What is goodwill? What factors affect goodwill?
Goodwill is an intangible asset that represents the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits. It can be defined as "the present value of a firm's anticipated excess earnings" or as "the capitalised value attached to the differential profit capacity of a business".
Goodwill exists only when the firm earns super profits. Any firm that earns normal profits or is incurring losses has no goodwill.
The main factors affecting the value of goodwill are:
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Nature of business: A firm that produces high value added products or having a stable demand is able to earn more profits and therefore has more goodwill.
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Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill tends to be high.
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Efficiency of management: A well-managed concern usually enjoys the advantage of high productivity and cost efficiency. This leads to higher profits and so the value of goodwill will also be high.
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Market situation: The monopoly condition or limited competition enables the concern to earn high profits which leads to higher value of goodwill.
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Special advantages: The firm that enjoys special advantages like import licences, low rate and assured supply of electricity, long-term contracts for supply of materials, well-known collaborators, patents, trademarks, etc. enjoy higher value of goodwill.
Explanation
The answer covers both parts of the question as required for a 5-mark question. The definition of goodwill is taken directly from the textbook context, explaining it as an intangible asset representing the reputation of a firm and its capacity to earn super profits. The five factors affecting goodwill (Nature of business, Location, Efficiency of management, Market situation, and Special advantages) are listed with brief explanations as provided in the context. The answer is structured in 5 paragraphs with key terms bolded for exam presentation.