Comparison between Cost of Capital in Capitalistic and Islamic Systems
Iraj Toutounchian, Ph.D.
Professor of Economics
Islamic Money and Banking
Interest and profits
are returns to money and capital,respectively. In Capitalistic system,
cost of capital has correctly been proved to be the rate of interest.
This paper argues that in the justification of the opportunity cost,
one crucial element is missing; that is, the independence of the
rate of interest from that rate of profit (in fact, internal rate
of return). In other words,return to event B is the opportunity
cost of the return to event A only if A and B are independent(i.e.,mutually
exclusive). Hence, in a pure Islamic state where interest has no
place whatsoever, the cost of capital is zero.
Since investment projects can no longer be assumed to be independent
from one another and each project competes with others. Therefore,in
deciding which project to be undertaken in an Islamic state, a lower
rate-of-return project plays the cut-off-rate role without it being
cost of capital for the project of a higher rate of return.
An important conclusion
is that these two concepts,i.e. cost of capital and cut-off rate,
are not the same (however, rate of interest plays the cut-off rate
role,as well); hence different implications. The most important
implication is greater investment in an Islamic state and welfare
improvement due to bigger consumption basket enjoyed by Muslim consumers