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 EBIT of $1500 million, owed $2 billion in both book value and market value terms and had a net worth of $4 billion (the market value was twice the book value). It had a beta of 1.50, and the interest rate on its debt is 10% (the Treasury bond rate is 6%). ERP is 5% and tax rate is 40%

If it moves to its optimal debt ratio of 40%, the cost of capital is expected to drop by 2%.

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?

a.

Invest in new projects since return on invested capital < cost of capital

b.

Buyback shares of pay dividends since return on invested capital < cost of capital

c.

Buyback shares of pay dividends since return on invested capital > cost of capital

d.

Invest in new projects since return on invested capital > cost of capital