Capitalization of Profit Method

Capitalisation method is a method of determining the value of a firm by calculating the net present value of expected future profits or cash flows of the firm. It is used when the actual profits of the firm are less than the normal profits. It is calculated by dividing the adjusted profit by normal rate of return.

= {Profit (Adjusted)/Normal Rate of Return} *100

(i) Capitalization of Average Profits: Under this method, the value of goodwill is calculated by deducting the actual capital employed from the capitalized value of the average profits on the basis of the normal rate of return.

• Goodwill = Normal Capital – Actual Capital Employed
• # Normal Capital or Capitalized Average profits = Average Profits x (100/Normal Rate of Return)
• # Actual Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities

(ii) Capitalization of Super Profits: Under this method, Goodwill is calculated by capitalizing the super profits directly.

• Goodwill = Super Profits x (100/ Normal Rate of Return)