Explain briefly on Capitalisation Method

Capitalisation method is one of the methods that is used for goodwill valuation. In this method, the value of goodwill is calculated by deducting actual capital employed from the capitalisation value of average profits based on the normal rate of return.

There are two ways of calculating profits in capitalisation method and these methods are:

1. Capitalisation of Average Profit Method

2. Capitalisation of Super Profits Method

Capitalisation of Average Profit Method: In the method of capitalisation of average profit, the goodwill value is determined by subtracting the actual capital employed from the capitalised value of the average profits on the basis of normal rate of return.

Goodwill = Normal Capital – Actual Capital Employed or

Goodwill = Capitalised Average Profits – Actual Capital Employed

where,

Capitalised Average Profits or Normal Capital = Average estimated profits x 100 / Normal Rate of Return

Actual capital employed or Net Asset of Business = Total Assets ( excluding goodwill, non-traded investments and fictitious assets ) – Outsiders liabilities

Steps in calculating goodwill by capitalisation of average profit method

Step 1: Calculate average estimated profits

Step 2: Calculate the capitalised average profits

Step 3: Calculate the value of Actual capital employed or net assets of the business

Step 4: Calculate goodwill by subtracting the actual capital employed from the capitalised average profit

Capitalisation of Super Profits Method: In this method, the goodwill valuation is determined by capitalising the super profit on the basis of normal rate of return.

The formula for the Capitalisation of Super Profits Method is

Capitalisation of Super Profits Method = Average of Annual Super Profits x 100 / Normal rate of return

Example of Capitalisation Method

The following illustration will help in understanding the concept of capitalisation of average profit method more clearly.

Bhatt and Sons are able to earn a profit of 90,000 by infusing a capital of 5,00,00. The normal rate of return is 15%. Determine the value of goodwill by using capitalisation of super profit method.

Solution

Normal profit = Capital employed x Normal rate of return / 100

= 5,00,000 x 15 / 100

= 75000

Super profit = Average profit – Normal Profit

= 90000 – 75000

= 15000

Goodwill = Average of annual super profit x 100 / Normal Rate of return

= 15000 x 100 / 15

= 100000