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Modern Islamic finance has initiated many methods to substitute interest return for cash flows (incomes) generated from investments and business activities (DTZ, 2008). These include returns from trading in real assets and rental income obtained

from leasing of assets, etc. There are three main modes of Islamic financing which include:

1. Debt-based: refers to the loans initiated through a repurchase agreement transaction or back-to-back trades of borrower or third parttheld assets (DTZ, 2008). The most famous type of debt-based financing is Al-Murabahah produced from the acquisition and resale of a current or future asset at a mark-up (i.e. initial price plus a margin) instead of interest payments (Jobst, 2007).

Al-Murabahah

Often called the ‘mark-up’ or ‘cost-plus’ sale, Al-Murabahah is analogous to buy – sell back or back-to-back sales arrangements. It is a contract where a customer willing to buy an asset (such as apartment, equipment, etc.) request from an Islamic bank to buy it for him. Afterwards, the bank sells this asset to the borrower at a price that include the face value of this given asset, any charges or expenses applied for the asset’s acquisition and an additional pre-agreed reasonable profit. The total price is made usually through a series of installments

The basic features of Al-Murabahahare outlined below (Shinger, 1994):

(i) The buyer should know about all associated costs and the initial price of the asset. The profit (or markup) should be displayed as a percentage of the total price plus costs.

(ii) The subject of the sale should be tangible assets or goods against money; (iii) The seller should hold and own the asset, which underpins the contract.

Moreover, the seller should be able to deliver the asset to the buyer. (iv) The repayment should be delayed postponed.

2. Asset-based:also referred to as lease contract where a sale-leaseback (i.e. operating lease) agreement is put in place . It also includes the lease of a third party asset with option of purchase it. Such a type of lease contract is known as financing lease. The most common type of asset-based financing is Al-Ijarah. Based on Al-Ijarah contract,

credit is received in exchange for rental fees during the temporary use of an asset (Jobst, 2007). The borrower (or entrepreneur) also has an option to purchase this asset at maturity (Jobst, 2007).

Al-Ijarah

This Islamic method of financing is equivalent to operating leases (sale- leaseback/lease-buyback) or financing leases (lease-purchase). The investor rents a given project or asset for a definite amount and over a specific period of time. The investor retains ownership of the asset during the transaction where he sustains all the expenses related to the asset’s ownership. On the other hand, the lessee has to cover all the costs resulting from utilizing the asset. In the case of a lease-purchase, each payment presents a portion of the final price of purchase and transfer of ownership of the asset. Two types of leasing finances are promoted by Shari’ah:

1) Ijarah(simple leasing)

2) Ijarah Wa Iqtinaa(purchase lease)

 Ijarah depends on a contract between the lesser (Investor) and the lessee (client) (DTZ, 2008). The investor, represented by the Islamic bank in our case, buys a capital asset and rents it to a client. In return, the client should pay the bank a pre-agreed regular rental fees during the period of the transaction. The maturity of the contract depends on the requirement of the lessee, the lifetime of the capital asset, and the agreement between the investor (i.e. Islamic bank) and the customer (i.e. lessee). During the period of the transaction, the ownership of the asset remains with the Islamic bank but the customer has the limited right to utilize this asset in return for rental fees. At the maturity of the contract, the asset is returned to the bank.

 Ijarah Wa Iqtinaa is equivalent to hire-purchase arrangement. The rental payments are recovered by the lesser throughout the contract period in series of periodical installments. At maturity, the lessee obtains ownership of the given asset after the amount of the contract is paid in full (Chapra, 1985). In our case, the Islamic bank purchases equipment and leases it to the customer. The latter makes a yearly payment that represents a portion of the total price of the equipment owned by the lessee when the entire amount of the contract is paid.

The advantages of finance leasing

In a leasing contract, there is a chance that the lessee misuses the leased asset as the lessor takes the total risk (Iqbal and Molyneux, 2005). However, the Islamic financial leasing, known by Al-Ijarah, has many features that may tackle this problem (Iqbal and Molyneux, 2005):

(I) The period of a leasing contract is sufficiently long to permit the lessor to amortize the cost of the asset with additional profit. The length of Al-Ijarah

generally covers the complete service life of a leased asset (Ariff et al., 2012).

(II) At maturity of a leasing contract (Al-Ijarah), the lessee has the option to buy the leased asset from the lessor at fair market value (Iqbal and Molyneux, 2005).

(III) The contract cannot be before the expiry date without the agreement of both participants.

(IV) In a case of default, the lessor is able to repossess the equipment without the need to a court order.

(V) The high level of depreciation associated with the equipment helps the lessor to decrease his tax obligations towards authorities.

(VI) The lessor has the right to sell the equipment during the term of a contract. Consequently, the new owner collects any leasing fees. This enables the lessor to get cash liquidity.Shari’ahallows only the trading of physical assets and, exceptionally, any monetary debts can be sold at their nominal values.

3. Equity-based: this is regarded as profit and loss sharing contract where investors

(i.e. financers) and entrepreneurs make an agreement to distribute any gain or loss resulting from the underlying project or business (DTZ, 2008). The profit or loss is shared based on the level of participants’ ownership or the portions of capital provided by each party (DTZ, 2008). The two most frequently exercised equity-based contracts are Al-Mudarabahand Al-Musharakah.

Al-Mudarabah

This method of Islamic financing is treated as a contract between two parties. In this transaction, the investor, known asrabb-al-mal, provides money to expertise, referred to as Mudareb, for the purpose of business and trading management (Iqbal and Molyneux, 2005). One of the major features of this contract is that any potential profit is split between the investor and the Mudareb according to a pre-agreed ratio (DTZ, 2008). However, uniquely the investor absorbs any resulted loss. (Saeed, 1996)

In Al-Mudarabahfinancing, the bank does not play a part in the management of the investment being financed. However, it sufficiently regulates the underlying business to assure that funds are used in compliance with Al-Mudarabah agreement. This is what has come to be termed two tiers Mudarabahin current Islamic literature. Out of the total funds assigned to the financed business, a share might be given for the complete agreed term, whereas another share might be available for a short period as an overdraft to counterbalance the funds being in route to Mudareb and to manage any potential or seasonal deficiency in liquidity (Chapra, 1985).

Al-Musharakah (partnership)

It is the second Islamic financing method and is based on profit and loss sharing (PLS) concept (Iqbal and Molyneux, 2005). In Arabic Literality, Al-Musharakah

means sharing, and its financial term is extracted from the Islamic legal wordshirkah. In fiqh, shirkah consist of two types: (i) shirkat al-mulk refers to joint ownership of two or more participants in a specific property. This kind of partnership may arise through either inheritance or joint purchase. (ii) Shirkah al 'aqd stands for a partnership and is originated through a contract. This contractual PLS generally exists for commercial reason and takes several forms such as partnership in the capital of the enterprise, partnership in labor and management, mutual goodwill or a combination of these elements. (Iqbal and Molyneux, 2005)

Al-Mudarabah differs from Al-Musharakah in at least one aspect. In the latter, the financier is allowed to engage in the management of the business in which he invested i. On the other hand, in Al-Mudarabah, the investor is unable to participate in managing the business or project that he is funding (Iqbal and Molyneux, 2005).

These two types of partnership have a common feature that is the provider of funds share the profits and tolerates any possible losses resulting from his investment. Based on this fact, these two methods of financing are referred as to profit and loss sharing method (Khan, 1995).

The fundamental principles regulatingAl-Musharakahare as follows:

(i) Profits, generated from the underlying business, are shared based on a pre-agreed proportion. However, no party is allowed to receive any fixed lump amount of profit .

(ii) Any possible loss should be shared in accordance with each party’s capital contribution.

(iii) All partners should generally contribute capital and management in the business. However, a partner may be exempt from participating in the management, but the profit should be distributed always according to the capital contribution of each partner.

(iv) All partners are unlimitedly liable.