valuation of Shares of A. Ltd. Rs. Valuation of Shares of B. Ltd Rs Average Profit of 2 years = 1,30,000 Average Profit 1,30,000 (Rs. 1,10,000 + Rs. 1,50,000) / 2 Less: Pref. Dividend 6% on Rs. 1,00,000 6,000 Less: Preference Dividend 6% on Maintainable Profit 1,24,000 Rs. 10,00,000 60,000 Capitalised Value of Profit: Maintainable Profit 70,000 Capitalised Value of Profit = Rs. 70,000 / 8 x 100 Rs. 1,24,000 / 8 x 100 = 15,50,000 = Rs. 8,75,000 Value of each Equity Share Value of each Equity Share = Rs. 8,75,000 / 10,000 = Rs. 87.50 = Rs. 15,50,000 / 1,00,000 = Rs. 15.50
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Dividend basis - Valuation of shares may be made either
(a) On the basis of total amount of Dividend:
Normal Rate of Return, i.e., Yield Value of each Equity Share = Capitalised Value of Profit
Normal Rate of Return x No. of Equity Shares (b) On the basis of percentage or Rate of Dividend:
Normal Rate of Return When the Rate of Dividend is not given Rate of Dividend = Profit / Equity Share Capital (Paid-up) x 100
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Examples
Calculate the value of each Equity Share from the following information: Of which 20% was placed to Reserve, this proportion being considered reasonable in the industry in which the company is engaged and where a fair investment return may be taken at 10%.
The Net Profit for the three years were: Rs. 2007 51,600 2008 52,000 2009 51,650
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Solution:
Rs. Average Profit = Rs. 51,600 + Rs. 52,000 + Rs. 51,650 / 3 51,750 Less: Transfer to Reserve @ 20% 10,350 Maintainable Profit 41,400 Here, the rate of dividend is not given, the same can be found out with the help of the following: Rate of Dividend = Profit / Equity Capital (Paid-up) x 100 = Rs. 41,400 / Rs. 4,00,000 x 100 = 10.35 % Value of each Equity Share = (Rate of Dividend / Normal Rate of Return ) x (Paid-up value of each Equity Share) = Rs. 10.35 / 10 x Rs. 10 = Rs. 10.35 Alternatively, it can also be found out by Profit Basis method = Profit / Normal Rate of Return x 100 = Rs. 41,400 / 10 x 100 = Rs. 4,14,000 Value of each Equity Share = Capitalised Value of Profit / Number of Equity Shares = 4,14,000 / 40,000 = Rs. 10.35
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3. Fair value method – the Fair Value Method which is the mean of intrinsic value and Yield Value method and the same provides a better indication about the value of shares than the other methods.
Fair Value = Intrinsic Value + Yield Value / 2 |
Example
Ascertain the value of equity share under fair value method
Liabilities | Rs. | Assets | Rs. |
Share Capital: Equity Shares of Rs. 10 each 12% Pref. Shares of Rs. 100 each General Reserve Profit and Loss A/c 15% Debentures Creditors |
1,00,000 1,00,000 60,000 40,000 1,00,000 80,000
| Goodwill Building Plant Investment in 10% stock (Market value of Rs. 52,000, Nominal value Rs. 50,000) Stock Debtors Cash Preliminary Expenses | 50,000 1,50,000 1,00,000
48,000
60,000 40,000 10,000 22,000 |
4,80,000 | 4,80,000 |
Building Rs. 3, 20,000, Plant Rs. 1, 80,000, Stock Rs. 45,000 and Debtors Rs. 36,000. Average Profit of the company is Rs. 1, 20,000 and 12½% of profit is transferred to General Reserve, Rate of taxation being 50%. Normal dividend expected on equity shares is 8% whereas fair return on capital employed is 10%. Goodwill may be valued at 3 years’ purchase of super-profit.
Actual Profit Rs. Average Profit 1,20,000 Less: Non-trading Income (i.e., income from investment) @ 10% on Rs. 50,000 5,000 1,15,000 Add: Debentures Interest 15,000 1,30,000 Less: Pref Dividend 12,000 1,18,000 Less: Taxation @ 50% 59,000 59,000 Less: Transfer to Reserve @ 121/2 % 7,375 51,625 Super-Profit = Actual Profit – Normal Profit = Rs. 51,625 – Rs. 51,100 = 525 Value of Goodwill = Rs. 525 x 3 = Rs. 1,575 or Rs. 1,600
Valuation of Shares Asset-Backing Method Rs.
Sundry Assets (as above) 5,11,000 Add: Investments 48,000 Add: Goodwill 1,600 Funds available for Equity Shareholders 5,60,600
Intrinsic Value of Share = Rs. 5,60,600 / 10,000 = Rs. 56.06 Yield-basis Value of Share = Rs Rate of Dividend / Normal Rate of Return x Paid-up Value of each Share = 8 / 10 x Rs. 10 = Rs. 8. Note: In the present we can also apply ‘Profit Basis Method’ instead of ‘Dividend Basis’.
Fair Value Fair Value = Intrinsic Value + Yield-basis / 2 = Rs. 56.06 + Rs. 8.00 = Rs. 32.03
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Key takeaways –
References
