Valuation of Goodwill By The Capitalization Of Expected Future Net Profits

This Part 5 looks at the valuation of goodwill using the capitalization of expected future net profits.

Situation where Capitalization of Expected Future Net Profits is viable when there are clear steps that the following can be undertaken:

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

Salient Point:

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:

Assuming, Mr A wants to sell his business. He has concrete proof that his business is generating average yearly profit of $50,000. This past profit trend fairly represent the profit likely to be earned in the future except for the following existing expenses:

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 1	$
Average Net Profits	50,000
Add:Rental no longer required in the future	10,000
Add:Director fees no longer required	20,000
Less:Increased in Existing Expenses	(30,000)
Estimated Future Maintainable Profits	50,000

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

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