• Step 1: to ascertain the average future net profit that is expected to be earned. The need to add or less for items for example:

• Deduct from future profit for expenses not already done ( eg proprietor’s salary,etc) and expenses that can most likely increase

• Add to future profits for expenses that are not going to recur

• Step 2: to capitalize this average future net profit at the rate which can commensurate to a suitable rate of return on capital invested in a business of the type under consideration

• Step 3: to find the net tangible assets ( Assets less external liabilities less any intangible assets like recorded goodwill/patents/trademark value)

• Step 4: Take the capitalized profit and minus the net tangible asset to determine the difference which is the required goodwill

The difficult part of this method to value goodwill is the determination of the rate of return on capital which is deemed to be appropriate to the particular business concerned.

Illustration:

• Rent at $10,000 per annum need not be charged in the future as the buyer has his own premise
• Director’s fee of $20,000 no longer require once the buyer put in his own board of directors.
• Certain annual expenses need to be increased by $30,000 per annum with the change in new buyer.

The net tangible asset of the business at the date of sale is computed as $500,000. 7% is considered a reasonable rate of return on capital invested for the type of business. Question : Compute the value of goodwill ignoring income tax.

Solution:

Step 2:

Future Profits Capitalized at 7% =$50,000/0.07=$714,300

Step 3:

Net Tangible Assets ( given)

[ note : net tangible assets = shareholders funds less intangible assets]

Step 4:

Capitalized Profit ( step 3) $714,300

Less:Net Tangible asset (given) ($500,000)

Difference = Goodwill $214,300