What is Capitalisation Method (Goodwill)?

S7-SA7-0300

Grade Level:

Class 12

AI/ML, Physics, Biotechnology, FinTech, EVs, Space Technology, Climate Science, Blockchain, Medicine, Engineering, Law, Economics

Definition

What is it?

The Capitalisation Method is a way to calculate the value of 'Goodwill' for a business. Goodwill is the extra value a business has because of its good reputation, brand name, or customer loyalty, beyond the actual value of its assets. This method assumes that a business's super profits (profits above normal) are due to its goodwill.

Simple Example

Quick Example

Imagine a famous chai shop, 'Amma's Chai,' in your neighbourhood. It earns ₹2,00,000 profit a year, while similar chai shops in the area only earn ₹1,50,000. The extra ₹50,000 Amma's Chai earns is its 'super profit' due to its brand and loyal customers. The Capitalisation Method helps us figure out how much this 'goodwill' (Amma's fame) is worth.

Worked Example

Step-by-Step

Let's calculate goodwill for a company using the Capitalisation Method.

Step 1: Calculate Average Profit. Suppose a company's profits for the last 3 years were ₹1,00,000, ₹1,20,000, and ₹1,10,000.
Average Profit = (₹1,00,000 + ₹1,20,000 + ₹1,10,000) / 3 = ₹3,30,000 / 3 = ₹1,10,000

---Step 2: Calculate Normal Profit. Assume the capital employed in the business is ₹8,00,000 and the normal rate of return in this industry is 10%.
Normal Profit = Capital Employed × Normal Rate of Return / 100 = ₹8,00,000 × 10 / 100 = ₹80,000

---Step 3: Calculate Super Profit.
Super Profit = Average Profit - Normal Profit = ₹1,10,000 - ₹80,000 = ₹30,000

---Step 4: Calculate Goodwill using Capitalisation of Super Profit Method.
Goodwill = Super Profit × (100 / Normal Rate of Return) = ₹30,000 × (100 / 10) = ₹30,000 × 10 = ₹3,00,000

---Step 5: Alternatively, calculate Goodwill using Capitalisation of Average Profit Method.
Capitalised Value of Average Profit = Average Profit × (100 / Normal Rate of Return) = ₹1,10,000 × (100 / 10) = ₹11,00,000
Goodwill = Capitalised Value of Average Profit - Net Assets (Capital Employed) = ₹11,00,000 - ₹8,00,000 = ₹3,00,000

Answer: The Goodwill of the company is ₹3,00,000.

Why It Matters

Understanding goodwill valuation is crucial for anyone interested in FinTech, Economics, or even starting their own business. It helps companies decide fair prices when buying or selling businesses, like when a big tech company acquires a small startup. Future entrepreneurs and financial analysts use this to assess a company's true worth.

Common Mistakes

MISTAKE: Confusing Normal Rate of Return with the actual profit percentage. | CORRECTION: Normal Rate of Return is the expected return in the industry, not the specific company's profit margin.

MISTAKE: Using total assets instead of capital employed (Net Assets) for the Capitalisation of Average Profit method. | CORRECTION: For Capitalisation of Average Profit, compare the capitalised value of average profit with Net Assets (Capital Employed), which is Assets minus External Liabilities.

MISTAKE: Forgetting to annualise profits if they are given for a period less than a year. | CORRECTION: Always ensure profits used in calculations are for a full year to avoid misstating average profits.

Practice Questions

Try It Yourself

QUESTION: A business earns average profits of ₹60,000. The normal rate of return is 12%. The capital employed is ₹4,00,000. Calculate goodwill using the Capitalisation of Super Profit Method. | ANSWER: Normal Profit = ₹4,00,000 * 12% = ₹48,000. Super Profit = ₹60,000 - ₹48,000 = ₹12,000. Goodwill = ₹12,000 * (100/12) = ₹1,00,000.

QUESTION: A company's average profit is ₹90,000. Net tangible assets are ₹6,00,000. The normal rate of return is 15%. Calculate goodwill using the Capitalisation of Average Profit Method. | ANSWER: Capitalised Value of Average Profit = ₹90,000 * (100/15) = ₹6,00,000. Goodwill = Capitalised Value - Net Tangible Assets = ₹6,00,000 - ₹6,00,000 = ₹0.

QUESTION: A firm's average profit for the last 5 years is ₹80,000. Total assets are ₹7,00,000 and external liabilities are ₹1,00,000. The normal rate of return is 10%. Calculate goodwill using both Capitalisation of Super Profit and Capitalisation of Average Profit methods. | ANSWER: Capital Employed = Assets - Liabilities = ₹7,00,000 - ₹1,00,000 = ₹6,00,000. Normal Profit = ₹6,00,000 * 10% = ₹60,000. Super Profit = ₹80,000 - ₹60,000 = ₹20,000. Goodwill (Capitalisation of Super Profit) = ₹20,000 * (100/10) = ₹2,00,000. Capitalised Value of Average Profit = ₹80,000 * (100/10) = ₹8,00,000. Goodwill (Capitalisation of Average Profit) = ₹8,00,000 - ₹6,00,000 = ₹2,00,000.

MCQ

Quick Quiz

Which of the following is NOT required to calculate goodwill using the Capitalisation of Super Profit Method?

Average Profit

Normal Rate of Return

Capital Employed

Market Value of Shares

The Correct Answer Is:

The Capitalisation of Super Profit Method requires Average Profit, Normal Rate of Return, and Capital Employed to determine Super Profit and then goodwill. The Market Value of Shares is not directly used in this method.

Real World Connection

In the Real World

When a large company like Reliance Retail acquires a smaller, popular local brand or a startup like Dunzo, they don't just pay for the physical assets. They also pay for its 'goodwill' – its brand name, customer base, and market reputation. Financial advisors and accountants use methods like capitalisation to determine this goodwill value during such mergers and acquisitions.

Key Vocabulary

Key Terms

GOODWILL: The extra value of a business due to its reputation and customer loyalty. | SUPER PROFIT: The profit earned by a business above the normal profit earned by similar businesses. | CAPITAL EMPLOYED: The total funds invested in a business by its owners. | NORMAL RATE OF RETURN: The typical profit percentage expected from businesses in a particular industry.

What's Next

What to Learn Next

Next, you can explore other methods of goodwill valuation, like the Annuity Method or Weighted Average Profit Method. These build on your understanding of profits and help you see how different assumptions can lead to different goodwill values.