Time Value of Money

‘it is widely known that Islamic finance prohibits the charging of interest on loans. But most do not know that Islamic law does not reject the notion of the time value of money. The capital provider is permitted an adequate return. For instance:

  • If money is committed to another party to use for a period of time, compensation for the financing may not be a predetermined amount guaranteed by the other party to the contract; instead, it should be a share in the actual profits of the venture. Money is not treated as a commodity, as in the West, but as a bearer of risk, and therefore subject to the same uncertainties as those borne by other partners in the enterprise.
  • If investors finance the acquisition of tangible goods by sale or lease, they may legitimately compensate themselves for foregone opportunities. Profits deriving from lease payments or from credit sale may reflect, even explicitly, a time factor.

[…]

Islamic rules do permit businesses to utilize credit, and do not prescribe that all businesses be financed entirely with equity capital. Islamic businesses can and do utilize financial leverage in their capital structures, thereby exposing their owners to both the potential enhancement of returns on equity if things go well and to value reduction if results are disappointing.

There are many similarities between Islamic and conventional finance, since both deal with a common set of operating business realities. In most cases, Islamic and conventional finance simply travel different paths toward the same goal, but there are important differences. Consider these examples

  • Most businesses need long-term financing. In conventional finance, this is accomplished through some mix of long-term debt and owners’ capital. In one Islamic solution, passive partners contract for a certain share of the profits, with another share going to the entrepreneurs who manage the business. This solution meets the concept of partnership required by doctrine and is similar to a conventional preferred shareholder contract. If the business does not want to dilute its ownership by brining in partners, other options exist, such as leasing. A lease does not involve the formal interest or a partnership stake, yet satisfies the businesses’ need for long-term financing of plant and equipment and the investor’s need to earn a fair return.
  • Inventory financing is a requirement common to both Islamic and conventional commerce. An Islamic business in need for short-term, inventory financing can purchase the inventory on credit, that credit being supplied either by the inventory supplier or a bank. The bank can purchase the inventory for the business based on the business’s promise to buy the inventory later for cost plus a fair markup.
  • Many businesses find it necessary to supply credit to their customers through accounts receivable. An Islamic business can do this but is not permitted – as in conventional finance – to refinance by pledging or selling those receivables because they are not real assets. Under Islamic law, financial assets cannot be sold or used as collateral. So the Islamic business either has to finance its credit extensions from internally-generated funds or arrange for a third party to buy the goods on behalf of its customers and resell them to those customers with a markup – just as the Islamic business would finance its own purchases from suppliers.’

 

by Frank E. Vogel and Samuel L. Hayes, III, Islamic Law and Finance (Kluwer Law International, 1998), 2-3