9/26/08

During the technical interview portion, I was asked how a PIK note would flow through all the statements. Let me know your opinion on the below answer. Let's assume that it is a $100mm note with 10.0% interest.

Income Statement
The interest from the note drives up your interest expense costs by $10mm
That would create a tax shield and tax would decrease by $4mm, assuming a 40.0% tax rate
Net income would be lowered by $6mm

Cash Flow Statement
Net income would be lowered by $6mm
The $10mm in interest from the PIK note would be added back since it is not paid out in cash
The net change in cash would be an increase of $4mm

Balance Sheet
Cash would be increased by $4mm
Interest payable would increase by $10mm
Retained earnings would decrease by $6mm

Comments (33)

9/26/08

you wouldn't classify the PIK as interest payable - the face value of the security grows by 10%

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2/28/09

I'm pretty sure even though the PIK interest is non-cash, it shows up as an interest expense during the year accrued. The revenues generated during the year required the PIK expense, so regardless of when or how it will finally be settled in cash, the expense should be recognized as it accrues.

1/17/13

mlamb93:
you wouldn't classify the PIK as interest payable - the face value of the security grows by 10%

So this is correct?

3/1/09

True. PIK loans have no immediate interest payable. In other words, cash is not affected in terms of PIK interest payments until repayment of the principal. But then what is cash interest and PIK interest?

I know PIK interest (a very small fraction of the total interest) is added onto the principal. But what is cash interest? How do they affect the 3 statements?

3/6/09

Cash interest just flows through the statements as any other cash item...

And the way that ibanker26 described the accounting for PIK interest is correct

3/9/09

All mentioned by ibanker is correct except BS changes. mlamb93 got this right...interest payable remains unchaged and the loan principal on the balance sheet increases by 10mm.

Think of PIK as interest that was "paid" to and simultaneously "borrowed" from the lender (of course, no cash is exchaged). The end result is an increase in the lender's principal position in the company.

3/10/09

Actually, I agree with naija. I didn't read the original poster's response carefully enough.

1/17/13

Face value of debt goes up. There's no impact to "interest payable". It still shows up as an expense in your income statement.

1/22/13

Connecticut Yankee:
Face value of debt goes up. There's no impact to "interest payable". It still shows up as an expense in your income statement.

Great, thanks for clarifying.

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1/22/13

P&L = Int Exp of 10
Tax Shield of 4

As a result Retained Earnings down by 6

But PIK Borrowing goes up by 10

So on liabilities side the difference is 4

Now the tax shield of 4 increases cash by 4

B/S now balances

1/22/13

The correct method would be to create a bi-annual model with a debt and interest schedule that rolls up into the model. If the tranche of debt that PIKs isn't material to the overall capital structure then it may not make sense to spend the time building a bi-annual model, but it is up to you.

1/22/13

how is pik different than regular interest?

1/22/13

[x]

1/22/13

I'm assuming that your model is already quarterly, and you're trying to add a tranche of PIK debt that pays interest biannually?

If that's the case, the question is really what happens to the debt in a change-of-control situation mid-period. So if interest is paid on June/Dec basis and the company is sold in March, do the debt-holders get a half-period accrual? If you're modeling this for an actual deal or for an existing tranche debt, that information would be somewhere in the debt docs. There's probably a prepayment penalty too.

1/22/13

Lets say you have pik interest of $10mm.

I/S interest expense of $10, NI goes down by $6 (assuming 40% tax rate)

CFS reverse out the $10mm of non cash interest expense in cash flow from ops (cash up by $4)

B/S - cash is up by 4, your piking debt is up by 10 and retained earning is down by 6

1/22/13
tuaj:

I have two questions about PIK equity in an LBO.

- IS: No change
- CF: Add back amount accreted, which would increase your cash balance

You mention 'adding back' the amount accreted, but what are you adding it back to with no change in the income statement?

The PIK interest is accounted for on the IS the same way as a preferred dividend. Net Income - Preferred Dividends (PIK or otherwise) = Net Income Available to Common. You hen add back the non-cash amount of any dividends (the PIK amount) to Net Income on the CF. This causes a reduction in Retained Earnings (lower Net Income) and an increase in the Preferred balance.

Not sure I understand the second question.

Hope this helps.

1/22/13

Agree with SCLID on the first question.

On #2

You don't account for Holdco's debt in Opco's financials... OpCo only pays a dividend (known as dividend leakage) to holdco so it can meet its interest obligations (amounts governed by restricted payments clauses in the credit agreements). As far as opco is concerned, it is not a direct borrower, only an guarantor and as such, it does not have to account for the parent company's debt.

You only see these two (opco & holdco) in TopCo (or holdco, whatever the case may be) when it consolidates the financials for all subsidiaries.

1/22/13

Thanks for the replies guys, really appreciate it.

What if you have PIK preferred that isn't paying dividends, but just accreting? In that case you don't have dividends, so from an accounting sense, would you increase interest income to reduce NI?

1/22/13

Any PIK preferred accreating means its adding its dividend "in kind", not that it's not paying a dividend at all... It can never accreate without affecting Net Income to Common otherwise your balance sheet will never balance...

1/22/13

got it. makes sense now. Thanks SCLID and MezzKet!!

1/22/13

Accounting-wise, treatment is the same as any noncash expense. Interest is based on principal, which increases every year as the interest payments are rolled onto the principal. So say at the outset you have $100 in PIK debt at 10%, year one the interest expense is $10, principal goes up to $110. Year two interest expense is $11, etc...

1/22/13

IS - Interest expense increases by the PIK coupon (but it is non-cash)
CF - Add back non-cash interest expense
BS - PIK note principal increases by PIK coupon

And PIK interest on year 2 is calculated off PIK balance at the end of year 1

1/22/13

PIK interest will show up on IC because it is accrued during the year. It is then added back on the CF because PIK interest is not paid, but rather the interest is added to the original principal, thus increasing the level of debt on the BS, and the entire loan will be paid off at maturity.

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1/22/13

Got it.....thanks.

1/22/13

1) PIK just adds to the principal amount each month/period, and is expensed on the IS, but added back to CFO (non-cash item). So if you have $100,000 note with 10% PIK, year 2's starting balance for the note would be $110,000 on the BS and the PIK expense would then be $11,000 (@10%).

2) Do you have an lbo model built or do you have a template? Much easier to do if everything is laid out.

What you have sounds somewhat right and no, you wouldn't include the seller note in the IRR of the equity component. Keep them isolated. If they ask for the net to the seller, then you add the interest from the note, equity value, dividends, etc.

1/22/13
1/22/13
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