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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.

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Explanation

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?

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.

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, becoming the opening balance for the next period.

Ending Balance = Outstanding Balance + PIK Interest

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

Examples of payment-in-kind interest are as follows :

Example #1

Let us take the example of a PIK loan of $15,000 as of January 2023. 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 2023.

Solution:

Given the Opening balance of 2023 = $15,000

Amortization = $15,000 / 3 = $5,000

Interest rate = 10%

The outstanding balance of 2023 calculates as

Outstanding balance 2023 = Opening balance 2023 – Amortization

Outstanding balance 2023 = $15,000 – $5,000

Outstanding balance 2023 = $10,000

payment-in-kind interest accrued for the year 2023 can calculate as,

payment-in-kind interest 2023= (Opening balance 2023 + Outstanding Balance 2023) / 2 * Interest Rate

PIK interest 2023 = ($15,000 + $10,000) /2 * 10%

PIK interest 2023 = $1,250

The ending Balance at the end of 2023 can calculate as,

Ending Balance 2023= Outstanding Balance 2023 + PIK Interest 2023

Ending Balance 2023 = $10,000 + $1,250

Ending Balance 2023 = $11,250

Outstanding Balance 2023 = Opening balance 2023 – Amortization

Outstanding Balance 2023 = $11,250 – $5,000

Outstanding Balance 2023 = $6,250

The payment-in-kind interest accrued for the year 2023 can calculate as,

PIK Interest 2023 = (Opening Balance 2023 + Outstanding Balance 2023) / 2 * Interest Rate

PIK Interest 2023 = ($11,250 + $6,250) /2 * 10%

PIK Interest 2023 = $875

The ending Balance at the end of 2023 can calculate as,

Ending Balance 2023 = Outstanding balance 2023 + PIK interest 2023

Ending Balance 2023 = $6,250 + $875

Ending Balance 2023 = $7,125

The outstanding Balance at the end of 2023 can calculate as,

Outstanding Balance 2023 = Opening balance 2023 – Amortization

Outstanding Balance 2023 = $7,125 – $5,000

Outstanding Balance 2023 = $2,125

payment-in-kind interest accrued for the year 2023 can calculate as,

PIK Interest 2023 = ($7,125 + $2,125) /2 * 10%

PIK Interest 2023 = $462.50

The ending Balance at the end of 2023 can calculate as,

Ending Balance 2023 = Outstanding Balance 2023 + Pik Interest 2023

Ending Balance 2023 = $2,125 + $462.50

Ending Balance 2023 = $2,587.50

Therefore, the amount that has to be paid on 31st December 2023 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.

Advantages

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.

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.

Conclusion

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.