Q.Firm's Capital in a business is ₹2,00,000. The normal rate of return on firm's capital is 15%. During the year 2015 the firm earned a profit of ₹48,000. Calculate goodwill on the basis of 3 years purchase of super profit?
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Start your 14-day free trial to unlock the full solution →Goodwill by Super Profit Method = ₹54,000 (3 years' purchase of super profit of ₹18,000).
Concept: Valuation of Goodwill – Super Profit Method
Goodwill represents the value of a firm's reputation and its ability to earn profits above the normal return expected in the industry. The Super Profit Method captures this excess earning capacity.
The treatment rests on three pillars:
-
Normal Profit = Capital Employed × Normal Rate of Return
This is what any business with similar capital should earn in the industry.
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Super Profit = Actual Average Profit − Normal Profit
The excess over and above the normal expectation.
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Goodwill = Super Profit × Number of Years' Purchase
We capitalize the super profit for a given number of years to arrive at the lump-sum value of goodwill.
The logic: if a firm consistently earns ₹18,000 more than normal every year, an investor would pay a premium (goodwill) equal to, say, 3 years of that extra earning stream to acquire the business.
Solution
We compute goodwill in three steps, shown in the working notes below.
Working Notes
W.N. 1: Calculation of Normal Profit
Normal Profit = Capital Employed × (Normal Rate of Return)/100
= 2,00,000 × 15/100 = ₹30,000
The firm, with a capital of ₹2,00,000, is expected to earn ₹30,000 per annum at the industry's normal rate of 15%.
W.N. 2: Calculation of Super Profit
Super Profit = Actual Profit - Normal Profit
= 48,000 - 30,000 = ₹18,000
The firm earned ₹48,000 during 2015, which is ₹18,000 more than the normal expectation. This ₹18,000 is the super profit.
W.N. 3: Calculation of Goodwill
Goodwill = Super Profit × Number of Years' Purchase
= 18,000 × 3 = ₹54,000
We capitalize 3 years of the super profit to arrive at the goodwill figure.
Statement of Goodwill
| Particulars | Amount (₹) |
|---|---|
| Capital Employed | 2,00,000 |
| Normal Rate of Return | 15% |
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