1. Average annual net profit x an agreed figure

• the profits for an agreed number of years preceding the valuation are averaged to arrive at an average annual profit earned and
• then goodwill is estimated to be worth so many years’ purchase of such average profit

Illustration No 1:

Say Partnership A registered the following annual profits:

Year 1 : Profits $10,000 Year 2: Profits $20,000 Year 3: Profits $30,000

If goodwill is agreed to be valued as:(a) two years’ purchase of average profit for the last three years

Solution:

Goodwill computation:

(a) Average profit = $10,000+$20,000+$30,000 / 3 = $20,000

(b) Goodwill = $20,000 x 2 agreed years = $40,000

Illustration No 2

In the Partnership, the three partners A B C has the profit/loss sharing ratio of 2/5 ,2/5 and 1/5 respectively.In the partnership agreement, it states that in the event of death or retirement of a partner, goodwill should be valued on the basis of two years’ purchase of the average net profits for the preceding three years. Eventually Mr A retires on 31 /12 /xx.

Compute the goodwill due to Mr A.

Solution:

Following net profits registered:

Year 1 : $10,000 Year 2 : $20,000 Year 3 : $30,000

Total profits for preceding 3 years = $10,000+$20,000+$30,000=$60,000

Average profit = $60,000/3 = $20,000

Total goodwill = $20,000 x 2 = $40,000

Mr A’s share of goodwill = $40,000 x 2/5 = $16,000