A few questions about DAC basics

I have been making a few upgrades to my system and a friend suggested that I consider a decent used DAC as a good upgrade. He was not really sure if my CD/DVD player could use a DAC. He has very high end equipment and has separate transport/DAC etc. Guess he hasn't slummed it with off the shelf integrateds for awhile:)

Here is my system:

My system is:
Denon 5 ch DTS receiver (1801)
Parasound 1000 hca amp for the fronts only
RBH Sound 61SE fronts
RBH 661SE Center
Polk Audio S6’s for rears
ACI Titan Sub
Pioneer Elite DVD/CD player DV-C36
DH Labs T14 silversonic speaker wire
Tekline TL 2000 RCA interconnect from the Denon L/R preouts to the Parasound amp
Glass Toslink digital cable from Pioneer to Denon

My first question is can I add a DAC to this system?
I am assuming that the Pioneer d/a converter is what I am using now when I play CD's.
I have coax, optical and regular RCA outputs on the Pioneer.
Presently using a Glass Toslink to the optical in on the Denon. The Denon has two optical ins, a digital coax in, and several RCA analog pairs in, as well as additional Ext. in for 6.1.

My second question is more like several and I apologize if it is too simplistic. From reading these forums it seems that an external DAC is connected from a digital output from a CD or DVD player and then has outputs that go into the preamp, or in my case the Denon DTS receiver. Does the DAC connect to the preamp via analog in or digital in to the receiver?

I am also assuming that the DAC handles the digital signal in such a way as to improve or expand it? I read stuff about upsampling, etc and it sounds very interesting.

Another question I have is what happens when I am playing a DVD? This is where I start to get confused.When I am playing a DVD right now, the Pioneer sends the DTS or Dolby Digital signal to the Denon for processing into 5.1.
Does adding a DAC still allow this process? I mostly listen to music, but still want to watch movies in 5.1 dts or DD sometimes.

Finally, is this a reasonable upgrade for this modest of a system, and do you have any suggestions for around 3-500$ used?

Thanks for your input and patience. I have improved my system quite a bit from the info on these forums and appreciate the expertise here.