THE NET PRESENT VALUE

OF MUDHARABAH AND
MUSHARAKAH MODELS
Zia-ur-Rehman
Adapted from
Jaffar M. M. and Isa, N. B. M. (2011). The net present value of
Mudharabah and Musharakah models. International Conference
on Business, Engineering and Industrial Applications, 2011

EMERGENCE OF ISLAMIC BANKS

Islamic banking emerges as a rapidly growing part of the financial
sector in the Islamic world.
In the seventies, a number of Islamic banks came into existence in
the Middle East, such as

the Dubai Islamic Bank in 1975,

the Faisal Islamic Bank of Sudan in 1977,
the Faisal Islamic Bank of
Egypt in 1977, and
the Bahrain Islamic Bank in 1979 and etc

Currently global Islamic banking assets and asset under Islamic

financial management have reached USD750 billion.
There are over 300 Islamic financial institutions worldwide across 75
countries.
According to the Asian Banker Research Group, the Worlds 100
largest Islamic banks have set an annual asset growth rate of 26.7%
and the global Islamic Finance industry is experiencing average
growth of 15%-20% annually

FORM OF ISLAMIC BANKS

Islamic banking has a similar rationale as

conventional banking except that it operates in
accordance with

rules on transactions,
forbidding interest
as well as investment in businesses that provide
goods or services that considered haram, or contrary
to Islamic principles.
shariah

For example, In 1983, Bank Islam Malaysia Bhd

(BIMB) which is the full-fledge Islamic banking
system has developed alongside a conventionalbanking system.

MUDARABAH DEFINED

Mudharabah is an agreement between a provider

of capital (rabbul mal) who provides 100% capital
for a business and entrepreneur (mudharib) who
manages the business applying his expertise.
Under this contract, the resulting profit is to be
shared between them according to a pre-agreed
ratio, while any loss is to be borne solely by the
provider of capital.

MUSHARAKAH DEFINED
Musharakah literally means sharing.
In the context of business and trade it means a
joint enterprise in which all the partners share
the profit or loss of the joint venture that depends
on an agree proportion.

It is an ideal alternative for the interest-based

financing with far reaching effects on both
production and distribution

NPV GROWING IN ITS USAGE

According to a survey, project evaluation
techniques used by many largest companies in
year 1978 and 1991, they found that these
companies has shifted from the use of the
internal rate of return method (IRR) to the net
present value (NPV),method and a decrease in
use of the payback period method.
Out of 27 companies surveyed in 1978, only 52%
reported were using NPV, whereas out off 33
companies surveyed in 1991, 97% reported were
using NPV.

The NPV consists of the estimated cash flow Ft

for the project at the end of the period t and may
be positive, negative or zero; i is the rate of
return per period. The formula of the NPV, N is:

OUR ASSUMPTIONS
1- all the cash flows received from project are
reinvested at the same fixed rate used to
calculate the equivalent worth.
2- the rate of return or interest rate used in
calculating the value of NPV is fixed.
3- Repeated projects assumption should be used
in comparing two projects of unequal life.
4- Profits are reinvested in the same project at a
MARR or Required Rate of Return.

PRIOR REQUIREMENTS
The procedures are first to determining the
minimum attractive rate of return (MARR) for
which all future cash flows can be reinvested,
followed by estimating the economic useful life of
the project,
the positive and negative cash flows for each
period over the analysis period, calculating the
net cash flows of each period, and lastly
calculating the present worth of each of the net
cash flows.

INVESTMENT MODELS

The Mudharabah Investment Model

The Musharakah Investment Model

THE MUDHARABAH MODEL

The capital provider invests E0 at the initial time

t=0 and the entrepreneur does not put in any
capital in the joint venture, that is Q0 = 0.

Investment of the capital provider at time t, Et

earns the profits of rt Et1 that is on the
investment at time t1.
The profit is then shared between the capital
provider and the entrepreneur with the profit
sharing rates of k:(1 k) .

MUDHARABAH INVESTMENT
MODELS

The investment models of capital provider- called

Rab al Maal- Et and the entrepreneur- called
Mudharab- Qt at time t are as Follows
Rab

al Maals Investment Model

Mudharabs
for

Investment Model

t = 1, 2, 3....n.

THE MUSHARAKAH MODEL

Maheran (2010) introduced a musharakah model
involving two parties and used two profit sharing
ratios.
At initial stage of the joint venture t = 0 , capital
provider and entrepreneur invest E0 and Q0
respectively.
Assumptions:

Throughout

the contract, both parties do not take out

their investments
and there is no additional investment as well.

TWO PROFIT SHARING RATIOS

The profit gained from the investment of the
capital provider is shared between the capital
provider and the entrepreneur with a ratio of k :
(1 k) .
Here, the model uses another profit sharing rate j
to share the profit gained from the investment of
entrepreneur. The profit is shared between the
capital provider and the entrepreneur with a
ratio of (1 j):j .
The profit sharing rate j is necessary as the two
rates k and j may not be of the same value.

TWO INVESTMENT MODELS

If the profit rate at time t is rt , then

the

investment models of capital provider Et and the

entrepreneur Qt at time t are as follows:
Investment model of Capital provider

Investment

for

model of entrepreneur

t = 1, 2, 3...n.

WHY TWO RATIOS

The new musharakah model takes into account
two profit sharing rates in order to perform a fair
and justified investment of joint venture between
the capital provider and the entrepreneur.
It encourages the opportunity for the
entrepreneur to invest and provides initial
capital which indirectly secures the inefficiency
and mismanagement on his part as his own
capital will be at stake.
With the existence of two profit sharing rates, the
risks are also shared accordingly.

NET PRESENT VALUEMUDHARABAH MODEL

The NPV for the Investment of Rabb al Maal:

Where

E0 is the capital provider initial cash flow,

En1rnk is the capital provider cash flow at time n
and
rtk is the capital provider rate of return.

The negative sign for the initial cash flow E0

means the outflow of the money spent for the
investment.

NET PRESENT VALUE- MUDHARABS

MODEL

where

Q0is the entrepreneur initial cash flow,

En1rn(1 k) is the entrepreneur cash flow at time n
and rt(1 k) is the entrepreneur rate of return.

The negative sign for the entrepreneur initial

cash flow Q0is the outflow where the money spent
for the investment.
Note there is a little mistake in the equation.

THE MUSHARAKAH MODEL

The basic Musharakah model- capital provider

Where

Vn= En-1rnk- the profit from capital providers

investment in time n.
Wn=Qn-1rn(1-j)- the capital providers profit from
entrepreneurs investment.
iE= rtk- the capital providers rate of return
iQ=rt(1-j)

RE-WRITING THE CAPITAL

PROVIDERS MUSHARAKAH MODEL

THE ENTREPRENEURS MODEL

Xn=En-1rn(1-k) is the entrepreneurs profit from

capital providers investment at time n.
Zn=Qn-1rnj is the entreprenuers profit from his
investment at time n.
iE=rt(1-k) is the capital providers rate of return and

iQ=rtj

is the entrepreneurs rate of return

REWRITING THE ENTREPRENURS

MODEL