A different way to confirm the relationship is to work with concrete numbers for one value of $L$ and see how the tag field changes when index bits move to associativity, rather than deriving both $M$ and $N$ abstractly at once.
Take $L=2$, so $K=2^2=4$, meaning the cache is 4-way set associative.
Step 1: As before, the block offset uses $\log_2(128)=7$ bits, and the cache holds $2^{23}/2^{7}=2^{16}$ total blocks (lines).
Step 2: For the direct mapped organisation, every line is its own set, so there are $2^{16}$ sets, needing 16 index bits, leaving$$ M = 32-16-7 = 9 \text{ bits of tag.} $$Step 3: For the 4-way set associative organisation with the same total capacity and block size, each set now holds 4 lines instead of 1, so the number of sets drops by a factor of 4:$$ \text{sets} = \frac{2^{16}}{4} = 2^{14} $$which needs only 14 index bits, 2 fewer than the direct mapped case (this matches $L=2$, the exponent of $K$, exactly). The freed 2 index bits are reassigned to the tag field so that tag + index + offset still totals 32 bits:$$ N = 32-14-7 = 11 $$Step 4: Compare $N$ and $M$.
$N-M = 11-9=2$, which is exactly $L$. So $N=M+2=M+L$ for this case, confirming option (A). Repeating the same steps for $L=1$ (2-way, sets $=2^{15}$, tag $=10=9+1$) and $L=3$ (8-way, sets $=2^{13}$, tag $=12=9+3$) gives $N-M=L$ again in both cases, so the relationship $N=M+L$ holds for every $L \in \{1,2,3\}$, not just one special case.$$ \boxed{N=M+L \ \text{(Option A)}} $$