UNIT III

Valuation of Goodwill and Shares

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.

A1)

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.

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.

A2) 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.

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.

A3)

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:

A4)

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.

A5)

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.

A6)

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.

A7)

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.

A8)

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.

A9)

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.

A10)

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.

A11)

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.

A12)

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.

A13)

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.

A14)

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.

A15)

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 /-