Super Profit Method of Valuation of Goodwill

11/07/2020 2 By indiafreenotes

Goodwill can be attached only to a business which is earning above normal profits of super-profits. If there are no anticipated excess earning over normal earnings, there can be no goodwill.

Such excess profits are known as super-profit and it is the difference between the average profit earned by the business and the normal profit based on the normal rate of return.

Hence for find­ing to the super-profits the following information will be required:

(a) The estimated average future profits of the firm (ascertained as already explained),

(b) The normal rate of return on investment and

(c) The fair value of average capital employed in the business.

Normal rate of return:

The normal rate of return refers to the rate of earnings which inves­tor in general expect on their investments in a particular type of industry. It varies depending upon general factors like the bank rate, general economic conditions, political stability, etc., and specific factors like period of investment, risk attached to the investment, etc.

(i) The Number of Years Purchase Method: Under this method, the goodwill is valued at agreed number of years’ of purchase of the super profits of the firm.

Goodwill = Super Profit x No. of years’ of purchase

Super Profit = Actual or Average profit – Normal Profit

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

(ii) Annuity Method: This method considers the time value of money. Here, we consider the discounted value of the super profit.

Goodwill = Super Profit x Discounting Factor