Spot Co is considering how to finance the acquisition of a machine costing $750,000 with an operating life of five years. There are two financing options.

Option 1

The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.

Option 2

The machine could be bought for $750,000 using a bank loan charging interest at an annual rate of 7% per year.

At the end of five years, the machine would have a scrap value of 10% of the purchase price. If the machine is bought, maintenance costs of $20,000 per year would be incurred.

Taxation must be ignored.

Required:

In Islamic finance, explain briefly the concept of riba (interest) and how returns are made by Islamic financial instruments. (5 marks)