Discussion on Discounting of in Project Evaluation

Though Dr. Ali Khan is right in saying that the assumptions made by Dr. Zarqa may not really be valid, I think, the assumptions are not important and crucial and it would not make any difference to Dr. Zarqa’s model whether or not these assumptions are valid. I, however, disagree with Dr. Ali Khan’s view, that since we do not have a certain rate of discount available we should not discount. I go along with Dr. Zarqa’s view in this respect.

Dr. Munawar Iqbal


I would like to have your answer to a question. Suppose a bank rents an equipment where the rent is decided in advance. Can we treat this rent equal to the discount rate? If not, what are the alternatives in this situation?

Dr. Muhammad Tahir


There is no doubt that we must discount, because that is how we will have savings. The use of the rate of return on equity is absolutely an Islamic principle and we can use it. Dr. Zarqa’s model, however, will be valid only at micro level and not at macro level. I would also like to mention that he did not discuss in detail the other part of the paper relating to the welfare function of an Islamic economy which deserved much more attention.

Dr. M. M. Metwally


My first question is that when the author says that we may use rate of profit as discount rate; does he simply mean private rate of return or does he mean overall social profitability? My second question is whether Dr. Zarqa has thought of indexing the rate of return with the inflation rate before making it a discount rate?

Dr. Syed Aftab Ali


While discussing the ranking of projects, Dr. Zarqa mentioned that the first priority should be given to the projects providing the necessities and the second priority to the projects providing conveniences. The projects providing luxuries should be taken up last. I think Dr. Zarqa is ignoring the concept of diminishing marginal utility. Due to the diminishing marginal utility it is possible that a project providing necessities of life at a stage, may be having utility lesser than the project providing conveniences. What we should do, in fact, is that we should rank the basket of projects, containing a combination of projects, providing the same utility.

Dr. Ahmet Klicbay


Dr. Zarqa could make real contribution if he had pointed out how the problems arising out of the varying degrees of capital intensities and varying life of projects will be dealt with; how the changes in the external environments and character shall be treated and how the problem of capital budgeting will be solved in a situation where there are possibilities of negative rate of return arising on a future date.

Also there exists a certain amount of confusion with regard to the distinction made between the rate of interest and the rate of discount. To my mind the rate of interest does not happen to be the basic concept while discussing the discount rate.

I do not agree with Dr. Ali Khan that we cannot maintain that there shall be a positive time preference. As a matter of fact the question of a time preference arises simply because there is uncertainty in the external environment. What Dr. Ali Khan could say was that because of the presence of uncertainty in the external environment, we cannot be sure of one definite rate at which the stream of future income should be discounted.

Dr. Mahfooz Ali


I think much time has been spent on the controversies of various kinds of opinion. These issues are worthwhile but I think the discussion should really centre on what kind of economic model or economic arrangement would arise if we adopt a suggested scheme. For example, whether the suggested model would require an organised capital market or would it assume that the investors are somewhat risk-lovers; are the implications of no-debt in the investment.

The other point is that an assumption usually made in literature, and also made in Dr. Zarqa’s paper, is that the rate of return between different projects are independent. That may not be so and it should be taken into account, i.e. what would happen, if the costs and benefits from one project spill over to the other project.

Dr. Ishaq Nadri


there are two kinds of uncertainties. One is implied in the rate of return itself, and the second is implied in the distribution of that return between Muqarid and the entrepreneur. Dr. Zarqa should make a reference to this.

It seems to me that Dr. Zarqa has assigned collective objectives to the private investors or entrepreneurs. I think there is too much mixing between collective and individual welfare functions. I may say that the private decision-maker should be required not to harm the collective objective but I cannot say that private entrepreneur should pursue the collective objective.

Dr. Monzer Kahf


It would have been proper if Dr. Zarqa had in some place, at least, specified that there is a substantial difference between the return on equity or profit that he is talking about and the counterpart of this term in capitalism. It very often creates a misunderstanding in the minds that switching from interest rate to profit does not imply a substantial change in the project evaluation in Islamic perspective. In the Islamic system when we talk about profit we talk of the residual after all costs have been met excluding interest. In other words, in Islamic system the profit or return will be equal to what it is in capitalism in the form of profit plus interest. The rate of return in Islamic system is completely different concept from the profit rate in capitalism. Such distinction between the rate of profit in Islamic system and Western system is crucial in explaining project evaluation in Islamic perspective. Unless this distinction is made, the confusion will prevail in our mind why you are trying to get away from interest rate and concentrating on profit rate.

Dr. Umer Chapra


Whether discounting is permissible in Islam or not, I cannot make any comment because I am not competent to do it. But assuming that discounting is desirable and permissible in Islam, I am not sure why Dr. Zarqa wants to replace interest rate with profit rate. Dr. Zarqa asserts that profit rate is a market indicator and, therefore, is valid for discounting. But interest rate is also a market indicator. Then how can one be Islamic and the other un-lslamic?

Dr. Mohamed Ariff


I will confine myself to some practical points of view. It is believed that discount rate is used to determine the profitability of a project. I think the discounting should be applied with respect to project evaluation and the basis of discounting in an Islamic economy. I do not claim that I have answered all the questions in this respect. There are many questions unanswered. These questions I have left for the future writers on the subject.

The other type of objection basically raised by Dr. M. Fahim Khan relates to the proper or the best discount rate. If you want to defeat any author’s argument you just ask him the question what do you do in disequilibrium. Of course, in disequilibrium, you do not have prices equal to market prices. The answer to the question of a discount rate in the capital markets of developing countries is not simple. If Dr. Fahim Khan has the answer, he may present it.

Dr. Ali Khan’s comments were generally due to lack of communication. I never claimed that the time preference could not be positive. The only thing I wanted to point out is that the human beings consistently do not have a positive time preference. In this case if you want to base your discount rate on the basis of time preference then this would mean that sometimes you will discount and sometimes you will not. I have elaborated this in my paper. My point is that time preference is not a stable basis for the discounting neither for Muslims nor for non-Muslims. I would not feel easy on the idea of an intrinsic value of time. I do not think this is realistic. What is realistic is the consistency of the positive marginal productivity of capital.

Dr. Ariff and brother Akram Khan asked me about the substantial difference in the concept of discounting by replacing interest by the rate of profit. The difference is that one is legitimate and the other is illegitimate. We should not jump to the conclusions that two things which are physically same are same in nature also. What I am saying is that in Islamic economy, interest will be abolished but we will still have a market indicator to be used as the discount factor. Another objection is that I give the impression that discounting will be done only under uncertainty. This is obviously not true. We will discount even- when we have perfect certainty. My point is that when there is perfect certainty, interest and profit are one and the same thing and it does not make any difference, as to what concept you use? They are identical. But in the uncertain work the two concepts diverge and as Muslims we are not allowed to use interest rate. So the only legitimate discount rate is the profit rate.

I agree with my brother from Turkey about using the idea of Diminishing Marginal Utility in my deliberations. The concept is acceptable in Islam and I should include this concept when I revise my paper.

Dr. Sultan Abu Ali


Dr. Nadri made a very lucid comment and I agree that the author wasted much time in explaining things which are not strictly relevant. For example, his discussion of the concept of time preference is entirely irrelevant. I think, on this, there is a consensus and one should not waste time on the question whether or not time preference is positive.

The second point raised by Dr. Zarqa which is again not strategically very right is that he has spent a lot of time on proving that any model that talks about perfect foresight is silly and hence he proves that it is only uncertainty that counts. I do not think that Western economists committed some mistake or conspiracy when they have adopted models of perfect certainty or perfect foresight. The problem is purely of mathematics. The mathematics of uncertainty is so compJicated that you cannot explain the matters in that context. Secondly, for dynamic systems we have a theorem which says that the expected values have tendency to converge to a path of certainty even if they are fluctuating around it. I will advise Dr. Zarqa against being sentimental about certainty and uncertainty.

On the whole, I, however, agree with the following:

All the accounting practices are not invariant with respect to the value systems of the society. Actually he should have started his argument with this concept rather dealing it at the end.

In the project evaluation, it is not the question of efficiency of investment but it is a question of ordering projects in order of priority. In this respect I would say, he had rightly pointed out that we should exclude all Haram projects. He is perfectly correct on this and this is what distinguishes the Islamic project evaluation from non-lslamic project evaluation. However, I think he ought to make another restriction on the choice set which is that if we have people below poverty line then the projects for these people should get precedence over everything else. So instead of talking about the welfare function, we should think in terms of lexicographic ordering. So there was no need of the discussion of social welfare function that he has made.

Winding up by Professor Syed Nawab Haider Naqvi (Chairman)


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

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