Munich Personal RePEc Archive

Theory and evidence of the impacts of shariah debt screening on firm behaviour.

Abdul Halim, Asyraf (2021): Theory and evidence of the impacts of shariah debt screening on firm behaviour.

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Abstract

A Shariah compliant firm faces a trade-off between keeping their Shariah compliancy versus having their long-term debt to assets or market-capitalisation ratio above 30%, when they operate within a market with little or no access to a liquid Islamic debt market. On the other hand, Proposition 1 of Modigliani & Miller (1963) posits that interest tax shield benefits, derived from long-term debt, reduce the hypothetical firm’s investment cut-off rate and therefore provide extra value for the firm. Facing a ceiling value on their long-term debt to assets or market-capitalisation ratio, Shariah compliant firms therefore should be unable to fully enjoy lower interest tax shield benefits, and consequently, lower investment cut-off rate vis-à-vis their conventional counterparts. Subsequently, any samples of Shariah compliant firms formed within a market without access to a liquid Islamic debt market should demonstrate a consistent tendency towards a specific set corporate financial behaviour due to the consistently higher than average investment cut-off rate. This paper extends the theoretical work of Modigliani & Miller (1963) to, firstly, demonstrate how a higher-than-average investment cut-off rate is a natural consequence of the debt ratio screening incorporated within the contemporary Shariah Stock Screening Methodology for a Shariah compliant firm that is devoid of access to a liquid Islamic debt market. Next, the paper outlines (with supporting empirical stylised facts) the subsequent corporate financial characteristics that samples of Shariah compliant firms are more skewed towards. The paper finds that Shariah compliant firm faces a theoretical floor limit to their investment-cut off rate, implying that the average Shariah compliant firm may find that lesser projects pass their internal rate of return vis-à-vis the projects of a similar conventional firm. Consequently, samples of Shariah compliant firms consistently show the following corporate financial characteristics; above-average size, larger marginal change in size and profitability in response to a given marginal change in investments, low book-to-market ratio and lower investment rates, when compared to a sample of conventional firms.

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