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Chapter 3 of 5 · 11 min

PIK interest and accreting balances

Interest that is added to the loan instead of paid: cash today, a bigger balance at exit.

By the end of this chapter you can
  • Compound a PIK note to its balance at exit
  • Work out how long a PIK note takes to double
  • Back out a PIK rate from the balance
  • Compare total debt at exit with the coupon paid in cash or in kind
1

The intuition

A student loan that charges interest while you study but asks for nothing until you graduate. The interest is added to what you owe, and next year's interest is charged on that larger amount. Nothing leaves your bank account, but the balance snowballs.

That is payment-in-kind (PIK) interest. A PIK toggle lets the borrower choose, each period, whether to pay the coupon in cash or add it to the loan. It keeps cash in the business when cash is tight, at the price of interest on interest.

The key idea

PIK balance = original × (1 + rate)^years. Compared with paying the same coupon in cash, PIK costs extra by exactly the interest on interest.

2

Why it works

  • The conventions here: the note compounds once a year and nothing is paid until exit. In the cash-pay alternative, the same coupon comes out of free cash flow that would otherwise repay senior debt. Free cash flow is flat; senior interest is left out because it is the same either way.
  • Accreted interest = balance at exit − original balance. Part of it is the simple coupons; the rest is interest on interest.
  • Cash-pay: senior is repaid more slowly, because the coupon is paid first, but the note stays at its original size.
  • PIK: senior is repaid faster, because all the cash flow goes to it, but the note compounds.
  • The difference in total debt at exit is exactly the interest on interest. It is small for a short hold at a moderate rate and grows quickly as either stretches.
  • In the accounts PIK interest is an expense that lowers net income, added back as non-cash on the cash flow statement, with the liability growing on the balance sheet.
  • When it makes sense: a temporary squeeze in a business expected to grow into the bigger balance. In a business that does not grow, the note eats the equity beneath it.
A $100M note at 12% for 5 years; $500M of senior debt; $60M of free cash flow a year
Balance at exit: 100 × 1.12^5176.2
Accreted: 176.2 − 10076.2 (60 simple, 16.2 interest on interest)
Years to double: ln 2 ÷ ln 1.126.1 (rule of 72: 6.0)
Cash-pay total debt: 500 − 5 × (60 − 12) + 100360.0
PIK total debt: 500 − 5 × 60 + 176.2376.2
Extra cost of PIK: 376.2 − 36016.2
3

The formulas

PIK balance after n years = B₀ × (1 + r)^n

The coupon is added to the loan every year.

Accreted interest = B₀ × (1 + r)^n − B₀

Everything the note has grown by.

Total debt at exit, cash-pay = senior − n × (FCF − B₀r) + B₀

The coupon slows senior paydown; the note stays put.

Total debt at exit, PIK = senior − n × FCF + B₀(1 + r)^n

Senior repaid faster; the note compounds.

Extra cost of PIK = accreted interest − n × B₀ × r

The interest on interest.

Rate = (Bₙ ÷ B₀)^(1/n) − 1; years to double = ln 2 ÷ ln(1 + r)

Run the compounding backwards.

4

Worked example

Compound the note, subtract the original, then split out the interest on interest.

Drawing the numbers…
5

See it move

Same note and the same company. Change the PIK rate. The timeline shows what happens over longer and shorter holds.

Drawing the numbers…
Try this
  • Raise the PIK rate. The note compounds faster, takes fewer years to double, and the extra cost of PIK grows.
  • Follow the timeline. The gap between the two bars is interest on interest, and it widens every year.
  • Compare the total-debt bars. Under PIK, senior debt is repaid faster, yet total debt ends higher, by exactly the interest on interest.
  • Set the rate to 12%. The rule of 72 says 72 ÷ 12 = 6 years to double; the curve shows the exact answer, 6.1.
6

Run it backwards

Same note, reversed: you know what was borrowed and what is owed now. What rate was it compounding at?

Drawing the numbers…

The balance grew by (1 + r) every year, so the growth factor is (1 + r)^n. Take the n-th root of the factor and subtract one.

It is how you read a company's accounts when only the opening and closing balances of a holdco note are given.

7

Traps

Adding simple interest to a PIK note.
Each year's coupon is charged on the bigger balance. Compound it: B₀ × (1 + r)^n.
Treating unpaid interest as free.
It is the most expensive money in the structure: a high rate, compounding, and a claim ahead of the equity at exit.
Forgetting that paying cash slows senior paydown.
The coupon comes out of the same cash flow. Compare total debt, not just the note.
Leaving PIK out of the income statement.
It is interest expense like any other. It is added back only on the cash flow statement.
Toggling in a business that is not growing.
The note compounds while the business stands still, so the equity beneath it shrinks.
8

Say it in the interview

The interviewer asks

“What is PIK interest, and when would a borrower use a PIK toggle?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • PIK balance = B₀ × (1 + r)^n.
  • PIK saves cash now, not cost.
  • Extra cost versus cash-pay = the interest on interest.
  • Use it for a temporary squeeze in a growing business.