OEA, Inc., a manufacturer of aerospace and automobile products, at the end of their 1992 fiscal year-end had a $2.5 million line of credit, with the interest rate equal to the lending institution’s prime interest rate minus 0.5%. OEA is required to keep a compensating balance on deposit with the lending institution equal to 5% of the line of credit, plus add 5% of any usage. [Source: OEA 35th Annual Report—1992, page 14].

a. What do you need to consider in determining OEA’s cost of the line of credit?

b. How does the compensating balance affect OEA’s cost of borrowing?