Goodwill Calculation: Capitalization Methods

The Capitalization Method: A Different Perspective

The core idea of the capitalization method is to answer this question: "Based on the profits our firm is making and the normal rate of return in our industry, how much capital should our business have?" By comparing this "Capitalized Value" to the actual capital invested, we can figure out the value of our intangible asset, goodwill.

This method is divided into two approaches:

1. Capitalization of Average Profit
2. Capitalization of Super Profit

Let's dive into the first one.

1. Capitalization of Average Profit Method

The logic here is to find the excess of the capital that should be employed to earn the average profit over the capital that is actually employed. This excess is considered goodwill.

For a clear breakdown of the formulas and steps, please review the first part of the following article.

To summarize the steps you've just read:

1. Calculate Average Adjusted Profit: As you learned in the previous lesson, this is the firm's normal operating profit, after removing any abnormal gains or losses.
2. Calculate the Capitalized Value of the Business: This determines the total capital needed to earn the average profit at the normal rate of return.
   $\text{Capitalized Value of Business}=\text{Average Profit}\times \frac{100}{\text{Normal Rate of Return (NRR)}}$
3. Ascertain the Actual Capital Employed (or Net Assets): This is the capital currently invested in the business. You'll recall this from our last lesson.
   $\text{Capital Employed}=\text{Total Assets (excluding goodwill)}-\text{Outside Liabilities}$
4. Calculate Goodwill: The difference between the value the business should have and the value it actually has is goodwill.
   $\text{Goodwill}=\text{Capitalized Value of Business}-\text{Capital Employed}$

Now, let's watch a video where this method is applied to a practical problem.

2. Capitalization of Super Profit Method

This method is more direct and often considered simpler. It works by first calculating the "super profit" (the profit earned above the normal profit) and then capitalizing that amount to find the value of goodwill directly. The logic is that goodwill is the capital value of the super profits.

Let's return to the GeeksForGeeks article to see the steps.

As you've seen, the steps are:

1. Calculate Super Profit: This is exactly as you learned before.
   $\text{Super Profit}=\text{Average Profit}-\text{Normal Profit}$
   where,
   $\text{Normal Profit}=\text{Capital Employed}\times \frac{\text{Normal Rate of Return}}{100}$
2. Calculate Goodwill: You directly capitalize the super profit.
   $\text{Goodwill}=\text{Super Profit}\times \frac{100}{\text{Normal Rate of Return (NRR)}}$

Notice there is no final subtraction step. The goodwill is the capitalized value of the excess profits.

Let's see this in action with another video.

Conclusion

Congratulations on completing the topic of goodwill valuation! You now have a full set of tools to determine the value of a firm's intangible reputation.

Key Takeaways:

• The Capitalization Method values goodwill based on the capital needed to earn a certain level of profit, rather than using a "number of years' purchase."
• Capitalization of Average Profit Method: This is a multi-step process.
  • Goodwill = Capitalized Value of Business - Actual Capital Employed
• Capitalization of Super Profit Method: This is a more direct approach.
  • Goodwill = Super Profit × (100 / NRR)
• When calculated correctly from the same base information, both capitalization methods will give you the same answer.

Preview of the Next Lesson:

Now that we know how to calculate the value of goodwill, we are ready to handle the accounting entries when a new partner joins the firm. In our next lesson, we will begin the process of admitting a partner by learning how to calculate the new profit-sharing ratio and the sacrificing ratio, which are crucial for adjusting the partners' claims on the firm's future profits.