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# Capitalisation Method of Calculating Goodwill

• Last Updated : 02 Sep, 2022

In a common language, Goodwill means a ‘reputation’ or a ‘good name’. Therefore, a Partnership firm’s Goodwill is the reputation earned by the firm through rendering quality services to its customers. A satisfied customer will return to the firm, again and again, helping the firm build up a solid customer base that yields more profit in the future. Thus, Goodwill is a market value of the firm’s reputation that enables the firm to earn a profit above the normal profit earned by the other firms in the same industry. Goodwill is an intangible asset that cannot be touched or seen but is not a fictitious asset as it has some value in case of profit-making concern. A Goodwill of a firm, like any other asset, is shown on the asset side of a Balance Sheet. The valuation of Goodwill is done under certain circumstances such as Change in Profit-sharing ratio among the partners, Amalgamation and Merger, Reconstruction of the business, Dissolution or closure, Sale of the business, etc.

“Goodwill is nothing more than the probability that the old customers will resort to the old place.” – Lord Eldon

“Goodwill may be said to be that element arising from the reputation, connections, or other. advantages possessed by a business which enables it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business.” – Spicer and Pegler

### Capitalisation Profit Method:

There are several methods to calculate Goodwill. One such method of valuing Goodwill is a Capitalisation Profit Method. Under the Capitalisation Method, the capitalised value of the firm’s profit is determined to know the amount of capital required to earn the desired profit. The value of Goodwill can be calculated in two ways:

### A. Capitalisation of Average Profit Method:

Capitalisation refers to the capital that is required to earn a given amount of profit at a normal rate of return. In this method, the capitalised value of the average profit is calculated on the basis of a normal rate of return. Once the capitalised value of the average profit is known, the Net assets of the firm are considered to calculate the Goodwill. This helps in the assessment of the amount of capital needed for earning such an average profit.

The following steps are to be followed to calculate the value of the goodwill under this Method:

Step 1: Calculation of Actual Average Profit.

#### Average Profit =

Step 2: Calculation of Capitalised Value of the Average Profit.

Capitalised Value of the Average Profit =

Step 3: Calculation of Firm’s Goodwill.

Goodwill = Capitalised Value of the Average Profit − Capital Employed

here, Capital Employed/Net Assets (as on the date of Valuation of Goodwill) = Assets − Liabilities

Illustration 1:

Calculate goodwill according to the Capitalisation of Average Profit Method when a firm earned an Average Profit of ₹30,000. The Normal Rate of Return is 10% and the Capital Employed (as on the date of Valuation of Goodwill) is ₹2,40,000

Solution:

Calculation of Capitalised Value of the Average Profit:

Capitalised Value of the Average Profit =

Capitalised Value of the Average Profit =

Capitalised Value of the Average Profit = ₹ 3,00,000

Calculation of Firm’s Goodwill:

Goodwill = Capitalised Value of the Average Profit − Capital Employed

Goodwill = 3,00,000 − 2,40,000

Goodwill = ₹ 60,000

Illustration 2:

Ram and Mohan are partners in a business with a credit balance of ₹ 1,25,000 each in their Capital account and a credit balance of ₹15,000 and 10,000 in their current A/c, respectively. The Average Profit of the firm is ₹50,000, and the Normal Rate of Return is 10%. Calculate goodwill according to the Capitalisation of Average Profit Method.

Solution:

Calculation of Capitalised Value of the Average Profit:

Capitalised Value of the Average Profit =

Capitalised Value of the Average Profit =

Capitalised Value of the Average Profit = ₹ 5,00,000

Calculation of Firm’s Goodwill:

Goodwill = Capitalised Value of the Average Profit − Capital Employed (Net Assets)

Capital Employed = 1,25,000+ 1,25,000+ 15,000+10,000

Capital Employed = 2,75,000

Goodwill = 5,00,000 − 2,75,000

Goodwill = ₹ 2,25,000

### B. Capitalisation of Super Profit Method:

In this method, the capitalised value of the Super Profit is calculated on the basis of a normal rate of return for the assessment of the amount of capital needed for earning such a Super Profit.

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

Step 1: Calculation of the Super Profit.

Super Profit = Actual or Average Profit − Normal Profit

Step 2: Calculation of the Firm’s Goodwill:

Under the Capitalisation of Super Profit Method, the Value of Goodwill is equal to the capitalised value of the Super Profit. Therefore,

Goodwill =

Illustration 1:

From the following data, calculate goodwill according to the Capitalisation of Super Profit Method:

Average Profit- ₹ 36,000

Capital Employed (as on the date of Valuation of Goodwill)- ₹ 2,85,000

Normal Rate of Return- 10%

Solution:

Calculation of Normal Profit:

Normal Profit

Normal Profit =

Normal Profit = ₹ 28,500

Calculating Super Profit:

Super Profit = Average Profit – Normal Profit

Super Profit = 36,000 – 28,500

Super Profit = ₹ 7,500

Calculation of Firm’s Goodwill:

Goodwill =

Goodwill =

Goodwill = ₹ 75,000

Illustration 2:

Calculate the value of Goodwill by Super Profit Method when the goodwill is valued at 3 years’ purchase of super profit.

The average Profit during the last few years is ₹ 50,000, and the Normal Rate of Return is 10%. Assets of the business were ₹ 5,00,000 and external liabilities were ₹ 90,000.

Solution:

Calculation of Net Asset/Capital Employed:

Capital Employed = Assets − Liabilities

Capital Employed = 5,00,000 − 90,000

Capital Employed = ₹ 4,10,000.

Calculation of Normal Profit:

Normal Profit =

Normal Profit =

Normal Profit = ₹ 41,000

Calculation of Super Profit:

Super Profit = Actual or Average Profit − Normal Profit

Super Profit = 50,000 − 41,000

Super Profit = ₹ 9,000

Calculation of Firm’s Goodwill:

Goodwill =

Goodwill =

Goodwill = ₹ 90,000

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