In the simple average method for the valuation of goodwill the average profit of the past certain years are taken into consideration. Then, this average profit is to be multiplied by the certain number of years for the valuation of goodwill. Here it is assumed that a new business will take certain number of years to earn the same profit. Therefore, the business purchaser is ready to pay the value of goodwill equal to the number of years of average profit.
Generally, the multiplication of average profit and the number of years during which the anticipated profit are expected is known as goodwill.
Illustration : Profit of a firm for last four years is 40,000; ₹ 45,000; ₹ 35,000 and ₹ 60,000 respectively. Value of the goodwill to be determined on the basis of 3 year purchase of last 4 years average profit.
Total profit = ₹ 40,000 + ₹ 45,000 + ₹ 35,000 + ₹ 60,000 = ₹ 1,80,000
Goodwill = Average profit × No. of years of purchase
