DGF Corporation has come to you for some advice on how best to increase their leverage over time. In the most recent year, DGF had an EBITDA of $300 million, owed $1 billion in both book value and market value terms, and had a net worth of $2 billion (the market value was twice the book value). It had a beta of 1.30, and the interest rate on its debt is 8 percent (the Treasury bond rate is 7 percent). If it moves to its optimal debt ratio of 40 percent, the cost of capital is expected to drop by 1 percent.
a. How should the firm move to its optimal? In particular, should it borrow money and take on projects or should it pay dividends/repurchase stock?
b. Are there any other considerations that may affect your decision?