The following key pointers are important for you to ensure you comply with the MRI regulations from the onset and avoid the penalties and interest that come with non-compliance.
1. MRI is a tax payable by resident persons on residential rental income received.
It is payable by property owners whose residential rent income is Kshs. 12,000 per month (Kshs 144,000 per year) to Kshs. 10 million per annum.
2. The rate of tax is 10% on the gross rent income received. No expenses are allowed for deduction.
3. MRI returns are filed monthly through the iTax portal, on or before the 20th of the following month.
For example Rent received in January is declared and tax paid on or before 20th February.
4. Where there is no rent income received in a given month, you are required to file a NIL return for that month.
5. MRI is a final tax and therefore rental income declared under MRI shall not be declared under the annual return.
6. Late filing of MRI returns attracts a penalty of:
a. Kshs. 2,000 or 5% of the tax due whichever is higher for individuals.
b. Kshs. 20,000 or 5% of the tax due whichever is higher for corporates
7. Late payment penalty is 5% of the tax due while late payment interest is 1% per month.
FRINGE BENEFIT TAX
For the purposes of Section 12B of the Income Tax Act, the Market Interest Rate is 7%. This rate shall be applicable for the three months of January, February and March 2020.
DEEMED INTEREST RATE
For purposes of section 16(5), the prescribed rate of interest is 7%. This is applicable for the months of January, February and March 2020.
Withholding tax rate of 15% on the deemed interest shall be deducted and paid to the Commissioner by 20th of the month following the month of computation.
LOW INTEREST BENEFIT
For the purposes of section 5(2A) of the Income Tax Act, the prescribed interest rate for the period of six months covering January-June 2020 shall be 7%.
Turnover tax was re-introduced in the Finance Act 2019 effective 1st January 2020 with similar regulations previously applied.
Notable changes are;
Monthly submission of the TOT returns by 20th of the following month.
Presumptive tax is still applicable in addition to the TOT
Presumptive tax can be claimed as a credit against TOT payments.
Previous regulations include;
3% TOT on gross turnover. No expenses deductible.
Gross turnover should not exceed 5 million a year.
TOT does not apply to Limited Companies, Employment Income, Management Income, Professional Income, Rental Income and VAT registered individuals’ or businesses with over 5m turnover a year.
Commissioner approval is required to remain in the normal income tax regime.
Late submission penalty – Kshs. 5,000 for each month.
PRESUMPTIVE TAX (PT)
Presumptive tax remains at 15% of the single business permit.
Notable changes as a result of the Finance Act 2019;
PT is no longer a final tax.
PT can be claimed as a credit against TOT payable.
Previous regulations that are still effective;
Payable by individuals to whom a business permit or a trade license is issued by the County Government.
Payable at the time of payment for the County Government business permit or trade license.
Commissioner approval is required to remain in the normal income tax regime.
PT does not apply to Limited Companies, Employment Income, Management Income, Professional Income, Rental Income and VAT registered individuals’ or businesses with over 5m turnover a year.
Late submission penalty – 5% of the PT due.
FINANCE ACT – SUMMARY OF TAX CHANGES
Income earned by individual in the Ajira Programme is exempt from tax for first three years on set criteria.
The amount withdrawn from the National Housing Development Fund to purchase a house by a contributor who is a first-time home owner is exempt from tax
The amount of affordable housing relief shall be 15% of the employee’s contribution but shall not exceed KES 108,000 per annum.
Plastics recycling plant will be entitled to a reduced corporate income tax rate of 15% for the first five years upon commencement of its operations.
Import Declaration Fee (IDF) to 3.5% of the customs value of goods imported for home use.
IDF reduced to 1.5% on customs value of raw materials imported by manufacturers, approved imports by the CS and input for construction of homes under the affordable housing scheme approved by CS.
Railway Development Levy (RDL) from 1.5% to 2% of the customs value of goods imported for home use.
Withholding VAT reduced to 2%.
Non-registered persons importing taxable services will now be required to account for reverse VAT.
Excise Duty rate changes
Excise Duty rate changes – Other items (Sin Tax)
INDIVIDUAL TAXATION
A person is considered to be tax resident in Kenya if they:
have a permanent home in Kenya and were present in Kenya for any period in a particular year of income under consideration, or
do not have a permanent home in Kenya but were:
present in Kenya for 183 days or more in that year of income, or
Present in Kenya in that year of income and in each of the two preceding years of income for periods averaging more than 122 days in each year of income.
Individual Tax Bands and Rates
Monthly Pay Bands-1st January 2018
Annual Pay Bands-1st January 2018
Rate of Tax
1 – 12,298
1 – 147,580
10%
12,299 – 23,885
147,581- 286,623
15%
23,886 – 35,472
286,624 – 425,666
20%
35,473 – 47,059
425,667 – 564,709
25%
Above 47,060
Above 564,710
30%
Personal Tax Relief
1,408.00
16,896.00
Residential rental income – 10% of gross residential rental income received payable monthly before the 20th of the following month. Annual gross residential rental income should not exceed 10 million shillings.
Life, health and education relief is 15% of the premium paid but cannot exceed Kshs. 60,000 p.a
Affordable housing tax relief – 15% of gross emoluments at a maximum of Kshs. 108,000 p.a (Starts at time of application and awaiting allocation of a house under the affordable housing scheme)
Mortgage interest on owner occupied house at a maximum amount of Kshs. 300,000 p.a is deductible
Gratuity and payments to a registered pension scheme is deductible to a maximum of Kshs. 240,000 p.a but cannot exceed 30% of the emoluments.
Home ownership savings plan – Contributions not exceeding Kshs. 96,000 p.a are deductible.
Bonuses and overtime paid to low income earners is tax free.
Kshs. 2,000 per day allowance for travelling for an individual outside his normal place of work is tax free.
TAXABLE EMPLOYEE BENEFITS
Motor vehicles benefit taxed at 2% of the cost of the vehicle or the prescribed rate; whichever is higher.
Telephone and mobile is taxed at 30% of cost to employer
Furniture – 1% of the cost to the employer
Housing – higher of market rate or actual rent paid or 15% of total employee income.
Employee loans are subject to Fringe Benefit Tax (FBT)
MONTHLY NHIF CONTRIBUTIONS
Changes in NHIF Regulations;
Limit cover to a maximum of one spouse and five children
New members will have to wait for 90 days before accessing services or benefits in addition to making a one year upfront payment within the 90 days waiting period.
Late payment of contributions will attract a fine of 50% of the monthly contribution and a requirement to pay one year in advance. Benefits and services will be restricted for a period of 30 days.
Defaulting for more than 12 months will require re-registration and benefits and services can only be accessed after 90 days of resuming payments. A one year upfront payment will be required.
Access to specialized services shall be restricted to a 6 months waiting period following card maturity for new members.
Access to maternity benefit will be restricted to 6 months waiting period following card maturity for both principal members and spouse declared.
Any dependent declared after registration shall be subject to the 6 month waiting period for specialized and maternity services.
For inpatient and medical outpatient, additional dependents will be eligible for the benefit apply after 30 days waiting period. Same applied for a change of spouse.
Government funded programmes like free maternity, health insurance subsidy, elderly persons with severe disabilities and Inua Jamii have been exempted from this changes.
Istisna’ is a sale transaction where a commodity is transacted before it comes into existence. It is an order to a manufacturer/contractor to manufacture/construct a specific commodity/asset for the purchaser.
The manufacturer uses his own material to manufacture the required goods.
In Istisna’, the price must be fixed with the consent of all parties involved. All other necessary specifications of the commodity must also be fully settled upon.
Cancellation of contract
After giving prior notice, either party can cancel the contract before the manufacturing party has begun its work. Once the work starts, the contract cannot be cancelled unilaterally.
Istisna and Salam are closely related as both do not need to have the subject matter in existence at the time of the signing of the contract. However, there some differences which are explained below.
Difference between Istisna’ and Salam
Istisna
1) The subject-matter must be an item that is to be made or built
manufactured.
2) The price does not necessarily have to be paid in advance and in full. It need not necessarily be paid in full at delivery either. It may be deferred to any mutually agreed date or even paid in instalments.
3) The time of delivery does not have to be fixed.
4) The contract may be cancelled unilaterally before the manufacturer begins the work.
Salam
1) The subject-matter may be anything that may or
may not need manufacturing.
2) The price has to be paid in advance and in full.
3) The time of delivery is an essential part of the
contract.
4) The contract cannot be cancelled unilaterally.
Furthermore, Istisna and Ijarah tul Ashkhaas, are also closely related, as this type of lease agreement, is a build/make using labour and then to lease contract.
Differences Between Istisna’ and Ijarah tul Ashkhaas
Istisna
1) The manufacturer uses his own material or obtains it to make the ordered goods.
2) The purchaser has a right to reject the goods upon inspection as Shariah permits the buyer who has not seen the goods to cancel the sale after seeing them. The right of rejection only exists if the goods do not conform to the specifications agreed between the parties at the time of the contract.
Ijarah tul Ashkhaas
1) The customer provides the material, and the manufacturer uses only his labour and skill, i.e. his services are hired for a specified fee.
2) The right to reject goods upon inspection does not exist.
Time of Delivery
As pointed out earlier, it is not necessary for Istisna’ that the time of delivery is fixed. However, the purchaser may fix a maximum time for delivery which means that if the manufacturer delays the delivery after the appointed time, he will not be bound to accept the goods or to pay the price.
To ensure that the goods are delivered within the specified period, some modern agreements of this nature contain a penalty clause to the effect that in case the manufacturer delays the delivery after the appointed time, he shall be liable to pay a penalty which shall be calculated on a daily basis. Can such a penal clause be inserted in a contract of Istisna’ according to Shariah? Although the classical jurists seem to be silent about this question while they discuss the contract of Istisna’, yet they have allowed a similar condition in the case of Ijarah. They say that if a person hires the services of a person to stitch his clothes, the fee may be variable according to the time of delivery. The hirer may say that he will pay Kshs. 100/- in case the tailor stitches the clothes within one day and Kshs. 80/- in case he prepares them after two days. Based on the same analogy, the price in Istisna’ may be tied up with the time of delivery. It will be permissible if it is agreed between the parties that in the case of delay in delivery, the price shall be reduced by a specified amount per day.
Istisna’ as a mode of financing
Istisna’ could be used as a mode of financing in the following ways:
House Financing or infrastructure Construction Project
Istisna’ may be used to provide financing for house financing/infrastructure construction project financing. Istisna’ may also be used for similar projects like installation of an air conditioning plant in the client’s factory, building a bridge or a highway etc.
If the borrower owns a piece of land and seeks financing for the construction of a house or a construction project, the financier may undertake to construct the house/construction project on the basis of an Istisna’.
The financier does not have to construct the house or carry out the infrastructure construction himself. He can either enter into a parallel Istisna’ with a third party or hire the services of a contractor do so on the financiers’ behalf. The financier then calculates his cost and fix the price of Istisna’ with his client that allows him to make a reasonable profit over his cost.
The payment of instalments by the client may start right from the day when the contract of Istisna’ is signed by the parties. In order to secure the payment of instalments, the title deeds of the house or land, or any other property of the borrower may be kept by the financier as security until the last instalment is paid by the borrower.
The financier will be responsible to strictly conform to the specifications in the agreement for the construction of the house or infrastructure project. The cost of correcting any discrepancy would have to be borne by him.
BOT (Built, Operate and Transfer) agreements may be formalized through an Istisna’ agreement as well. So, if the government wants to build a highway, it may enter into an Istisna’ contract with the builder. The price of Istisna’ maybe the right of the builder to operate the highway and collect Toll Taxes for a specific period.
Istina for financing working capital of a manufacturer
Istisna’ can also be used for financing the working capital requirements of a manufacturer. The bank will order the manufacturer to manufacture certain specified goods and pay the Istisna’ price to the customer. Upon manufacturing the goods, the customer will deliver the goods to the bank.
After taking possession of the goods, the buyer will sell the goods in the market at the same price. For this purpose, the bank may sell the goods directly or may appoint the same agent (including the customer) to sell their goods in the market.
Working Capital Financing Using Istisna
An Islamic Bank can also finance the Working Capital requirements of the Company through the mode of Istisna’ in the following manner.
i) When a customer requires funds for fulfilling his working Capital requirements, then the Islamic Bank will place an order to manufacture with the customer to provide finished goods of certain specifications.
ii) After placing the order, the bank may make the payment of the Istisna’ Price lump sum or in installments.
iii) After the finished goods are ready for delivery, the bank would receive the goods from the
customer.
iv) After receiving the goods the bank will sell the goods in the market, either directly or through some agent, to recover its cost price and earn some profit from the transaction.
Uses of Istisna’
• Individual House financing
• Financing of building/ factory / office/commercial building/residential building projects
• BOT (build, operate, transfer) arrangements for public infrastructure like highways, water desalination plants, dams, sewerage disposal plants by Governments
• Construction of buildings, factories and industrial plants
When businesses have grown to a size that the ‘rule of thumb’ approach is no longer appropriate, then some form of market-based pricing methodology must be used. The principle here is to find some standard variable within companies which appear to be consistently priced by the capital market.
As expected, there are a large number of such variables, including annual earnings, sales turnover, book value, fixed asset value, and net worth. The variable to be used depends on the type of company. The three most commonly used in practice are:
Price Earnings (P/E) multiples
Market to net worth (Tobin’s Q)
Market to book (M/B) value ratios
103.1 Price Earnings Multiples
The price-earnings ratio is calculated as the ratio of the price per share divided by the underlying earnings per share.
Usually, a company publishes it’s earning per share under a number of different bases: basic earnings per shares which is simply the published earnings divided by the numbers of shares in issue.
If the company has a number of share options in issue to its employees and directors, then it will also produce a ‘diluted’ earnings per share calculated on the basis that all options are taken up.
Analysts can use different variants of the PE ratio. Some prefer to use a historical PE using the average of quoted figures over the last 12 months. This historical or ‘trailing’ PE ratio is claimed to remove price ‘noise’ (the random fluctuation) from the share price. Other analysts prefer a ‘leading’ PE ratio being the estimate from forecasts of the next twelve months earnings figures.
The magnitude of the PE ratio indicates the degree of volatility attaching to the firm’s earnings stream. A low ratio suggests a low value is being placed on the earnings stream and hence (other things being equal) the higher its volatility and vice versa.
The Challenges to using PE methods
The challenges of using the PE method are as follows:
First, it is reliant upon an accounting estimate of earnings. As we outlined earlier, the accounting model makes a number of assumptions about the temporal matching of cash flows to time periods which even though firms may be acting quite consistently in their application of the Generally Accepted Accounting Principles (GAAP) can result in quite different outcomes across and between industries.
Second, is that the model avoids the valuation issue in that it is transferring the problem of valuation to the market in assuming that a benchmark PE say for the market as a whole, or an industrial segment, however, constructed, represents an appropriate price for earnings either across the market or across the industry.
Third, it assumes that the market does in fact value earnings rather than some other aspect of the companies financial output such as dividends, or growth in earnings or indeed risk and the market is an efficient market.
103.2 Market to net worth (Tobin’s Q)
This particular ratio has an impeccable academic pedigree. It was first proposed by the Nobel Prize-winning economist James Tobin in 1969 and since that time has developed a small but influential following.
Its principal advantage as a metric is that it would appear to allow us to determine whether a market is over or undervalued. However, its use at the individual stock level is more questionable.
Tobin defined Q as the ratio of total capital value (equity plus debt) to the replacement (or reproduction cost) of all capital market assets. The long-run equilibrium for this ratio is one. Taking this ratio to the firm level:
Following Modigliani and Miller’s proposition 1 that total market capitalisation is the sum of the value of equity and the value of debt, then an ‘equity version of Q can be defined as:
When viewed this way all that Tobin’s Q is saying is that the rate of return the firm generates on the replacement cost of its net assets is equal to the rate of return required by equity investors. To see this, let us assume that the market value of the firm’s equity is the capitalised value of the economic earnings of the business (E):
However, the economic profit of the business is the replacement cost of the firm’s net assets (CR) multiplied by the rate of return on that invested capital (rRC):
As a result, Q becomes:
If Q = 1, then this ratio simply asserts that at long-run equilibrium the rate of return on invested capital must equal the firm’s cost of capital (i.e., the required rate of return on equity) or, to put it another way, the rate of return on new capital invested in firms (the internal rate of return on the capital invested) is equal to the rate of return on existing capital traded in the market (the required rate of return on equity). We have met this concept already in that, in the long run, the net present value of an internal investment is driven down to zero, i.e., the point at which the internal rate of return on the firm’s investments equals the firm’s cost of capital. This is important (even if it is a rather unsurprising result) for reasons we return to when we discuss the problems of estimating the growth rate of the firm.
To what extent can Tobin’s Q and the implied relationship between equity value and a firm’s net worth be used for prediction purposes? Smithers and Wright (2000) have conducted studies on the properties of their equity version of Q. They demonstrate that over time, and at the level of the market Q exhibits strong mean reversion. This is what we would expect if at the market level, the internal rate of return on invested capital was markedly different from the prevailing market required rates of return. Firms that earned greater than the market rate would attract investors, and hence their equity prices would rise, and firms earning a lower than the market rate would find their share price falling.
There is some evidence that Q is also a superior leading indicator for share price changes than either the P/E ratio (where earnings are the fundamental lead indicator) or dividend yield (where dividends are the fundamental lead indicators). In causality tests, Smithers and Wright report that net worth (the fundamental in the Q ratio) has only a 1.4per cent probability of no predictive power, whilst dividends and earnings have 43.8 per cent and 88.6 per cent probability respectively. They also found that net worth only really works as a predictor when used as a ratio with equity value rather than on its own.
In practice, the application of Tobin’s Q invariably relies upon the use of accounting information as a proxy for replacement cost. This leads to a more measurable market to book ratio.
103.3 Market to book (M/B) value ratios
The market to book ratio is a pragmatic interpretation of Tobin’s Q. This ratio assumes that there is a consistent relationship between market value and the net book value of the firm, or to put it another way that the market prices one Unit (pound, dollar, shilling, dinar, riyal, dirham) of book value in one firm, the same as in another.
Summary and Conclusion
Like with all other valuation methods, this method is suited to particular situations and has fundamental assumptions, which need to hold, which would due to market inefficiencies not always hold. Therefore it is an indicative value subject to negotiation. It should be noted that the concept can be applied to the valuation of non-quoted companies too.
The Black and Scholesoption pricing theory(OPT) offers a clue as to how the equity in a firm may be valued. Suppose we recognise the fact, that an equity investor in a geared firm with limited liability has a call option on the underlying assets of the firm. In that case, we have, potentially, a method for valuing the business.
Conceptually this is an influential theory; the use of option pricing methodology in the valuation of a business creates difficulties in estimating the necessary input parameters into the model.
Using the real options methodology, one approach is to simulate the future cash flows of a firm given realistic current conditions and estimates of the volatility of key input variables.
With this, we can generate an overall estimate of the future volatility of the business and then using a specified set of assumptions about the terminal value of the company creates an option value for the business. This modelling approach has many refinements but essentially provides both methods and insights into the valuation of all firms that are financed partly by debt and, in particular, highly leveraged, fast-growing start-up companies.
The limits on the value
Traditionally, the value of the firm in the hands of its investors will have a lower limit equal to the break-up value of the firm, less all external claims on the business (the sum of its short and long term liabilities). Generally, it was argued that once the present value of the firm’s future cash flows (when discounted at the equity investors rate of return) falls below this value then it would be rational for the investors to cut their losses, liquidate the firm and salvage what value they could. However, this relatively simple analysis is tempered in the light of options theory. From an options theory perspective, the equity investors in a geared firm have a call optionon the value of the firm’s assets over and above the value of the debt. If the value of the assets should fall below the value of the debt then given limited liability the equity investors could put the firm into members’ voluntary liquidation and walk away leaving the debt holders to bear the loss. Thus in a geared firm, the equity value of the business is the value of a call option on the firm’s net assets. In an ungeared firm, the option value does not exist. Thus the value of the firm to the equity investors is simply the present value of the net cash flows anticipated over the lifetime of the business.
This line of reasoning suggests that valuing a firm depends upon the existence of gearing and that the value of the firm is not simply the present value of its assets in current use minus the amount of its outstanding debt.
If the firm is not geared, the critical numbers are: (i) the realisable value of its assets and (ii) the present value of the firm’s assets in continued use. The greater of these is its equity value. In the presence of gearing the critical numbers are: (i) the present value of the firm’s assets and (ii) the value of the firm’s outstanding debt. The value of the firm, in this case, will be the value of the option to continue in business.
This perspective on the value of a firm suggests that the following variables are critical:
(i) The present value of the firm’s assets in use. Generally, the greater this value, the greater will be the value of a call on those assets at exercise.
(ii) The value of the outstanding debt (the exercise value of the firm) – generally the lower this value, the more valuable the call becomes until at the limit of zero leverage the call value equals the present value of the firm’s assets in use.
(iii) The term to maturity of the debt – the longer the time, the greater the value of the equity call.
(iv) The risk-free rate of return used to discount the exercise value multiplied by the probability of exercise. Given the inverse relationship between exercise value and firm value, this would suggest that the higher the rate, the greater the call value. However, this is unlikely to be the case overall given that the present value of the firm’s assets (i) will be determined in part by the discount rate and that this in its turn is partly influenced by the risk-free rate.
(v) The expected volatility of the present value of the firm’s assets, which leads to the somewhat paradoxical result that the higher the uncertainty about future cash flows, the more valuable is the call option on those cash flows.
Valuing the firm as an option
In the more general valuation context, a firm’s equity should not be traded, or we may have reason to believe that the correct valuation is considerably different from that revealed by the share price.
Schwartz and Moon (2000) developed a procedure for the contingent valuation of equities using option pricing and simulation methods.
They used as their case study Amazon.com which at that time had been in business for just over three years. The company was still not profitable in the conventional sense but was growing its market and its revenues at a rapid rate.
In March 1996 the quarterly sales of Amazon.com were $0.875 million. By September 1999 its sales had risen to $355.8 million. Here, in outline, is the procedure Schwartz and Moon followed:
A stochastic model was created of the firm’s revenue-generating process and its cost structure. This model contained a drift term which reflects the expected rate of growth in its revenues and a stochastic period reflecting the degree of uncertainty about that growth rate. The expenditure model reflected not only the company’s fixed and variable cost structure but also the impact of taxation upon the company’s profits.
Refinements of this stochastic model included a mean-reverting process to the estimated long-run rate of revenue growth as well as a procedure for carrying forward losses for tax purposes from one period to the next.
A bankruptcy condition was imposed were given a starting amount of cash bankruptcy was defined as the point when the amount of cash and other monetary assets reached zero.
A time horizon was defined for the simulation of the firm’s future cash flows, and a terminal value invoked. In their study, Schwartz and Moon, set the final value as ten times EBITDA. Another approach would be to take the net cash flow figure and to capitalise the following year’s projected earnings at the risk-free rate of return less the terminal growth rate of profits. However, the time horizon should be such that by that time, the equity holder’s option is so far into the money that there is zero default risk.
A simulation is then undertaken to generate a large number of cash flow paths. In the simulated series of quarterly cash flows for Amazon assuming a starting revenue of £356million per quarter, a growth rate of 11 per cent a quarter and a starting volatility of revenues of 10 per cent per quarter. The factors were built-in, and the firm’s starting balance of cash resources available was assumed to be £200 million.
The key point to note is that a number of the price paths had been generated one of which shows default in period 5. Indeed, depending upon the software used, a model can be built which will permit many hundreds of such price paths to be generated. The model can be refined to reflect a wide range of different circumstances: different patterns of growth and the decline in growth as the firm matures, other cost structures, the correlation between variables, differing tax regimes and different initial conditions. From the simulation, the volatility of the cash-flow projection can then be determined, and the likely default in each time period determined. This volatility, expressed as the standard deviation of the company’s future cash flows, can then be adjusted to a continuous-time basis and a valuation of the options component of the company’s valuation determined.
The challenge with this approach of valuation lies in estimating the initial volatilities of the future revenue growth and, in later variants of the model, the volatilities of future costs.
Nevertheless, the technique does offer a potential route for valuing companies that are in their early stages of growth and which rely upon substantial investment in intangible assets.
Paramount to understanding the basics of valuation recognises the financial flows within the firm. Any business is affected by two financial flows: the first and in my opinion the most important is its cash flow, which is the cash generation and expenditure of the firm that determines the short term success and the long term survival of the business.
The second flow is where revenues are recognised as chargeable to the period in question, and accounting costs are matched to the process of earning that revenue and then allocated to different categories of accounts, this is the profit flow.
When valuing the equity of the firm, the most apparent flow is the cash flow received by the investors. In terms of what is paid to the investors by the firm (and ignoring any share repurchase scheme) all they receive is a flow of variable dividend payments. Therefore the investor can be regarded as holding a variable interest rate bond of the indefinite term. However, many firms do not pay dividends, and for these, some alternative flow measure is necessary.
One approach is to use projections of the annual free cash flow to the equity investors, which is retained within the firm. Another method is to use some measure of residual value from the company’s accounts again projected over the lifetime of the firm.
The challenge with these methods is that they rely upon (a) a calculation of an appropriate discount rate and (b) the forecasting and projection of the future flow measures.
One of the annual free cash flow proxies is the dividend paid to equity investors. A common valuation technique is the dividend valuation model.
104.1 The Dividend Valuation Model and Dividend Growth Model
A return to equity investors is the total monetary gain or loss to the investor, both from capital gain and dividends, over a specified holding period. So over the next holding period (however long that may be), the return is the difference between the current price and end of period price plus any dividend paid.
or by rearrangement:
Because this model refers to a future period it is described as an ex-ante model and the return (r1), the price at the end of the period (p1) and the dividend receivable (d1) are all expected values.
Given that the return formula (i) is purely definitional the question then arises as to what is the most straightforward set of assumptions necessary to create an equity valuation model which is not dependent upon some future estimate of the value of the equity concerned.
The three assumptions that dramatically simplify the model:
(i)
The firm is a going concern which implies there is no foreseeable prospect of its failure,
(ii) The rate of return in future periods is expected to be constant which means that there is a flat term structure on equity returns and,
(iii). There is an expectation of a constant rate of change in the dividends paid over the indefinite life of the firm.
Invoking these assumptions we can demonstrate that the current price of the firm’s equity is simply the present value of the future dividend stream (which ‘grows’ at a constant rate ‘g’) accruing to the investor. The rate of growth can be assumed to be a zero or indeed a negative value without doing violence to the underlying integrity of the model.
The resulting model derived is as follows:
Which resolves to the dividend growth model first derived by John Burr Williams in 1938:
‘A stock is worth the present value of its future dividends, with future dividends dependent on future earnings. The value thus depends on the distribution rate for earnings, which rate is itself determined by the reinvestment needs of the business’, Williams, J, B. 1938 The Theory of Investment Value.
This insight was further developed by Myron Gordon in 1962 into what is now known as Gordon’s Growth Model:
Thus the current share price is a function of just three variables: the dividend paid during the last 12 months (D0), the rate of return required by equity investors when discounting the dividend flow receivable by them (re) and the expected growth rate attaching to those dividends over the lifetime of the firm (g).
The three assumptions upon which the dividend growth model is based (i) to (iii) are an example of the rigorous application of Ockham’s Razor to the problem of how expectations are built in the equity market. Each assumption is designed to reduce the model to a progressively simpler form whilst retaining the key features of the valuation process.
One common objection to the dividend growth model is that it violates Modigliani and Miller’s dividend irrelevance hypothesis. This is a misconception partly brought about by focusing on the ‘dividend’ in the model’s name and forgetting that the model values both dividends and dividend growth and partly because of a misclassification error. Dividend growth is generated by, amongst other things, the firm’s ability to retain earnings for future investment, so in reality, the model is valuing dividends and reinvestment capacity, which are both created by earnings. That is precisely Modigliani and Miller’s position concerning valuation.
The dividend growth model can be classified, depending on how you view growth as either an accounting flow model where earnings are either distributed or retained for growth or as a cash flow model where the shareholder’s value the cash flows they receive as dividends and as a capital gain. Given the importance of the model and its analogues, we will review the assumptions upon which it is based in some detail.
The Perpetuity Assumption
The dividend growth model represents the limiting value of a firm’s equity in the hands of its shareholders. In principle, the value of the shares is assumed to be the present value of an infinite stream of constantly growing dividend payments discounted at the investors’ required rate of return. Any finite stream of discounted dividend payments assuming the same rates of growth and return will necessarily have a present value less than the value generated by this model.
Typically, a limited company is assumed to have an indefinite life. This is embedded in the accountant’s ‘going concern’ concept. However, this is a fairly restricted concept in that it requires that management should prepare their accounts on a ‘going concern basis’ unless they ‘intend to liquidate the entity, cease trading, or have no realistic alternative to do so’ (IAS1). In a market-based setting, we mean something more than this in that shareholders do not have any expectation that the company will cease trading and will therefore continue indefinitely.
Where there is a significant difference between the expected rate of growth of the firm and the rate of return required by the equity investors, then the cumulative present value of the dividends paid to investors rapidly approaches the present value of a stream of dividends extending into perpetuity. However, where the difference is narrow the model does not resolve towards its limiting value quickly and even assuming a 60-year life there may be a considerable difference between the value generated by the model and an equivalent dividend pattern but assuming a finite life of 60 years (i.e., p61 = 0).
We demonstrate this effect in the below exhibit 104.1 where we show the value of a firm of different lifetimes (from 1 to 250 years) assuming a 10p initial dividend growing at the rates as shown and with a required rate of return on equity of 8 per cent. Note how a high growth rate brings the model into an agreement with the perpetuity (i.e., the point where the curve become horizontal) much more quickly than when lower growth rates are applied.
Exhibit 104.1 How the value of the firm changes with different assumed time horizons to failure
One way of dealing with this problem is to use a time-restricted version of the growth model:
This suggests that the dividend growth model is only likely to be a fair representation of corporate value, where the growth return spread is greater than 4 per cent. In periods of high nominal returns, this may be reasonable, in periods where both real and nominal returns on equity are very low, this severely limits the validity of the model.
The constant return assumption
The rate of return, which we assume investors use to discount the dividend flow from a company should be the rate that they would use to discount an earnings stream of that risk in the market. Given that dividends (and the growth on dividends) are an equity flow, we should assume that the rate to use is the minimum required rate of return for an investment of that risk.
The capital asset pricing model is usually used as a predictor of the equity investors’ required rate of return. In principle, the capital asset pricing model is a one-period model in that it measures the expected return over a single holding period. The extent that it is legitimate to extend the rate of return predicted by the capital asset pricing model over a long series of holding periods is open to question.
Bansal, Dittmar and Kiku (2005) were concerned with this issue. Using a process called stochastic co-integration, these researchers investigated the relationship between asset beta and consumption beta over long time horizons. The Bansal et al study demonstrated is that in the short run, variations in returns are principally explained by transitory price shocks, but over the long run it is dividend shocks that are the major source of return volatility. However, although dividends appear to be the strongest predictor of consumption betas over the longer time horizon, and the consumption betas are closely related to the asset betas, there is little to suggest the consistency in the term structure that the valuation model requires.
This throws a question mark over the use of the model if long-run returns are not valued by investors in the same way as short-run returns. One answer to this problem is that over the very long run, errors in the discount rate will have a receding impact upon current valuations. However, near term errors are likely to be much more significant.
The Constant Dividend Growth Assumption
What this implies is that future dividends grow at a constant, predictable rate. At first sight, this appears to be very unlikely, but the important question when building a valuation model is not what we think might happen but what the market as a whole expects to happen. Given our earlier discussion about the pricing process in markets variability and inconsistency in growth, assumptions are likely to be cancelled out, and a single dominant expectation of future growth emerge. Our simplest assumption is that future growth is a constant percentage (predicting changing rates adds a layer of complexity which we can incorporate at a later stage if the circumstances suggest that is appropriate).
The model also requires what we will term the long-run equilibrium growth rate, that is a growth rate which assumes that the firm’s opportunities for earning a rate of return in excess of the cost of its capital have been exhausted (which we assume will be the case over the long run).
How value varies with growth
The dividend discount model has some important implications.
First, it places a limit on the long-run rate of growth (g), which cannot exceed the investors’ required rate of return when discounting dividends. This is often taken as a fatal flaw with the model, but a moment’s thought reveals that it is not the model that is at fault. If a firm’s limit on growth is constrained by its ability to create new investment through retention then in the very long run the rate of return on new investment must converge on the investors required rate of return (to assume otherwise implies that the firm can keep finding positive net present value projects indefinitely). If the firm reinvests all of its surpluses then the maximum rate of return it will earn is the rate of return required by its equity investors and that will be the rate of growth of its capital account. If it only reinvests 50 per cent of its earnings (say) then the maximum growth rate will be 50 per cent of the shareholders’ required rate, and so on. What it cannot do is consistently reinvest more than 100 per cent of what it earns.
The second implication concerns the volatility of value and its relationship to growth. Where growth is low relative to the shareholder’s required rate of return, then the volatility of the share price will also be low, where growth is high volatility will be increased. If growth relative to return is very high, then even minor changes in investor sentiment towards future growth rates can have sudden and dramatic effects upon market values. Much has been talked about bubbles and crashes in the equity markets with the most recent and spectacular occurring in the years 2007 – 2008 Global Financial Crises.
However, what the model suggests is that these are not due to ‘irrational exuberance’ in the pricing of shares (Robert Schiller, 2000) nor necessarily to the domination of the market by speculators.
The model suggests that prices will always rise steeply when beliefs about future growth rates converge on the required rates of return on equity. The Gordon Growth Model does, therefore, give us some very interesting insights into the way real markets may work. However, concerns about the veracity of earnings numbers, or indeed, when faced with a company that does not pay dividends, may lead us to an alternative flow valuation method.
104.2 The Free Cash Flow to Equity Model
This modelling procedure is based upon the concept behind the dividend valuation model except that instead of dividends, we employ the Free Cash Flow to Equity (FCFE) after reinvestment in their place.
The intuition behind the model is slightly different in that instead of working from the definition of return we use the idea that the value of the firm to its investors is the discounted value of the future net cash flow available either for payment as a dividend or reinvestment. Working on the basis of the net free cash flow to equity per share, then the price of the share is given by:
Following the same intuition as before the growth rate will be the rate of cash reinvestment (bc) times the rate of return on reinvestment.
This model is a ‘pure cash flow’ model, and as such, there is no ambiguity about the reinvestment rate – it should be the firm’s current internal rate of return on future investment. However, given that we are again trying to impute a long term rate of growth we can make the case again that the simplest assumption is, that over the longer run, the firm’s internal rate of return will be driven down to its cost of capital.
Murabaha is currently the most widely used Islamic sharia compliant mode of finance, used by Islamic sharia-compliant financial institutions: it is as simple as buy an asset for the customer; sell the asset at a premium (profit), allow payment of the sale price in instalments to the customer. That is a Murabaha. A Murabaha is a sale in which the seller’s purchase price of acquiring the asset and the profit earned from it is revealed to the customer or buyer. Murabaha based sales were mentioned in the first known book of Islamic jurisprudence, the Al-Muatta’a of Imam Malik ibn Anas (d. 795 CE) (Sultan and Ebrahim, 2011).
In practice, Murabaha works as follows, a master facility agreement for Murabaha is drawn up between the financing institution and the customer requiring the financing. The following steps then take place:
I. The approval of the customer’s credit facility
ii. The terms and conditions of the underpinning Murabaha contract terms are agreed upon
iii. The Murabaha underlying asset or item identification is made
iv. The customer undertakes to purchase the Murabaha asset or item once the institution acquires it.
3. The customer gives a unilateral commitment to purchase the Murabaha items, and the institution accepts the collateral, required as per the agreement. At this point, the Islamic financial institution in order to safeguard its position in the event that the customer backs out from entering into a Murabaha requests the customer to furnish earnest money called “haamish jiddiah”. In the event that the customer backs out from entering into the Murabaha arrangement, the Islamic financial institution charges for the actual loss incurred and returns the balance to the customer.
4. An agency contract is signed between the Islamic Financial Institution and the customer, as the Islamic Financial Institution does not usually possess the expertise to purchase the required asset; hence they appoint the customer as its agent to procure the asset from the supplier on their behalf.
Murabaha Conditions (Usmani, 2002).
Asset or item underlying a Murabaha
1. The underlying Murabaha asset has to be in existence at the time of the execution of the contract.
For instance, a Murabaha can be executed for a car that exists not for one that is to be assembled.
2. The bank should own the asset and have either physical or constructive possession.
3. The underlying Murabaha asset must be an item of value and shariah-compliant.
4. The underlying Murabaha asset must be a tangible good, clearly identified and quantified.
For instance, if the buyer wants to purchase rice, its exact quality and quantity in terms of weight.
Must be specified in the Murabaha contract to avoid gharar or uncertainty that leads to
A dispute between contracting parties.
Price
1. The Murabaha asset cost should be declared to the client.
2. The cost refers to all expenses involved in the asset’s acquisition.
3. The asset’s price includes all direct expenses.
4. Parties to the contract establish a profit rate by mutual consent or connected with a specified benchmark.
5. The Murabaha price may be charged at spot or be deferred and paid as a lump sum at the end of the contract or in instalments on fixed dates during the term of financing.
6. The Murabaha profit must be disclosed as a specific amount to the customer.
It is important to remember that the Murabaha’s execution must adhere to a particular sequence of process steps in order to ensure sharia compliance.
Steps in the execution of a Murabaha contract
1. The client’s submission of a purchase requisition for Murabaha goods:
Based on the requisition, the bank approves the credit facility before entering into an actual agreement.
2. The master facility agreement for the Murabaha between the financial institution and the customer, is drafted and signed. This master facility agreement includes:
I. An approval of the customer’s credit facility
ii. The terms and conditions of the Murabaha contract
iii. Murabaha asset specification
iv. Client’s undertaking to purchase the Murabaha asset once the bank acquires it (if not included in the master Murabaha facility agreement,
3. The client’s unilateral promise to purchase the Murabaha assets and the financial institutions
Acceptance of the collateral given. At this stage, the bank in order to safeguard its position in the event the customer backs out from entering into a Murabaha, requests the customer to furnish security or earnest money called Hamish Jedidiah. In case the customer backs out from entering into the Murabaha, the financial institution makes up for the actual loss from it and returns the remainder to the client.
4. The agency agreement between the financial institution and the client or a third party
Since financial institutions do not possess the expertise or human resources to purchasing the assets, they appoint the client as the agent to procure the asset from the supplier on their behalf.
Agency agreements are of two types:
1) The agent is restricted to purchase a specific asset from a specific supplier or
2) The agent may purchase the specified asset from any source of his choice. Such an agreement also lists several assets which the agent may procure on the financial institution’s behalf without executing a new agency agreement each time.
Key points to remember about the agency
During the agency stage, the financial institution’s exposure to asset risk is highest, and it is in the financial institution’s best interest to shorten this period as much as possible. The financial institution may minimize risk by ensuring the supplier receives payment for the Murabaha asset, not the customer.
The financial institution must also ensure that the Murabaha asset to be purchased is not already in the customer’s possession. To maintain the correct sequence of steps, the financial institution must disburse the money to the agent before the agent purchases the goods.
Note: The agency agreement is not a prerequisite but motivated by logistical ease, as the financial institution can procure Murabaha goods directly or establish a third party agency.
5. The agent takes possession on behalf of the Islamic financial institution
6. The exchange of a contract denoting an offer and acceptance between the client and the financial institution to implement the Murabaha sale. Either party can make the offer; the client may offer to buy the Murabaha goods, or the Islamic financial institution may offer to sell them the asset. The Murabaha sale is completed at the time of offer and acceptance.
7. The transfer of possession of Murabaha goods from the financial institution to the customer. Then the
The customer becomes the owner of goods and all the associated risk and rewards of ownership transfer to him. However, his obligation to make payment as agreed does not conclude until he makes complete payment of the Murabaha price.
Risks in Murabaha financing
Elgari, 2003 elaborates on the existence of the risk of extending credit in Islamic banking and financial institutions. He claims that direct financing offered by the bank is not reliance on the existence of credit risk. Besides that, the problem arises in terms of acceptance paper and guarantees because of the inability of financial instrument’s originator which is owed by the bank to meet his obligations, and it is faced by the most of Islamic banking modes of financing that they offered especially in Murabaha financing.
Khayed and Mohammed, 2009 studied the existence of risks of Islamic modes of finance in
Banking institution’s offered, and they found the existence of various types of risks in Islamic banking operations, including the risk of default by customers not meeting liabilities when they fall due.
Mitigating Murabaha Risks
• The sharia point of view regarding the validity of a Murabaha arrangement is intensely sensitive to following the designated steps in the correct sequence.
• A deferred Murabaha may not be executed for mediums of exchange (i.e. commodities such as
Gold, silver and currencies). Only a spot Murabaha may be executed for them.
• The financial institutions should obtain sharia-compliant takaful insurance for Murabaha goods or assets to cover transit period risk (i.e. the risk posed to the financial institutions once it purchases the goods from the supplier and has their possession and before it sells them to the customer).
Default in a Murabaha
There is no concept of a late payment penalty in a Murabaha contract. However, a charity clause is Inserted at contract execution to serve as a deterrent to default.
In case of a default in payment or delay in time, which triggers the charity clause, the client is obliged to pay a contribution of a predetermined amount to a designated charity.
Murabaha prohibitions
A roll-over provision which is an extension of the duration in return for an increase in the original amount payable is not allowed in a Murabaha arrangement, as it constitutes repricing and rescheduling:
Repricing is prohibited because the sharia principles do not permit an increase in debt once it is fixed.
Rescheduling is only allowed when the financial institution provides an extension of duration to ease the burden of the customer. However, this should be without an increase in the amount payable. Hence, a roll-over where the bank increases the debt in return for an extension is also not allowed, as the resulting amount of increment of debt is analogous to riba or interest which is forbidden in Islam.
The literary meaning of Musharaka is “sharing”. The root of the term “Musharaka” in Arabic comes from the word “Shirka”, which means ‘being a partner’. Under Islamic jurisprudence, Musharaka means; “a joint enterprise formed for conducting some business in which all partners share the profit according to a specific ratio while the loss is shared according to the ratio of the contribution of capital”.
It is an ideal alternative to interest based financing with far reaching effects on both the production and distribution of wealth in the economy. The connotation of this term is more limited than the term “Shirka”, more commonly used in Islamic jurisprudence. For the purposes of clarity in the basic concepts, it is pertinent at the outset to explain the meaning of each term, as distinguished from the other.
“Shirka” means “Sharing” and in the terminology of Islamic Fiqh, it has been divided into two kinds:
Shirkat-ul-Milk (Partnership by joint ownership)
It means joint ownership of two or more persons in a particular property. This kind of “Shirkah” may come into existence in two different ways:
a) Optional (Ikhtiari):
At the option of the parties. For example, if two or more persons purchase equipment, it will be owned jointly by both of them and the relationship between them with regards to that property is called “Shirkat-ul-Milk Ikhtiari.” Here, this relationship has come into existence at
their own option, as they themselves have opted to purchase the equipment jointly.
b) Compulsory (Ghair Ikhtiari):
This comes into existence automatically without any effort/action taken by the parties. For example, after the death of a person, all his heirs inherit his property, which comes into their joint ownership as a natural consequence of the death of that person.
There are two more types of Joint ownerships (Shirkat-ul-Milk)
• Shirkat-ul-Ain
• Shirkat-ul-Dain
A property in shirkat-ul-milk that is jointly owned but not divided, is called “Musha.” An undivided asset can be utilized in the following manner:
Mushtarik Intifa'(Mutual Utilization):
Mutually or jointly using an asset alternatively under circumstances where the partners or joint owners are on good terms.
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Muhaya (Alternate Utilization):
Under this arrangement the owners will fix the number of days within a specific time interval for each partner to get usufruct of the asset. For example one may use the product for 15 days and then the other may use it for the rest of the month.
3) Taqseem (Division):
This refers to division of the jointly owned asset. This may be applied in cases where the asset that is owned can be divided permanently. For example, jointly taking a 1,000 sq.
yards plot and making a house on 500 sq. yards by each of the two owners. In a situation where the partners are not satisfied with the alternate utilization arrangement, the property or asset jointly held can be sold off and the proceeds be distributed between the partners.
Shirkat-ul-Aqd (Partnership by contract)
This is the second type of Shirkah, which means, “a partnership effected by mutual contract”. For the purpose of brevity, it may also be translated as “joint commercial enterprise.” Shirkat-ul-Aqd” can further be classified into three kinds:
1) Shirkat-ul-Amwal (Partnership in capital)
Where all the partners invest some capital into a commercial enterprise.
2) Shirkat-ul-Aamal (Partnership in services)
Where all the partners jointly undertake to render services for their customers, and the fee charged from them is distributed among them according to an agreed ratio. For example, if two people agree to undertake accountancy services for their clients on the condition that the earnings will go into a joint pool which shall be distributed between them, net of the costs and/or expenses, irrespective of the size of work each partner has actually done, this partnership will be a shirkat-ul-aamal which is also called Shirkat-ut-taqabbul or Shirkat-us-sanai or Shirkat-ul-abdan.
3) Shirkat-ul-Wujooh (Partnership in goodwill):
The word Wujooh has its root in the Arabic word Wajahat meaning goodwill. Here, the partners have no investment at all. For example they purchase commodities on a deferred price, by getting favourable credit terms because of their goodwill and sell goods at spot. The profit so earned is distributed between them at an agreed ratio.
Each of the three types above of Shirkat-ul-Aqd are further divided into two types:
Shirkat-Al-Mufawada (Capital, Labor & Profit at par):
All partners share capital, management, profit, risk & reward in absolute equality. It is a necessary condition for all four categories to be shared amongst the partners; if any one category is not shared in absolute equality, then the partnership becomes Shirkat-ul-’Ainan. Every partner who shares equally is a Trustee, Guarantor and Agent on behalf of the other partners.
Shirkat-ul-Ainan:
A more common type of Shirkat-ul-Aqd where capital, management or profit ratio is not equal in all respects.
All these modes of “Sharing” or partnership are termed as “Shirkah” in the terminology of Islamic Fiqh, while the term “Musharakah” is not found in the books of Fiqh. This term (i.e. Musharakah) has been introduced recently by those who have written on the subject of Islamic modes of finance and it is normally restricted to a particular type of “Shirkah”, that is, the Shirkat-ul-Amwal, where two or more persons invest some of their capital in a joint commercial venture. However, sometimes it includes Shirkat-ul-Aamal also, where a partnership takes place in the business of services.
It is evident from this discussion that the term “Shirkah” has a much wider sense than the term “Musharakah” as is being used today. The latter is limited to “Shirkat-ul-Amwal” only i.e. all the partners invest some capital into a commercial enterprise, while the former includes all types of joint ownership and those of partnership.
Rules & Conditions of Shirkat-ul-Aqd
The specific conditions of Shirkat-ul-Aqad are three, these are as follows:
1) The existence of Partners (Muta’aqidain)
The partners must be sane & mature and capable of entering into a contract. The contract must take place with free consent of the parties without any fraud or misrepresentation.
2) The presence of the Item:
This means the existence of the item itself.
3) The commodity of partnership should be capable of an Agency:
As each partner is responsible for managing the project, therefore he will directly influence the overall profitability of the business. As a result, each member in Shirkat-ul-Aqd should duly qualify as legally being eligible of becoming an agent and of carrying on business. For example, ‘A’ has written a book and owns it, ‘B’ cannot sell it unless ‘A’ appoints ‘B’ as his agent.
There are also two specific conditions on sharing of profits and losses, which are as follows:
1) The rate of Profit & Loss sharing should be determined:
The share of each partner in the profit earned should be identified at the time of the contract. If however, the ratio is not determined before-hand, the contract becomes void (Fasid). Therefore, determining and agreeing on the profit sharing ratio is necessary.
2) Profit & Loss Sharing:
All partners will share in the profit as well as the loss. By placing the burden of loss solely on one or a few partners makes the partnership invalid. A condition for Shirkat-ul-Aqd is that the partners will jointly share the profit. However, defining an absolute value of profit is not permissible, therefore only a percentage of the total return is allowed.
This is guided by the saying of the Rashidun Caliph Ali Ibn Abi Talib (May Allah be pleased with him) that is “Loss is distributed exactly according to the ratio of investment and the profit is distributed according to the agreement of the partners.”
The basic rules of Musharakah
Musharakah or Shirkat-ul-Amwal is a relationship established by the parties through a mutual contract. Therefore, it goes without saying that all the necessary ingredients of a valid contract must be present here also. For example, the parties should be capable of entering into a contract; the contract must be made with the free consent of the parties without any duress, fraud or misrepresentation, etc.
But there are certain conditions, which are specific to the contract of “Musharakah”.
They are stated below:-:
Basic Rules of Capital Contribution
The capital in a Musharakah agreement should be: –
a) Quantified (Ma’loom): Meaning how much money is invested.
b) Specified (Muta’aiyan): Meaning specified in terms of currency.
c) Not necessarily be merged: The mixing of capital is not required.
d) Not necessarily be in liquid form: Capital share may be contributed either in cash/liquid or in the form of commodities/assets. In case of a commodity, the market value of the commodity/asset shall determine the share of the partner in the capital.
Management of Musharakah
The normal principle of Musharakah is that every partner has a right to take part in its management and to work for it. However, the partners may agree upon a condition that the management shall be carried out by one of them, and no other partner shall work for the Musharakah. But in this case the sleeping partner shall be entitled to the profit only to the extent of his investment, and the ratio of profit allocated to him should not exceed the ratio of his investment, as discussed earlier.
However, if all the partners agree to work for the joint venture, each one of them shall be treated as an agent of the other in all matters of business. Any work done by one of them in the normal course of business shall be deemed as authorized by all the partners.
Basic rules of distribution of Profit
a) The ratio of profit for each partner must be determined in respect of the actual profit earned by the business and not in proportion to the capital invested by him. For example, if it is agreed between them that ‘A’ will get 1% of his investment, the contract is not valid.
b) It is not allowed to fix a lump sum amount for anyone of the partners or any rate of profit tied up with his investment. Therefore, if ‘A’ & ‘B’ enter into a partnership and it is agreed between them that ‘A’ shall be given Kshs.10,000/- per month as his share in the profit and the rest will go to ‘B’, the partnership is invalid.
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c) If both partners agree that each one will get a percentage of profit based on his capital proportion, whether both take part in the management of the business or not, it is allowed.
d) It is also allowed that if a partner is working, his profit share (%) could be more than his capital share (%) irrespective of whether the other partner is working or not. For example, if ‘A’ & ‘B’ have invested Kshs 1,000,000/- each in a business and it may be agreed that only ‘A’ will work and will get 2/3rd of the profit while ‘B’ will only get 1/3rd. Similarly, if the condition of work workalso imposed on ‘B’ in the agreement, then the proportion of profit for ‘A’ can still be more than his investment.
e) If a partner has put an express condition in the agreement that he will not work for the
Musharakah and will remain a sleeping partner throughout the term of Musharakah, then his share of profit cannot be more than the ratio of his investment, due to specific knowhow etc..
NB, the Hanbali school of thought considers fixing the sleeping partners profit share more than his investment share to be permissible.
f) if a partner is not working, his profit share can be less than his capital contributed.
g) If both are working partners, the share of profit can differ from the ratio of investment. For
example, ‘Zaid’ & ‘Bakar’ both have invested Kshs.1,000,000/- each. However, Zaid gets 1/3rd of the total profit and Bakar gets 2/3rd, this is allowed.
This opinion of Imam Abu Hanifa is based on the fact that; capital is not the only factor for profit distribution but also labor and nature of work. Although the investment of two partners is the same but in some cases, quantity and quality of work might differ.
Basic rules of distribution of Loss
All scholars are unanimous on the principle of loss sharing in Shariah, based on the saying of Caliph Ali Ibn Abi Talib (May Allah be pleased with him) that is as follows:
“Loss is distributed exactly according to the ratio of investment and the profit is distributed according to the agreement of the partners.”
Therefore, the loss is always subject to the ratio of investment. For example, if ‘A’ has invested 40% of the capital and ‘B’ has invested 60%, they must suffer the loss in the same ratio as their investment proportion, not more, not less. Any condition contrary to this principle shall render the contract invalid.
5) Powers & Rights of Partners in Musharakah
After entering into a Musharakah contract, partners have the following rights:-
a) The right to sell the mutually owned property since all partners are representing each other in Shirkah and all have the right to buy & sell for business purposes.
b) The right to buy raw materials or other stocks on cash or credit, using funds belonging to Shirkah to put into the business.
c) The right to hire people to carry out business, if needed.
d) The right to deposit money and goods of the business belonging to Shirkah as a depositor trust where and when necessary.
e) The right to use Shirkah’s funds or goods in Mudarabah.
f) The right of giving Shirkah’s funds as hiba (gift) or loan. If one partner for purpose of investing in the business has taken a Qard-e-Hasana, then paying it becomes liable on both.
6) Termination of Musharakah
Musharakah will stand terminated in the following cases: –
If the purpose of forming the Shirkah has been achieved. For example, if two partners form a Shirkah for a certain project such as buying a specific quantity of cloth in order to sell it and the cloth is purchased and sold with mutual investment, the rules are simple and clear in this case. The distribution of profit will be as per the agreed rate, whereas in case of loss, each partner will bear the loss according to his ratio of investment.
2) Every partner has the right to terminate the Musharakah at any time after giving his partner a notice that will cause the Musharakah to end. For dissolving this partnership, if the assets are liquidated, they will be distributed between the partners on the following basis:
a) If there is no profit and no loss to the assets, they will be distributed on pro rata basis.
b) In case of loss as well, all assets will be distributed on pro rata basis.
3) In case of the death of any one of the partners or any partner becoming insane or incapable of effecting a commercial transaction, the Musharakah stands terminated.
4) In case of damage to the share capital of one partner before mixing the same in the total
investment and before affecting the purchase, the partnership will stand terminated and the loss will only be borne by that particular partner. However, if the share capital of all partners has been mixed and could not be identified singly, then the loss will be shared by all, and the partnership will not be terminated.
Termination of Musharakah without closing the business
If one of the partners wants termination of the Musharakah, while the other partner or partners would like to continue with the business, this purpose can be achieved by mutual agreement. The partners who want to run the business may purchase the share of the partner who wants to terminate his partnership, because the termination of Musharakah with one partner does not imply its termination between the other partners. However, in this case, the price of the share of the leaving partner must be determined by mutual consent. If there is a dispute about the valuation of the share and the partners do not arrive at an agreed price, the leaving partner may compel other partners on the liquidation or on the distribution of the assets themselves.
The question arises whether the partners can agree, while entering into the contract of Musharakah, on a condition that the liquidation or separation of the business shall not be effected unless all the partners or the majority of them wants to do so. And that a single partner who wants to come out of the partnership shall have to sell his share to the other partners and shall not force them on liquidation or separation.
This condition may be justified, especially in modern day situations, on the grounds that the nature of business, in most cases today, requires continuity for its success. The liquidation or separation at the instance of a single partner only may cause irreparable damage to the other partners.
If a particular business has been started with huge amounts of money which has been invested in a long-term project, and one of the partners seeks liquidation in the infancy of the project, it may be fatal to the interests of the partners, as well as to the economic growth of the society, to give him such an arbitrary power of liquidation or separation. Therefore, such a condition seems to be justified, and it can be supported by the general principle laid down by the Holy Prophet (Allah bless him and give him peace) in his famous hadiths:
“All conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful”.
Dispute Resolution
There shall be a provision for adjudication by a Review Committee to resolve any difference that may arise between the bank and its clients (partners) with respect to any of the provisions contained in the Musharakah Agreement.
Security in Musharakah
In case of a Musharakah agreement between the Bank and the client, the bank shall in its own right and discretion, obtain adequate security from the party to ensure safety of the capital invested/financed and also for the profit that may be earned as per profit projection given by the party. The securities obtained by the bank shall, also as usual, be kept fully insured at the party’s cost and expenses with Takaful (Islamic Insurance). The purpose of this security is to utilize it only in case of damage or loss of the principal amount or earned profit due to the negligence of the client.
Issues Relating to Musharakah
Musharakah is a mode of financing in Islam. The following are some issues relating to the tenure of Musharakah, redemption in Musharakah and the mixing of capital in conducting Musharakah
Liquidity of Capital
A question commonly asked in the operation of Musharakah is whether the capital invested needs to be in liquid form or not. The answer as to whether the contract in Musharakah can be based on commodities only or on money, varies among the different schools of thought in Islam. For example, if ‘Zaid’ and ‘Bakar’ agree to invest Kshs.1,000,000/- each in a garment business and both keep their investments with themselves. Then, if ‘Zaid’ buys cloth with his investment, will it be considered to belong to both Zaid and Bakar or only to Zaid? Furthermore, if the cloth is sold, can Zaid alone claim the profit or loss on the sale?
In order to answer this question, the prime consideration should be whether the partnership becomes effective without mixing the two investments profit or loss. This issue can be resolved in the light of the following schools of thought of different fiqhs:
Imam Malik is of the view that liquidity is not a condition for the validity of Musharakah. Therefore, even if a partner contributes in kind to the partnership, his share can be determined on the basis of evaluation according to the prevalent market price at the date of the contract.
However, Imam Abu Hanifa and Imam Ahmad do not allow the capital of investment to be in kind. The reason for this restriction is as follows:
• Commodities contributed by one partner will always be distinguishable from the commodities given by the other partners, therefore, they cannot be treated as homogenous capital.
• If in case of redistribution of share capital to the partners, tracing back each partner’s share
becomes difficult. If the share capital was in the form of commodities then redistribution cannot take place because they may have been sold by that time.
Imam Shafi has an opinion dividing commodities into two:-
Dhawat-ul-Amthal (Homogenous Commodities)
Commodities which if destroyed can be compensated by similar commodities in quality and
quantity. Example rice, wheat etc.
Dhawat-ul-Qeemah (Heterogeneous Commodities)
Commodities that cannot be compensated by similar commodities, like animals.
Imam Shafi is of the view that commodities of the first kind may be contributed to Musharakah in the capital, while the second type of commodities cannot be a part of the capital. In case of Dhawatul- Amthal, redistribution of capital may take place by giving each partner similar commodities to the ones he had invested earlier, the commodities need to be mixed so well together that the commodity of one partner can not be distinguished from the commodities contributed by the other.
The illiquid goods can be made capital of investment and the market value of the commodities shall determine the share of the partner in the capital. It seems that the view of
Imam Malik is more simple and reasonable and meets the need of the modern business, therefore this view can be applied.
We may conclude from the above discussion that the share capital in a Musharakah can be
contributed either in cash or in the form of commodities. In the latter case, the market value of the commodities shall determine the share of the partner in the capital.
The difference between interest based financing and Musharakah
Interest-Based Financing
Musharakah
A fixed rate of return on a loan advanced by the financier is predetermined irrespective of the profit earned or loss suffered by the borrower
Musharakah does not envisage a fixed rate of return. The return is based on the actual profit earned by the joint venture.
The financier cannot suffer loss.
The financier can suffer loss if the joint venture fails to produce fruits.
Mixing of the Capital
According to Imam Shafi the capital of the partners should be mixed so well that it cannot be
distinguished and this mixing should be done before any business is conducted. Therefore, the partnership will not be completely enforceable if any kind of discrimination is present in the partners’ capital. His argument is based on the reasoning that unless both investments will be mixed, the investment will remain under the ownership of the original investor and any profit or loss on trade of that investment will be entitled to the original investor only. Hence such a partnership is not possible where the investment is not mixed.
According to Imam Abu Hanifa, Imam Malik and Imam Ahmed bin Hanbal, the partnership is
complete only with an agreement and the mixing of capital is not important. They are of the opinion that when two partners agree to form a partnership without mixing their capital of investment, then if one partner bought some goods for the partnership with his share of investment of Kshs.1,000,000/-, these goods will be accepted as being owned by both partners and hence any profit or loss on sale of these goods should be shared according to the partnership agreement.
However, if the share of investment of one person is lost before mixing the capital or buying
anything for the partnership business, then the loss will be borne solely by the person who is the owner of the capital and will not be shared by other partners. Though if the capital of both had been mixed and then a part of the whole had been lost or stolen, then the loss would have been borne by both.
Since in Hanafi, Maliki and Hanbali schools of thought mixing of the capital is not important,
therefore, a very important present day issue is addressed with reference to this principle. If some companies or trading houses enter into a partnership for setting up an industry to conduct business, and they need to open an LC for importing the machinery. This LC reaches the importer through his bank. Now when the machinery reaches the port and the importing companies need to pay for taking possession, the latter need to show those receipts in order to take possession of the goods.
Under the Shafi school of thought, the imported goods cannot become the capital of investment but will remain in the ownership of the person opening the LC because, at the time of opening the LC, the capital had not been mixed and without mixing the capital, Musharakah cannot come into existence. Under this situation, if the goods are lost during shipment, the burden of loss will fall upon the opener of the LC, even though the goods were being imported for the entire industry. This is because even though a group of companies had asked for the machinery or imported goods, the importers had not mixed their capital at the time of investment.
Contrary to this, since the other three schools of thought believe that a partnership comes into existence at the time of an agreement rather than after the capital has been mixed, the burden of loss will be borne by all. This has two advantages:
a) In case of loss the burden of loss will not fall upon one partner rather, it will be shared by all the partners.
b) If the capital is provided at the time of the agreement, it stays blocked for the period during which the machinery is being imported. While if the capital was not kept idle till the actual operation could be conducted with the machinery, the same capital could have been used for something else as well.
This shows that the decision of the three combined schools of thought is better equipped to handle the current import/export situation.
Tenure of Musharakah
For conducting a Musharakah agreement, questions arise pertaining to fixing the period of the agreement. For fixing the tenure of the Musharakah, the following conditions should be kept in mind:
a) The partnership is fixed for such a long time that at the end of the tenure no other business can be conducted.
b) It can be for a very short time period during which the partnership is necessary and neither partner can dissolve the partnership.
Under the Hanafi school of thought, a person can fix the tenure of the partnership because it is an agreement and an agreement may have a fixed period of time.
In the Hanbali school of thought, the tenure can be fixed for the partner as it is an agency agreement and an agency agreement in this school can be fixed.
The Maliki school however says that Shirkah cannot be subjected to a fixed tenure.
The Shafi school like the Maliki school consider fixing the tenure to be impermissible. Their
argument is that fixing the period will prohibit conducting the business at the end of that period.
Uses of Musharakah / Mudarabah
These modes can be used in the following areas (or can replace them according to the Shariah rules)
Asset Side Financing
• Short/medium/long – term financing
• Project financing
• Small & medium enterprises setup financing
• Large enterprise financing
• Import financing
• Import bills drawn under import letters of credit
• Inland bills drawn under inland letters of credit
• Bridge financing
• LC with margin (for Musharakah)
• Export financing (Pre-shipment financing)
• Working capital Financing
• Running accounts financing / short term advances
Liability Side Financing
• For current/ saving/mahana amdani/ investment accounts (Deposit giving Profit based on
Musharkah/Mudarbah – with predetermined ratio)
• Inter- Bank lending / borrowing
• Term Finance Certificates & Certificate of Investment
• T-Bill and Federal Investment Bonds / Debenture.
• Securitization for large projects (based on Musharkah)
• Certificate of Investment based on Murabahah (e.g: Meezan Riba Free)
• Islamic Bank Musharakah bonds (based on projects requiring large amounts – profit based on the return from the project).
Risks in Musharkah Financing
Some of the risks and problems that are being faced by Islamic Banks in extending Musharkah or Mudarbah based financing are as follows:
Business Risk: In Musharakah Financing, the bank is sharing the business risk with the customer since the return in Musharkah financing is dependant on the actual performance of the business. The bank should make a feasibility study of the customers business of the customer and should prudently evaluate all the risks before making Musharakah financing decisions, since the exposure of the business’s performance is on the bank and not on the customer, unless fraud or negligence is established on the part of the customer.
Risk of Proper Book Keeping: Another problem in a Musharkah transaction is the lack of transparent book keeping practices adopted by various companies due to taxation issues. Due to this lack of transparency, it is difficult to evaluate the actual performance of any business since it is not completely portrayed in the disclosed accounts of the company and in the absence of such information, it is difficult to enter into a Musharkah arrangement with the customer.
Customer Mindset: In Musharkah financing the actual profits and losses of the business are shared between the partners. If the business performs better than expected, then it will generate higher profits. If higher profits are generated by the business then the Bank too will be getting higher profits, as per the profit sharing arrangement. But many customers are hesitant to provide profit that is more than the average market benchmark rate of financing.
Dishonesty: Another apprehension against Musharakah financing is that dishonest clients may exploit the instrument of Musharakah by not paying any return to the financiers. They can always show that the business did not earn any profit by manipulating the records of the company. They can claim that it has suffered a loss in which case not only the profit, but also the principal amount will be jeopardized.
Operational Risk: Success of Musharakah depends upon better management of the factors of operational risks, which include:
a. Control over management
b. Transparency in income
c. Commitment by management
Islamic Banks can take the following steps for proper management of Operational risks in the Musharakah by appointing bank’s representatives in the Company’s Board Of Directors, Finance committee and Internal audit committee. These representatives should be given proper authority & will be directly reporting to the Bank’s management.
Credit Risk: In Musharakah, the Musharik bank is exposed to similar credit risks if some amount is payable by customs under the Musharkah Agreement, as other banks, which include: Risk of default and Counter Party risk.
Credit risk can be mitigated by:
a. Proper evaluation of the customers financial position
b. Any Shariah Compliant security can be taken to secure the bank against any dishonesty or act of negligence by the customer.
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