Islamic Capital Markets: Theory and Practice

Chapter 5

The Cost of Capital

The purpose of this chapter is to analyze the cost of capital and its role in corporate finance and capital markets. Cost of capital, or discount rate, is meaningless without a future stream of income, or future net cash flow. The market value of any capital goods does not depend on its past cost; it depends on its future income stream. For instance, the value of an apple tree depends only on the future stream of apples. Hence, the capital value of any asset or project is a forward-looking concept. Risk of a project is defined in terms of uncertainty of its income stream. The most widely used model for cost of capital in a risky environment is the capital asset pricing model (CAPM). Companies also evaluate risk using a certainty-equivalent approach for an uncertain income stream. The certainty-equivalent cash flow (CECF) is derived from the uncertain cash flow using the risk-free rate of return. The Miller and Modigliani theorem is a main result in capital cost theory. The theorem states that the debt/equity structure of financing of a firm has no bearing on the firm’s value. Moreover, the expected rate of return on equity is directly related to the debt/equity ratio. The implications of the Miller–Modigliani theorem for investment is that projects that have higher returns than average cost of capital may qualify for investment. Agency problem arises in the assessment of risk. Mudaraba has an insignificant share in Islamic banks’ financing owing to ...