Earlier, we provided an alternative mechanism for public finance by issuance of a Nominal GDP linked instrument. But, there is a problem with pricing of capital this way in commercial banking. As per Islamic teachings, Capital is to be priced in an activity in which it participates and earns an actual reward. If one allows replication of this pricing methodology for public finance to seep into commercial financing, then, if an Islamic bank sells cotton, wheat, textile machinery, car or house, it will earn the rate of return on nominal GDP growth rate which has no causal relationship with cotton market, wheat market, textile machinery market, car and house market.
The real issue can not even be solved if one takes into account growth in particular sector. It is, because that is like giving an opportunity cost to capital and akin to interest. Variability is not the issue, linked to production is also not the issue. The real issue is that capital can only get profit on entrepreneurship in which it participates.
Preferably, house and car market should have a separate index, and pricing should be based upon that index. There is no big issue in house and car financing as they have secondary value. But, industrial machinery does not have a secondary value. Bank cannot take market/price risk in that regard. It has to lock the sale with combining two contracts. Islamic Banks do it with a unilateral promise which is binding legally, but not islamically as per them. In my humble opinion, it is like binding two contracts, confirming the 2nd leg with customer that it will buy machinery and only then we will execute the 1st leg i.e. bank will purchase if customer agrees to buy (and for that it will promise which is legally binding).
The solution to this is as follows:
The bank can 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 current Islamic Banking. It should be clear now why Islamic Banks rests on asset backing because they want rent on assets and not profit on entrepreneurial participation in business.
In the proposed model, the bank will give money, invest in the business (no asset involved) of the financee and shares profit at the gross profit level. No business exists or should exist if it is operating below shutdown point. There should not be many based upon economic theory. 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. It can participate with blue chip companies as equity partner and with growth companies as creditor by issuing Income bonds i.e. participating in profit only and that too at gross profit level.
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Debt financing is a double-edge sword. Leveraged companies can magnify their returns in booms, but in slumps, they lose the edge and can even go bankrupt and make both their shareholders and creditors suffer. Debt financing results in a zero-sum game in which at least one stakeholder i.e. shareholders or creditors suffer. Equity financing ensures normal returns in booms and survival in slumps. Therefore, the company will not be squeezed of liquidity as interest expense as an ‘autonomous expense’ will not feature as a significant portion of total operating expenses.
A simplified economic model will highlight the point that equity financing is less risky and better prone to give profitable results in boom and in recession. In view of EMH, profitability would be reflected in market prices.
Non-Leverage Company
Assets Rs. (in millions) L + O.E Rs. (in millions)
F.A 60 Debt 0
C.A 40 Equity 100
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Case 1: Economic Boom Income Statement (Non-Leverage
Company)
Case 2: Economic Recession Income Statement (Non-Leverage
Company)
Rs in mln Rs in mln
Net Sales 100 Net Sales 60
CoGS (70% of sales) 70 CoGS (70% of sales) 42
Gross Profit 30 Gross Profit 18
Operating Expenses 10 Operating Expenses 10
PBIT 20 PBIT 8
Interest Expense (12%) 0 Interest Expense (12%) 0
PBT 20 PBT 8
Tax Expense (20%) 4 Tax Expense (20%) 1.6
Net Income 16 Net Income 6.4
ROE 16% ROE 6.4%
A simplified economic model will highlight the point that debt financing can provide better profitability ratios in boom but it is more risky and less prone to give profitable results in recession. Keeping in view Efficient Market Hypothesis, profitability would be reflected in market prices.
Leveraged Company
Assets Rs. (in millions) L + O.E Rs. (in millions)
F.A 60 Debt 60
C.A 40 Equity 40
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The model shows that in economic booms, leveraged companies are more profitable than non-leveraged companies, but in recessions, leveraged companies are less profitable and hence riskier than non-leveraged companies. Hence, leveraged companies are depending on the assumption that the economic boom will last indefinitely.
Modigliani & Miller (1963) argued that value of a levered firm is greater than the value of an unlevered firm. The difference in value comes from the tax benefit accruing to a levered firm. But, they ignored the bankruptcy costs and the case where even if a company is solvent, the economy may go through a recession. Furthermore, if this tax benefit is provided to an unleveled firm by making dividends to be tax deductible; then, value of a levered firm may cease to have any extra value greater than an unlevered firm.
Case 1: Economic Boom Income Statement (Leveraged
Company)
Case 2: Economic Recession Income Statement (Leveraged
Company)
Rs in mln Rs in mln
Net Sales 100 Net Sales 60
CoGS (70% of sales) 70 CoGS (70% of sales) 42
Gross Profit 30 Gross Profit 18
Operating Expenses 10 Operating Expenses 10
PBIT 20 PBIT 8
Interest Expense (12%) 7.2 Interest Expense (12%) 7.2
PBT 12.8 PBT 0.8
Tax Expense (20%) 2.56 Tax Expense (20%) 0.16
Net Income 10.24 Net Income 0.64