Articles on Islamic Finance

Zakat Rate as Base Risk Free Rate in Post-LIBOR Era

Salman Ahmed Shaikh

A key maxim of Islamic jurisprudence suggests that in the matter of commercial transactions, everything is deemed permissible unless explicitly stated otherwise. As long as the transacting parties adhere to the principles of Islamic jurisprudence while applying the benchmark to their transaction, it is acceptable to utilize a consensus methodology.

However, in Islamic finance, Qard is a non-compensatory contract. It is an act of virtue like donating blood. For instance, one can provide voluntary service in a social cause or may decide not to. Islamic principles recommend to help someone financially with virtuous giving like providing charity or Qard. Else, if one wants to earn profit on capital investment, then one needs to invest in Musharakah, Mudarabah or participate in the production process by providing usufruct of an asset while claiming its risk and ownership.

Islamic principles do not allow risk free returns. Since risk is involved in any productive enterprise, rather than concentrating it to the disadvantage of one party, Islamic principles favour broad based risk sharing. This can reduce overall systemic risk with less failures.

In place of risk free rate or base rate of expected return on investment, some thinkers in Islamic finance suggest the possible use of Zakat rate. Two rationales are possible to consider from the economics viewpoint.

Zakat Rate as Implied Differential Between Spot and Credit Price

First rationale is that receiver of money in an intertemporal exchange would expect at least 2.5% difference in cash and credit price to keep intact the net value of the receipt after the payment of Zakat.

The argument goes as follows. Suppose the cash price is Rs 100 for an article. Then, if payment is received after the passing of one year, then the person receiving the payment will have to pay Zakat. Thus, Rs 100 received now and Rs 100 received one year from now do not have the same reinvestment potential. Rs 100 received from now can be spent or invested in non-Zakatable assets now. But, if the amount remains receivable for the whole year, then, Zakat is to be paid on the amount receivable and yet it remains unavailable for spending or investment during the year. Thus, the Zakat rate can be used to equate the value of both cash flows, i.e. Rs 100 received after the passing of one year has a present value of Rs 97.5.    

Zakat Savings Rate as Opportunity Cost of Capital with Exemption

The second rationale looks at Zakat from another perspective in corporations which have some assets which are Zakatable and some assets which are not Zakatable. In corporate finance, Zakat could also be used as a proxy for risk free return on the premise that once the capital is invested and converted into a means of production, i.e. physical capital stock; then at least the implied minimum return equals savings on Zakat.

For long-term indirect investment in stocks purchased with the intention of earning dividend income, the savings on Zakat would not equal 2.5%. Rather, if the mainstream method on estimation of Zakat on stocks is followed, then the Zakat Savings Rate (ZSR) would equal:

For illustration, suppose a firm has total assets equalling Rs 100,000 divided between Rs 30,000 of current assets and Rs 70,000 of fixed assets. Against these assets, the firm has liabilities of Rs 40,000 and equity of Rs 60,000. The liabilities are divided into Rs 10,000 worth of current liabilities and the rest is long term liabilities. Net current assets value is the difference of current assets and total liabilities. The face value of each of the shares is Rs 10. Suppose that an investor has purchased 100 shares of the firm. The total investment equals Rs 1,000. In this case, the Zakat Savings Rate (ZSR) would be 1.67%.

No matter what the level of profit of investing liquid assets as physical capital stock in a business is, this much savings in Zakat would accrue as reflected in equation above. This rate can possibly replace the risk free cost of capital in corporate finance valuations in areas of capital budgeting, project valuation, asset pricing, security analysis and portfolio management.

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