Goodwill is the by product of acquisitions made by the company in the past. The difference between consideration paid and book value of asset acquired is recorded under goodwill.
Goodwill = Consideration paid for acquisition + Book value of asset
Now the question is while calculating invested capital, should the goodwill be part of it or not. To answer this, we first need to understand what does goodwill include and why the acquirer has paid for it. Broadly the goodwill generated in acquisition can be categorised into three components:
-Value of growth asset: growth asset are not part of book value of asset as they represent excess return a firm would generate from future investments. should not be part of capital invested as this investment has not yet been made.
-Value of synergies: should be part of capital invested, assuming company would start generating synergies immediately after acquisition
-Over payment for the target: if the acquirer has overpaid for acquisition then that overpayment should be part of capital invested
How to split goodwill in to the value of growth asset and other?
Method 1: Assuming entire goodwill is for growth asset, thus excluding total goodwill from invested capital
Method 2: Assuming entire goodwill is for synergies and overpayment, thus leaving total goodwill as part of capital invested
Method 3: Assuming that the market price of company before acquisition is the correct market value of the company
- a) Market Value = Book value + value of growth asset (i.e. excess return a company is expected to generate from future investments)
- b) Value of synergies and overpayment = Consideration paid – market value of the company before acquisition (in a above)
- c) Goodwill for value of growth asset = Total Goodwill – Value of synergies and overpayment (in b above)