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Background
An Islamic financial system requires elimination of any fixed and pre-determined interest rate and thus closes the door to any form of debt instruments. Instead, it promotes equity participation and direct sharing of risks and rewards. In simple terms, although the system prohibits a fixed and predetermined interest rate on capital, it fully recognizes return on investment. As compared to a conventional debt-based system where capital is rewarded on the basis of a rate fixed ex-ante or determined by the expectations of the future demand and supply of capital, an Islamic system calls for rewarding the capital on the basis of ex-post (actual) return on capital. Whereas market interest rate plays the role of an equilibrium rate for financial intermediation and a benchmark for making efficient investment decisions in a conventional system, so far no equivalent substitute has been available for an equity-based system to determine the internal rate of return or the marginal efficiency of investments. The Islamic financial system recognizes that investment decision-making will have to be based on the concept of rate of return on capital as it participates in real sector activities and not on the opportunity cost of capital as represented by the interest rate. Though discounting expected future stream of cash flows based on a risk-adjusted expected rate of return does not violate any Islamic principle, and standard techniques for project evaluation are acceptable, the issue is how to determine the so-called "risk-adjusted expected rate of return," or cost of capital, in the absence of a system-wide benchmark or reference rate. Thus far, the literature on Islamic economics and finance has not developed techniques to determine a rate of return at the firm (micro) or economy (macro) level so that investments can be compared for efficient allocation of capital. In the absence of such a reference rate or benchmark, Islamic financial institutions have resorted to adopting a proxy rate borrowed from their counterparts in the conventional system. It has become a common practice to use the London Inter-Bank Offer Rate (LIBOR) as a reference rate for mark-up instruments or a benchmark to price trade financing instrument and Islamic leasing funds. Without a doubt, this practice is questionable and raises several concerns. Practitioners claim that this arrangement is temporary until a better substitute and viable solution is offered. This paper summarizes the findings of a recent research proposing a model for determining the cost of capital in an economy where debt-instruments are eliminated. This model is based on Tobin's q theory of investment and attempts to devise a benchmark compatible with the Islamic financial system. 
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