Rosewood is currently an all-equity firm. Its stock has a beta of 1.2. Rosewood management team is considering alternative financing. The firm can borrow unlimited amounts at an interest rate of 10% as long as it finances at its target capital structure, which calls for 40% debt and 60% common equity. The market risk premium is 8% and the risk-free rate is 3%. The firm faces a 40% tax rate.

1. Compute the cost of Rosewoods common equity under the target capital structure.

2. What is Rosewoods WACC if it adopts the target capital structure?

3. Do you think Rosewood should change from its current capital structure to the target capital structure? Explain your answer and relate this example to the theories on capital structure.