## What is PIK Interest?

**PIK Interest**, or “Paid-in-Kind” interest, is a feature of debt that allows interest expense to be accrued for a set number of years, rather than be paid in cash in the current period.

In exchange for the deferred payout of the cash interest expense and the borrower retaining the cash for additional time, the debt principal coming due on the date of maturity increases.

Table of Contents

- How to Calculate PIK Interest
- How Does PIK Interest Work
- PIK Interest Formula
- How to Model the PIK Toggle
- Is PIK Interest Tax Deductible?
- How to Adjust Coverage Ratio for PIK Interest
- PIK Interest Calculator
- 1. Subordinated Notes Assumptions
- 2. PIK Interest Calculation Example
- 3. PIK Interest Analysis Example

## How to Calculate PIK Interest

PIK interest stands for “Paid-in-Kind” and is defined as the amount of interest expense charged by a lender which accrues towards the ending debt balance (principal).

Opting for PIK interest helps the borrower conserve cash, since the interest payments are pushed back to a later date.

Or in the case of preferred equity, the payout of cash dividends could be deferred for a set, agreed-upon duration.

The downside to the accrued interest, however, is that the total debt principal increases each year until maturity. In effect, this increases the interest expense due to growth in the principal amount.

With each passing period, the amount of accrued interest due can accumulate quickly due to the effects of compounding interest, which can significantly heighten default risk.

## How Does PIK Interest Work

PIK interest benefits the borrower by providing the optionality to push back cash interest payments on debt.

In turn, lenders are compensated by the periodic interest expense that accrues towards the ending balance (i.e. higher principal) until maturity.

The PIK rate also typically accrues at a rate higher than the cash interest rate in lieu of immediate cash compensation.

Each year after the issuance of a PIK security, the following factors impact the PIK interest expense:

- Initial Principal Amount
- “Rolled-Up” Interest

Certain debt instruments are structured with a partial PIK component.

For example, a loan with a 10.0% interest rate and 50.0% PIK component means half of the interest will be paid using cash, while the remaining half is accrued.

## PIK Interest Formula

To calculate the paid-in-kind interest, the formula consists of the PIK rate being multiplied by the beginning balance of the applicable debt security or preferred equity.

**PIK Interest =**PIK Interest Rate (%)

**×**Beginning PIK Debt Balance

Note that if there are mandatory repayments (i.e. principal amortization) associated with the debt, the formula must account for the repaid debt.

This would reduce the interest expense due and the end-of-period debt balance.

Whether the interest expense is paid in cash or PIK, the debt principal and accrued interest payments must be paid by maturity at the end of the borrowing term, per the lending agreement.

Hi, I don’t really understand why when the switch for circularity is on, the cash interest would turn 0. Company is still ought to pay for that cash interest amount every year despite the circularity right? So why you make it to 0 in the table above? Thanks in advance!

Hi Savio – the inclusion of the circularity switch is intended to manage the circular reference introduced via the average balance in the cash interest expense formula. There are instances where more complex financial models “break” (and become populated with error messages), so the method to “fix” that issue in… Read more »