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Capitalization Method

Goodwill, under this method, is ascertained by deducting the actual capital employed from the capitalized value of business. Under this method, the value of the whole business is determined by applying normal rate of return.
 

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There are two ways of calculating goodwill under this method:

  • Capitalisation of average profits method
  • Capitalisation of super profits method
  • Capitalisation of Average Profits method: Under this method, we calculate the average profits and then assess the capital needed for earning such average profits on the basis of normal rate of return. Such capital is called capitalised value of average profits. The formula is:-

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Illustration 5

 

A firm earns profits of ₹ 2,00,000. The normal rate of return in a similar type of business is 10%. The value of total assets (excluding goodwill) and total outsiders’ liabilities as on the date of valuation of goodwill are ₹ 22,00,000 and ₹ 5,60,000 respectively. Calculate the value of goodwill according to capitalization of average profits method.
 

Solution:

 

  1. Average profits = ₹ 2,00,000
  2. Capitalised value of average profits = ₹ 2,00,000 x 100/10 = ₹ 20,00,000
  3. Net assets = Total assets – Outsiders’ liabilities = ₹ 22,00,000 - ₹ 5,60,000 = ₹ 16,40,000
  4. Goodwill = ₹ 20,00,000 - ₹ 16,40,000 = ₹ 3,60,000
  • Capitalisation of Super Profits Method: Under this method, we first calculate the super profits and then calculate the capital needed for earning such super profits on the basis of normal rate of return. This capital is the value of goodwill. The formula is:-

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Illustration 6

 

A firm earns profits of ₹ 2,00,000. The normal rate of return in a similar type of business is 10%. The value of total assets (excluding goodwill) and total outsiders’ liabilities as on the date of valuation of goodwill are ₹ 22,00,000 and ₹ 5,60,000 respectively. Calculate the value of goodwill according to capitalization of super profits method.
 

Solution:

 

  1. Average profit (given) = ₹ 2,00,000
  2. Normal profit = Capital employed × normal rate of return
     
    Normal profit = (₹ 22,00,000 - ₹ 5,60,000) × 10/100 = ₹ 16,40,000 × 10/100 = ₹ 1,64,000
  3. Super profit = ₹ 2,00,000 - ₹ 1,64,000 = ₹ 36,000
  4. Goodwill = ₹ 36,000 × 100/10 = ₹ 3,60,000





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