Question

A partnership firm earned net profits during the last three years as follows: 

The capital employed in the firm throughout the above mentioned period has been ₹8,00,000. Having regard to the risk involved, 15% is considered to be a fair return on the capital. The remuneration of all the partners during this period is estimated to be ₹2,00,000 per annum. 
Calculate the value of Goodwill on the basis of the following: 
(a) Two years' purchase of super profits earned on average basis during the above mentioned 3 years. 
(b) Capitalisation of Average Profit method. 
 

Hint:

In Goodwill valuation, the method you choose (super profits or capitalisation of average profits) can significantly impact the value.

Answer 1

(a) Two years' purchase of super profits earned on average basis during the above mentioned 3 years. 
Step 1: Calculate the Average Profit. 
The average profit for the last 3 years is calculated as: \[ \text{Average Profit} = \frac{(3,80,000 + 4,40,000 + 5,00,000)}{3} = \frac{13,20,000}{3} = 4,40,000 \] Step 2: Calculate the Normal Profit. 
The normal profit is calculated based on a 15% return on the capital of ₹8,00,000: \[ \text{Normal Profit} = 8,00,000 \times 15% = 1,20,000 \] Step 3: Calculate the Super Profit. 
Super profit is the difference between the average profit and the normal profit: \[ \text{Super Profit} = 4,40,000 - 1,20,000 = 3,20,000 \] Step 4: Calculate Goodwill. 
The value of Goodwill is calculated as two years' purchase of the super profit: \[ \text{Goodwill} = 3,20,000 \times 2 = 6,40,000 \] (b) Capitalisation of Average Profit Method. 
Step 1: Calculate the Average Profit. 
The average profit for the last 3 years is ₹4,40,000 (calculated above). 
Step 2: Calculate the Normal Profit. 
The normal profit is calculated based on a 15% return on the capital of ₹8,00,000: \[ \text{Normal Profit} = 8,00,000 \times 15% = 1,20,000 \] Step 3: Calculate Goodwill. 
The value of Goodwill under the capitalisation method is calculated by dividing the average profit by the normal rate of return (15%): 

\[ \text{Goodwill} = \frac{3,20,000}{0.15} = 21,33,333.33 \] Step 4: Conclusion. 
The value of Goodwill based on: - (a) Two years' purchase of super profits is ₹6,40,000. - (b) Capitalisation of Average Profit method is ₹21,33,333.33.