Question

A firm earned Rs 60,000 as profit, normal rate of return being 10%. Assets of the firm are Rs 7,20,000 (excluding goodwill) and Liabilities are Rs 2,40,000. Find the value of Goodwill by Capitalisation of Average Profit Method.

• A. Rs 2,40,000
• B. Rs 1,80,000
• C. Rs 1,20,000
• D. Rs 60,000

Hint:

Under the capitalisation of average profit method, if the capitalised value of the average profits is less than or equal to the actual capital employed, the firm does not possess any goodwill (goodwill is zero).
Always make sure to exclude existing goodwill, fictitious assets, and non-trade investments from total assets while calculating Capital Employed.

Answer 1

The Correct Option is C

Step 1: Understanding the Question:
The question asks us to compute the value of goodwill of a firm using the Capitalisation of Average Profit Method.
We are given the actual profit (average profit) of the firm, the normal rate of return, total assets (excluding goodwill), and external liabilities.

Step 2: Key Formula or Approach:
The formulas required for the Capitalisation of Average Profit Method are:
\[ \text{Capitalised Value of Average Profit} = \frac{\text{Average Profit}}{\text{Normal Rate of Return}} \times 100 \]
\[ \text{Capital Employed (Net Assets)} = \text{Total Assets} - \text{External Liabilities} \]
\[ \text{Goodwill} = \text{Capitalised Value of Average Profit} - \text{Capital Employed} \]

Step 3: Detailed Explanation:

• Calculate Capitalised Value of Average Profit:
  The average profit earned by the firm is Rs 60,000.
  The normal rate of return in this line of business is 10%.
  Using the formula:
  \[ \text{Capitalised Value} = \frac{60,000}{10} \times 100 = Rs 6,00,000 \]
  This represents the amount of capital needed to earn a profit of Rs 60,000 at the normal rate of return.
  
• Calculate Capital Employed (Net Assets):
  The actual capital employed is calculated by subtracting external liabilities from total assets (excluding goodwill).
  Given Assets = Rs 7,20,000 and Liabilities = Rs 2,40,000.
  Using the formula:
  \[ \text{Capital Employed} = 7,20,000 - 2,40,000 = Rs 4,80,000 \]
  
• Calculate Value of Goodwill:
  Goodwill is the excess of the capitalised value of average profits over the actual capital employed.
  Using the formula:
  \[ \text{Goodwill} = 6,00,000 - 4,80,000 = Rs 1,20,000 \]
  
• Analysis of Options:
  Option (A) Rs 2,40,000 is incorrect as it represents the liability value.
  Option (B) Rs 1,80,000 is incorrect due to calculation error.
  Option (C) Rs 1,20,000 is the correct valuation.
  Option (D) Rs 60,000 is incorrect as it equals the annual profit.
  

Step 4: Final Answer:
The value of goodwill calculated using the Capitalisation of Average Profit Method is Rs 1,20,000, which corresponds to Option (C).