From Debt to Equity Advocacy: Islamic Model Firm Capital Structure

Abstract

Legal experts and economists advocate that the century-old debt-equity distinction is responsible for the global financial crisis (GFC) and instability. This regulation advocates and subsidizes debt (unlike equity financing) as tax deductible. This regulation, in turn, reduces the cost of debt financing and eludes debt as a relatively cheap source of financing. Later, theoretical developments related to corporate financing policies explicitly materialized interest tax deductibility and advocated debt over equity financing. Researchers have highlighted the need to reframe these debt subsidizing corporate tax regulations. This thesis offers a critical analysis of debtincentivized corporate tax and financing policies and provides an Islamic perspective on this vital tax deductibility debate. This study aims to help abolish the corporate tax incentive to debt and shift the incentive toward equity. This study also attempts to empirically test the implications of proposed interest taxability and dividend tax deductibility on corporate financing policies. This thesis estimates a modified Modigliani and Miller (1963), (later M & M) firm valuation model to incorporate interest taxability and dividend tax deductibility. The estimated model is linear and static to the single period t. This thesis uses a simulation technique to evaluate the estimated model and conducts various policy experiments to observe the potential impacts of proposed policy reforms on a firm’s cost of capital and overall value. The simulated results indicate that, in the presence of debt tax incentives, firms lose value over every subsequent unit of debt financing. Zero-leverage firms, in the presence of the interest tax shield, may stabilize their value. The present study finds that aligning a corporate financing policy with the fundamentals of Islamic finance helps restrain corporate indebtedness and promote profit and loss sharing. According to the proposed model, firms have a reduced cost of financing, tend to be more stable, and are valueoriented, especially when they avoid debt to the maximum extent. The results indicate that minimum debt financing in the presence of a dividend tax shield reduces firms’ costs of financial distress and their proneness to bankruptcy. Islamic finance can provide a corporate financing model for sustainable and equitable wealth creation.