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.
