Final answer:
The correct answer is option B. If market interest rates increase, the cost of capital for a leveraged firm will tend to increase because the cost of debt financing becomes more expensive, affecting both new and existing debt.
Step-by-step explanation:
If market interest rates increase, then the cost of capital for a leveraged firm will tend to increase. This concept is grounded in the basic principles of financial markets where the laws of demand and supply play a critical role in determining interest rates and, by extension, the cost of capital.
When interest rates go up, the cost of debt financing becomes more expensive for firms. This includes not only new debt but also existing variable rate debt that may be tied to the market interest rate. Since a leveraged firm relies on borrowed funds, its cost of financing increases as rates rise. Therefore, higher market interest rates make it more costly for firms to service their debt, which in turn raises their overall cost of capital.
Moreover, an increase in interest rates typically leads to a decrease in the present value or market price of existing bonds, as observed with Ford's bonds when the market rate rose from 3% to 4%. This inverse relationship between interest rates and bond prices directly affects a leveraged firm's cost of capital.
Therefore, the correct answer to the student's question is: B. increase.