Corporate Finance Decisions in Islamic Finance Framework, by Muhammad Ayub

© Islamic Finance Today

Muhammad Ayub is the Author of a well known work on Islamic Finance Understanding Islamic Finance (2007). He is the Former Head of Islamic Banking, National Institute of Islamic Banking and Finance (NIBAF) and Senior Joint Director, Islamic Banking Department, State Bank of Pakistan

Corporate Finance’ is related to the relationship between business decisions and the value of shares of the firm in the business. Corporate managers, investment bankers and the financial analysts have to make a number of decisions in any financial environment – conventional or Islamic. Islamic Corporate Finance activities of investment institutions are similar to conventional corporate finance except that the products and services offered are Shari´ah compliant.  The decisions may pertain to the following major activities:

i)    What investments a firm should  make of funds

ii)    How can funds be arranged to pay for investment decisions – internal and external sources

iii)    Raising private and public funds

iv)    Securitization – Equity, Sukuk issues

v)    What should be reward policy in case the business is successful

vi)    Financial restructuring

vii)    Acquisitions, divestments, mergers

With Islamic banking and finance emerging vastly, the corporate firms and finance managers are required to have conceptual clarity about the bases of Islamic finance and develop analytical skills to evaluate corporate finance decisions for Shariah compliance and for safeguarding the interests of all major stake holders – shareholders, financiers and financial intermediaries.

Three main decisions taken by any corporate firms are investment decision, financing decision, and the dividend decision that are inter-related in the long run and, therefore, should be solved together. Investment decision is, however, more important as it alone affects the firm’s value.

The sources of funds can be divided into the new funds raised (financing decision) and the flow of funds from operations of the business (part of the investment decision). The use of funds can also be divided into two parts, i.e. asset and non asset expenditure (the other part of investment decisions) and payment to the shareholders (dividend decision). In terms of investment decisions, companies working in Islamic finance framework cannot invest in conventional financial products, gambling, short selling and Haram and immoral items and activities relating to pork, alcohol, pornography, etc.

The basic contracts used in Islamic finance are i) loans, ii) selling goods on credit or forward purchases thus creating debts, iii) leasing the assets against rentals; iv) equity based financing for sharing of profits and absorbing business losses; and v) fee or commission based agency services. A large number of products are being used by Islamic financial institutions (IFIs) either singly or as combination of various modes.

An Islamic finance manager must have clear views on nature and Shariah position of some critical issues like sale of debt, receivables / monetary assets, financial options, swaps and hedge funds that could play a decisive role achieving the level of Shariah compliance in investment and financing activities. He has to keep in view the following principles of Islamic finance:

1.    Loaning is a virtuous act and not a business mode in Islamic finance because of prohibition of interest. Any types of funds taken in the shape of loans have to be guaranteed to the extent of principal without provision of any return – return and reward go side by side.

2.    Trade based contracts entitle fixed return to the banks as price of goods has to be stipulated without any ambiguity at the time of execution of any sale. While fixing the price, IFIs can keep in view the time involved for performance by the client. While credit price of the goods can genuinely be higher (as in case of Murabaha), forward price in Salam can be lower than their spot payment price of the goods. Prices of goods have to be stipulated without any ambiguity at the time of execution of any sale. Bai al Inah (sell and buy-back) is prohibited due to being a trick to circumvent the prohibition of interest. Tawarruq (getting cash through purchase and sale) is legally permissible according to the majority of the contemporary Shari´ah scholars. But essential conditions of valid sales must be fulfilled.

3.    In Ijarah (leasing), the lessor has to bear the ownership related expenses and risks of the leased assets. It can be used directly for plants & machinery, and indirectly for Sukuk issues by public and private sector corporations. In the arrangement of ‘Sale & Lease Back’ a corporate body may sell an asset to an IFI or SPV and then lease it back to get the required finance.

4.    In partnership modes, profit to any partner cannot be in the form of a fixed amount or any percentage of the capital employed and the loss has to be borne by the investor(s) pro-rata with the proportion of the invested capital.

5.    IFIs have to bear the asset risk, market risk and all counter party risks – they can manage to mitigate but not eliminate such business risks. Once the contract is executed, they have to give or receive delivery/possession irrespective of upward or downward movement of the prices. If general rate of return or price levels in the economy rise, they can loose in terms of Murabaha receivables as prices once finalised cannot be increased.

6.    Short selling as facilitated and practiced by brokers in conventional finance is not allowed. One must have ownership and possession of what he is selling. Salam (forward sale) of goods of certain nature that do not exist and are not in possession of the seller is allowed, but subject to conditions relating to quality, quantity, availability of the wares in the market, pre-payment of the full price and delivery of the Salam commodity at stipulated date irrespective of the price movement in the market. Further, the subject matter in sales must be valid assets. Accordingly, all transactions in which exposure to the parties is only the difference between the agreed price / interest rate and the settlement price / rate applicable at the date of settlement are not acceptable in Islamic finance.

7.    Arbun sale in which the seller takes a part of the settled price of an item of sale (earnest money) from the buyer with the understanding that the earnest money will be credited to the agreed price if the sale is concluded, and forfeited if not concluded, is allowed according to the contemporary Shariah scholars associated with the IFIs. But the question is: can the purchaser, after paying the earnest money to the seller, dispose of the item before finally purchasing and taking the same in his possession? In my view it should not be allowed as a policy because it is more likely to become a back-door for selling goods without taking ownership and possession and ultimately corrupt the investment practices of IFIs.

This view is based on a precedent that Shaikh Taqi Usmani had earlier allowed (in T+ 3 days settlement framework) on-ward sale (prior to final settlement) of shares purchased with firm commitment to conclude the deal on payment of margin. But Islamic banks practically mis-utilized the permission and resorted to serious irregularities leading to non-Shariah compliance. Therefore, Shaikh Usmani had to reconsider the issue and advise the banks to dispose of the shares only after making full payment on the settlement day.

In case of Arbun, where the very intention negates the firm commitment to buy, it is more likely that any open permission may lead to unethical practices and fictitious deals by a series of maneuvering between the brokers and the investment managers. Some efforts have been made to operate Islamic hedge funds on the basis of Arbun, but due care needs to be taken in coordination with the Shariah boards to ensure Shariah compliance.

8.    Sale of debts and receivables is not allowed except at their face value along with recourse to the original debtor. Similarly all instruments based on asset portfolios representing cash and debts more than 33 % are not eligible for trading as per screening criteria approved by AAOIFI and Shariah Committees of Islamic investment funds and companies.

Islamic financial market instruments are mainly of two types in terms of their nature and flow of return: Fixed/ Quasi Fixed (Stable) Income Securities based on trade and Ijarah based modes. These instruments accommodate risk-averse investors and generate resources for additional intermediation and income flow to the banks; and Variable Income securities based on partnership modes that offer a stream of variable income based on the strength of the underlying projects.

Trading in the above instruments is subject to the following principles:

a)        Instruments representing real physical assets and usufructs are negotiable at market price. Certificates or Sukuk issued on the basis of Musharakah, Mudarabah and Ijarah are covered under this category.

b)        Instruments that represent receivables  and  money  are subject to the rules of Hawalah (at face value with recourse to the original debtor) and Bai´ al Sarf (exchange of monetary units : hand to hand in case of different currencies and equal for equal as also hand to hand in case of same monetary unit on both sides).

c)    Instruments representing a pool of different categories are subject to the rules relating to the dominant category. If cash and debts / receivables are relatively larger, the rule of Bai´ al Sarf would apply, and if real/physical assets and usufructs are overwhelming, trading would be based on the market price.

Shariah scholars have developed certain investment criteria for investment that pertain to portfolio selection keeping in view the nature of business and certain financial ratios. These criteria require that: i) Prohibited activities such as gambling, interest-based financial institutions, alcohol production etc must be excluded; ii) The investee company’s capital structure should be predominantly equity based.  These criteria might be different in different jurisdictions as decided by the scholars on the basis of tolerance level in different financial markets depending on the nature of financing and the level of development of capital markets in respective areas.

Time value of money is accepted to the extent of pricing of goods and their usufruct and not in the form of ‘opportunity cost’ or the ‘cost of funds’ in the sense of interest based finance. This concept is important in CF to determine the present value of cash flows expected in the future in the process of business. It has direct bearing on the pricing benchmarks adopted by IFIs. The trade-off between money now and the money later depends on, among other things, the rate one can earn by investment.

The benchmarks play an important role in deciding the profit sharing ratio in partnership modes as also in respect of finding out the future value in investment for a number of periods in debt-creating trade and Ijarah based modes – IRR, NPV and profitability of the firms and in making financing, investment and dividend decisions.  Corporate finance experts have to try to evolve benchmarks based on real sector activities in the economies so that Islamic banking and finance could yield real benefits for all stakeholders.

Although Shariah scholars have allowed using the conventional benchmarks for pricing of goods and their usufructs, such benchmarks reflective of the fictitious assets may not be helpful in achieving the real objectives of Islamic banking and finance.

It is hoped that the above explanations will be helpful in understanding the nature of corporate finance practices in an Islamic finance framework.