5. The Basics of Corporate Finance: The Miller–Modigliani Theorem

The previous chapter illustrated that our intuition is not a very reliable guide when it comes to designing complex policies and that formal analysis is often needed. The issue of tax burden, though important, is of no direct relevance to the theory and practice of Islamic finance (IF). The example we consider in this chapter, how the value of the firm is affected by the way it is financed, is of direct relevance to IF. When you decide to start a business, one of your first questions is likely to be how to raise the money to finance your operations. Broadly, there are two ways to raise funds: taking debt or issuing equity. Debt financing, however, requires one to pay interest to the lender, typically a bank. Islamic law prohibits charging interest or entering into a contract that requires one to pay interest. Is such a requirement a significant handicap for Islamic businesses?