What is PIK Interest?
The term “PIK interest” or payment-in-kind interest refers to the option that the borrower is provided to pay the interest on debt instruments or other securities in an alternative way instead of immediate cash payment. It can either be paid in the form of accumulated interest at the time of maturity or issue of additional securities to the bondholders or even at times equity. payment-in-kind interest is a very attractive option for companies that suffer cash crunch or are in the growth phase.
Explanation of PIK Interest
In the case of payment-in-kind interest, no cash interest is paid to the bondholder until the redemption or maturity of the debt instruments. Effectively, payment-in-kind interest provides the issuers the opportunity to postpone the cash outflow and in return, the issuers offer a higher rate of return on these debt instruments.
How to Model PIK Interest?
The below-mentioned steps need to be followed to model payment-in-kind interest:
- Firstly, determine the number of years for payment-in-kind interest for the particular debt instrument. Basically, it signifies the period during which there will be no cash interest payment.
- Next, build the debt schedule initially with the assumption of no payment-in-kind interest. The debt schedule should include the amortization and any other prepayment plans.
- Next, calculate the interest payment for the corresponding period based on the interest rate, opening balance, and outstanding balance.
Outstanding Balance = Opening Balance – Amortization – Prepayment
PIK Interest = Interest Rate * (Outstanding Balance + Opening Balance) / 2
- Next, add the accrued payment-in-kind interest to the outstanding principal at the end of the period, which will increase the ending balance of the debt instrument. So, the ending debt balance is revised which then becomes the opening balance for the next period.
Ending Balance = Outstanding Balance + PIK Interest
- Finally, the non-cash interest expense (PIK interest) has to be added back to the cash flow statement as the net income includes the payment of all interest expenses.
Examples of payment-in-kind interest are given below:
Let us take the example of a PIK loan of $15,000 as of January 2020. The loan has a payment-in-kind interest rate of 10% and it has to be repaid in equal annual installments over a period of 3 years. Determine the amount that has to be paid on 31st December 2022.
- Given, Opening balance 2020 = $15,000
- Amortization = $15,000 / 3 = $5,000
- Interest rate = 10%
Outstanding balance 2020 is calculated as
Outstanding balance 2020 = Opening balance 2020 – Amortization
- Outstanding balance 2020 = $15,000 – $5,000
- Outstanding balance 2020 = $10,000
payment-in-kind interest accrued for the year 2020 can be calculated as,
payment-in-kind interest 2020= (Opening balance 2020 + Outstanding Balance 2020) / 2 * Interest Rate
- PIK interest 2020 = ($15,000 + $10,000) /2 * 10%
- PIK interest 2020 = $1,250
Ending Balance at the end of 2020 can be calculated as,
Ending Balance 2020= Outstanding Balance 2020 + PIK Interest 2020
- Ending Balance 2020 = $10,000 + $1,250
- Ending Balance 2020 = $11,250
Outstanding Balance at the end of 2021 can be calculated as,
Outstanding Balance 2021 = Opening balance 2021 – Amortization
- Outstanding Balance 2021 = $11,250 – $5,000
- Outstanding Balance 2021 = $6,250
The payment-in-kind interest accrued for the year 2021 can be calculated as,
PIK Interest 2021 = (Opening Balance 2021 + Outstanding Balance 2021) / 2 * Interest Rate
- PIK Interest 2021 = ($11,250 + $6,250) /2 * 10%
- PIK Interest 2021 = $875
Ending Balance at the end of 2021 can be calculated as,
Ending Balance 2021 = Outstanding balance 2021 + PIK interest 2021
- Ending Balance 2021 = $6,250 + $875
- Ending Balance 2021 = $7,125
Outstanding Balance at the end of 2022 can be calculated as,
Outstanding Balance 2022 = Opening balance 2022 – Amortization
- Outstanding Balance 2022 = $7,125 – $5,000
- Outstanding Balance 2022 = $2,125
payment-in-kind interest accrued for the year 2022 can be calculated as,
PIK Interest 2022 = (OpenIng Balance 2022 + Outstanding Balance 2022) / 2 * Interest Rate
- PIK Interest 2022 = ($7,125 + $2,125) /2 * 10%
- PIK Interest 2022 = $462.50
Ending Balance at the end of 2022 can be calculated as,
Ending Balance 2022 = Outstanding Balance 2022 + Pik Interest 2022
- Ending Balance 2022 = $2,125 + $462.50
- Ending Balance 2022 = $2,587.50
Therefore, the amount that has to be paid on 31st December 2022 is $2,587.50.
Why PIK Interest is Appealing?
The payment-in-kind interest is very popular among borrowers, especially private equity professionals, for the following two reasons:
- It eases the interest expense burden of a project at its start and hence supports liquidity.
- Given lower debt repayment obligations, it enables the companies to borrow more to support business requirements.
How does PIK Interest Accrue?
The interest expense incurred during the period is not paid out in cash, rather it is added back to the outstanding balance, and hence the ending debt balance increases due to accrued interest expenses. Subsequently, the following year the interest rate is applied to the higher ending balance. Given the compounding nature, a PIK debt results in higher lifetime interest expenses as compared to a normal debt.
Some of the major advantages of payment-in-kind interest are as follows:
- It is suitable for borrowers who face liquidity issues owing to growing business operations. The cash available due to non-payment of interest can be used for various business needs.
- Most PIK loans are unsecured in nature, which means that they don’t have any collateral requirements. It is useful for borrowers.
- The lenders or investors of PIK debt instruments earn a relatively higher return as compared to that of normal debt instruments.
Some of the major disadvantages of payment-in-kind interest are as follows:
- The lenders don’t receive any cash income until redemption or maturity.
- The lenders are exposed to the risk of huge losses in case of default as these loans are mostly unsecured in nature.
So, it can be seen that despite the high-interest rates PIK loans enjoy high demand among the borrowers who are in the growth phase. However, the compounding nature of the interest increases the principal repayment at maturity.
This is a guide to PIK Interest. Here we also discuss the introduction and how to model payment-in-kind interest? along with advantages and disadvantages. You may also have a look at the following articles to learn more –