Final answer:
The question involves financial leverage and its effect on return on equity (ROE). Firm H, being highly leveraged, will generally achieve a higher ROE than Firm C (which is conservatively leveraged) when the return on assets (ROA) is greater than the cost of debt. This is due to the leverage effect, assuming consistent earnings and cost of debt conditions.
Step-by-step explanation:
The student's question is related to the concept of financial leverage and its impact on a firm's return on equity (ROE). When firms borrow money, they can do so either through banks or by issuing bonds. The ROE, which measures a firm's profitability from the shareholders' perspective, can be greatly affected by the amount of debt or leverage a firm uses.
Considering that firms C and H have the same earnings before interest and taxes (EBIT) and that the return on assets (ROA) is greater than the cost of debt, the effect of financial leverage comes into play. As Firm H is highly leveraged compared to conservatively leveraged Firm C, it means that Firm H has more debt relative to its equity. Since the cost of debt is lower than the ROA, the use of additional debt will amplify the returns for Firm H's equity holders, as long as the interest rate on borrowed funds remains less than the return that the firm earns on its assets.
Therefore, the correct answer is B. Firm H will have a higher return on equity than Firm C, due to the higher level of financial leverage and the assumption that the return on assets exceeds the cost of debt. This is known as the leverage effect, where the use of borrowed funds can amplify the returns on equity when the returns on investment exceed the cost of borrowing.