Project finance has gained popularity over the last few decades and people use it to acquire assets and properties that are somehow expensive and beyond the reach of commoners. Project finance does not differ so much from other forms of financing only that it caters for development such as properties, infrastructure and other forms of tangible assets.
Islamic finance applies Mudarabah contract for project finance. Such a contract has two parties where one is the financier (the financial institution) and the customer (who is the fund manager). The IFI provides the finances needed for this investment and the fund manager puts his or her expertise in running the investment.
How Mudarabah differs from conventional project finance
Let us take for instance when you want finance to acquire a house. Conventional banks will give you a mortgage to acquire a house that is already built. Mudarabah contracts mostly deal with projects that have not yet started. The fund manager may be owning a piece of land and then seeks help from the IFI to build the house.
Profit and loss sharing
An investment can either generate profit and losses and thus the parties must agree on how to share this. In most cases, the financial institution contributes 100% of the finances needed for this investment. However, there can be other arrangements if the fund manager has some cash. The two parties agree on how they will share profits from this venture and put it in the agreement. The IFI gets profits for risking the money while client gets payment for time commitment and management of the investment. However, when there are losses, the IFI will bear all of them if it had financed the project fully.
Termination of the contract
Mudarabah contracts do not run forever but seek to fulfill a certain purpose. Let us take for instance when it was building a house. Once the project is over, both parties can decide to sell the property and share the proceeds. The client also has an option to buy the property at the existing market value. The two can then decide on how the client will pay for the project which can either be on cash basis or installments.
Why Islamic project financing is better than conventional project financing
We shall take an example of house financing to understand this concept better. It is easy to budget when you get financing from an IFI because they do not charge interest rather an agreed fee that you know before you sign the contract. The fee will remain the same irrespective of whether there is inflation rate which pushes interest rates up or not.
Conventional mortgages, on the other hand, will charge you floating interest based on the economic situation. They are very cunning because they are fast to raise the interest rates when inflation is high while they are slow to lower when the economy is performing well.
What happens when you settle your payments earlier than expected? Remember that in Islamic finance you are a partner. You can thus receive a share of future profits even if you settle your payments earlier than agreed as long as the stipulated time of the first contract has not lapsed.