Question

The following steps are of which method of goodwill:

1. Calculate the average profit.
2. Calculate the normal profit on the capital employed on the basis of the normal rate of return.
3. Calculate the super-profits by deducting normal profit from the average profits, and
4. Calculate goodwill by multiplying the super-profits by the given number of years' purchase.

Options

• Average Profits Method

• Super Profits Method

• Capitalization Method

• None of these

Answer 1

Super Profits Method

Explanation:

The main assumption behind the average profits (simple or weighted) method of estimating goodwill is that a new business will be unable to produce any profits during its first few years of operation. As a result, a buyer of an existing business must pay in goodwill an amount equivalent to the overall earnings he expects to make in the first "few years." However, it is argued that the buyer's true benefit does not lie in total profits; rather, it is confined to earnings that exceed the typical return on capital in similar businesses. As a result, it is preferable to value goodwill based on excess profits.