The profits for the five years of a firm are as follows - year 2013 Rs. 4,00,000; year 2014 Rs. 3,98,000; year 2015 Rs. 4,50,000; year 2016 Rs. 4,45,000 and year 2017 Rs. 5,00,000. Calculate the goodwill of the firm on the basis of a 4-year purchase of 5 years average profits:
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Rs. 17,54,400
Average Profits Method: Under this method, the goodwill is valued at agreed number of ‘years’ purchase of the average profits of the past few years. It is based on the assumption that a new business will not be able to earn any profits during the first few years of its operations. Hence, the person who purchases a running business must pay in the form of goodwill a sum which is equal to the profits he is likely to receive for the first few years. The goodwill, therefore, should be calculated by multiplying the past average profits by the number of years during which the anticipated profits are expected to accrue.
Step 1: Find the average profit
Profits of 5 years =
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2013 = 4,00,000
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2014 = 3,98,000
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2015 = 4,50,000
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2016 = 4,45,000
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2017 = 5,00,000
Total = 21,93,000
Average Profit=21,93,000/5 =4,38,600
Step 2: Goodwill
Goodwill = Average Profit × Number of years’ purchase
= Rs 4,38,600×4
=Rs. 17,54,400