Capitalization Method – Calculation & Analysis

Introduction

Under this method, we calculate the total capital required to earn the current profits, and compare it with actual capital employed.

1. Capitalization of Average Profit

Formula:

Total Capitalized Value = Average Profit × (100 / NRR) Goodwill = Total Capitalized Value - Net Assets (Capital Employed)

Logic: If my profit is ₹10k and NRR is 10%, the "Value" of my business is ₹1 Lakh. If my actual Net Assets are only ₹80k, the extra ₹20k value is Goodwill.

2. Capitalization of Super Profit

Formula:

Goodwill = Super Profit × (100 / NRR)

Logic: Directly finding the capital value of the extra profit. Interesting Fact: Mathematically, Capitalization of Avg Profit and Capitalization of Super Profit usually yield the SAME result.

Illustration

Data:

• Actual Average Profit: ₹72,000.
• NRR: 10%.
• Assets: ₹9,70,000.
• Liabilities: ₹4,00,000.

Solution:

1. Net Assets (Capital Employed): 9,70,000 - 4,00,000 = 5,70,000.
2. Normal Profit: 5,70,000 x 10% = 57,000.
3. Super Profit: 72,000 - 57,000 = 15,000.

Valuation by Cap of Super Profit:

Goodwill = 15,000 x (100/10) = ₹1,50,000.

Valuation by Cap of Average Profit:

Total Capitalized Value = 72,000 x (100/10) = 7,20,000. Goodwill = 7,20,000 - 5,70,000 = ₹1,50,000.

Both match!

Summary

• Cap of Avg Profit: Total Value - Net Assets.
• Cap of Super Profit: Super Profit / NRR %.
• Result: Identical.

Quiz Time! 🎯

Loading quiz…