Final Project

Download as docx, pdf, or txt
Download as docx, pdf, or txt
You are on page 1of 39

AN INTRODUCTION TO VALUATION

Valuation is the process of estimating what something is worth. Valuation can be used
as a very effective business tool by management for better decision making throughout
the life of the enterprise. Valuations are needed for many reasons such as investment
analysis, capital budgeting, merger and acquisition transactions, financial reporting,
determination of tax liability.
Companies are governed and valuations are influenced by the market supply- demand
life cycles along with product and technology supply-demand lifecycles.
Correspondingly, the value of an enterprise over the course of its life peaks with the
market and product technology factors. Both financial investors such as venture
capitalists and entrepreneurs involved in a venture would ideally like to exit the venture
in some form near the peak to maximize their return on investment. Thus, valuation
helps determine the exit value of an enterprise at that peak. This exit value typically
includes the tangible and intangible value of the company’s assets. Tangible value
would typically include balance sheet items recorded as the book value of the enterprise.
Intangibles would typically include intellectual property, human capital, brand and
customers, and others. In more traditional companies considering the private equity
markets, the value of intangibles is much higher than the value of the tangible assets.
Therefore, an effective enterprise valuation methodology needs to be developed.
One can also define valuation as Measurement of value in monetary terms.
Measurement of income and valuation of wealth are two interdependent core aspects of
financial accounting and reporting. Wealth comprises of assets and liabilities. Valuation
of assets and liabilities are made to portray the wealth position of a firm through a
balance sheet and to supply logistics to the measure of the periodical income of the firm
through a profit and loss account.
Again valuation of business and valuation of share are made through financial statement
analysis for management appraisal and investment decisions. Valuation is pivotal in
strategic, long term or short term decision making process in cases like reorganization
of company, merger and acquisition, extension or diversification, or for launching new
schemes or projects. As the application area of valuation moves from financial
accounting to financial management, the role of accountant also undergoes a transition.
That order of transition in the concept and use of valuation process is followed in the
subsequent units of this chapter.
CONCEPT OF VALUATION
Valuation means measurement of an item in monetary term. The subjects of valuation
are varied as stated below:
 Valuation of Tangible Fixed Assets
 Valuation of Intangibles including brand valuation and valuation of
goodwill
 Valuation of Shares
 Valuation of Business
The objectives of valuation are again different in different areas of application in
financial accounting and in financial management.

NEED FOR VALUATION


Financial statements must give a “true and fair view” of the state of affairs of a company
as per provisions of the Companies Act. Proper valuation of all assets and liabilities is
required to ensure true and fair financial position of the business entity. In other words,
all matters which affect the financial position of the business have to be disclosed.
Under or overvaluation of assets may not only affect the operating results and financial
position of the current period but will also affect these for the next accounting period.
The present unit deals with different principles involved in the valuation of different
types of assets.
Assets can be classified as (i) Non- current assets and (ii) Current assets. Non-current
assets have been further sub-classified into (a) fixed assets i.e. tangible assets, intangible
assets, capital W.I.P. and intangible assets under development (b) non- current
investments (c) deferred tax assets (Net) (d) long term loans and advances and (e) other
non-current assets. Current assets have been further sub-classified into
(a) Current Investments (b) Inventories (c) Trade Receivables (d) Cash and Cash
Equivalents (e) Short Term Loans and Advances and (f) Other Current Assets.
The students are expected to learn the essence and modalities of valuation, a core
function in financial accounting. Valuation is done sometimes by the Valuers/Engineers
in cases where technical inputs and knowledge is required to arrive at the Fair value and
accepted by various Government and Statutory Authorities. Students should be familiar
with these valuation Reports and their basis of valuation.
Different approaches to valuation of different kinds of assets and liabilities in different
perspectives have pushed the role of accountant to a complex position. This chapter is
aimed to differentiate the objectives, approaches and methods of valuation in order to
integrate them in a comprehensive logical frame.

BASES OF VALUATION
A number of different measurement bases are employed to different degrees and in
varying combinations in valuation of different assets in different areas of application.
They include the following:
(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents
paid or the fair value of the other consideration given to acquire them at the time of their
acquisition.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents that
would have to be paid if the same or an equivalent asset were acquired currently.
(c) Realizable (settlement) value. Assets are carried at the amount of cash or cash
equivalents that could currently be obtained by selling the asset in an orderly disposal.
(d) Present value. Assets are carried at the present value of the future net cash
inflows that the item is expected to generate in the normal course of business.
Other generally used valuation bases are as follows:
Net Realizable Value (NRV): This is same as the Realizable (settlement) value. This is
the value (net of expenses) that can be realized by disposing off the assets in an orderly
manner. Net selling price or exit values also convey the same meaning.
Economic value: This is same as the present value. The other name of it is value to
business.
Replacement (cost) value: This is also same as the current cost.
Recoverable (amount) value: This is the higher of the net selling price and value in use.
Deprival value: This is the lower of the replacement value and recoverable (amount)
value.
Liquidation value: This is the value (net of expenses), that a business can expect to
realize by disposing of the assets in the event of liquidation. Such a value is usually
lower than the NRV or exit value. This is also called break-up value.
Fair value: This is not based on a particular method of valuation. It is the acceptable
value based on appropriate method of valuation in context of the situation of valuation.
Thus fair value may represent current cost, NRV or present value as the case may be.
In financial accounting ‘An asset is recognized in the balance sheet when it is probable
that the future economic benefits associated with it will flow to the enterprise and the
asset has a cost or value that can be measured reliably.’ ‘The measurement basis most
commonly adopted by enterprises in preparing their financial statements is historical
cost. This is usually combined with other measurement bases.
The requirements of regulations and accounting standards as to recognition of assets,
reliability of measurement and disclosure in financial reports have set certain limitations
to the freedom of valuation so far as financial accounting is concerned.

TYPES OF VALUE
The following are six types of value:
• Going-concern value is the value of a firm as an operating business.
• Liquidation value is the projected price that a firm would receive by selling its
assets if it were going out of business.
• Book value is the value of an asset as carried on a balance sheet. In other words,
it means (i) the cost of an asset minus accumulated depreciation (ii) the net asset value
of a company, calculated by total assets minus intangible assets (patents, goodwill) and
liabilities (iii) the initial outlay for an investment. This number may be net or gross of
expenses such as trading
costs, sales taxes, service charges and so on. It is the total value of the company’s assets
that shareholders would theoretically receive if a company were liquidated. By being
compared to the company’s market value, the book value can indicate whether a
Inventory is under or overpriced. In personal finance, the book value of an investment is
the price paid for a security or debt investment. When an inventory is sold, the selling
price less the book value is the capital gain (or loss) from the investment.
• Market value is the price at which buyers and sellers trade similar items in an
open market place. It is the current quoted price at which investors buy or sell a share
of common Inventory or a bond at a given time. The market capitalization plus the
market value of debt, sometimes referred to as “total market value”. In the context of
securities, market value is often different from book value because the market takes
into account future growth potential.
• Fair market value is the price that a given property or asset would fetch in the
market place, subject to the following conditions: (i) Prospective buyers and sellers are
reasonably knowledgeable about the asset; they are behaving in their own best interests
and are free of undue pressure to trade. (ii) A reasonable time period is given for the
transaction to be completed. Given these conditions, an asset’s fair market value should
represent an accurate valuation or assessment of its worth. Fair market values are widely
used across many areas of commerce. For example, municipal property taxes are
often assessed based on the fair market value of the owner’s property. Depending upon
how many years the owner has owned the home, the difference between the purchase
price and the residence’s fair market value can be substantial. Fair market values are
often used in the insurance industry as well. For example, when an insurance claim is
made as a result of a car accident, the insurance company covering the damage to the
owner’s vehicle will usually cover damages up to the fair market value of the
automobile.
• Intrinsic value is the value at which an asset should sell based on applying data
inputs to a valuation theory or model. The actual value of a company or an asset based
on an underlying perception of its true value including all aspects of the business, in
terms of both tangible and intangible factors. This value may or may not be the same as
the current market value. Value investors use a variety of analytical techniques in
order to estimate the intrinsic value of securities in hopes of finding investments
where the true value of the investment exceeds its current market value. For call
options, this is the difference between the underlying Inventory’s price and the strike
price. For put options, it is the difference between the strike price and the underlying
Inventory’s price. In the cases, if the respective difference value is negative, the intrinsic
value is given as zero. For example, value investors that follow fundamental analysis
look at both qualitative (business model, governance, target market factors etc.) and
quantitative (ratios, financial statement analysis, etc.) aspects of a business to see if the
business is currently out of favor with the market or is really worth much more than its
current valuation.
• Extrinsic value is another variety. It is the difference between an option’s price
and the intrinsic value. For example, an option that has a premium price of ` 10 and an
intrinsic value of ` 5 would have an extrinsic value of ` 5. Denoting the amount that the
option’s price is greater than the intrinsic value, the extrinsic or time value of the option
declines as the expiration date of an option draws closer.
These types of values can differ from one another. For example, a firm’s going- concern
value is likely to be higher than its liquidation value. The excess of going- concern value
over liquidation value represents the value of the operating firm as distinct from the
value of its assets. Book value can differ substantially from market value. For example,
a piece of equipment appears on a firm’s books at cost when purchased but decreases
each year due to depreciation charges. The price that someone is willing to pay for the
asset in the market may have little relationship with its book value. Market value reflects
what someone is willing to pay for an asset whereas intrinsic value shows what the
person should be willing to pay for the same asset.
APPROACHES OF VALUATION
Three generally accepted approaches to valuation are as follows:
(1) Cost Approach: e.g. Adjusted Book Value
(2) Market Approach: e.g. Comparables
(3) Income Approach: e.g. Discounted Cash Flow
Each approach has advantages and disadvantages. Generally there is no “right” answer
to a valuation problem. Valuation is very much an art as much as a science! These
approaches can be briefly discussed as:

Cost Approach:
This technique involves restating the value of individual assets to reflect their fair
market values. It is useful for valuing holding companies where assets are easy to value
(for example, securities) and less useful for valuing operating businesses. The value of
an operating company is generally greater than that of its assets. The difference between
that value of the expected cash flows and that of its assets is called the “going concern
value”. It is a useful approach when the purpose of the valuation is that the business will
be liquidated and Trade payables must be satisfied. While doing this valuation following
adjustments to book value can be made:
• Inventory undervaluation
• Bad debt reserves
• Market value of plant and equipment
• Patents and franchises
• Investments in affiliates
• Tax-loss carried forward

Market Approach:
The market approach, as the name implies, relies on signs from the real market place
to determine what a business is worth. It is to be understood that business does not
operate in vacuum. If what one does is really great, then chances of others doing the
same or similar things are more. If one is looking to buy a business, one decides what
type of business he is interested in and then looks around to see what the "going rate" is
for businesses of this type. If one is planning to sell business, he will check the market
to see what similar businesses sell for. So the market approach to valuing a business is a
great way to determine its fair market value - a monetary value likely to be exchanged in
an arms-length transaction, when the buyer and seller act in their best interest.

Income approach:
The income approach considers the core reason for running a business ie. making
money. Here the so-called economic principle of expectation applies. Since the business
value must be established in the present, the expected income and risk must be translated
to today. The income approach generally uses two ways to do this translation: (i)
Capitalization and (ii) Discounting.
GOODWILL

Goodwill is said to be that element arising from reputation, connection or other


advantages possessed by a business which enables it to earn greater profits than the
return normally to be expected on the capital represented by net tangible assets
employed in the business. In considering the return normally to be expected, regard
must be had to the nature of the business, the risk involved, fair management
remuneration and other relevant circumstances.
Goodwill of a business may arise in two ways. It may be inherent to the business that is
generated internally or it may be acquired while purchasing any concern. Purchased
goodwill can be defined as being the excess of fair value of the purchase consideration
over the fair value of the separable net assets acquired. The value of purchased goodwill
is not necessarily equal to the inherent goodwill of the business acquired as the
purchase price may reflect the future prospects of the entity as a whole.
Goodwill in financial statements arises when a company is purchased for more than the
fair value of the identifiable net assets of the company. The difference between the
purchase price and the sum of the fair value of the net assets is by definition the value of
the "goodwill" of the purchased company. The acquiring company must recognize
goodwill as an asset in its financial statements and present it as a separate line item on
the balance sheet, according to the current purchase accounting method. In this sense,
goodwill serves as the balancing sum that allows one firm to provide accounting
information regarding its purchase of another firm for a price substantially different
from its book value. Goodwill can be negative, arising where the net assets at the date
of acquisition, fairly valued, exceed the cost of acquisition. Negative goodwill is
recognized as a gain to the extent that it exceeds allocations to certain assets. Under
current accounting standards, it is no longer recognized as an extraordinary item.
For example, a software company may have net assets (consisting primarily of
miscellaneous equipment, and assuming no debt) valued at ` 1 million, but the
company's overall value (including brand, customers, intellectual capital) is valued at `
10 million. Anybody buying that company would book ` 10 million in total assets
acquired, comprising ` 1 million physical assets, and ` 9 million in goodwill. Goodwill
has long been and continues to be a highly debatable subject in accounting. Accountants
as well as jurists have been deliberating on it for long but are yet to come to a
meaningful conclusion as to its precise nature. It belongs to that twilight region where
accounting abandons all its attempts to be a science. It is referred to as an unidentified
accounting object analogous to UFO i., e., unidentified flying object usually seen in the
sky (Cohen, 1990, p-28). However, although it has remained a mystery, it is very often
required to be considered in the world of trade, industry and commerce. Its importance
in business has been emphasized by using different connotations. It has been
biologically described as the ‘sap’ and life of the business. Architecturally it has been
described as the ‘cement’ landing together tire business and its assets as a whole. It has
been described in terms of magnet as the ‘attractive force’ that brings in customers. In
terms of competitive dynamics goodwill has been described as the ‘differential return of
profit’.

Nature of goodwill
Existence of goodwill in a firm enables it to earn more than the normal profit, which is
supposed to be earned by a new firm in the industry. But goodwill has got no physical
form. It is an intangible asset In fact, it is the most intangible of intangibles. The
uniqueness of goodwill is that it has got no separate existence. It can not be sold or
purchased as an independent asset Only along with the business it can be sold or
exchanged. As goodwill can not be purchased or sold separately from business,
Chambers, the noted accounting academician, was not in favor of recognizing goodwill
as an asset (Chambers, 1966). But exchangeability is an important but not the sole
criterion of asset recognition. There are several views on goodwill as developed by
accounting academicians. The Master Valuation Account View as propounded by John
Canning is noteworthy. According to this view, goodwill is not treated as an asset It is
simply considered as the residual value of the firm that can not be associated with any
tangible or identifiable intangible assets. This concept considers that the value of a firm
arises out of contribution of all assets towards its cash flow. Its value should, therefore,
be thought to consist of values of all assets. After assigning the value of the firm to each
tangible and intangible asset, if anything is left, that is recorded as goodwill. The slice of
die value of the firm to be assigned to an asset may be equal to its net realizable value in
case of assets like land, machinery, patent, inventory etc. In case of receivables, values
to be attributed to them may be equal to tie present value of expected cash receipts.
Whatever value remains unallocated is termed as goodwill. So more the assets are
identified and assigned value, the less will be the goodwill residual. Accordingly, it has
no meaning. It is purely and simply a plug not capable of deserving the status of an asset
. But it would be too drastic to deny goodwill its recognition as an asset. Like other
assets, it also has future benefit potential The Hidden Asset View is another view of
goodwill. In course of operation, a business develops various assets like good customer
relation, good business connection, workforce with experience and high degree of
loyalty, favorable location, outstanding sales, net work etc. The organization derives
substantial benefits from these assets. But these assets are not recognized on the balance
sheet Balance sheet recognition requires fulfilment of the objectivity criterion. These
assets can not fulfil this criterion. They can not be objectively measured. According to
some authorities, goodwill represents those hidden assets. Because of the hidden assets,
the going concern value exceeds the sum of the values of assets recorded on the balance
sheet The excess value is attributed to goodwill . The hidden assets view is, however,
not above criticism. Many argue that these hidden assets may be attributed to some
specific assets including other intangible assets. For example, the value of excellent
reputation may attach to the value of brand names. A favorable location may mean that
the value of land and building is more than similar land and building located elsewhere.
The Excess Profit View is the most popular view of goodwill According to this view,
goodwill represents the present value of expected future earnings in excess of what is
considered normal. The excess profit view, however, does not say much about the nature
of goodwill. It actually deals with the measurement of the value of goodwill. To find out
excess profit, it is first required to determine the future maintainable profit. The second
stage involves ascertainment of normal profit that is supposed to be the reasonable
return on invested capital. This invested capital is determined in terms of market value.
Excess profit is the difference between future maintainable profit and the normal profit
on invested capital Then goodwill is determined by multiplying the excess profit with a
chosen factor representing the number of years over which the excess profit is likely to
be enjoyed. According to this view, the value of goodwill is dependent upon the
subjective assessment of future maintainable profit and to some extent the arbitrary
selection of the number of years of purchase. Moreover the question that may arise is
how far it is justified to assume that identifiable tangible and intangible assets can earn
only a normal rate while other factors are responsible for excess profit An asset may
earn more than a normal rate of profit because of its efficient utilization, increased
demand for the product, market imperfection and so on. So any attempt to develop a
concept of goodwill on the basis of capitalization of superior earning is completely
artificial (Hendriksen & Breda, 1992). It appears that goodwill is still a nebulous
concept in accounting. The available views on goodwill as offered by experts Jack
comprehensiveness and are subject to some or more limitations. A variety of factors are
responsible for goodwill creation. And it is very difficult to make a generalization about
them. Examples of factors that lead to goodwill creation are:
 favorable location ,
 good customer relation,
 efficient management team,
 favorable Government regulation,
 efficient and effective production process,
 secret formulae,
 customer databases,
 software and information system,
 good credit rating,
 dedicated labour force,
 reputation,
 absence of competition,
 supply contracts,
 franchise,
 advertisement campaign .
It is to be noted that the price offered for acquisition of a business over and above the
fair value of its net assets might not represent goodwill of the business. A buyer may
offer price for his own convenience like avoiding die time for setting up a new business,
getting adjacent space etc. He may not even care whether or not old customers will
return to the old place. In this case the excess price offered does not represent the value
of goodwill in the true sense. Only when the excess price is offered for any one or more
of the above- mentioned favorable factors, that excess price should be termed as
goodwill. Again the existence of one or more favorable factors does not always result in
goodwill. Goodwill depends upon the hard fact of superior profit earning. It may so
happen that excess profit resulting from good customer relation or advantageous
location is eaten up by inefficient administration or faulty spending. So goodwill is an
umbrella concept embracing several favorable factors which enable a firm to earn profit
at a rate higher than the rate of profit normally expected by a new firm in the industry.
Factors contributing towards goodwill may differ from firm to firm. Again in a firm the
favorable factors may change with the passage of time. Some factors may disappear and
some new ones may appear. From the above discussion, some distinguishing
characteristics of goodwill can be identified as follows:
 The value of goodwill has no reliable and predictable relationship to costs, which
may have been incurred for its creation.
 Individual factors that contribute towards goodwill can not be valued.
 The value of goodwill may fluctuate widely according to internal and external
circumstances over a short period of time.
 The goodwill is not consumed in die generation of earning.
 The assessment of goodwill is highly subjective.
Thus any value attributed to goodwill is unique to the value and to a specific point in
time at which it is measured and is valid only at that time and in the circumstances
prevailing then.

Classification of goodwill
Goodwill can be classified in different ways. While delivering judgment in the
Whiteman Smith Motor Co. vs. Chaplin case, the learned judge zoologically classified
goodwill as follows:
1) Cat Goodwill: Cat prefers its old home regardless of its actual owner. As such
cat goodwill represents loyalty of customers who always go to old shops
whoever keep it running.
2) Dog Goodwill: Dog is always faithful to its master and follows him wherever he
goes. Similarly some customers have special attachment to some particular
employees. Goodwill developed out of some personal attachment is called dog
goodwill.
3) Rat Goodwill: Rat has no attachment and moves everywhere in search of food.
Likewise some customers have no inclination to any particular shop and move
from shop to shop in search of goods. So goodwill arising out of such customers
is known as rat goodwill.
4) Rabbit Goodwill: Rabbit prefers to move around its hole and does not go
further. Similarly some customers like to buy from nearby shops. So these shops
receiving patronage of neighboring customers enjoy rabbit goodwill.
According to Paton (1952, P. 488), goodwill represents value of the enterprise which
may be attributed to the entire range of advantageous connections: Commercial
Industrial, Financial and Political. Accordingly goodwill can be classified as follows:

(a) Commercial Goodwill: It refers to the advantage enjoyed by the firm due to
past efforts made like supply of quality goods and services at right prices and at the right
time, timely fulfilment of commitment to suppliers etc.

(b) Industrial Goodwill: li arises out of factors advantageous to the growth of a


particular industry. For example, TISCO enjoys industrial goodwill as it is situated in a
region where all kinds of raw materials required for manufacture of steel are available at
a cheaper rate.

(c) Financial goodwill: Financial goodwill represents financial and economic


advantages enjoyed by a firm. For example, good credit rating, access to international
capital market, enjoying lenders’ confidence etc., indicate that the firm has a sound
financial goodwill.

(d) Political goodwill: It refers to advantage enjoyed by the firm due to its affinity
with Government and political parties. It may include special permit for import or
export, tax concession, favorable attitude of politicians, etc.

(e) Public goodwill: It refers to good public image enjoyed by the firm. Good public
relationship, community development programme etc. help the company acquire this
goodwill.
Kaner (1937), another authority on fire subject divided goodwill into seven categories:

(a) Locality goodwill: Business situated in a favorable locality enjoys such


goodwill. For example, goodwill of a firm situated in a busy locality will definitely be
more than that enjoyed by one situated at the outskirts of the city although they are of
the same type and size.

(b) Efficiency Goodwill: Efficiency goodwill arises out of efficient management of


all functions of the organization namely innovation, design and development,
production, sales, finance, administration, purchase etc. A firm enjoys greater efficiency
goodwill if it produces quality goods and services according to changing requirements of
society and with minimum resources and costs. There are two kinds of efficiency -
technological and economic. Technological efficiency means innovative ability of the
firm. Well-established research and development activities with good technicians and
scientists can result in innovative ideas about products or services that are capable of
meeting the changing requirements of society at the minimum cost Economic efficiency
means producing and selling goods or rendering services in the most economic way.
When the film ensures fullest customer satisfaction with overall efficiency and thereby
generates higher profit, it is said to have efficiency goodwill.

(c) Establishment Goodwill: It is the natural tendency of customers to place


greater reliance on an old firm than on a new firm. This is because they do not have
previous knowledge about the ability of the new firm to cater to their requirements. So
they become inclined to visit old and established firms to meet their needs. The goodwill
enjoyed by a firm because of its long existence is called establishment goodwill .

(d) Organizational Goodwill: An enterprise with a sound, effective and efficient


organization is said to have organizational goodwill. A good organization structure puts
the concern in an advantageous position. It enables the firm to achieve its objective more
efficiently and earn profit at a higher rate. An effective and efficient goodwill ,
therefore, enhances the organizational goodwill of the firm.

(e) Advertising Goodwill : Goodwill developed by advertising is called advertising


goodwill In the present competitive market, to get the product sold is a very tough job.
Several firms produce and sell the same type of product or service with more or less the
same quality and almost identical features. Under these circumstances advertisement
plays a vital role. It makes the product known to the public, highlights the advantages of
using the product, awakens the desire to buy the product, helps to create new market and
keeps up steady demand So firms now a days make huge investments in advertisement.
If the advertisement is appealing, sales will increase and thereby profit will increase. In
this way goodwill is generated and that goodwill is called advertising goodwill

(f) Monopoly Goodwill: A firm with no competitor enjoys assured market for its
product So monopoly position results in a goodwill which is called monopoly goodwill.

(g) Personal Goodwill : Goodwill arising out of personal reputation of owners is


called personal goodwill.
Kaner contends that each of these seven types of goodwill should be separately
measured and valued. According to him, severe divergent and misleading results of
valuation of goodwill arise because they are bundled into one and valued in a lot under
the number of years’ purchase method or annuity method. But Kaner’s proposition has
been criticised by other authorities. Thus, Lall (1967) in an article said “.....I would
suggest that such classification is absurd and more absurd would be a valuation made on
the basis of any of the factors to the exclusion of others. The factors that make goodwill
are apparently different in nature but really interdependent and inter-related, that it is
impossible to evaluate the effect of any one of die factors in terms of monetary units. To
cite but one example, cordial and healthy employer-employee relations will naturally be
reflected in quality and price of the product and in turn, the attitude of the customers.
The fact of the matter is that it is impossible to segregate the financial effect of specific
factors”.
Regarding the classification of Kaner, Basu (1969) has mentioned in his research study
that Kaner is found to associate goodwill with the cause of some benefit He has opined
that causes leading to the creation or happening of anything can not be the thing itself.
Accordingly, it would be justified to equate goodwill not with causes but with benefits
arising out of causes. Despite of the contradictory views expressed by Dr. Lai and Dr.
Basu, Kaner’s classification of goodwill will be of definite use for valuation of
goodwill. If the causes responsible for goodwill creation are duly considered and given
weightage on the basis of the degree in which they exist, the valuation would be more
realistic.

Internally Generated Goodwill vs. Purchased Goodwill


A firm is not born with goodwill. Goodwill has to be either generated within the firm or
purchased along with some existing business. But generation of goodwill within the firm
is not automatic and instantaneous. It is developed over a period of time through
constant effort and sacrifice. Apart from regular production, administration and sales,
the firm is required to take various actions like community development, employee
development, better liaison with customers, product development etc., which have
favorable effects on its reputation. Again goodwill, once generated, has to be nurtured,
otherwise it will disappear. So these activities have to be continuously undertaken. All
these activities involve costs. It is the well-established idle of accounting that a cost
expected to benefit the organization in future over a period of time should be capitalized
and charged.to the profit and loss account of different years according to the benefits
derived in those years. On the other hand, costs whose benefits are restricted to the
year of incurring are expensed in that year. Now in order to recognize the internally
generated goodwill, it is necessary to segregate costs, which will have favorable effects
on the future earnings from those which will expire within the year. But any such
segregation will be arbitrary and without any basis. As accounting is based on the
principle of objectivity and conservatism, accountants have preferred to expense away
all goodwill generating costs in the year in which they are incurred. Thus, internally
generated goodwill is not recognized in accounts. The problem, which is encountered in
case of internally generated goodwill, is not however faced in case of purchased
goodwill. It has already been mentioned that purchased goodwill can not be purchased
alone. It can be purchased only along with an existing business. When an existing
business is purchased, some excess payment over the fair value of net assets taken over
has to be paid for its superior profit earning capacity. Such excess payment is recorded
as goodwill.
Accounting for Purchased Goodwill
After recognition of purchased goodwill in accounts, the question that arises is what
should be done with it .The following alternatives are available:
 Purchased goodwill is written off against ownership equity at the time of
acquisition.
 Purchased goodwill is fully charged to the profit and loss account in the
year of acquisition.
 Purchased goodwill is capitalized and amortized over its useful economic
life.
 Purchased goodwill is capitalized and amortized over a specific period of
time.
 Purchased goodwill is capitalized and it is then subjected to periodic
impairment test .
 Purchased goodwill is capitalized and retained as a permanent asset .
Between the first two alternatives - immediate writing off against reserve or owner’s
equity and write off against the profit and loss account, the former is a preferred
treatment, as it does not distort the current year’s profit The immediate writing off is
justified for more than one reason. Firstly, it ensures consistency of treatment between
internally generated goodwill and purchased goodwill. It is argued by many that since
internally generated goodwill is not recognized in accounts, purchased goodwill should
be eliminated from accounts instantly. Secondly, many have the notion that goodwill is
an asset of doubtful character. So if financial statements are to maintain their credibility,
they must get rid of this kind of soft asset. Thirdly, if goodwill is written off
immediately after its recognition, the future profit of the company will be relieved of
bearing the burden of amortization. In feet, if the profitability is understated artificially,
there may be an adverse impact on the market value of the firm. This is because market
is interested only in the bottom-line of the firm and not how it has been arrived at
Fourthly, immediate writing off of goodwill spares the company of the decision
regarding the period of amortization. There is no denying the fact that a great deal of
subjectivity is involved in determining the suitable period over which the goodwill is to
be amortized and the method by which it is to be amortized. However instant writing off
is not above criticism. Firstly, it ignores the economic reality of goodwill. That goodwill
has a significant bearing on the profitability of the firm is ignored here. Secondly, if the
amount of goodwill is substantial, the reserve may not be sufficient to wipe it off. This
possibility is very much there in die ease of a knowledge- based company where
intangible assets are far more valuable than tangible assets. Thirdly, as this method
erodes the net worth of the firm, the debt-equity ratio tends to be very high.
Consequently the cost of borrowing increases. Fourthly immediate writing off is
contrary to die matching principle. As goodwill refers to the amount paid for super profit
likely to be earned in future, it should be amortized gradually over a period so that there
is matching of amortization with super profit. Deferral of goodwill and its gradual
amortization however involves several problems. Firstly, die period over which
amortization will be done is to be selected. Generally amortization is done over the
period during which the benefit of goodwill is supposed to flow to the business. But it is
next to impossible to assess objectively the period over which the benefit of goodwill
will flow. Any selection of period for amortization will be arbitrary. That is why
different standard setters have prescribed different time limits for the purpose of
amortization. For example, the UK accounting standard FRS-10 has prescribed
amortization of goodwill over its useful life subject to a refutable assumption that its life
does not exceed 20 years. According to the Japanese GAAP, purchased goodwill is to be
amortized within a reasonable period, which should not normally exceed 5 years. The
Indian GAAP AS- 14 has considered it appropriate to amortize goodwill over a period
not exceeding 5 years unless a somewhat longer period can be justified. The selection of
the method of amortization is also a key issue of the deferral policy of goodwill. Usually
the method to be used for amortization should reflect the pattern of benefits likely to be
flowing from goodwill. But in most of the cases that pattern can not be determined
reliably. So the normal tendency is to follow the straight- line method of amortization.
Amortization of goodwill through die profit and loss account is also not always favored
The critics of amortization say that it leads to double charging the profit and loss
account It is argued that a company is constantly incurring expenses towards training,
advertisement, promotion etc. These expenses which are instantly charged to the profit
and loss account help to create and maintain goodwill. Now if capitalized goodwill is
amortized, the profit and loss account is required to accommodate the double charge.
The other alternative i.e., capitalization and subjecting to periodic impairment test is not
without criticism. Periodic impairment test is done to see whether the carrying value of
goodwill is matching with its recoverable amount The recoverable amount is defined as
the higher of the net realizable value amount the value in use. If the carrying value
happens to be lower than the recoverable value, the amount of goodwill is said to have
been impaired. The amount of goodwill thus impaired is charged to the profit and loss
account But impairment review is much more problematic. It involves calculation of net
realizable value of the asset and, of its value in use. The question of net realizable value
of goodwill does not arise, as it can not be sold separately. The calculation of the value
in use requires identification of the future cash flow from goodwill. The estimated future
stream of cash flows from goodwill is restated at present value by using an appropriate
discount rate. The present value of future cash flows from goodwill, known as the use
value of goodwill, is compared with its carrying value for impairment review. The
whole process is much more oblique. Moreover there may be much volatility in reported
earnings because impairment losses are likely to occur irregularly and in varying
amounts. The immediate writing off of goodwill can relieve the company of this
botheration. Many accountants are in favor of keeping the goodwill as permanent asset
as long as the earning is sufficient It is argued that as purchased goodwill is being used
up, it is constantly being replaced by internally generated goodwill. So the total amount
of goodwill of a firm remains unimpaired. That is why it is argued that there is no need
to amortize purchased goodwill. However allowing goodwill as a pennant asset in the
balance sheet may encourage corporate predation as the own earning of predators will
not be diluted by amortization.

Negative goodwill
If the acquisition price of a business is less than the sum total of fair values of net assets
(total assets minus total liabilities) taken over, the difference is known as negative
goodwill. Theoretically negative goodwill is not supposed to arise. This is because, if the
acquisition price happens to be less than the aggregate price of net assets, the owner of
the company will be better off in selling all assets and meeting all liabilities separately
instead of selling the business as a going concern However, if die owner has poor
negotiation skill or if he has to sell die business under any political compulsion or for
any other reason beyond his control, the purchase price may be less than the fair value of
net assets taken over . Divergent accounting practices are in vogue regarding negative
goodwill. For example, negative goodwill arising on acquisition of business is to be
transferred to the Capital Reserve Account as per die Indian Accounting Standard AS-
14. The British standard FRS-10 states that negative goodwill is to be disclosed in the
intangible fixed asset category directly under positive goodwill. Then to the extent of
fair values of the non-monetary assets taken over, it should be recognized in the profit
and loss account in the periods in which the non-monetary assets are recovered, whether
through sale or depreciation. Any excess of negative goodwill over the fair value of the
non-monetary assets acquired should be recognized in the profit and loss account in the
period expected to be benefited. The stipulation of FRS-10 has been criticized for more
than one reason. Firstly , release of negative goodwill against recovery of non-monetary
assets is problematic. Further, the stipulation of crediting excess of negative goodwill
over the fair values of non-monetary assets to the profit and loss account during the
period expected to be benefited is meaningless. In fact no period can be benefited from
the existence of negative goodwill (Paterson, Accountancy, Feb., 1998).
As per the US GAAP, SFAS-141, Business Combination, if negative goodwill arises on
the acquisition of business, the values of acquired assets except (a) financial assets other
than investments accounted for by the equity method, (b) assets to be disposed of by sale
or otherwise and assets of a discontinued operating segment; (c) deferred tax assets, (d)
prepaid pension assets and (e) other current assets, are to be reduced proportionately by
the amount of negative goodwill. If any negative goodwill remains alter this allocation,
the excess should be recognized as an extraordinary gain in the period of acquisition.
The approach of the International Accounting Standard Board (IAS 22) towards
accounting for negative goodwill is again entirely different According to this standard,
the portion of negative goodwill, which relates to future losses and expenses foreseen at
die time of acquisition should be recognized as income when such future losses and
expenses are incurred. However, two conditions must be fulfilled for this treatment.
Firstly, the future losses and expenses can be measured reliably and secondly they must
not represent identifiable liabilities at the date of acquisition. To the extent it does not
relate to identifiable expected future losses and expenses or the expected or planned
losses do not occur, the negative goodwill not exceeding the fair values of non-monetary
assets acquired is recognized as income on a systematic basis over the remaining
weighted average useful life of the acquired depreciable assets. Negative goodwill in
excess of the fair values of the non-monetary assets acquired should be recognized as
income immediately. Again IFRS 3 which has been introduced by IASB replacing IAS
22 in March 2004 requires that negative goodwill, if it arises, should be immediately
recognized in the Income Statement as gain.
VALUATION OF GOODWILL

There are basically two accounting methods for goodwill valuation. These are:
(i) Capitalization Method and (ii) Super Profit Method. A third method called annuity
method is a refinement of the super profit method of goodwill valuation.
Capitalization method
Under this method future maintainable profit is capitalized applying normal rate of
return to arrive at the normal capital employed. Goodwill is taken as the excess of
normal capital employed over the actual capital employed.

Normal Capital employed =Future maintainable profit Normal rate of


return
Goodwill = Normal Capital Employed – Actual Closing Capital
Employed
Factors considered in this method are:
 Future maintainable profit;
 Actual capital employed in the business enterprise for which
goodwill is to be computed;
 Normal rate of return in the industry to which the business
enterprise belongs.
For example, Capital employed in X Ltd. is Rs 17,00,000, future maintainable
profit is Rs 3,00,000 and normal rate of return is 15%.

So GOODWI.L = Rs 300000/0.15 – Rs1700000 = Rs 300000

Naturally, if normal capital employed becomes less than actual capital employed there
arises negative goodwill.
It is to be noted that under Capitalization method the actual capital employed is to be
taken at (closing) balance sheet date.

Super profit method


Excess of future maintainable profit over normally expected profit is called super profit.
Under this method goodwill is taken as the aggregate super profit of the future years for
which such super profit is expected to be maintained.
Factors considered in this method are:
 Future maintainable profit;
 Actual capital employed;
 Normal rate of return;
 Period for which super profit is projected.
Super profit = Future maintainable profit minus (Actual Capital employed ×
Normal rate of return)
Goodwill = Super profit × No. of years for which Super Profit can be maintained.

Annuity method
It is a refinement of the super profit method. Since super profit is expected to arise at
different future time periods, it is not logical to simply multiply super profit into
number of years for which that super profit is expected to be maintained. Further future
values of super profits should be discounted using appropriate discount factor. The
annuity method got the nomenclature because of suitability to use annuity table in the
discounting process of the uniform super profit. In other words, when uniform annual
super profit is expected, annuity factor can be used for discounting the future values for
converting into the present value. Here in addition to the factors considered in super
profit method, appropriate discount rate is to be chosen for discounting the cash flows.
Example:
Super Profit of X Ltd. Rs 95,000 p.a. can be maintained for 5 years. Discount rate is
15%
Goodwill = Rs 95,000 × 3.352 = Rs3,18,440
There are at least two frequently used approaches for arriving at the Capital employed:
(i) based on a particular Balance Sheet and (ii) average of Capital employed at different
balance sheet dates.
Capital employed is determined using historical cost values available at the balance
sheet date. However if revalued figures are given that should be considered.

DETERMINATION OF CAPITAL EMPLOYED


Conventionally ‘Capital Employed’ means Total Assets Minus non-trading assets i.e.
assets not used in the business Minus miscellaneous expenditure and losses Minus
all outside liabilities.
As per this concept capital employed becomes equivalent to net worth less non- trading
assets. But this concept has its own shortcomings:
(i) This approach ignores other long term fund in the business;

(ii) On the other hand, it considers preference share capital which bears fixed rate of dividend.

The argument in favor of adopting this approach is to count only such fund which is
attributable to the shareholders. Alternatively, by capital employed one can mean long term
capital employed. However, leverage gives some advantage as well as riskiness. Use of lower
amount of owned fund results in higher return because of using borrowed fund
advantageously. This is called leverage effect. By taking only ‘shareholders fund’ as capital
employed, one can give weightage to leverage while calculating goodwill.

Example
Liabilities Rs in lakhs Assets Rs in lakhs
Share Capital 80 fixed assets 1,80
P & L A/c 20 Inventory 40
13% Debentures 1,20 Trade receivables 20
Trade payables 40 Cash & Bank 20
2,60 2,60

Capital employed (shareholders’ fund approach)


Rs 260 lakhs – Rs 160 lakhs outside liabilities = Rs
100 lakhs. Capital employed (long term fund
approach):
Rs 260 Lakhs – Rs 40 lakhs Trade payables = Rs 220 lakhs
Suppose normal return on shareholders’ fund is 20% and normal return on long term
fund is 18%
Also suppose Future Maintainable Profit (before interest) of X Ltd. is ` 38.4 lakhs.
Future Maintainable Profit (after interest) of X Ltd. Is Rs 22.8 lakhs i.e. (Rs 38.4 lakhs –
Rs15.6 lakhs debenture interest)
If long term fund approach is followed value of goodwill as per Capitalisation method is
i.e.,
Rs 38.4 lakhs/0.18 -Rs 220 lakhs = Rs 213.33 lakhs – Rs 220 lakhs
i.e., (-) Rs 6.67 lakhs, negative goodwill.

If shareholders’ fund approach is followed, value of goodwill as per capitalization


method is,
Rs 22.8 lakhs/0.20 – Rs 100 lakhs = Rs 114 lakhs – Rs 100 lakhs
i.e., Rs14 lakhs, positive goodwill.

In this example, when long term capital employed was considered there was negative
goodwill, but it became positive when shareholders’ fund was considered. In the
second approach leverage advantage has been taken into consideration. Thus, in
goodwill valuation generally shareholders’ fund approach is preferred.
Non-trading assets are ignored while computing capital employed. This is because
surplus fund invested outside does not influence the future maintainable profit.
Particularly, Non-trade investments are not counted while computing capital employed,
but trade investments should be taken into consideration.
Another important aspect is often discussed regarding valuation of capital employed.
What value should the accountant put for fixed assets and inventory. Since historical
cost is not true indicator of the value of these assets, then it is suggested to take current
cost of such assets. Current cost represents the cost for which asset can be replaced at
its present state. However, if the asset cannot be replaced at its present state because of
obsolescence, then cost at which its best substitute is available may be taken as current
cost.
Capital employed may be determined using the value given by the latest balance sheet or
taking simple average of the capitals employed at the beginning of the accounting period
as well as at the end.
AIMS

1. To ascertain the reputation of business.

2. To find out the prospective earning capacity of the Business.

3. To determine value of goodwill in case of re-Organization of partnership


firm.

4. To find out success and profit of business based on Personal skill which
affects value of goodwill.

5. To gain better economic and political conditions in Business

6. To find out goodwill arising out of super profits as Compared to the


profits earned by other business in the same industry.

OBEJCTIVES

Identifying disclosures to enable investors to assess:


 Management’s rationale for the business combination.
 If the post-acquisition performance of the business combination
meets expectations set at the acquisition date.
Simplifying the accounting for goodwill by:
 Permitting an indicator-only approach as to whether an
impairment test is required.
 Exploring whether to reintroduce amortization of goodwill.
Improving the calculation of value in use by permitting:
 cash flow projections that may include future enhancements to
the asset.
 the use of post-tax inputs in the calculation of value in use.
REVIEW OF LITERATURE
Dorisz Tálas
University of Debrecen Faculty of Economics and Business Institute of Accounting and
Finance, Debrecen, Hungary
This paper is a theoretical overview of the often used valuation methods with
the help of which the value of a firm or its equity is calculated. Many experts (including
Aswath Damodaran, Guochang Zhang and CA Hozefa Natalwala) classify the methods.
The basic models are based on discounted cash flows. The main method uses the free
cash flow for valuation, but there are some newer methods that reveal and correct the
weaknesses of the traditional models. The valuation of flexibility of management can be
conducted mainly with real options. This paper briefly describes the essence of the
Dividend Discount Model, the Free Cash Flow Model, the benefit from using real
options and the Residual Income Model. There are a few words about the Adjusted
Present Value approach as well. Different models uses different premises, and an overall
truth is that if the required premises are real and correct, the value will be appropriately
accurate. Another important condition is that experts, analysts should choose between
the models on the basis of the purpose of valuation. Thus there are no good or bad
methods, only methods that fit different goals and aims. The main task is to define
exactly the purpose, then to find the most appropriate valuation technique. All the
methods originates from the premise that the value of an asset is the present value of its
future cash flows. According to the different points of view of different techniques the
resulted values can be also differed from each other. Valuation models and techniques
should be adapted to the rapidly changing world, but the basic statements remain the
same. On the other hand there is a need for more accurate models in order to help
investors get as many information as they could. Today information is one of the most
important resources and financial models should keep up with this trend.
In the last few years valuation and calculation of firm value became more and more
important because of the changes in the business environment. Thus nowadays firms
have the possibility to go directly to financial markets. To achieve this the information
about the value of the firm is needed. Theoretically managers control the firm’s property
keeping in mind the stakeholders’ interest, but actually the investors’ decisions form the
distribution of capital. Another need for business are present in nowadays business
environment (Rogers, 2002).
The main purpose of a firm is to invest into assets that generate the biggest cash flows,
to form production in order to have more and more incomes and profit, thus managers
would like to increase firm value (Damodaran, 2006).
In order to calculate the changes in the value, first they have to be able to calculate the
initial value and to define those factors, indicators which can have effects on it.
Basic terms
According to Natalwala, 2011 value is the present value of the future cash flows that
originate from the analyzed possessions. Price, as he considers, the amount of money
what a buyer paid for a property. Price is not equal to value, but in certain conditions
they can be the same. Value depends on the valuation technique, which is determined by
the purpose why the value is defined. One of the purposes is to create buy or sell
agreements for which the value of the firm is indispensable. In the case of valuation
process time is one of the most important parameter. The value calculated during the
valuation process is valid at a definite point of time. Before or after this date another
sum of money is the actual value of a property (Natalwala, 2011).

Traditional discounted cash flow models


Natalwala, 2011 introduces three approaches to valuation (the asset approach, the
income approach and the market approach). From these the income approach uses the
discounted cash flow model for valuation. With the help of the free cash-flow to firm the
firm value could be determined, while with the help of the free cash flow to equity, the
value of the firm equity could be calculated (Natalwala, 2011).
The free cash flow to firm is the free money that remains after paying the operational
costs and taxes, meeting the working capital need, and fulfilling the capital
reinvestment. The free cash flow to firm can be determined using the net income or the
EBIT. The main goal of calculating the free cash flow is to define the amount of money
which can be freely used by the debt and equity owners. Thus the earnigs before interest
and taxes are corrected by some items in order to calculate the free cash flow. Such
items are depriciation, amortization and all the other costs that were subtracted from the
income in order to calculate profit, but did not involve actual cash outflows. Another
item that should be taken into consideration is the so called capital expenditures, those
investments that are necessary for the business. The type of the investments depends on
the activity of the firm. The last main category of the items that are used to modify the
EBIT is the working capital needs. The depriciation, amortization and other items that
did not involve cash outflows should be added to the earnings before interest and tax,
and the capital expenditures and working capital needs should be subtracted from it
(Allman, 2010).
Net income is used for calculating not only the free cash flow, but this is the basis for
the profitability ratios as well. These ratios are often used for comparing firms to each
other within an industry. For example in the analytic framework of Rózsa, 2014
profitability ratios are included in order to compare firms with each other in Hungarian
building industry. (Rózsa, 2014).
There are two main methods of value calculation based on free cash flows depending on
the expected growth of the company. If one period of extraordinary growth is expected,
then the company’s growth rate reduces to a stable, lower long-term rate for the further
period of time. In this case a multi-period model is used. Another case is when there is
only one expected growth rate, then a single-period model is used based on the formula
of the present value of perpetuity with stable growth rate (Natalwala, 2011).
Figure 1 shows the general corporate valuation model using free cash flows.

Figure 1: Corporate valuation process based on free cash flows Source: Allman, 2010

Zhang, 2014 shows three finance approaches to evaluate a firm. He confirms that these
approaches are a matter of choice but their main theoretical background is the same. The
first approach is the dividend discount model, which essential is that the main payoff
from the asset is the dividends, thus these cash-flows should be discounted in order to
calculate the value of equity. This model is inappropriate when the forecasting of
dividends is problematic because of a firm’s less developed dividend policy (Zhang,
2014).
If the firm does not have a clear dividend policy, a kind of solution can be another
model, which is based on the free cash flows. Theoretically the two approaches should
result in the same outcome. Because of the fact that the dividend is the amount of money
that is distributed and the free cash flow is the amount of money that can be distributed.
Thus theoretically these two values should be equal to each other. But this situation
emerges only when all the free cash flows are paid off as dividends or from the
remaining surplus zero net present value investments are financed (Zhang, 2014). All the
models belong to the discounted cash flow- based models.
The third model is using the investments for calculating the value. In this approach the
value consists of two parts. The first is the capitalization of current earnings (which
represents the value of the existing assets), the other is the capitalization of positive net
present value investment possibilities. (Zhang, 2014)
To my mind using free cash flows to calculate value is the best effective method,
because the amount of the dividends depend on many subjective parameters, like the
managerial decision. Thus calculating all the capital that can be divided between the
shareholders can show the value more effectively. On the other hand the cash flow
which a firm can generate reflects its value better than its assets in my opinion.
According to Damodaran, 2013 one of the most useful approach to value a firm is using
the free cash flow to firm. On the same basis for the valuation of equity free cash flow to
equity should be used. He wrote down that the value of a firm is equal to the free cash
flow to firm (FCFF) discounted by the weighted average cost of capital (WACC). This
is the so- called intrinsic valuation, more precisely the discounted cash flow approach
(Damodaran, 2013).
There are cases when the free cash flow to equity could not be calculated, for example in
the case of financial service firms. In these cases not the cash flows, but the dividends
will be discounted for calculating value (Damodaran, 2013).
For making the value calculation, there are several parameters that should be estimated.
The first parameter is the cash flow, then the discount rates and the expected growth
(how the calculated cash flows will change over time) should be evaluated (Damodaran,
2013). A special issue is when a firm has got common and preferred stocks. If its free
cash flow to firm is calculated using the net income to common stocks, then the
dividends on preferred stocks should be added to it in order to get (beside other
modifying factors) the free cash flow (Pratt, 2002).
Each of the discounted cash flow methods makes an assumption that the price of a
company’s stock embeds the expectation of the market how much rate of return can be
expected from investing into the subject stock. The multistage DCF models (as above
mentioned) use two or more expected growth rates for different periods of time (Pratt,
2002).

The analyst should choose such a discount rate for valuation that reflects the risks in the
expected cash-flows (Damodaran, 2006).
According to Damodaran, 2006 there are four types of discounted cash-flow models. In
the first model the expected cash flows should be discounted by a risk-adjusted discount
rate, the main purpose in the second model is to get a certainty equivalent cash flow
which is discounted at the risk-free rate in order to value an asset. The third model is the
adjusted present value model. The last type of the discounted cash flow model
calculates the value of a firm by using the excess returns that are expected from its
investments (Damodaran, 2006).

There is a technique to get a final, conclusive value that is when an appraiser gives
different weights to different techniques (Natalwala, 2011).
In my opinion this is not the most applicable method, because the different techniques
have different purposes and premises, and the essence is to find a methodology that fits
perfectly for the reason the analysis would serve.
One of the main problems of the discounted cash flow based approaches is that the
decision should be made at the present, while the value of the cash flows are estimated
for the future. Thus these models can many times underestimate the value of a firm.
Another problem is that these models are static thus they do not calculate with the
possibly changing business conditions (Abrams, 2010).
By contrast real option approach demonstrates the value of flexibility through taking
into account the capability of the firm and its management to adapt to the variable
conditions and environment (Rózsa, 2004).
Real option method is used for valuing assets that have similar attributions like options
(Damodaran, 2006).
The discounted cash flow model can be complemented by the real options methodology
which causes another aspect of valuation. Thus when a firm value is calculated, first the
traditional methods should be used then the additional analysis can consist of value-
adding analytics for example Monte Carlo simulation, portfolio optimalization and real
options analysis. This process can result in a more appropriate and real value (Abrams,
2010).
Real options can complete traditional methods through being able to value assets in an
uncertain business environment (Tarnóczi et al., 2011).
In my opinion the traditional methods are well-usable for valuation, but the value-
adding processes take parameters and premises into consideration, that cannot be
included in other valuation methodology. Thus the result can be more accurate and more
realistic, and the investors can get more useful information for decisions.

Adjusted Present Value Approach

The adjusted present value (APV) approach is mentioned by Damodaran, 2006 as the
third model of discounted cash flow-based valuation.
It separates the expected debt financing costs and benefits from the value of the assets.
While in the traditional discounted cash flow models this effect is included in the
discount rate, in the APV approach firm value is expected in three steps eliminating the
debt effects. First the estimation of firm value without leverage should be conducted,
then the positive and negative effects of borrowing money is taken into consideration
through the present value of tax savings and the expected bankruptcy cost. The latter is
subtracted from the sum of the firm value with no leverage and the present value of tax
benefits. According to Natalwala, 2011 the asset approach is the one from the market,
income and asset approaches that use the less objective parameter and assumptions. But
the most important criterion is to choose a method that fits the most to the final goal and
to choose the premises and standard sin order to serve the purpose of valuation
(Natalwala, 2011).

Residual Income Model

Besides the above mentioned models there is another one which estimates equity value
on the basis of the book value of equity and the expected future residual income (Zhang,
2014).
The Residual Income Model is considered an accounting-based valuation process,
because the required elements can be acquired from the financial statements preparing
by the firm. In this model the total firm equity consists of the book value of equity and
the present value of residual income (Thomas and Gup, 2010).
Compared to the above mentioned approaches the new term is residual income which
can be calculated as the difference between forecasted accounting earnings and normal
earnings. The latter can be calculated using the book value of equity and the cost of
capital (Thomas and Gup, 2010).
The so called normal earning is the multiplication of the book value of equity and the
cost of capital for a firm (Thomas and Gup, 2010).
This residual income is calculated as the difference of earnings and cost of equity
capital. This is a kind of net income which means the net value a firm generates during a
period of time after it pays all the operation costs including the cost of equity capital. In
the income statement there is a term „net income” but that is different form the one used
in the Residual Income Model, because the former does not take into consideration the
cost of equity capital. This approach is not fully new, previously the term „residual
income” was mentioned (Zhang, 2014).
The first big difference between the discounted models and the residual income model is
that the latter does not calculate the earnings for time of infinity because it considers this
kind of calculation and forecasting impracticable. Meanwhile the discounted cash flow
models calculate the present value of dividends and free cash flows if only they were
infinite cash flow series (Zhang, 2014).
The residual income model is appropriate for firms that have only operating activities.
The basic concept is that the financial assets are traded on markets that price these assets
correctly, thus these are investments with zero net present value. But the operating assets
are traded on less perfect markets thus they generate profit or loss. From the attributions
of the two types of assets results that the book value of equity can be generated as the
sum of the book value of financial assets (which show the exact value of these assets
because of the perfect markets) and the book value of operating assets (which can be
expressed as the present value of the free cash flows originating from operating
activities). This kind of residual income model can be only used when the analyzed firm
does not make its accounting on accrual basis (Zhang, 2014).
Thus there is a strict limitation on the use of this version of residual income model
which can be used in the case of pretty few companies in Hungary for example.
The model of residual income has a feature that makes the accounting measures irrelevant to the
valuation process. This can be conducted through a so called self-correction process. This is
regarded as a favorable feature by some researchers (e.g. Bernard in Zhang, 2014). But on the
other side there are some experts who presume that this cause that the firms will not motivated
to make correct and global financial reports. Kothari (in Zhang, 2014) mentions that this feature
of the model is unfavorable from his point of view (Zhang, 2014).
In my opinion this feature is useful for the prediction and the valuation because self- correction
makes it possible to correct the accidental misleading or unrealistic information. If we consider
the free cash flow model, in that case investors also have to make calculations besides the
financial statements, thus this is not an additional work for them, they only have a choice to
make better calculations with this method.
The Residual Income Model has two basic conditions, DDM and the clean surplus relation
(CSR), which is the only one that is needed for the transformation of DDM into RIM. Through
this condition, in the equation of calculating the value instead of forecasted dividends,
accounting variables are used (Zhang, 2014).
DDM is the dividend discount model, which estimates equity value as the present value of
expected future dividend payoffs. This method can be efficiently used if there are no unexpected
events and if the firm has got a predictable and well-planned dividend policy on the basis of
which investors can forecast exactly when and exactly how much dividend will be paid (Zhang,
2014).
According to Damodaran, 2006 the basis for RIM is the assumption that lays behind net present
value calculation as well. When net present value is defined, experts presume that only those
investments increases the firm value that have positive net present value. Thus cash flows and
earnings will only be calculated into the value (i.e. increases firm value) if they have got a
bigger return than their cost (Damodaran, 2006).
Damodaran, 2006 highlights one of the weakness of the discounted cash flow models, that they
do not make an explicit relationship between reinvestment and growth rate, while in the case of
firms if they use their assets more effectively or they buy new assets and operate them, they can
expect a higher growth rate. This weakness is corrected in the residual income model which link
the two mentioned parameters (Damodaran, 2006).
In my opinion this feature makes the residual income model more accurate because there is an
obvious relationship between the higher growth rate and innovation. Firms make new
investments in the hope of higher earnings, thus the valuation model should take this
relationship into consideration.

According to some researches the residual income model has better results, it can more precisely
estimate the value than the models based on the discounted dividends or discounted free cash
flows (e.g. Sougiannis in Zhang, 2014, Courteau et al. in Zhang, 2014, Francis et al. in Zhang,
2014). Other researchers (e.g. Lundholm and o’Keefe in Zhang, 2014) declare that there is no
sense in comparing these methods because they have theoretically common basis, thus if one
model gets a more precise value, it cannot be stated that this model is more effective or more
precise than another one (Zhang, 2014).

Conclusion on review of literature on the basis of model

All the mentioned models and techniques attempt to calculate the firms’ value. All of them is
based on the assumption that basically the value of a property is equal to the present value of the
money it will generate in the future. The newer methods try to adapt to the new demands, the
constantly changing world and the resulted new information claims.
There are several methods and techniques with which experts can evaluate a firm, but the most
important criterion for choosing among them is the main purpose of valuation. All the
techniques can be used for different aims, simultaneously they use different assumptions and
premises.

Thus the first important task before starting a valuation process is to define the exact
goal of it. Then the valuation method should be selected, and the premises have to be
formed on the basis of the purpose and the model.
NEED AND IMPORTANCE
Generally goodwill may be valued at the time of disposal of business of the firm. But in
many cases the goodwill may be valued to find out value of the firm. In   case of
proprietorship business it will be valued at the time of disposal of business, in case of
firm it may be calculated at the time of addition, resignation and disposal of firm. Now
in case of companies the need for valuation of goodwill arises in the following
circumstances;

 In case of Amalgamation of company;


 In case of takeover of one company by another or sold of business of one
company;
 In case of a company wants to write off or reduce debit balance in its profit and
loss account;
 In case of a company wants to exercise controlling interest in other company;
 In case of valuation of shares of an Unlisted Company;
 In case of conversion of shares from one class to another class;
 In case of company’s management has been taken over by Government and some
other events in which valuation of Goodwill held.

WHEN GOODWILL IS VALUED


 When the business is sold as a going concern.
 When the business is amalgamated with another firm.
 When business is converted into private or public company.
 When there is a change in the profit-sharing ratio amongst the existing partners.
 When a new partner is admitted.
 When a partner retires or dies or reconstruction.
PRESENTATION OF DATA

Goodwill is the reputation created and enjoyed by firm. It generates high profits
therefore the value of goodwill is calculated on the basis of profit of the concern,
generally the future profit is takes into account while ascertaining the value of goodwill.
The future profits of the concern are estimated on the past profits so the value of
goodwill is based on future profits estimated with the help of past profits. The valuation
of goodwill of the firm is made on the basis of certain methods.

There are four methods for valuation of goodwill:-


1. Average Profit Basis,
2. Super Profit Basis,
3. Annuity Basis,
4. Capitalization Basis

1. Average Profit Basis:


Under this method, goodwill is valued/ calculated at certain number of year’s purchase
of the average profit of the firm.
This average profit is to be considered as a base for the valuation of goodwill because a
single year’s performance is not sufficient basis for judgment. Similarly it is expected
that the firm will earn average profit for the next certain numbers of years and therefore
goodwill is valued of certain number of year’s purchase of average point.
The steps for average profit method are:-
A. Calculation of Total Profit

Years Amount
I 1,50,000 ( Profit)
II 2,25,000 ( Profit )
III 75,000 ( Loss)
IV 2,00,000 (Profit )
V 2,50,000 ( Profit )

The total profit will be as follows:


Total Profit = (1, 50,000 + 2, 25,000 – 75,000 + 2,00,000 + 2,50,000)
Total Profit-Loss = 8, 25,000 – 75,0000
= Rs. 7, 50,000
B. Calculation of Average Profit
Average profit refers to the profit earned by the firm for one year. It can be calculated
by using the following formula.
Average Profit = Total Profit / Number of Years
In the above example the average profit will be calculated as follows:-
Average Profit = 7, 50,000 / 5
= Rs. 1, 50,000/-
C. Calculation of Goodwill
Under average profit method, goodwill is valued at certain number of years purchase of
average profit. Thus goodwill can be calculated by using the following formula.
Goodwill= Average X Number of year’s purchase Average profit as calculated in step
no. 2 is
Rs. 1, 50,000/- and of goodwill is valued at three years purchase of average profit hen
goodwill will be as under:
Goodwill = Average Profit X No. of year’s Purchase
Goodwill = Rs. 1, 50,000 X 3
Goodwill = Rs. 4, 50,000
2) Super Profit Basis:
In case of average profit basis, goodwill is calculated on the basis of average profit
multiplied by certain number of years. On the other hand, super profit means, excess
profit that can be earned by a firm over and above the normal profit usually earned by
similar firms under similar circumstances. Under this method, the partner who gains in
terms of profit sharing ratio has to contribute only for excess profit because normal
profit he can earn by joining any partnership firm. Under this method, what excess profit
a partnership firm can earn is to be determined first.
Factors considered in this method are:
 Future maintainable profit;
 Actual capital employed;
 Normal rate of return;
 Period for which super profit is projected.
To value the goodwill under this method the following 4 steps are to be taken.
A. Calculation of Average profit:-
The procedure for the calculation of average profit is already explained above.
B. Calculation of Normal Profit:-
Normal profit refers to a reasonable expected profit to be earned by a business concern
after meeting all its business expenses. It is ascertained by using the following formula:
Normal Profit = Capital Employed X NRR / 100
 NRR = Normal Rate of Return

Capital Employed:-
Amount of capital used by the firm to run and manage its business activities, is called
capital employed. The term “Capital Employed “is made – up of fixed assets (other than
goodwill) plus current assets minus current liabilities.
Normal Rate of Return:-
Normal rate of return is the return of profit normally expected by the investors on the
capital employed by considering the returns or profit actually earned by other firm in the
same industry. Normal rate of return depends upon the nature of business and element of
risk is involved therein.

C. Calculation of Super Profit:-


Super profit is the profit earned by the business concern over and above the normal
profit on capital employed. It denotes extra earning of the firm. In other words, it is
nothing but the excess of average profit over the normal profit.
Eg. The normal earning rate of Amar & company is 155 on capital employed of Rs.
4,00,000/- therefore the normal profit or earning is Rs. 60,000/- If its actual profit or
earning is Rs. 1,00,000/-, Amar & company has earned super profit of Rs.40,000
(1,00,000- 60,000) .
Thus super profit is calculated as per the following formula.
 Super Profit= Average profit – Normal Profit
D. Calculation of goodwill:-
Under super profit method, goodwill is valued at certain number of year’s purchase of
super profit. It is calculated as per the following formula.
Goodwill = Super profit X Number of year’s Purchase
(Obviously if there is no super profit, the firm will have no goodwill)
 TREATMENT OF GOODWILL IN CASE Of ADMISSION
Goodwill means extra premium brought by new partner. There are two methods of
recording goodwill in the books of accounts while admitting new partner in the existing
partnership firm.
A) Extra Premium Method :-
Under this method incoming his partner proportionate share of goodwill in cash and it
may be retained in the business or withdrawn by old partners from the business.

i) When a new partner brings his share of goodwill in cash and it is retained in the
business. The following two journal entries are to be passed:-
a)
Cash/ BankA/c.................................................Dr.
To Goodwill A/c
(Being goodwill brought by new partner in cash)
b)
Goodwill A/c......................................................Dr.
To Old partner’s capital/current A/c (sacrifice Ratio)
(Being goodwill retained in the business)

ii) When goodwill is brought by new partner and it is withdrawn by old partners:
The following three journal entries are to be passed:-
a)
Cash/ Bank A/c.................................................Dr.
To Goodwill A/c
ii) When goodwill is brought by new partner and it is withdrawn by new partners:
The following three journal entries are to be passed:-
a)
Cash/Bank A/c..................................................Dr.
To Goodwill A/c
(Being goodwill brought in cash by new partner)
b)
Goodwill A/c......................................................Dr.
To Old partner’s capital/ current A/c (Sacrifice Ratio)
(Being goodwill credited to old partners)
c)
Old partner’s capital/current A/c .........Dr. (Actual amount withdrawn)
To Cash/Bank A/c
(Being goodwill withdrawn by old partners)
(Being goodwill brought by new partner in cash)
b)
Goodwill A/c......................................................Dr.
To Old partner’s capital/current A/c (sacrifice Ratio)
(Being goodwill retained in the business)
iii) When new partner bring his share of goodwill in cash & if it is paid to old partners
privately:- In this case no entry is required to be passed in the books of the firm, as it is
a private agreement between the partners.

B) Valuation Method:-
Under this method new partner does not bring the amount of goodwill in cash. So old
partners create/raise the Goodwill A/c in the books of the firm at the time of admission
of partner. The following is the accounting treatment of goodwill as per this method.
i) When the new partner does not bring the goodwill in cash and it is raised in the books
of the firm:
The following journal entry is passed.
d)
Goodwill A/c......................................................Dr.
To Old partner’s capital/ current A/c (In old Ratio)
(Being goodwill credited to old partners)
ii) When Goodwill is raised and written off:
The following two journal entries are passed.
a)
Goodwill A/c......................................................Dr.
To Old partner’s capital/ current A/c (In old Ratio)
(Being goodwill rose in the books of the firm)
b)
All partners’ capital/current A/c .........Dr. (in New profit sharing ratio)
To goodwill A/c
(Being goodwill written off)
iii) When goodwill already appears in the books of the firm:
In such case, if the goodwill is revalued, the entry is passed for the amount of difference
either through capital/current a/c or revaluation.
3) Annuity Basis

You might also like