Annuity Method of Valuation of Goodwill

The Annuity Method is a refined version of the Super Profit Method. Instead of simply multiplying super profits by years’ purchase, this method considers the time value of money. Since future profits will be earned year after year, their present value should be calculated. Under this method, goodwill is the present value of super profits treated as an annuity over a certain number of years, discounted at a normal rate of return.

Formula:

Goodwill = Super Profit × Present Value of Annuity Factor (PVAF)

Where:

• Super Profit = Average Profit – Normal Profit

• PVAF = Present value of ₹1 received annually for a given period, discounted at the normal rate of return

Steps

1. Calculate Average Profit (adjust past profits).

2. Find Normal Profit = Capital Employed × NRR ÷ 100.

3. Compute Super Profit = Average Profit – Normal Profit.

4. Find PVAF (from annuity tables or by formula):

5. Multiply Super Profit by PVAF to get goodwill

Advantages:

1. Considers the time value of money, making valuation more realistic.

2. More accurate than simple or super profit methods.

3. Fair representation of goodwill when profits are expected to be earned over a definite period.

Limitations:

1. Requires annuity tables or present value calculations, which makes it more complex.

2. Assumes super profits will remain constant over the period, which may not always be true.

3. Not widely used in small businesses due to complexity.