Riba vs. Rate of Return 67
economy, or that of any tenable scheme of social justice, for the state to
attempt to enforce an unconditional promise of interest payment regardless
of the use of borrowed money. If, on the other hand, the money is used to
create additional capital wealth, the question is raised as to why the lender
should be entitled to only a small fraction (represented by the interest rate)
of the exchange value of the utility created from the use made of the funds;
the lender should be remunerated to the extent of the involvement of his
fi nancial capital in creating the incremental wealth.
Sub - optimality of Debt - based Investments
Some researchers have attempted to explain the prohibition of interest and
debt by comparing risk for a given investment fi nanced exclusively by equity
with risk for the same investment if it is fi nanced by a mix of debt and
equity. Iqbal (2010) notes that risk aversion can be seen as rational human
behavior in both conventional and Islamic economics. In conventional
economics, this is evident from the extensive use of the Expected Utility
Hypothesis (EUH) in decision - making under uncertainty and of Modern
Portfolio Theory (MPT) in the selection of fi nancial instruments. Both EUH
and MPT are exclusively based on a risk - averse attitude. In Islamic econom-
ics, strong condemnation of mysir (games of chance, including gambling)
and gharar (excessive uncertainty about the price, quantity or quality of a
commodity or service) lends support to the conclusion that risk aversion is
acknowledged as rational human behavior.
Therefore, the author sets the null hypothesis as the variance of a given
investment is less if it is fi nanced exclusively on a PLS - basis than that if it is
fi nanced by a mix of debt and equity. An investment’s future profi t or loss
outcomes are probabilistic and, therefore, its expected cashfl ows remain the
same whether it is fi nanced exclusively by equity or by a mix of debt and
equity as stated in the Miller - Modigliani (MM) theorem of irrelevance of
capital structure. However, its variance comes out greater if it is fi nanced by
any mix of debt and equity rather than by equity exclusively. Furthermore,
its variance increases by a greater margin corresponding to every similar
increase in the debt–equity ratio.
The hypothesis is proved mathematically assuming a fi xed interest rate,
irrespective of its magnitude, in the case of debt fi nancing. The mathemati-
cal exercise also shows that similar increases in the debt–equity ratio add
to the investment risk posed to a shareholder proportionately more than
they add to his/her expected return. Moreover, successive increases in debt
fi nancing multiply the bankruptcy risk of underlying investment without
affecting its overall return. This means that debt fi nancing minimizes risk
for individual lenders, and adds a bankruptcy risk on top of uncontrol-
lable natural risk for underlying investments, leaving its expected return
unchanged. The Iqbal (2010) study shows that the risk for a given invest-
ment is smaller if it is fi nanced exclusively by equity rather than by a mix
of debt and equity. This means that, where interest is permitted, a 1 percent