Goodwill, the amount paid for a business in excess of the value of the net tangible assets; it represents the value of the advantages of acquiring an established business.
The price paid for goodwill is high if there is a large demand for the type of business or a desire to eliminate competition by taking over a rival firm. Conversely, an enforced sale may enable the buyer to get the goodwill at a low price.
The buyer pays a capital sum for the right to receive profits larger than those otherwise obtainable on new capital similarly employed. These are sometimes called super profits in accounting language.
Apart from any special influences, the normal method of valuing goodwill is to multiply the average adjusted profits by a figure which varies from one to five, representing the number of 'years' purchase'. The profits are adjusted for non-recurring and special items, a 'normal' rate of interest on capital is deducted, and the period over which the average is calculated must be long enough to give a 'reasonable' estimate for future years.
The number of years' purchase depends on the way in which the goodwill was created. Its value may expire after the sale and be replaced by the new goodwill created by the purchaser. For example, it may have depended on the personal skill of the proprietor (hairdresser, dentist) or a favourable location that may be worth less to the purchaser.
Grading, classifying products according to technical standards of quality. It is possible only for goods with uniform characteristics satisfying simple needs; thus, wheat is graded, but tea has to be sampled before a buyer can know what he is buying. Grading corresponds to standardization of manufactured goods. It widens markets by enabling buyers to buy at a distance without seeing the goods, and it makes possible sales for future delivery.
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