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Permissible vs Forbidden Discounting

In order to know whether the logic of discounting as such is acceptable or not in Shari'ah, I posed the following hypothetical situation to two prominent Shari'ah scholars.

“A man is earning JO per cent profit on the average on his invested capital. He is offered the chance to participate in a venture which has the prospect of giving back 130 dinars after three years, on each 1 00 invested now. He figures that if he keeps 100 dinars invested in his own business for three years, it is expected to grow to 7 JO at the end of the first year, J2J at the end of the second and more than 7 33 at the end of the third year. Based on this method of calculation he rejects the proposed venture on the ground that he expects to make better profit in his own business.”


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Both scholars agree that from an Islamic point of view, there is nothing wrong in this logic or method of calculation for comparing investment alternatives.

As we know, all discounting procedures are basically based on this type of calculation, usually tabulated and repeated for different values of the discount rate or assumed rate of return.

Another way of looking at this matter is to ask: Isn’t a Muslim permitted to choose any of several Halal investment opportunities open to him? The answer is certainly: Yes! It is equally permissible to choose, out of several Halal investments the one which gives a higher return. Discounting the cost and benefit streams of a project is equivalent to the assertion that we have the right and the opportunity to invest any resources used up or released by one project in another whose rate of return is equal to the discount rate. As long as that other project, whether actual or potential, is a permissible type of investment, the process of discounting is quite permissible.

We have been considering in this paper only the discounting of prospective cash flows of investments. We have not considered discounting of bills or promissory notes, as this falls completely outside the scope of this paper. It is important to note that discounting bills is nothing but lending at interest to the owner of the bill. This is clearly and unequivocally prohibited in Islam.

Using the “Compound Interest Tables”

Now we are ready to answer the question: Is it proper to use the so-called “compound interest tables” while condemning interest? Our conclusion is that this is entirely proper and involves no contradiction.

We should first of all recognise an often-forgotten truth which Irving Fisher was at great pains to assert, namely — that the rate of return is a primary phenomenon originating from real investment quite independently from the rate of interest which arises from lendingborrowing relationships. Robinson Crusoe may be able to calculate rates of return for some simple projects facing him even though an interest rate is inconceivable in his one-man economy. It is meaningless to think of Crusoe lending to himself at interest! Similarly, a modern firm which decides, for whatever reason, to completely shut itself off from the outside capital market (i.e. no borrowing and lending and no new equity financing) can still meaningfully calculate rates of return for various internal projects, and rationally allocate its retained earnings among them.

But even though the rate of interest and the rate of return have two different origins and consequences for economic agents, yet, the two rates have clear apparent similarities. Both are percentages, and have strong interaction as economic variables. And the formula for using one or the other in discounting, just like the physiology of bearing a baby in or out of wedlock, is exactly the same.

It is undeniable, however, that the expression: “compound interest tables” is repugnant to a careful Muslim, is non-neutral and in fact not quite correct as a name. The basic formula from which such tables are calculated have no intrinsic connection to interest nor even to economics. It is, simply, a mathematical expression for any quantity that grows or declines regularly, and has been used by scientists to represent the growth of bacteria, animal and human populations, and the decay of radioactive materials. The same formula has been used by economists and other social scientists to approximate the growth and decline of many economic and social variables. The fact that this same formula can also be used to calculate the growth of an interest-bearing loan is no reason for insisting on calling it “the compound interest formula”, nor for avoiding its use if it is so called.

It is useful here to recall a relevant rule of Shari'ah: “Contracts are to be judged by their intent and meaning, not by their terminology and form”.As long as discounting is permissible, the tool that is used to perform it — be it a table or a formula — is acceptable.

I do recommend nonetheless that Muslims refer to these tables (and the formulas on which they are based) by the neutral and more factually correct name:

  • Periodic Growth (and Decline) Table, for that based on the formula:

pt=p0<1+r>t

  • Continuous Growth (and Decline) Table, for that based on the formula:

P. = P0ert

It is also desirable in these formulae to use the letter (r) to stand for the rate of return as discount rate, and leave (i) to stand for the rate of interest.

 

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