Average Profit Method of Valuation of Goodwill

Capitalisation of Average Profit Method:

(i) Ascertain the average future maintainable profit, as explained already.

(ii) Capitalize this average profit at the normal rate of return on investment on the type

• Simple Average: Under this method, the goodwill is valued at agreed number of years’ of purchase of the average profits of the past years. Goodwill = Average Profit x No. of years’ of purchase
• Weighted Average: Under this method, the goodwill is valued at agreed number of years’ of purchase of the weighted average profits of the past years. We use the weighted average when there exists an increasing or decreasing trend in the profits giving highest weight to the current year’s profit.

Goodwill = Weighted Average Profit x No. of years’ of purchase

Weighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights

Of business under consideration:

This will give the net worth of the business.

(iii) Find out the value of net tangible assets (i.e., net assets other than goodwill) of the business.

(iv) Deduct the net tangible assets from the capitalised net worth of the business and the difference is goodwill.

Problem:

A company desirous of selling its business to another company has earned an average past profit of Rs. 1,60,000 per annum and the same amount of profit is likely to be earned in the future also, except that:

(1) Directors’ fees of Rs. 12,000 per annum charged against such profits will not be payable by the purchasing company whose existing Board can manage the new business also.

(2) Rent at Rs. 28,000 per annum which had been paid by the vendor company will not be incurred in the future since the purchasing company its owns premises and the necessary accom­modation can be provided.

The net assets, other than goodwill, were Rs. 18, 00,000 and it’ was considered that a reasonable return on investment in this type of business would be 10%.

Solution: