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Cost of Equity Deteriorating Melco’s WACC

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Capital employment

Casino companies make extensive use of leverage to fund their capital expenditures. Return on invested capital (or ROIC) is an important metric that shows how effectively a company employs its capital. A higher ratio indicates more dollars of profits are generated by each dollar of capital employed.

A company’s ROIC should be higher than the company’s weighted average cost of capital (or WACC), otherwise it indicates that the company is not employing its capital effectively. ROIC is calculated by dividing earnings before interest taxes (or EBIT) by the employed capital.

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Higher WACC 

The cost of debt is cheaper than equity because interest on debt is tax deductible. Because Melco Crown Entertainment (MPEL) uses less debt relative to its equity, the company’s higher WACC results from a higher proportion of equity in its capital structure. The cost of equity is higher than debt because investment in equity is riskier than debt, so the equity holders require a risk premium.

The above chart shows that Melco Crown Entertainment’s ROIC has been lower than its weighted average cost of capital for most of the last three years. However, it’s important to note that MPEL’s WACC has been declining steadily since the beginning of the previous year, and its ROIC has been increasing since June 2014. This is a positive sign for the company. As of January 9, 2015, MPEL’s ROIC and WACC stood at 10.5% and 10.4%, respectively. 

ROIC provides a better indication of financial performance for casino companies such as Caesars Entertainment (CZR), Boyd Gaming (BYD), and MGM Resorts (MGM), with leverage in excess of 70% in their capital structure. These companies are components of ETFs such as the Consumer Discretionary Select Sector SPDR Fund (XLY).

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