P. G.

DEPARTMENT OF COMMERCE
RAMA DEVI WOMEN’S UNIVERSITY
This report is submitted for the partial fulfillment of 3nd mid
semester examination

SUBMITTED TO:- Mr. Biswajit Sahoo

SUBMITTED BY:-
Sanjana Patnaik- 171R0022031
Sasmita Jena- 171R0022032
Sasmita Sahoo- 171R0022033
Sayda Quadri- 171R0022034
Seema Samal- 171R0022035
TOPIC:- Methods of Valuation of Goodwill
SUBJECT:- Advanced Accounting
SUBJECT CODE:- CE - 301
2023-2024
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Title Pg no
no.

1 Introduction 2

2 Average Profit Method 3

3 Super Profit Method 7

4 Conclusion 10

5 Photos from the day of Presentation 11

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 INTRODUCTION
Goodwill is the super earning power of company reputation that a company earns as a result of
its good relationships with customers, employees, suppliers, and other stakeholders. It represents
the positive public perception, trust, and the overall attractiveness of the business. Goodwill is
not a physical or tangible asset like machinery or real estate but is an essential element in
assessing a company's overall value.Goodwill can include factors such as brand recognition,
customer loyalty, a solid customer base, a positive company culture, and a strong market position.
It often plays a critical role in a company's long-term success and can impact its ability to
generate future revenues and profits.Goodwill is significant in financial reporting, as it affects a
company's overall net worth and can influence financial decisions, such as acquisitions, mergers,
and divestitures.

Methods of Goodwill

1. Simple Average method

2. Weighted Average method
3. Super Profit method
4. Capitalization Method
5. Purchase Method
6. Annuity Method

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Average profit method

The abnormal profit of the year is subtracted from the net profit of that year.

The abnormal loss of the year is added to the net profit of that year.

Income not earned from the business operations, such as income from investments is deducted
from the net profit of that year.

This method is further divided into two methods:

A. Simple Average Profit Method:

In this method, the number of past years’ profits serves as the basis for the valuation of goodwill.
The average of such profits is calculated by dividing the total of such profits by the number of
years. Then, the average of the profits is multiplied by the agreed number of years of purchase to
calculate the value of Goodwill.

Average Profit = Value of Goodwill = Average Profit × Number of Years of purchase

Illustration:

Calculate the value of the firm’s goodwill on the basis of 2 years of the purchase of the average
profit for the last three years.2019- ₹80,000 (Including an Abnormal gain of ₹ 10,000)2020-
₹1,00,000 (After charging Abnormal loss of ₹20,000)2021- ₹90,000

Solution:

Calculating Average Profit:Average Profit =

Average Profit = 93,334

Calculating Value of Goodwill:

Value of Goodwill = Average Profit X Number of Years of purchase

Value of Goodwill = 93,334 X 2

Value of Goodwill = ₹1,86,668.

B. Weighted Average Profit Method:

The weighted Average Profit Method is a modified form of the Average Profit Method, under
which each profit is assigned a weight. More weightage is assigned to the profits of the latest
year to ensure the accuracy in the calculation of anticipated future profits and Goodwill. The
weighted Average Profit Method is preferable when the profit over the past consecutive years
shows a continuous rise or fall.

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In this method following, steps are to be followed to calculate the value of the goodwill:

Step 1: Assigning weightage to the profits. The highest weight is assigned to the profit of the
most recent year.

Step 2: Product of profits is calculated by multiplying the weight with the respective profit of
that particular year.

Step 3: Weighted Average Profit is then calculated by dividing the Total of products of profits by
the Total Weights.

Weighted Average Profit = Total of products of profits ÷ Total Weights

Step 4: The value of Goodwill is calculated by multiplying the Weighted Average Profit by the
Number of years of purchase.

Goodwill = Weighted Average Profit × Number of years of purchase

Illustration:

Calculate the value of Goodwill based on two years’ purchase of the weighted average profit
after assigning weights 1,2,3,4,5 and to the profits for 2018, 2019, 2020, 2021, and 2022,
respectively from the following information:

Weighted Average Profit = ₹32,800

Calculating Value of Goodwill:

Goodwill = Weighted Average Profit X Number of years of purchase

Goodwill = 32,800 X 2

Goodwill = ₹65,600

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The simple profit method of valuing goodwill has several advantages:

1. Simplicity: As the name suggests, it is a straightforward method that is easy to understand and
apply.

2. Quick Assessment: It allows for a relatively quick assessment of goodwill value, which can
be useful in situations where a rapid valuation is required.

3. Focus on Profitability: This method directly considers the profit earned by a business, which
is a key indicator of its value. It reflects the earning capacity of the business.

4. Historical Data: It relies on historical profit figures, making it suitable for businesses with a
stable and consistent earnings history.

5. Applicability to Small Businesses: The simplicity of this method makes it particularly

suitable for small businesses that may not have complex financial structures or extensive.

The simple profit method of valuing goodwill, while straightforward, has several
limitations:

1. Ignores Future Growth: This method relies solely on historical profit figures and does not
account for the potential for future growth or changes in the business environment. It assumes
that past profits will continue indefinitely, which may not be the case.

2. Inadequate for Rapidly Growing Businesses: For businesses experiencing rapid growth or
those in dynamic industries, the simple profit method may significantly undervalue goodwill
because it does not capture the potential for increased future earnings.

3. Doesn't Consider Market Conditions: It doesn't consider factors like market conditions,
industry trends, or competitive forces, which can have a significant impact on a business's value.

4. Excludes Intangibles: This method does not account for the value of intangible assets such as
brand reputation, customer relationships, or intellectual property, which can be crucial
contributors to a company's value.

5. Relies on Historical Data: It is heavily reliant on historical financial data. If the business's
historical financial performance is atypical or inconsistent, the method may produce inaccurate
results.

6. Limited Applicability: The simple profit method is more suitable for businesses with stable
and consistent earnings. It may not be appropriate for startups, businesses with irregular profits,
or those undergoing significant changes.

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7. Ignores Risk Factors: It does not consider the risks associated with the business, which can
impact the value of goodwill. Factors like legal liabilities, economic risks, or changes in
regulations are not taken into account.

8. Subjectivity in Profit Selection: There can be subjectivity in selecting the appropriate level
of profit to use in the valuation, as different analysts may choose different historical periods or
profit measures.

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Super Profit Method

The "super profit method" is a financial valuation technique used to estimate the value of a
business or investment based on the premise that certain profits generated by the business are
above the normal or expected level of profitability. This method is often used in the context of
business valuation, especially when valuing companies with significant intangible assets or
competitive advantages.

Steps to calculate Goodwill using Super Profit Method

The following steps are involved in the calculation of goodwill using super profit method.

1. Calculate the total capital of the business. It will be the sum total of all the net current and
fixed assets along with the shareholders equity.

2. Determine the normal profit by multiplying the total capital employed with the normal rate of
return.

3. Calculate the average estimated profit or average manageable profit

4. Calculate super profit by subtracting the value of normal profit from the average estimated
profit to determine the super profit.

5. Multiply the super profit by the number of years of purchase to determine the goodwill.

It can be expressed in formula as follows:

Normal Profit = Capital Employed x (Normal Rate of Return/100)

Super Profit = Average estimated profit – Normal Profit

Goodwill = Super Profit x No. of years of purchase

Example of Super Profit Method

ABC Ltd has employed Rs.1000000 as the capital and the investors are not very happy when the
income obtained from the investment is 30% while the actual profit obtained is Rs. 4,00,000.

In this question, the normal profit is 30% of 1000000 which is 3,00,000 and the actual profit is
4,00,000.

Therefore, the super profit is

Super Profit = Average estimated profit – Normal Profit

= 4,00,000 – 3,00,000

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= 1,00,000

The Super Profit Method, used for business valuation, has its own set of advantages and
limitations. Here's a breakdown of both:

Advantages:

1. Applicability to Businesses with Unique Advantages: The Super Profit Method is

particularly useful when valuing businesses with unique competitive advantages or significant
intangible assets. It allows for the recognition of the value of these intangibles.

2. Focus on Economic Reality: It considers the actual profitability of the business, recognizing
that some businesses can generate profits well above the industry norm due to their unique
characteristics.

3. Flexible: The method is adaptable to various business types and industries. It can be
customized to fit the specific circumstances of the business being valued.

4. Considers the Duration of Superior Profits: By including a super profit period in the
valuation, it takes into account the expected duration of the business's competitive advantage.
This is particularly useful for businesses with time-limited advantages.

Limitations:

1. Subjectivity: The Super Profit Method heavily depends on assumptions and estimates, such as
the determination of normal profits, the super profit period, and the capitalization rate. These
estimates can be subjective and vary depending on who is performing the valuation.

2. Data Availability: It requires a significant amount of historical and financial data, which may
not be readily available or accurate for some businesses, especially small or private companies.

3. Difficulty in Estimating Super Profit Period: Determining the appropriate length of the
super profit period is challenging. If this period is estimated incorrectly, it can significantly affect
the valuation.

4. Sensitivity to Assumptions: Small changes in assumptions, such as the capitalization rate,

can result in significantly different valuations. This sensitivity to assumptions can make the
method less reliable.

5. Lack of Guidance: Unlike more standardized methods like the discounted cash flow (DCF)
method, the Super Profit Method lacks specific guidelines or standards, making it harder to
achieve consistency in valuation.

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6. Not Suitable for All Businesses: The Super Profit Method may not be suitable for businesses
with relatively stable or average profitability. It's primarily designed for businesses with unique
characteristics and potential super profits.

7. Limited in Application: It may not be the best choice for valuing certain types of assets, like
real estate, where traditional methods such as market comps or income capitalization are more
commonly used.

In summary, the Super Profit Method can be a valuable approach to value businesses with unique
advantages, but it has its limitations due to its subjectivity and reliance on estimates. When using
this method, it's important to exercise caution, use sound judgment, and consider consulting with
financial experts or valuation professionals to ensure the accuracy and reliability of the valuation
results.

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 Conclusion
We've explored two essential methods for calculating goodwill in the context of business
acquisitions: the Average Profit Method and the Super Profit Method.

In conclusion, understanding and calculating goodwill is crucial for making informed decisions
in business acquisitions and mergers. These methods provide a structured approach to
quantifying the intangible assets' value, helping stakeholders navigate the financial aspects of
such transactions effectively.

As you consider these methods in practice, always seek the guidance of financial professionals or
accountants who can apply these techniques accurately and in compliance with relevant
accounting standards.

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