Updated July 11, 2023
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.
Bondholders can receive payment in accumulated interest at maturity or the issuance of additional securities or equity. Payment-in-kind interest is very attractive for companies that suffer a cash crunch or are in the growth phase.
The bondholder does not receive any cash interest payments until the debt instruments are redeemed or reach maturity in the case of payment-in-kind interest. Effectively, payment-in-kind interest allows the issuers 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?
To model payment-in-kind interest are as follows:
- Firstly, determine the 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 assuming 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.
- 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, becoming the opening balance for the next period.
- Finally, the non-cash interest expense (PIK interest) must be added to the cash flow statement as the net income includes paying all interest expenses.
Examples of payment-in-kind interest are as follows :
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 has to be repaid in equal annual installments over 3 years. Determine the amount that has to be paid on 31st December 2022.
- Given the Opening balance of 2020 = $15,000
- Amortization = $15,000 / 3 = $5,000
- Interest rate = 10%
The outstanding balance of 2020 calculates 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 calculate 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
The ending Balance at the end of 2020 can calculate as,
Ending Balance 2020= Outstanding Balance 2020 + PIK Interest 2020
- Ending Balance 2020 = $10,000 + $1,250
- Ending Balance 2020 = $11,250
The outstanding Balance at the end of 2021 can calculate 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 calculate 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
The ending Balance at the end of 2021 can calculate as,
Ending Balance 2021 = Outstanding balance 2021 + PIK interest 2021
- Ending Balance 2021 = $6,250 + $875
- Ending Balance 2021 = $7,125
The outstanding Balance at the end of 2022 can calculate 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 calculate 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
The ending Balance at the end of 2022 can calculate 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 is PIK Interest 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.
- Lower debt repayment obligations enable 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 interest rate is applied to the higher ending balance the following year. Given the compounding nature, a PIK debt results in higher lifetime interest expenses than a normal debt.
Some of the major advantages of payment-in-kind interest are as follows:
- It is suitable for borrowers facing liquidity issues due 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 than 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 borrowers 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 –