Final answer:
Both firms will have the same return on equity because their return on assets is greater than the cost of debt.
Step-by-step explanation:
Return on equity (ROE) is a financial ratio that measures the profitability of a company by dividing its net income by its shareholders' equity. It indicates how much profit a company generates for every dollar invested by its shareholders. In this case, since both firms have the same level of earnings before interest and taxes (EBIT), the return on equity will depend on the capital structure and leverage of the firms.
Firm H, which is highly leveraged, has a higher proportion of debt in its capital structure. This means that it has a higher financial risk and higher interest expense compared to Firm C, which is conservatively leveraged. As a result, Firm H is expected to have a higher cost of debt. However, since the return on assets (ROA) is greater than the cost of debt for both firms, it implies that both firms have a positive return on equity.
Therefore, the answer is 3) Both firms will have the same return on equity because the ROA being greater than the cost of debt indicates that the firms are generating a return on their assets that is higher than the cost of financing those assets through debt.