Syllabus B. Advanced Investment Appraisal B3. Impact of financing on investment decisions and APV

B3a. Islamic Finance - Introduction 4 / 18

Syllabus B3a)

a) Identify and assess the appropriateness of the range of sources of finance available to an organisation including Islamic finance.

Islamic Finance - Introduction

Is it moral or ethical to wish wealth into existence without any underlying productive activity happening?

Islamic Finance is based on the principle that money must never spontaneously generate money. Instead capital must be made fruitful or “fecundated” by labour, material or intellectual activity or be invested in a wealth creating activity.

Islam therefore prohibits the payment of interest on loans, so observant Muslims require specialised alternative arrangements from their banks.

Many of the largest global financial companies, including Deutsche Bank and JPMorgan Chase, have established thriving subsidiaries that strive to meet these requirements

Consequently Islamic Finance frowns upon speculation and applauds risk sharing.

The major difference between Islamic finance and the other finance

Equity Financing not Lending

  • Under Islamic finance laws, interest cannot be charged or received due to the lack of underlying activity

    Therefore, Joint ventures under which the lender and the borrower share profits and risks are common because of the strict prohibition of the giving and taking of interest.

  • Due to a ban on speculation, Islamic transactions must be based on tangible assets such as commodities, buildings or land.

    Islamic banking has its emphasis on equity financing rather than lending

    Investing in businesses that provide goods or services considered contrary to the principles of Islam is haraam (forbidden) while those that are permitted are halaal.

The concept of interest (riba) and how returns are made

  • Interest is called riba and an instrument that complies with the dictates of Fiqh al-Muamalat (Islamic rules on transactions) is described as sharia-compliant.

    Instead of charging interest (deemed to be money making money), the lender agrees to buy the asset or part of the asset themselves (asset making money)

  • Shariah-compliant mortgages, for instance, are typically structured so that the lender buys the property and leases it out to the borrower at a price that combines a rental income and a capital payment. 

    At the end of the mortgage term, when the price of the property has been fully repaid, the house is transferred to the borrower.

    NB no calculations are required for this part of the exam

  • Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the perspective of the borrower, the lender and the economy. 

    For the borrower, riba can turn a profit into a loss when profitability is low. 

    For the lender, riba can provide an inadequate return when unanticipated inflation arises. In the economy, riba can lead to allocational inefficiency, directing economic resources to sub-optimal investments