Looking at an Islamic Investment: ‘Cost of Capital’ From

Authentic Hadiths

Ismail Bin Abd Rahman* And Arieff Salleh Bin Rosman**

The purpose of this study is to look into the Islamic perspective of ‘cost of
capital’ from the Quran, authentic hadith and various scholars. Many important
business decisions involving projects required the big amount of capital. In the
modern contemporary financial management, the capital structure or capital
components, with common and preferred stock, along with debt are the most
frequently used. The required rate of return on each component, and the cost of
capital used to analyze capital budgeting decisions should be a weighted
average of the various components’ costs which is known as the Weighted
Average Cost of Capital (WACC). The usage of various hadith with the profit as
a benchmark can be used as a basis as an alternative to interest in Islamic
financing. This study will enrich the fuller spectrum of Islamic financial
management in a dynamic and growing international arena.

1. Introduction
Cost of Capital is the cost of finance needed to acquire the physical capital. It
determines the minimum return required by the firm on capital deployed. In the
absence of an Islamic Rate of Return, IFI’s use the interest rate mechanism (LIBOR) as
a benchmark for procurement and placement of funds. Due to current market focus and
high priority development areas, little emphasis is being made on developing an
alternative to LIBOR.

In Malaysia, The Central Bank of Malaysia has basically uses an alternative to LIBOR. It
introduced the “Framework of the Rate of Return” to standardize the methodology on
the calculation of distributable profits and the derivation of the rates of return to the
depositors. The objectives of the framework are to set the minimum standard in
calculating the rates of return. It intend to provide the same playing level and term of
reference for the Islamic banking institutions (IBIs) in deriving the rates of return; and to
provide the Central Bank of Malaysia with an effective yardstick to assess the level of
efficiency of the IBIs.

*Ismail Bin Abd Rahman, International Business School, University of Technology Malaysia (UTM).
Email: m-ismail@utm.my and iarahman@gmail.com
**ARIEFF SALLEH BIN ROSMAN, Faculty of Islamic Civilization, University of Technology Malaysia
(UTM)
Email: aswar@utm.my
To have a thorough understanding of the Syariah- based is most important to look at the
authentic hadith that deals with profits and interest. This will be a good yardstick to look
into the Cost of Capital structure and then have a proper calculation of Islamic Cost of
Capital.

2. Literature Review
In order to go into the general benchmark of Islamic financing, it is important to look into
the authentic hadith on profit and interest. The essence of commerce is sincerity, safety,
and utmost kindness and utmost decency shown towards customers. One who do not
comply to this lacks the principle and can causes damage to the essence of commerce
and thus blocks his own livelihood.

The number of hadiths on trade and profitability can be seen as follows:

The Messenger of Allah (pbuh) also advised on commercial partnerships. A holy hadith
narrated by Abu Hurairah is as follows:

“As long as two partners in business do not betray each other, I am their third (I am with
them). If they betray each other, I leave them.” (Abu Dawud, Buyu 26).

Other hadiths are as follows:

“Allah’s hand of power is with partners in business as long as they do not betray each
other.” (Abu Dawud, Buyu 26).

“Profit return is shared according to conditions determined freely by partners. And the
loss is dealt with according to ratio of their capitals.” (Ibn Majah, Tijarat 63).

The Prophet has got many remarks, actions and statements related to commercial and
financial life. As a matter of fact, when the Messenger of Allah was asked what the best
way of livelihood was, he answered: “It is one’s elbow grease and acceptable trade.”
(Ahmad bin Hanbal, Musnad, 3/466).

And this refers to trade in which there are no betrayal and lying.

Some of the advice of the Messenger of Allah to tradesmen is as follows:

“A tradesman who is straight (honest) both in his words and actions is in the shadow of
the sky on the Day of Judgment.” (Ibn Majah, Commerce 1)

“If one collects eatables and sells them at the current market price, he earns thawabs as
if he gave them freely to the poor and the needy.” (Ibn Majah, Ruhun 16).
“O community of tradesmen! Doubtlessly, there are a lot of lies in trade. For this reason,
compensate for it with sadaqah.” (Abu Dawud, Buyu 1)

“A tradesman who is reliable in his words and actions is with prophets, the siddiq and
martyrs.” (Tirmidhi, Buyu 4; Ibn Majah, Tijarat 1).

The Prophet himself (pbuh), too, traded, lent, and had business partners. He became a
prophet in a time when people were involved in various commercial activities and he did
not forbid them from trade but contrarily encouraged them saying: “Nine tenth of
livelihood comes from trade.”

Business dealing with trickery and fraud and uncertainty which can lead to ill-gotten
gains were banned and a financial system in which the rightful person can have his right
and those who want to wrong others. For any business to be free of problems,
tradesmen must have enough knowledge in their fields or must have an expert to whom
they can resort to at any time.

Caliph Umar started a campaign for gaining knowledge and information in trade when
he became the caliph. The first notice of commerce that he sent to all governors is as
follows:
“One who does not know Islamic judgments related to his own trading may not trade in
our markets and bazaars because he may fall into interest due to his ignorance.”

Commerce and profit are mentioned in the Quranic verses and hadiths in general,

It can be generally seen that there are no limits to profits or profit rates from an Islamic
view. Moreover, Quranic verses have discouraged trading without profits.

Allah spoke disparagingly of certain people in the Qur’an:

“Their trade reaped no profit.” (Al-Baqarah: 16)

Profit made from commercial activities which are done according to their own rules and
Islamic principles are considered lawful. But precautions were also taken against
excessively greedy people who might want to exploit people making excessive profit. It
was aimed to protect the essence of open competition and to prevent exploitation of
people’s needs.

From hadith, it can be seen that the Prophet (peace be upon him) has allowed profits
of up to 100 percent, and some of the Companions earned more than 100percent. In
The Hadith narrated by al-Bukhari and others mentions that the Prophet (peace be
upon him) gave ‘Urwah one dinar to purchase a goat. Urwah then bought two goats
with that one dinar. Afterwards he sold one of the goats for one dinar. He came back to
the Prophet (peace be upon him) with a goat and one dinar. The Prophet (peace be
upon him) then prayed that he be blessed in his trading.
Some contemporary scholars, like Shaykh Wahbah al-Zuhayli, have suggested that the
net profit margin should be fixed by the authority in order to observe justice in the
market and to get blessings. They suggested that the profit rate should not exceed one-
third, based on the hadith,“Al-thuluth kathir”, which means “One-third is a lot,” in which
comment made by the Prophet (peace be upon him) when Saad ibn Abi Waqqas
wanted to make a bequest (wasiyyah).

The following answer of the Messenger of Allah to people on limits of profit is

meaningful:

“Doubtlessly, it is Allah who determines prices, gives abundance and poverty and
endows livelihood. I would not like to return to my Lord while one of you wants his rights
from me because of an injustice in property and life matters.” (Abu Dawud, Buyu 49;
Tirmidhi, Buyu 73; Ibn Majah, Tijarat 27).

But , it it is important to note that the absence of a limit to profit on a percentage basis in
sales contract does not mean that one can sell things at any price he likes.

The price becomes become prohibitive when something is sold above the current prices
by influencing customers with by hiding the good’s defect, praising the good by
attributing to it facilities which it does not really have, showing cost of the production
higher than it is and taking advantage of scarcity of the goods.

In this sense, the extra profit which is not rightful to the seller is not lawful for him.

In sum up, Islam does not treat capital and labor symmetrically with regard to
determining their rates of return It singled out interest specifically, making it unlawful. It
did not say the same thing of the ex-ante determined wages. Neither does the
socioeconomic justice of Islam, nor its principle of Gharar demand the ex-post
determination of all inputs prices. It does not mean that ex-post profit sharing by all
factors of production at a pre-negotiated rate is not allowed in Islam. It will, though, have
only limited applicability, because the sector of hired labor on daily wages and the
sector of hired labor where the output is not sold in the market for price is much larger
than the sector which uses borrowed capital for investment.

Amongst these precautions are prohibition of interest, lying and fraud and applying
government regulated prices when necessary can be listed. In this sense, it is
understood that Islam does not determine a limit to profit on a percentage basis added
to prices of various goods in trade. The pricing must be dependent on rules of supply
and demand and within the principles of open competition is taken as a main criteria.

Defrauding or illegally deceiving is expressed as “ghabn” in Islamic terminology. It is

divided into two as “exorbitant ghabn and moderate ghabn. It means defrauding to a
large extent and to a small extent because it is difficult to avoid it. Normally, people
consent to small differences in price. On the other hand, if the price is too much above
the current prices, customers think they are defrauded and do not make the extra price
they pay halal to sellers. Then, the issue of exorbitant price comes out. As a general
rule, the amount of exorbitant (prohibitive) price has been determined by jurisprudence
(case-law).

According to Hanafis, there is fraud (ghabn) in prices which are too low or too high
when compared to evaluations by experts.

Nusair ibn Yahya, who is a jurisprudent of Belh, (death 268 H/881) limited exorbitant
fraud to 20% for immovable properties, 10% for live animals and 5% for other movable
goods and stated that pricing above or below current prices in the market, exceeding
these limits, is considered exorbitant fraud. This takes into consideration the flow rate of
goods that are in sales contract in market and people’s demand for them. Extra pricing
which is below these percentages is considered moderate fraud.

The Majallah (Islamic-Ottoman civil code) made these criteria into an article of law with
article numbered 165. The exorbitant fraud can be a reason to cancel sales contract
only when there is trickery at the same time. There is not any Islamic objection when
one sells his goods at any price he likes, on condition that he gives true information
about them to customers, without any lies and tricks.

According to Malikis, it is exorbitant price when it is above or below general price in

market with the price being one third higher than the real cost of the good. This was the
same in Abu Bakr’s practice.

The reason why Islam has not determined a certain limit to the amount of profit to be
considered exorbitant is to leave its determination to the customs of countries and
regions. Different madhhabs putting forward different criteria on this subject indicates
this. It is necessary, however, to evaluate cash sales and credit sales separately
because it is known that the rate of profit is high in credit sales.

3. Methodology and Model

The methodology looks into all the authentic hadiths and the views from different
mazhabs pertaining to profit and interest . It also looks into ex exorbitant price and
moderate price.

The bad marketing is not recommended in Islam. Bad marketing means storing
something of people’s need and to wait until its price increases before putting it on the
market. It is an Islamic principle not to control commercial life strictly and to allow prices
to be determined by free competition. Thus, some goods are stocked for bad marketing,
it causes scarcity on the market and prices begin increasing due to too much demand.
This is already what bad marketers aim at. The Prophet (pbuh) said:
 “How evil is an black marketer! He is upset when he finds out that prices are
decreasing and is happy when he hears them increasing.” .
“One who keeps an eatable in store for 40 nights (while it is needed) is away from Allah
and Allah makes him away from Himself.” (Ahmad bin Hanbal, Musnad, 3/33).

The Prophet (SAW) also says that one who hoards some goods for forty days will not
be able to perceive the fragrance of Paradise, while the fragrance of Paradise reaches
upto a distance of five hundred year’s journey. When even the fragrance of Paradise is
prohibited to him there is no question of his entering Heaven.

According to Abu Yusuf, there exists profiteering in all kinds of items the storing of
which harms people along with eatables. The storing period of an item is normally forty
days; however, this period can be shortened in case of social difficulties. As a matter of
fact, today the society will have great difficulties if utility goods such as fuel and bottled
gas are taken off the market for more than two or three days. Otherwise, there is no
objection to fixing prices officially (narh), especially for necessary articles.

The model on the difference between profit and interest can be seen below:

Profit versus Interest

Interest
Profit
 Source is control over the
 Source is knowledge and quantity of money in circulation
Skill and EXCHANGE
 Unjust Transfer of Value
 Creation of value
 Exploitation of people
 Mutual Cooperation among
 Zero-sum Game or even
people
Negative Sum of Game
 Positive Sum of Game
 Ex-ante
 Ex-post

Source: from the literatures

Actual reception of goods that are bought is called “qabd.” In case of selling of goods by
the customer to a third party before they are actually received, any disagreement on the
reception of goods that may occur between the first seller and buyer will affect the
second sale. Goods may not be received as a result of the first seller breaking his
promise, goods being defected or destroyed for some reason. In this case, the second
seller will not be able to keep his promise until the other problem is solved.

The Prophet (peace be upon him) said:

“Whoever buys an eatable product, should not sell it to someone else until he receives
it.” (Bukhari, Buyu 54, 55; Muslim,Buyu 29-32; Abu Dawud, Buyu 65).

The eatable product mentioned in this hadith is just an example and it covers selling of
all movable items. If the goods are sold to someone else before they have actually been
received, it results in increase of price before the goods have not been taken over and
even before they have been actually produced.

Some resellers, this way, earn money on paper before seeing the goods. According to
Abu Hanifa and Abu Yusuf, it is permissible to make use of immovable items before
they are received. The evidence they base their opinion on is the principle of “istihsan”.
The possibility of an immovable property to be destroyed or changed before reception is
quite rare. And a rare thing cannot be accredited. According to Imam Shafii, it is
impermissible to sell immovable properties just like movable properties, before
reception.

4. Findings

The model above shows the difference between profit and interest. In conclusion, for
the one who sells something with a price higher than general price in market by lying
and tricks, the extra profit he makes is not lawful. He must seek customer’s forgiveness.
If this is impossible, he must donate to the poor and needy to compensate for it.

A hadith says: “O community of tradesmen! Doubtlessly, there are a lot of lies in trade.
For this reason, compensate for it with sadaqah.” (Abu Dawud, Buyu 1; Tirmidhi, Buyu
4: Nasai, Ayman 7)

It is important to keep promises that have been made in commercial life. It is important
to keep promises and to fulfill commercial contracts on due dates in commercial life,
which mostly deals with personal rights. Otherwise, personal rights will be violated and
they will be left to revenge in the hereafter unless wrongdoers seek forgiveness from the
ones they have wronged while alive. It is demanded from people to record mutual debts
on paper and to comply with promises and contracts.

The Quranic verses say: “O ye who believe! Fulfill (all) obligations.” (al-Maidah, 5:1).
“Fulfill (every) engagement, for (every) engagement will be enquired into (on the Day of
Reckoning).” (al-Isra, 17:34).

The following hadith of the Prophet interprets the verses above:

“Muslims comply with the conditions which they have determined amongst themselves.
However, conditions which make haram halal and halal haram are excepted.” (Bukhari,
Ijarah 14; Tirmdhi, Ahkam 17).

On the other hand, debtors who have got difficulties in paying their debts must be given
a chance. The Quranic verse says:

“If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit
it by way of charity, that is best for you if ye only knew.” (al-Baqarah, 2:280).

However, a debtor, who does not pay back although he can afford, is considered to be
unjust to creditor. The following is stated in a hadith:

“It is injustice of one who is able to pay his debt to delay it.” (Bukhari, Hawala 1, 2;
Muslim, Musakat 33; Abu Dawud, Buyu 10; Tirmidhi, Buyu 68).

The creditor has got the right to collect his payment from such a debtor through court.

Allah the Glorious helps those who get into debt with the intention of paying back later.
A hadith narrated by Abu Huraira says:

“Whoever gets into debt with the intention of paying back later, Allah enables him to
pay it back. Whoever takes one’s property with the aim of wasting it, Allah wastes him
away and he cannot pay back.” (Bukhari, Istiqrad 2).

The importance of aim in getting into debt is clearer in the following hadith narrated by
Abu Umamah:

“If anyone takes other people's money with the intention of repaying it and then he or
she should die without settling the debt, Allah will pay the debt on his behalf. And if
anyone takes money or property (of others) with the intention of destroying it, Allah will
destroy him.”.

In Islam, debt has to be moderate and not to get into a debt that is beyond the
capabilities of paying back. One can get into debt in order to meet his needs, to expand
his business and to increase his endorsements by buying more properties. There is no
objection to getting into debt to the degree that one can pay it back. The Prophet got
into debt from time to time in order to meet his needs, too. For instance, he bought food
from a Jew and left his armor as mortgage. (Bukhari, Jihad 89).

References

Dunduren, H., “http://www.questionsonislam.com/article/questions-commercial-

Ethic”
Hassan, Z., “Theory of Profit: The Islamic Viewpoint”, JRIE Vol 1, No. 1
ISRA Research Paper (No. 17/2010), Islamic Pricing Benchmark .
Alvi., I, “Islamic Cost of Capital,” International Islamic Financial Markets