Discount Rate in the Theory of Corporation Finance

The question of discounting looms large in corporation finance theory but goes there under the rubric of: “the cost of capital"6. The theory of the cost of capital has much significance for project evaluation, but has received surprisingly little attention from economists generally and no attention from Muslim economists in particular. That theory should prove to be a particularly fruitful area of study for Muslim economists because, unlike so much economic literature on capital and interest, it: (a) explicitly recognize uncertainty, and (b) analyzes the consequences of equity i/s. debt financing of corporations, which should throw some light on the economics of profit-sharing at the level of the individual firm.

The most commonly assumed goal for the firm in the literature of corporation finance is that it tries to maximize the market value of its common stocks, i.e. the value of its share-holders’ equity. The "cost of capital” to the firm is that rate of return which newly raised funds must generate in order to maintain the market value of the company’s outstanding shares (Lewellen, pp. 2 and 6). The cost of capital, in other words, is nothing but a discount rate that should be applied to prospective investment projects of an existing corporation to best serve the interests of its old share-holders. In still other words, the cost of capital is the required rate of return that a new project must achieve in order to be acceptable to a firm (Bromwich, p. 113).

Let us first pose the question to which the cost of capital theory seems to give an unequivocal answer: What is the cost of capital (discount factor) that an all-equity firm should apply to a new project? The answer is that it is the discount (capitalization) factor applied by the market to the future earnings of the firm, and is equal to:

Earnings per Share

Price per Share

This discount factor is nothing but the rate of return of the firm’s previous investments (Lewellen, p. 44 and Bromwich pp. 115—120). This answer is shared by both the "traditional” theory of corporation finance as well as by the “new” theory of Modigliani and Miller (M-M) (Bromwich, pp. 138 and 147).Thus even in a capitalist economy where interest is permitted, an all-equity firm should use a (risky) rate of return and not an interest rate as a discounting factor.

Since Islam permits only all-equity firms, we may let the argument rest here. But I cannot resist the temptation of making a brief excursion into the M-M model as it presently dominates the cost of capital discussion. According to M-M, even if a firm uses borrowed funds at a fixed rate of interest to finance a new project, it should not use that rate of interest for discounting but should use instead the same risky rate of return that an all-equity firm uses. This, in simple words, is M-M famous “proposition 3” (Bromwich, pp. 147—150; Lewellen, p. 72; Mossin, p. 123; and Baumol, pp. 494-95).

Several lucid presentations of M-M model are not available to the interested reader, so I shall not attempt here to summarise that model’s premises and logic. Suffice it to say that even after relaxing some of M-M assumptions, it remains true that the rate of interest is irrelevant to a firm’s cost of capital while the rate of return is still relevant (Lewellen, pp. 52, 72 and passim.)

To avoid misunderstanding, let me underscore the way in which the question of the cost of capital relates to this paper.

Both M-M model and the traditional view in corporation finance agree that the discount factor of an all-equity firm should be the rate of return of its risk class and not the rate of interest. (This conclusion depends as usual, on simplifying, assumptions, see Bromwich pp. 118—120.) This is quite relevant to an Islamic profit-sharing firm.

M-M proposition 3 is not universally accepted. For those who accept it, it provides additional support for taking a rate of return as a discount factor even for a non-lslamic debt-using firm.

The cost of capital discussion underscores the importance of distinguishing the rate of interest from the discount factor. "Confusion has stemmed from the use of cost of capital for both the rate at which funds can be borrowed and the rate at which a stream of future cash flows should be discounted to measure its present value. .." (Lamberton, p. 113).

Source: Fiscal Policy and Resource Allocation in Islam, Ziauddin Ahmed, Munawar Iqbal and M. Fahim Khan. Republished with permission.