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Implications
of Model
Deriving
a firm's cost of capital without referring to a fixed and
pre-determined rate such as an interest rate has immense
implications for Islamic financial markets. Extensive research on q
theory of investment suggests that it is possible to determine an
industry-wide as well as an economy-wide q ratio. An industry-wide q
ratio can very well serve the purpose of establishing the cost of
capital for new firms entering the industry and as an indicator of
efficiency relative to others in the same industry for existing
firms. Similar to the concept of an industry-wide q ratio, an
economy-wide q ratio can be used to determine a rate that reflects
economy-wide marginal efficiency of capital or internal rate of
return for efficient allocation of financial resources. Existence of
an economy-wide benchmark has implications at both the micro- and
macro-level. At the micro-level, such a benchmark can facilitate the
pricing of assets, utilizing an equity-based reference rate. At the
macro-level, it will help develop secondary markets, an Islamic
money market, and an interbank market and contribute toward
financial innovations. All these factors are known to be roadblocks
to further development and growth of Islamic financial markets.12
Development
of a secondary market will enhance liquidity in the market and
provide an extended maturity structure to investors. Establishment
of a money market and an interbank market will have a great impact
on the way Islamic financial institutions operate, since the problem
of unavailability of funds at extreme short maturity will be
resolved. No doubt, the financial innovations during the 1980s and
1990s changed the international financial markets in a revolutionary
fashion. Similarly, financial innovations will introduce new
products to Islamic financial markets to equip borrowers and lenders
with the tools to better manage business and financial risk.13
Another promising arena for applying an economy-wide q is in the way
governments in Islamic countries formulate economic policies and
raise funds for social sector projects. Central banks can perform
monetary operations to achieve economic objectives by influencing q
since this ratio is the principal link between the financial and
real sector of the economy.14
Governments
can finance public sector projects by issuing equity-based
securities where expected dividend is determined by the market price
of government securities (discounted value of streams of expected
earnings at a prevailing rate of return) and social rate of return
(discounted value of stream of expected earnings derived from
government surpluses).15 Since q is
the ratio of the social rate of return to the expected rate of
return on financial capital, governments have an incentive to invest
only if q exceeds unity. Investors will invest in equity-based
government securities provided the rate of return is comparable to
the market rate of return.
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