UNIT -III

Valuation of Goodwill and Valuation of Shares

3.1 Concept of calculation – Simple Problem Only.

Meaning of Assets:

A valuable resource owned, owned or managed by an individual or organization that has economic value, is capable of generating future profits (income), and can be represented in monetary or monetary value.

Assets can be tangible or intangible in nature.

Meaning of Tangible Assets:

An asset that can be touched, felt, and seen because it has a clear physical form.

Meaning of the term Intangible:

Anything that is non-physical and can generate future economic benefits for a company is an intangible asset.

An asset that is not financially identifiable and cannot be seen, felt, or physically measured.

Definition of Accounting Standard for Intangible Assets (AS) 26:

Intangible assets are non-physical, identifiable, non-monetary assets held for the purpose of producing or supplying goods or services, renting to others, or for management purposes.

Characteristics of intangible assets:

1) Non-physical – There is no physical form. Therefore, it cannot be seen, felt or touched. It cannot be measured physically.

2) Identifiable – May be in the form of legal or contractual rights. It is separable from other assets and is sellable, transferable or exchangeable. Therefore, you can get a license and rent it. It can also take the form of a completely intangible right.

3) Manageable – An entity or individual manages an asset. The power to enjoy future financial benefits is given to the individual or group that owns it.

4) Future Economic Benefits-The ability to generate future economic benefits in the form of cost savings, profits, future markets and more.

5) Long-term useful life: These assets have the ability to generate long-term economic benefits.

6) Self-created or acquired separately from those acquired through business combination.

Meaning of Goodwill

Goodwill is an intangible but not fictitious assets which means it has some realizable 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 favorable 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 trade marks, 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)     Favorable location

(iv)     Access to supplies

(v)     Patents and trademarks protection

(vi)     Exceptionally favorable contracts.

(vii)     Capital requirements and arrangement of capital.

(viii)  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.

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

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

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 favorable 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 realizable 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 and 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.

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

Weighted Average Profit =

Total product

Total of weight

After adjusting profit in the light of future possibilities, average profit is 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

2

= 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 summarized 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 valuer 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

(I)   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.

(II)   Goodwill by purchase of future maintainable profit method: Steps:

(a)   Find out future maintainable profit.

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

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

(III)  Goodwill by capitalization of future maintainable profit method: Steps:

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

Capitalization Value of Future Maintainable Profit = FMP x 100

NRR

c.      Calculate capital employed.

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

(IV)   Goodwill by purchase of super profit method: Steps:

(a)   Find out average trading profit.

(b)  Find out future maintainable profit.

(c)   Find out capital employed.

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

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

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

(g)  Find out super profit:

Super Profit = Future Maintainable Profit – Normal Profit

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

(V)    Goodwill by capitalization 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.

Q3. M / s Mehta and his son have an average profit of Rs 60,000 with a capital of Rs 4,00,000. The normal rate of return for a business is 10%. Calculate the value of a company's goodwill using the capitalization of the super-profit method.

Solution:

Goodwill = Super Profit x 100 / Normal rate of return

= 20,000 × 100/10

= 2,00,000.

Working notes:

(I). Normal profit = Capital used * 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

Q4. M / s Joe and John is a partnership company with Joe and John as a partner. They now have to decide to allow James to the company and therefore evaluate goodwill. The capital used at the end of the fourth year is 500,000. The normal rate of return is 15%. Suppose the interest rate is equal to the normal rate of return. Calculate goodwill using the pension law. Their interests over the last four years are:

Solution:

Goodwill = Super Profit x Discount Factor = 67500 x 2.855 = 192713

Working notes:

(I) Average profit = Total profit / Years = 570000/4 = 142500

(II) Normal profit = Capital used x (Normal rate of return / 100) = 500000 x (15/100) = 75000

(III) Super profit = average profit – normal profit = 142500 – 75000 = 67500

Q5. Following are the gain for of Rakesh Bakers.

The capital adopted in 2015 is Rs350000 /-and the normal rate of return is 10% p.a. Find the value of goodwill based on a three-year purchase of business super-profit.

Solution:

Step 1: Average profit = 5 years / 5 years gross profit

= 200000/5 = Rs40000 /-

Step 2: Normal profit = Capital used X Normal rate of return / 100

= Rs350000 X 10/100 = Rs35000 /-

Step 3: Super Profit = Average Profit – Normal Profit

= Rs40000 – Rs35000 = Rs5000 /-

Step 4: Goodwill = Super Profit X Years of Purchase

= Rs5000 X 3 = Rs15000 /-

Q6. The benefits of Bootwala & Sons are:

The capital adopted in 2015 is Rs900000 /-and the normal rate of return is 10% p.a.

Find the value of goodwill based on a three-year purchase of business super-profit.

Solution:

Step 1: Average profit = 5/5 years gross profit

= 575000/5 = Rs115000 /-

Step 2: Normal profit = Capital used X Normal rate of return / 100

= Rs900000 X 10/100 = Rs90000 /-

Step 3: SP=AP-NP

= Rs1150000 – Rs90000 = Rs25000 /-

Step 4: Goodwill = Super Profit X Years of Purchase

= Rs25000 X 3 = Rs75000 /-

Q7. Below are the benefits of Harsh Bakers

The capital adopted in 2015 is Rs400000 /-and the normal rate of return is 10% p.a.

Find the value of goodwill based on a three-year purchase of business super-profit.

Solution:

Step 1: Average profit = 5/5 years gross profit

= 290000/5 = Rs58000 /-

Step 2: Normal profit = Capital used X Normal rate of return / 100

= Rs400000 X 10/100 = Rs40000 /-

Step 3: SP = AP – NP

= Rs58000 – Rs40000 = Rs18000 /-

Step 4: Goodwill = Super Profit X Years of Purchase

= Rs18000 X 3 = Rs54000 /-

Q8. The value of the business's net worth is Rs.1240000 /-. This business has made an average profit of Rs150000 /-in the last few years. The normal rate of return for similar types of businesses is 10%. Find the value of goodwill in a capitalized way.

Solution:

Step 1: Market capitalization of average profit = average profit / normal rate of return X 100 Market capitalization of average profit = 150000/10 X 100 = Rs. 1500000 /-

Step 2: Goodwill = Capital Value – Net Asset Value

= 1500000 – 1240000 = Rs260000 /-

Q9. The value of the business's net worth is Rs.460000 /-. The business has made an average profit of Rs90000 /-in the last few years. The normal rate of return for similar types of businesses is 15%. Find the value of goodwill by the capitalization method.

Solution:

Step 1: Market capitalization of average profit = average profit / normal rate of return X 100 Market capitalization of average profit = 90000/15 X 100 = Rs. 600000 /-

Step 2: Goodwill = Capital Value – Net Asset Value

= 600000 – 460000 = Rs140000 /-

Q10. The value of the business's net worth is Rs.790000 /-. The business has made an average profit of Rs500000 /-in the last few years. The normal rate of return for similar types of businesses is 5%. Find the value of goodwill by the capitalization method.

Solution:

Step 1: Market capitalization of average profit = average profit / normal rate of return X 100 Market capitalization of average profit = 500000/5 X 100 = Rs. 1000000 /-

Step 2: Goodwill = Capital Value – Net Asset Value

= 1000000 – 790000 = Rs210000 /-

Q11. Find the value of goodwill from the capitalization of the super-profit method from the following details of Krishna Coffee House.

The capital adopted in 2015 is Rs250000 /-and the normal rate of return is 10% p.a. Solution:

Step 1: Average profit = 5/5 years gross profit

= 300000/5 = Rs60000 /-

Step 2: Normal profit = Capital used X Normal rate of return / 100

= Rs250000 X 10/100 = Rs25000 /-

Step 3: SP=AP-NP

= Rs60000 – Rs25000 = Rs35000 /-

Step 4: Goodwill = SP X 100 / NRR

= Rs35000 / -X 100/10 = Rs350000 /-

Q12. Find the value of goodwill according to the market capitalization of the Super Profit Act from the following details of Bihad & Sons.

The capital adopted in 2015 is Rs200000 /-and the normal rate of return is 10% p.a. Solution:

Step 1: Average profit = 5/5 years gross profit

= 124000/5 = Rs24800 /-

Step 2: Normal profit = Capital used X Normal rate of return / 100

= Rs200000 X 10/100 = Rs20000 /-

Step 3: SP=AP-NP

= Rs24800 – Rs20000 = Rs4800 /-

Step 4: Goodwill = SP X 100 / NRR

= Rs4800 / -X 100/10 = Rs48000 /-

Q13. Find the value of goodwill according to the present value of the Super Profit Act from the following details of Bashir & Sons.

Solution:

Goodwill Value = Rs159715 /-

Q14. Below are the five-year profits of Ambika Store.

Calculate the value of goodwill based on a two-year purchase of a five-year average profit.

Solution:

Step 1: Total profit for 5 years = Rs.330000 /-

Step 2: Average profit = 5/5 years gross profit.

= Rs330000 / 5 years = Rs.66000 /-Step 3: Goodwill = Average profit x 2 years

= Rs.66000 / -X 2 = Rs 132000 /-

Q15. Below are the benefits of Girija Tea Depot.

There was an extraordinary increase in Rs45000 /-in 2016 and an extraordinary loss of Rs25200 /-in 2017.

Calculate the value of goodwill based on a 4-year purchase of a 6-year average profit.

Solution:

Step 1: Total profit for 6 years = Rs.970200 /-

Step 2: Average profit = 6/6 years gross profit.

= Rs970200 / 6 years = Rs.161700 /-Step 3: Goodwill = Average profit X 4 years

= Rs.161700 / - X 4 = Rs 646800 /-

Key takeaways:

1. Goodwill is an intangible asset that describes the excess purchase price of another company.
2. The items contained in goodwill are ownership or intellectual property and brand awareness and cannot be easily quantified.
3. Goodwill is calculated by taking the purchase price of the company and subtracting the difference between the fair market values   of assets and liabilities.
4. Companies should check the value of goodwill in their financial statements and record impairment at least once a year. Goodwill, unlike most other intangible assets, has an indefinite useful life, but most other intangible assets have a finite useful life.
5. Goodwill is an intangible asset and is offered in a variety of forms, including reputation, brand, domain name, and intellectual property.
6. The need to determine goodwill often arises when one company acquires another.
7. Goodwill is calculated as the difference between the amount of consideration transferred from the acquirer to the acquiree and the net identifiable assets acquired.

Valuation of Shares

Stock Valuation

For stocks listed on an approved stock exchange, the price listed on the stock exchange is usually used as the basis for the valuation of those stocks. However, stock exchange prices are generally determined based on the supply and demand position of stocks and the business cycle. The London Stock Exchange believes the stock exchange may be linked to a scientific record of registering the actions and options of private institutional investors in the country / world rather than its own actions and options. I am. These actions and options are the result of fear, guesswork, intellectual or other methods, good or bad investment policies, and many other considerations. The resulting estimates do not articulate a company's valuation with reference to asset and revenue potential. Therefore, accountants are required to value the stock in other ways.

The value of a company's stock depends on many factors, including:

1. The nature of the business.
2. Government economic policy.
3. Supply and demand of stocks.
4. Dividend rate paid.
5. Yields on other related stocks on stock exchanges, etc.
6. Company net worth.
7. Profitability.
8. Market price of stocks on the stock market.
9. Profit gained over the years.
10. Dividends paid on shares over the years.
11. Growth outlook, increased earnings per share, etc.

Necessity and purpose of stock valuation

1. The need for stock valuation can be felt by any company in the following situations:
2. For assessment of wealth tax, real estate tax, gift tax, etc.
3. Fusion, absorption, etc.
4. To convert a share of one class to another.
5. Proceed with lending related to stock collateral.
6. Compensate shareholders for the acquisition of shares by the government under the nationalization scheme.
7. Acquisition of equity of opposition shareholders based on reconstruction scheme, etc.

Factors Affecting Evaluation

The valuation of a company's stock is based, among other things, on the following factors:

1. The current stock market price of the stock.
2. Profit earned over the years and dividends paid:
3. Reserve availability and future outlook for the company.
4. Realizable value of the company's net worth.
5. Company current and deferred liabilities.
6. Age and status of company plants and machines.
7. Company net worth.
8. A record of the efficiency, integrity and integrity of management on the board of directors and other companies.
9. The quality of top and middle management of the company and its professional ability.
10. A record of the company's financial performance.

Stock Valuation Method

Specific methods are recognized for valuing a company's stock, including

1. Open Market Prices,
2. Stock Exchange Estimates,
3. Net Worth Base,
4. Earnings Per Share Method, And
5. Yield Or Return Method,
6. Net Worth Method,
7. Split Value, Etc.

Intrinsic Value Method

This method is also known as the asset backing method, the real value method, the balance sheet method, or the split value method. In this method, the value of each share is calculated by dividing the company's net assets, including goodwill and non-trading assets, by the number of issued shares.

If the market value of the asset is available, the same is considered, and in the absence of such information, the book value of the asset is considered the market value. It should not be considered when reaching fictitious assets such as net worth, reserves and debit balances on the income statement. Liability paid to third parties and preferred shareholders is deducted from total assets to reach net assets. Shareholder-related funds such as general reserves, income statements, corporate bond redemption fund balances, dividend levelling reserves and reserves should not be deducted.

Key takeaways:

1. For stocks listed on an approved stock exchange, the price listed on the stock exchange is usually used as the basis for the valuation of those stocks.
2. However, stock exchange prices are generally determined based on the supply and demand position of stocks and the business cycle.
3. If the market value of the asset is available, the same is considered, and in the absence of such information, the book value of the asset is considered the market value.

Q16. 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

Q17. The following particulars are available in respect of Goodluck 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

Q18. 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

Q19. 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

Q20. 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

Q 8

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.

Q 9

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

Q 10

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 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

(b) 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

Q 11

Solve the following:

(i)    Calculate basic EPS as per AS-20 from the following information:

Share capital as on 1-4-2009 1 lakh equity shares of Rs 10 each.

Issue of right shares for cash on 1-7-2009 in the ratio of 1 share for every 5 shares.

Issue of Bonus shares (excluding right shares) in the ratio of 1 share for every 5 shares.

Net profit (before tax) for 2009-10 Rs 4 lakhs. Income tax rate is 40%.

(ii)   Capital employed Rs 8.05 lakhs. Normal rate of return is 12%

Net Profit (before tax) for 3 years: Rs 2.05 lakhs, Rs 3.10 lakhs and Rs 3.04 lakhs. Rate of Income Tax is 50 %.

Compute goodwill by capitalisation of F.M.P. Method.

(iii)   On 31-3-2010, Holding Company acquired 75% of shares in subsidiary for Rs 3.60 lakhs. On that date, subsidiary had 25,000 shares of Rs 10 each and Reserves Rs 1.50 lakhs. What is the value of goodwill on acquisition?

Solution:

1. Calculation of Weighted Average Number of Shares.

Basic E.P.S.

Notes:

Earnings        = 2,40,000/1,35,000 = Rs 1.78

Weighted Average Number of Shares

(i)   As per AS-20, Date of issue bonus shares not to be considered and period is to be taken from the date of commencement of the year.

(ii) Rate of tax is 40%, then earning = Rs 4,00,000 – 40% of 4,00,000 = Rs 2,40,000

2.     (i) Average Capital Employed = Rs 8,05,000

(ii)   Normal rate of Return = 12%

(iii)   F.M.P

Net Profit after Tax= 2,50,000+3,10,000+3,04,000 / 3

Net Profit after Tax is Rs 1,44,000.

(iv)  Value of Business by Capitalisation of F.M.P. At 12% = 1,44,000/12 ×100

= Rs 12,00,000

(v)   Goodwill = Value of Business – Capital Employed = 12,00,000 – 8,05,000

= Rs 3,95,000

3. Cost of Control/Goodwill Rs

Cost of Investment of Holding Company 3,60,000

Less: Paid-up Value of Shares 1,87,500

Less: Share of Capital Profit 1,12,500

60,000

Q 12

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