Islamic finance has been criticized by some circles in using conventional benchmark in pricing products, using more or less the same product structure and predominantly using debt based modes of financing. This research article takes an alternative approach and goes beyond practiced Islamic finance to suggest an alternative financial framework.
Corporate Finance in an Interest Free Economy: An Alternate Approach to
Practiced Islamic Corporate Finance
S a l m a n A h m e d S h a i k h M S ( S z a b i s t )
Assistant Professor, University of East, Pakistan
Islamic finance has been criticized by some circles in using conventional benchmark in pricing
products, using more or less the same product structure and predominantly using debt based
modes of financing. This research article takes an alternative approach and goes beyond practiced
Islamic finance to suggest an alternative financial framework.
Application of Time Value of Money
Time value of money is the basis of interest. Interest is said to be the charge on the use of money
for a particular time period. Islam prohibits interest that entails that no incremental amount can be
charged for the use of money for a particular time period.
According to Islamic principles, any investment will have to go through the entire process of a
business activity that involves risk taking at each stage and any compensation on investment will
be strictly dependent upon the outcome of the business activity. Time value of money is the
problem for the investor to avoid keeping his money idle and to avoid forgoing the use of money
that may bring positive value to his investment. However, it does not mean that the investor can
demand an arbitrary increase (or is given as the case may be) as the cost of using money without
taking the risk.
Dealing with Scarcity of Capital
Business cycles are a reality. Infact, as per Islam, they must exist as this world is a place for test
and this test requires some people to be privileged and some to be deprived. The deprived and
privileged are both tested for patience and thankfulness to Allah and how they take care of society
and its needs. But, interest as a system of allocation of resources ensures a stipulated return to one
and variable/uncertain for another. That is why, business cycles affect borrowers negatively.
Hence, leveraged companies thrive in upturns, but lose in downturns.
Interest makes capital scarce, brings oligopoly in capital goods industries and monopolistic
competition in consumer goods industries i.e. market imperfections. Market imperfections lead to
mismatch between supply and demand, hence create downturns every now and then in economy.
This downturn leads to monetary easing to increase Aggregate Demand, but the market remains
imperfect even then because capital is still scarce with interest and no wealth tax (more
prominently in developing countries with indirect taxes greater than direct taxes). If it is followed
by cost-push inflation, it may give rise to stagflation. In Stagflation, monetary economics fail and
further exacerbate the situation with output decreasing and capital made scarcer with increase in
interest rates. Inflation can be better checked through supply chain management and removing
market imperfections complimented by progressive taxation. Business Cycles will continue to
exist as they are natural, but the loss/profit would be shared. So, markets will not produce
speculative surplus output and that will stabilize business cycles.
Interest shall have to be abolished by a legal decree complimented by an obligation of broad
based wealth tax (Zakah). An obligation of wealth tax (Zakah) would ensure that loanable funds
increase even when there is no interest. The loanable funds would be invested in equity modes of
financing including Mudarabah and Musharakah. Investments in equity will be exempted from
wealth tax. This would ensure that investors get a minimum return i.e. tax savings plus income on
their equity investments. This tax exemption would also ensure the availability and supply of
By abolishing interest by a legal decree, primary market activities in equity markets will increase
since companies will no longer be able to generate finance through debt. Therefore, increase in
listed companies will expand the market and diversify trading opportunities for investors.
Pricing Capital in an Interest Free Economy
Pricing of Capital in Public Finance
In the figure below, data for the period 1970-2008 for a group of big economies i.e. America,
Britain, Canada, China, the euro area, India and Japan is shown on the variables Nominal Interest
Rates (t) and Nominal GDP Growth Rate (t-1) since Nominal GDP responds to interest rate
changes as it decreases aggregate demand for the subsequent period, a lag variable for GDP i.e.
GDP (t-1) is taken.
Figure 1: Nominal GDP (t-1) & Nominal Interest Rates (t) for a group of big economies
(Source: The Economist)
It can be seen that both variables virtually moved together throughout the period and especially
since 1990. Since this figure confirms the movement of both variables in the same directions, it
can be used for indexing loans from the rest of the world and initially by Islamic Development
Bank for its financing assets.
IMF provides lending to member countries for dealing with balance of payments crisis and
maintain stability in the economy in the form of Stand-By Arrangements (SBA), Flexible Credit
Line (FCL), Emergency Assistance (EA), Exogenous Shocks Facility (ESF) and Poverty
Reduction and Growth Facility (PRGF) etc. If these loans are pegged with IMF?s reserve
currency i.e. SDR which is composed of a basket of currencies namely USD, JPY, GBP and Euro
or pegged with USD or with any other hard currency, the financing facility so provided can be
benchmarked using nominal GDP growth rate of the lender?s country of origin or benchmarked
with weighted Nominal GDP growth rate in major donor countries.
Financing in development projects from World Bank and International Development Association
(IDA) can also be benchmarked with weighted Nominal GDP growth rate in major donor
countries or countries whose currency is included in the basket of currencies which make up
SDR. This will be an alternative for market based financing. For soft loans, aid and grants, the
Nominal GDP growth rate in the recipient country can be used. It will not only compensate the
financier for parting with liquidity and capital, but also provide a stable mechanism for recipient
countries to get out of debt trap with debt servicing linked with output performance benchmark.
Having this relief in the balance of payment and foreign debt, countries will be well set to
introduce the proposed benchmark for pricing treasury bonds. Financing from domestic
commercial banks can be benchmarked with the national nominal GDP growth rate.
Pricing of Capital in Corporate Finance
In corporate finance, NGDP growth rate will be used in following valuation models:
1. It will replace R in CAPM model.
2. It will help in calculating Ks and Capitalization rate in dividend discount model.
3. Income Bonds will be valued using DCF approach. The proposed benchmark rate i.e. NGDP
growth rate would be used as the discount rate.
4. FCF could be calculated using this benchmark rate.
5. In project valuation, this benchmark rate would be used to find PV of Cash Flows. This
would be appropriate due to following:
i. It will not lead us into falling in time value of money as we are using an enterprise or
output related benchmark rather than interest based benchmark
ii. The Cash Flows are obtained using equity contractual modes like Mudarabah and
iii. We are calculating valuation models for the investor and not for the borrower. Borrower or
financee will be in no obligation to provide the returns based on these valuations. But, the
investor can use this ?indicative valuation? to rank investment alternatives.
iv. In actual distribution of income between financier and financee, profit sharing ratio would
be used and applied to the gross profit earned by the financee.
Financing Alternatives in the Proposed Framework
In the following lines, holistic set of changes are recommended as part of the proposed financial
Limited Liability Partnership
In this form of business, the liability of the partners is limited up to their investment in the firm as
in the case of a limited company. Venture Capital Funds in developed markets are established on
limited liability partnership structure. In VC funds, income bonds can be issued first before the
company becomes profitable and then the stocks in the company can be acquired.
Ijarah with Options Contract
The concept of Gharar (uncertainty) should not be used as shield to avoid price/market risk. 1400
years ago, the economy was agricultural and the agricultural yield was not predictable and
homogenous. In Options contract, the obligation rests on one party and the other has an option.
Therefore, it does not have any element of Gharar (uncertainty). Call premium is also charged to
create financial discipline. If there is no call premium, then one will buy an unlimited number of
options contract to hedge for each date for a same or similar price. Hence, options could be used
in fixed asset/property financing to separate sale and tenancy contracts.
In the practiced Islamic banking, taking an undertaking from the financee is just like buying a put
option from the financee who is acting as a put option writer. If this is reversed, the financee
would buy the call option and the bank will sell the call option i.e. acts as call option writer.
The alternative is as follows:
The bank buys the asset/property paying the asset owner the full amount of the asset. The Bank is
now the owner of the asset. It gives the asset/property on rent to the financee and at the same
time, the bank enters into an option contract as the call option writer. In a European option
contract (exercisable only at expiration date), the financee buys that call option which gives him
the right to buy the asset at call expiration. He has the right but not the obligation to buy. The
option writer however, is obliged to sell the asset if the call buyer decides to exercise the contract.
For short term options contracts as in corporate financing, American style call options contracts
(exercisable on or before expiration date) can also be used.
If the call buyer does not exercise, the option contract expires and the bank is in a position to give
the asset/property on rent again. If the call buyer exercises the contract, the bank gets the asset
price plus the rental income for the period before the expiration of the contract. The rent would be
benchmarked using House Rent Index. This index could be established.
A partner can opt for partnering only in profits. This arrangement of partnering only in profits is
very different from interest based lending. An investor investing to earn interest gets the fixed
amount irrespective of profit or loss of the borrowing entity. When a partner in a Mudarabah
contract opts for partnering only in profits, he will only get a profit if the financee gets a profit.
Therefore, this does not result in any exploitation of the financee and does not contradict with any
of the Islamic laws. The modified Mudarabah will have the following characteristics. There will
be two types of Mudarabah i.e. Mudarabah Corporate and Mudarabah Consumer.
In practiced Islamic finance, the bank usually acts as a Mudarib. But, in the proposed framework,
the Bank will act as a Rabb-ul-maal (investor) and will provide finance to business entities and
corporations. This way, the fund will be utilized in productive uses rather than in the financial
In this contract, the bank acting as Rabb-ul-maal can opt to share only in the profits. This way the
bank will be minimizing the risks and will get the principal paid back in full if the business incurs
a loss. The Mudarib (Business enterprise) will not be willing to show losses because it will
deteriorate its credit ratings and make it difficult for it to obtain finance through Mudarabah
corporate in future.
In this contract, the bank will act as a Mudarib (Fund Manager). The investors acting as Rabb-ul-
maal will provide investment which is put together in a fund. The bank (Fund manager) will
invest the funds in the equity market, Mudarabah Corporate, Ijarah and permissible derivatives
like Options on Ijarah (as discussed above) and Sukuks based on Asset Backed Securitization etc.
The fund can declare the dividends either stock or cash as the case may be. The fund can be a
closed end fund or an open-end fund.
The calculation of profits for each investor will also be simple as it will be based on the capital
gains on investment as a difference between redemption and purchase prices calculated each day
on the basis of NAV. Therefore, the bank will also avoid the complex profit calculation based on
profit on daily product basis as in the current system.
Operating lease is in accordance with Islamic principles since no interest is involved in operating
lease. The bank can also give the capital without owning asset, no need for asset at all. Asset is
needed if one wants rent or profit out of an asset. But in the proposed model, the bank will
participate in business and not with the mentality that it wants rent on asset or profit on sale of
asset irrespective of what the business does as in practiced Islamic Banking. Instead of relying on
rent on assets, banks can participate in business and earn profits distributed at gross profit level.
Short Term Credit
In the proposed model, the bank will provide capital and invest in the business (no asset involved)
of the financee and share profits at the gross profit level. No business should exist if it
is operating below shutdown point. If almost all blue chip companies have positive net income,
and surely, all will have positive gross income, they can be profitable and so can bank if it
participates in their business.
In trade finance, the credit involved is usually for the short term. Bank as a financial intermediary
can altogether be avoided by incorporating time for payment in the price. If the buyer would pay
after 6 months and not at spot, price agreed upon can be set high. This would not contradict with
Islamic principles as the sale of asset is involved, delivery is made spot and only payment is
deferred. Price once agreed will not change. Bank would get agency fee for services, but not
interest on the short term credit as no credit gets involved with the bank.
Investment Alternatives in the Proposed Framework
Islamic Income Funds
Islamic Income Fund will derive its income from investment in Ijarah (with Options),
Musharakah (limited liability partnership) and Mudarabah. Islamic Banks provide income to their
depositors on the same principle. Islamic Income Fund will be more diversified as it will be able
to invest more funds in Islamic Banks with low NPLs and better risk management procedures. It
will invest some funds in equity markets to provide better returns than Islamic Banks.
Real Estate Investment Trust (REIT) will invest in property market and gain through
purchase/sale of properties and rental income. REITs investing funds in properties and giving
them on rent will get regular rental income and hence will be able to provide their unit holders?
regular source of income.
Investments in NGDP linked Treasury Bonds
Corporate finance managers and treasuries of financial and non-financial institutions can invest in
treasury bonds which are priced using Nominal GDP growth rate.
Investments in Foreign Currency
Corporate finance managers and treasuries of financial and non-financial institutions can trade in
different currencies as both are considered different commodities. This would be used to hedge
currency risk. However, forwards, futures, options, swaps in currencies can not be used.
Investments in Stocks
Corporate finance managers and treasuries of financial and non-financial institutions can make
equity investments in common stock of different companies diversifying risk and stabilizing
Investments in Venture Capital Funds
Corporate finance managers and treasuries of financial and non-financial institutions can make
equity investments in VC funds or providing seed/bridge financing as an angel investor if FCFE
permits to diversify risk and income stream.
Investments in Corporate Income Bonds
Income only bonds could be issued. These bonds need to be serviced provided there is income.
The service payments on these bonds will be tax deductible. Tax deductible feature would benefit
issuer and the compulsory servicing of bond in case of income would benefit investors to invest
in blue chip companies. Companies which are not in the ranks of blue chip companies would
issue convertible income bonds. Since there is a one sided obligation, it will not be against any of
the Islamic principles. Exemption of investment in income bonds would also ensure the
availability and supply of loanable funds in income bonds market.
Dividends will be allowed to be tax deductible; thereby, benefiting the company to benefit from
tax advantage and increase the frequency of dividend payments and make it a regular feature.
This will further boost and compliment the availability of loanable funds.
Corporate finance managers and treasuries of financial and non-financial institutions can increase
capacity to bring economies of scale and scope, increase market share by increasing size of firm,
diversity product line and target market, become a conglomerate, acquire a strategic target and tap
other long term opportunities if there is surplus FCF.