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CFA

UNIT 4

Valuation of goodwill

 

Q1) The profits of the company for the last three years are as follows

Year

Profits

2008

20000

2009

20000

2010

35000

A1)

The average profits of the company are = (20000+20000+35000)/3 = 25000

 

 

Q2) Calculated weighted average profit

Year

Profit

Weights

2010

2011

2012

2013

15,400

17,600

23,400

24,620

1

2

3

4

 

A2)

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

 

 

Q3) 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

 

 

 

              A3)

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

 

 

Q4)

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.

 

 

A4)

(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

 

 

 

Q5) 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.

A5)

                                   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

 

 

 

Q6) 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

A6)

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              

 

 

 

Q7)  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.

A7)

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

 

 

 

 

Q8) 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%.

Liabilities

Rs

Assets

Rs

Issued Capital in Rs. 10 shares

Reserves

Profit and Loss Account

5% Debentures

Current Liabilities

4,00,000

90,000

20,000

1,00,000

1,30,000

Fixed Assets

Current Assets

Goodwill

5,00,000

2,00,000

40,000

 

 

7,40,000

7,40,000

The Net Profit for the three years were:

                                                                                 Rs.

2007                                                                 51,600

2008                                                                 52,000

2009                                                                 51,650

 

 

                                                                                                                 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

 

 

 

Q9) 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.

 

A9)

 

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

 

 

 

 

Q10) Explain the valuation of shares

A10) 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 –

  • Sale or purchase of shares of a private limited company whose shares are not quoted on the stock exchange
  • Sale or purchase of large number of shares enabling the purchaser to acquire control of management of the company
  • Sale of entire company on amalgamation with, or absorption by another company
  • Valuation of assets held by investment company
  • Conversion of one class of shares into another
  • Ascertaining the value of shares offered as security against loan.
  •  

    Methods of valuation of shares

  • Net asset method of valuation of shares - This is also known as Balance Sheet Method or Intrinsic Method or Break-up Value Method or Valuation of Equity basis or Asset Backing Method. Under this method, net assets of the company are divided by the number of shares to arrive at the net asset value of each share. According to this method the following points should be considered.
    1. Goodwill must be properly valued
    2. The fixed assets should be taken at their realized value
    3. Provision of bad debts, depreciation, etc must be considered
    4. Floating assets should be taken at market value
    5. 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

     

    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;
  • Dividend Basis.
  • 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

     

     

    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