Interview Question - PIK Interest Accounting

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.

Paid In Kind Interest Impact on the 3 Financial Statements

We review below the impact of a $100mm PIK note with 10.0% interest.

Income Statement:

  • Interest expense must be recorded (regardless of the fact that it is not being paid out in cash - interest expense up $10
  • More interest expense results in a income tax shield of 4 dollars assuming a 40% tax rate. This results in a tax expense that is lower by $4
  • Net Income is down by $6

Statement of Cash Flows

  • Net Income is down by $6 from the income statement
  • PIK interest is then added back as it is not a cash expense (paid out in the form of additional debt)
  • Net Cash is up by $4

Balance Sheet

  • Assets side of the balance sheet is up by $4 due to the cash flowing in from the statement of cash flows
  • Liabilities side of the balance sheet is up by $10 assuming that there is additional debt principal issued for the interest payment
  • Shareholder's Equity is down by $6 flowing in from net income on the income statement

What is Payment-In-Kind Interest?

"Paid-in-Kind" or "Payment in Kind" interest is a type of security that pays its interest or dividend in the form of a more of the principal form (IE bond principal or equity). This is preferred for companies that do not have / want to use cash to make payments to investors.

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Agree with this. Just to note, the below is a nuance that really shouldn’t matter for interview questions.
 

For PIK, there’s a difference between being accrued and capitalized (when it actually hits the loan balance). When it’s accruing, it’s treated like cash interest (I.e. hits net income and is backed out as interest payable in the working capital section of the cash flow statement). The day that the interest capitalizes, it flows out of interest payable (reduction in non cash liability) and into PIK interest on the cfs (increase in non cash liability). At that point, the actual balance of the debt on the BS should increase.

 

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?

 

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

​* http://www.linkedin.com/in/numicareerconsulting
 
Best Response

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.

 

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.

 

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

 
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.

 

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.

 

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...

 

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

 

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.

"They are all former investment bankers that were laid off in the economic collapse that Nancy Pelosi caused. They have no marketable skills, but by God they work hard."
 

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.

 

I know that the usual PIK interest from a debt instrument would end up on the IS as an expense, and then would be added back in the CFS, but is it the same for a preferred PIK dividend? I was thinking that as a dividend, it wouldn't be expensed.

 

Could someone please clarify how PIK interest will flow through the three statements, if I start my CF statement at EBITDA ? The bank I am interviewing with prefers that presentation of CF and I heard they ask you to model PIK in an LBO. Since its non-cash and below the EBITDA line, would it not appear on the CF in that case at all? Then I would effectively have to add it to the balance sheet direct from the Debt Schedule?    

 

PIK interest is included in total interest expense. So in your CF statement, you would subtract interest, but since PIK is non-cash you would have another line item and add back the PIK interest portion. On the BS, the PIK note would increase each year by the PIK % (since the interest accrues). 

 

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