Final answer:
The after-tax cost of debt is used in WACC calculations to reflect the tax savings from interest deductions. The cost of retained earnings is typically lower than the cost of new equity issuance due to the avoidance of issuance costs and dilution of existing ownership.
Step-by-step explanation:
The after-tax cost of debt is relevant for calculating the Weighted Average Cost of Capital (WACC) because interest on debt is tax-deductible, which reduces the company's taxable income and thus its tax liability. Therefore, the effective cost to the company is less than the nominal interest rate paid to debt holders. When calculating WACC, which measures a firm's cost to borrow capital, the after-tax cost of debt is used to accurately reflect the lower effective cost.
There is a difference between the cost of retained earnings and the cost of issuing new equity because issuing new equity involves additional costs such as underwriting fees, legal costs, and other administrative expenses. Additionally, new equity issuance can dilute existing shareholders' ownership, potentially reducing their control and claim on future earnings. Contrarily, using retained earnings as a source of capital avoids these issues, although it still has an opportunity cost, measured by what those earnings could have generated if they were reinvested elsewhere.