Theory and evidence of the impacts of Shariah debt screening on firm behaviour

Purpose - The paper aims to construct a theoretical framework to investigate whether the Shariah debt ratio screening in contemporary Shariah stock screening methodologies results in a bias towards a certain set of corporate financial behaviour for Shariah-compliant firms in the USA where access to a liquid Islamic debt market is non-existent. Design/methodology/approach - The paper extends the earnings valuation approach of Modigliani and Miller (1963) to theoretically asses the impacts of the 33% conventional debt limit on Shariah-compliant firms’ corporate financial behaviour. Then, supporting evidence is shown via empirical stylised facts of samples of Shariah-compliant firms in the USA. Findings - A theoretical floor limit to investment cut-off rates is found for US Shariah-compliant firms so that lesser projects pass their internal rate of return versus conventional firms. Subsequently, such 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. Research limitations/implications - The findings of this paper may not hold where access to a liquid Islamic capital market is present. Practical implications - Caveat emptor. These findings may be inconsistent to the investor’s risk preferences. Social implications - The findings suggests that Shariah-compliant firms are more conservative compared to their conventional counterparts. Originality/value - The paper is the first to introduce a theoretical framework to address consistent biasness in corporate financial behaviour due to the Shariah debt screening. It may prove useful for future academic studies as well as investment managers.