{"id":28157,"date":"2024-02-07T07:13:25","date_gmt":"2024-02-07T12:13:25","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=28157"},"modified":"2024-12-29T23:38:46","modified_gmt":"2024-12-30T04:38:46","slug":"pik-interest","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/pik-interest\/","title":{"rendered":"Paid-In-Kind (PIK) Interest: Full Tutorial for LBO Models"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Paid-In-Kind (PIK) Interest: Full Tutorial for LBO Models<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/pik-interest\/#PIK_Interest_vs_Cash_Interest_in_a_Leveraged_Buyout_Model\">PIK Interest vs. Cash Interest in a Leveraged Buyout Model<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/pik-interest\/#How_Does_PIK_Interest_Affect_the_Returns\">How Does PIK Interest Affect the Returns?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/pik-interest\/#PIK_Interest_and_Its_Impact_on_the_Returns_to_Lenders\">PIK Interest and Its Impact on the Returns to Lenders<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/pik-interest\/#Debt_Principal_Repayments_and_PIK_Interest\">Debt Principal Repayments and PIK Interest<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/pik-interest\/#PIK_Interest_and_Taxes\">PIK Interest and Taxes<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/pik-interest\/#PIK_Interest_Conclusions\">PIK Interest: Conclusions<\/a><\/li><\/ul><\/nav><\/div>\n\n\r\n\r\n\r\n<blockquote class=\"wp-block-quote is-layout-flow wp-block-quote-is-layout-flow\">\r\n<p><strong>PIK Interest Definition:<\/strong> Unlike normal Interest on Debt, PIK Interest (PIK = \u201cPaid-in-Kind\u201d) <em>accrues to the loan principal<\/em> rather than being paid in cash, which results in an increasing loan balance and higher interest payments in the future.<\/p>\r\n<\/blockquote>\r\n\r\n\r\n\r\n<p>PIK Interest is most common on \u201cjunior Debt\u201d instruments in <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/what-is-an-lbo-model\/\" target=\"_blank\" rel=\"noopener\">leveraged buyouts<\/a>, such as Subordinated Notes, Mezzanine, and Preferred Stock.<\/p>\r\n\r\n\r\n\r\n<p>These instruments are riskier than Senior Debt (Bank Loans and Revolvers), and, therefore, have higher interest rates and may have some type of equity option as well (please see our <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/debt-schedule\/\" target=\"_blank\" rel=\"noopener\">Debt Schedule tutorial<\/a> for more).<\/p>\r\n\r\n\r\n\r\n<p>PIK Interest essentially \u201ckicks the can down the road\u201d by reducing the company\u2019s <em>cash interest burden but ballooning its future Debt balance<\/em> \u2013 so that more needs to be repaid upon maturity or exit.<\/p>\r\n\r\n\r\n\r\n<p>Therefore, it is <strong>MOST<\/strong> appropriate for riskier companies with \u201cspotty\u201d cash flows, as it allows them to carry more Debt than they would ordinarily be able to do with cash interest.<\/p>\r\n\r\n\r\n\r\n<p>PIK Interest on Debt changes the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/cash-on-cash-return-vs-irr\/\" target=\"_blank\" rel=\"noopener\">money-on-money multiple<\/a> but <strong>NOT<\/strong> the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/how-to-calculate-irr-manually\/\" target=\"_blank\" rel=\"noopener\">internal rate of return (IRR)<\/a> for the lenders, assuming full repayment.<\/p>\r\n\r\n\r\n\r\n<p>This is because the IRR function assumes <em>full reinvestment of the proceeds at the IRR<\/em>, so an 8% compounding balance is equivalent to earning 8% in cash each year on the initial investment (for example).<\/p>\r\n\r\n\r\n\r\n<p>The private equity firm\u2019s IRR and multiples do not change much due to PIK Interest, but they may <strong>decrease slightly<\/strong> because of the \u201cballooning effect,\u201d which results in a higher Debt balance that must be repaid upon exit.<\/p>\r\n\r\n\r\n\r\n<p>You can use the Excel file below to try different scenarios and see the impact of PIK Interest:<\/p>\r\n\r\n\r\n\r\n<h3 class=\"wp-block-heading\"><strong>Files &amp; Resources:<\/strong><\/h3>\r\n\r\n\r\n\r\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/109-23-PIK-Interest-LBO.xlsx\" target=\"_blank\" rel=\"noopener\">Simple LBO Model &#8211; PIK Interest (XL)<\/a><\/p>\r\n\r\n\r\n\r\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/109-23-PIK-Interest-Slides.pdf\" target=\"_blank\" rel=\"noopener\">PIK Interest in LBO Models &#8211; Slides (PDF)<\/a><\/p>\r\n\r\n\r\n\r\n<h3 class=\"wp-block-heading\"><strong>Video Table of Contents:<\/strong><\/h3>\r\n\r\n\r\n\r\n<p><strong>0:00:<\/strong> Introduction<\/p>\r\n\r\n\r\n\r\n<p><strong>4:15:<\/strong> Part 1: PIK vs. Cash Interest in an LBO<\/p>\r\n\r\n\r\n\r\n<p><strong>7:39:<\/strong> Part 2: The Returns to Lenders<\/p>\r\n\r\n\r\n\r\n<p><strong>9:07:<\/strong> Part 3: Debt Principal Repayments and PIK<\/p>\r\n\r\n\r\n\r\n<p><strong>10:35:<\/strong> Part 4: PIK Interest and Taxes<\/p>\r\n\r\n\r\n\r\n<p><strong>12:12:<\/strong> Recap and Summary<\/p>\r\n\r\n\r\n\r\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"PIK_Interest_vs_Cash_Interest_in_a_Leveraged_Buyout_Model\"><\/span><strong>PIK Interest vs. Cash Interest in a Leveraged Buyout Model<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\r\n\r\n\r\n\r\n<p>Suppose you have a \u201cstandard\u201d leveraged buyout model for a deal done at 12x <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebitda\/\" target=\"_blank\" rel=\"noopener\">EBITDA<\/a> with 5x Debt \/ EBITDA and an 8% cash interest rate on the Debt.<\/p>\r\n\r\n\r\n\r\n<p>We\u2019ll look at the initial assumptions here and then modify them to use 100% PIK Interest so you can understand the changes:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1204\" height=\"822\" class=\"wp-image-28158\" title=\"Standard LBO Model\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070736\/01-Standard-LBO-Model.jpg\" alt=\"Standard LBO Model\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070736\/01-Standard-LBO-Model.jpg 1204w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070736\/01-Standard-LBO-Model-300x205.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070736\/01-Standard-LBO-Model-1024x699.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070736\/01-Standard-LBO-Model-768x524.jpg 768w\" sizes=\"(max-width: 1204px) 100vw, 1204px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<p>These are standard assumptions for a <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/cash-free-debt-free-basis\/\" target=\"_blank\" rel=\"noopener\">cash-free, debt-free<\/a> leveraged buyout.<\/p>\r\n\r\n\r\n\r\n<p>If we now assume <strong>100% PIK Interest<\/strong>, we need to make the following changes:<\/p>\r\n\r\n\r\n\r\n<h3 class=\"wp-block-heading\"><strong>Step 1: Still Record Interest on the Income Statement, But Note That It Is PIK or Non-Cash<\/strong><\/h3>\r\n\r\n\r\n\r\n<p>This interest is still based on the Interest Rate * Debt Balance; we use the beginning Debt balance in each period to avoid <a href=\"https:\/\/breakingintowallstreet.com\/kb\/excel\/circular-reference-excel\/\" target=\"_blank\" rel=\"noopener\">circular references<\/a>:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1210\" height=\"940\" class=\"wp-image-28159\" title=\"PIK Interest on the Income Statement\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070810\/02-PIK-Interest-Income-Statement.jpg\" alt=\"PIK Interest on the Income Statement\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070810\/02-PIK-Interest-Income-Statement.jpg 1210w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070810\/02-PIK-Interest-Income-Statement-300x233.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070810\/02-PIK-Interest-Income-Statement-1024x796.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070810\/02-PIK-Interest-Income-Statement-768x597.jpg 768w\" sizes=\"(max-width: 1210px) 100vw, 1210px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<h3 class=\"wp-block-heading\"><strong>Step 2: Add Back This PIK Interest on the Cash Flow Statement<\/strong><\/h3>\r\n\r\n\r\n\r\n<p>Like Depreciation, PIK Interest is a non-cash expense.<\/p>\r\n\r\n\r\n\r\n<p>So, just like with Depreciation, we reverse it on the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cash-flow-statement\/\" target=\"_blank\" rel=\"noopener\">Cash Flow Statement<\/a> or in the cash flow projections:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1215\" height=\"688\" class=\"wp-image-28160\" title=\"PIK Interest Addback on the Cash Flow Statement\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070836\/03-PIK-Interest-Addback.jpg\" alt=\"PIK Interest Addback on the Cash Flow Statement\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070836\/03-PIK-Interest-Addback.jpg 1215w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070836\/03-PIK-Interest-Addback-300x170.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070836\/03-PIK-Interest-Addback-1024x580.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070836\/03-PIK-Interest-Addback-768x435.jpg 768w\" sizes=\"(max-width: 1215px) 100vw, 1215px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<h3 class=\"wp-block-heading\"><strong>Step 3: Make This PIK Interest Increase the Debt Balance in Each Period<\/strong><\/h3>\r\n\r\n\r\n\r\n<p>To do this, we can modify the Debt formula so that it <strong>adds<\/strong> the PIK Interest in the period rather than just subtracting the Debt principal repayments:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1207\" height=\"558\" class=\"wp-image-28161\" title=\"PIK Interest Impact on Debt Balance\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070902\/04-PIK-Interest-Debt-Balance.jpg\" alt=\"PIK Interest Impact on Debt Balance\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070902\/04-PIK-Interest-Debt-Balance.jpg 1207w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070902\/04-PIK-Interest-Debt-Balance-300x139.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070902\/04-PIK-Interest-Debt-Balance-1024x473.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070902\/04-PIK-Interest-Debt-Balance-768x355.jpg 768w\" sizes=\"(max-width: 1207px) 100vw, 1207px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<h3 class=\"wp-block-heading\"><strong>Step 4: Make Sure All the Other Formulas Reflect These Changes<\/strong><\/h3>\r\n\r\n\r\n\r\n<p>For example, it\u2019s worth checking the final Debt balance in the exit calculations to ensure it has grown due to the PIK Interest.<\/p>\r\n\r\n\r\n\r\n<p>You should also ensure that the PIK Interest counts as a tax deduction and appropriately reduces Pre-Tax Income and <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/net-income\/\" target=\"_blank\" rel=\"noopener\">Net Income<\/a>.<\/p>\r\n\r\n\r\n\r\n<p>Finally, the PIK Interest Expense should <strong>grow over time<\/strong> because the Debt balance keeps increasing, and there are no principal repayments in this model (so far).<\/p>\r\n\r\n\r\n\r\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"How_Does_PIK_Interest_Affect_the_Returns\"><\/span><strong>How Does PIK Interest Affect the Returns?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\r\n\r\n\r\n\r\n<p>In this case, it <strong>reduces the IRR and multiple for the PE firm<\/strong> because it increases the Debt balance upon exit:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1148\" height=\"618\" class=\"wp-image-28162\" title=\"Cash vs. PIK Interest and Effect on Equity IRR\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070928\/05-Cash-vs-PIK-Interest-Equity-IRR.jpg\" alt=\"Cash vs. PIK Interest and Effect on Equity IRR\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070928\/05-Cash-vs-PIK-Interest-Equity-IRR.jpg 1148w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070928\/05-Cash-vs-PIK-Interest-Equity-IRR-300x161.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070928\/05-Cash-vs-PIK-Interest-Equity-IRR-1024x551.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07070928\/05-Cash-vs-PIK-Interest-Equity-IRR-768x413.jpg 768w\" sizes=\"(max-width: 1148px) 100vw, 1148px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<p>Cash flows are higher because there is no cash interest, <strong>but that doesn\u2019t help because the cash flows are not <em>distributed<\/em> during the holding period<\/strong>.<\/p>\r\n\r\n\r\n\r\n<p>Instead, the improved cash flows accumulate to the Cash balance, but <strong>the final Debt balance increases by more than the final Cash balance<\/strong>.<\/p>\r\n\r\n\r\n\r\n<p>As a result, the Net Debt upon exit is higher, which reduces the equity proceeds, the IRR, and the multiple.<\/p>\r\n\r\n\r\n\r\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"PIK_Interest_and_Its_Impact_on_the_Returns_to_Lenders\"><\/span><strong>PIK Interest and Its Impact on the Returns to Lenders<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\r\n\r\n\r\n\r\n<p>Just as the equity investors (the private equity firm) earn a multiple and IRR in a leveraged buyout, so do <strong>the lenders<\/strong> (the Debt investors).<\/p>\r\n\r\n\r\n\r\n<p>With PIK Interest rather than Cash Interest, <strong>the lenders\u2019<\/strong> <strong>multiple changes, but the IRR does not<\/strong> because of the \u201creinvest all proceeds <em>at<\/em> the overall IRR\u201d assumption.<\/p>\r\n\r\n\r\n\r\n<p>In other words, earning 8% cash interest per year on the initial balance is the same as earning no interest but getting back the Initial Balance * (1 + 8%) ^ 5 at the end of 5 years \u2013 according to the IRR function.<\/p>\r\n\r\n\r\n\r\n<p>Here\u2019s a comparison of the returns with Cash Interest vs. PIK interest:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1196\" height=\"658\" class=\"wp-image-28163\" title=\"PIK Interest and Returns to Lenders\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071004\/06-PIK-Interest-Returns-to-Lenders.jpg\" alt=\"PIK Interest and Returns to Lenders\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071004\/06-PIK-Interest-Returns-to-Lenders.jpg 1196w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071004\/06-PIK-Interest-Returns-to-Lenders-300x165.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071004\/06-PIK-Interest-Returns-to-Lenders-1024x563.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071004\/06-PIK-Interest-Returns-to-Lenders-768x423.jpg 768w\" sizes=\"(max-width: 1196px) 100vw, 1196px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Debt_Principal_Repayments_and_PIK_Interest\"><\/span><strong>Debt Principal Repayments and PIK Interest<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\r\n\r\n\r\n\r\n<p>Allowing for Debt principal repayments <strong>mostly helps the PE firm<\/strong> because instead of letting the Cash accumulate, the company <em>uses its Cash<\/em> to do something useful: repay Debt.<\/p>\r\n\r\n\r\n\r\n<p>However, this is true in all <a href=\"https:\/\/mergersandinquisitions.com\/lbo-modeling-test\/\" target=\"_blank\" rel=\"noopener\">LBO models<\/a> and <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/debt-schedule\/\" target=\"_blank\" rel=\"noopener\">Debt Schedules<\/a> and is not specifically related to the PIK Interest.<\/p>\r\n\r\n\r\n\r\n<p>If we modify the model to allow Debt principal repayments, the equity IRR and multiple change as follows:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1202\" height=\"838\" class=\"wp-image-28164\" title=\"Debt Principal Repayments and Impact on Returns\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071036\/07-Debt-Principal-Repayments-Returns.jpg\" alt=\"Debt Principal Repayments and Impact on Returns\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071036\/07-Debt-Principal-Repayments-Returns.jpg 1202w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071036\/07-Debt-Principal-Repayments-Returns-300x209.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071036\/07-Debt-Principal-Repayments-Returns-1024x714.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071036\/07-Debt-Principal-Repayments-Returns-768x535.jpg 768w\" sizes=\"(max-width: 1202px) 100vw, 1202px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<p>For the <strong>lenders<\/strong>, once again, the multiple changes \u2013 it <strong>decreases<\/strong> with early principal repayments \u2013 but the IRR stays the same because of the reinvestment assumption.<\/p>\r\n\r\n\r\n\r\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"PIK_Interest_and_Taxes\"><\/span><strong>PIK Interest and Taxes<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\r\n\r\n\r\n\r\n<p>In <em>most cases<\/em>, PIK Interest is tax-deductible, just like the Cash Interest Expense.<\/p>\r\n\r\n\r\n\r\n<p>That is why we show it as a deduction to calculate the Pre-Tax Income above and why the Deferred Tax line item in the cash flow projections is $0.<\/p>\r\n\r\n\r\n\r\n<p>However, there may be <strong>exceptions<\/strong> when the PIK Interest is attached to an \u201cequity-like security,\u201d such as <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/convertible-preferred-stock\/\" target=\"_blank\" rel=\"noopener\">convertible preferred stock<\/a> or <a href=\"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/convertible-notes\/\" target=\"_blank\" rel=\"noopener\">convertible notes for a startup<\/a>.<\/p>\r\n\r\n\r\n\r\n<p>These rules vary based on your region and the tax treatment of different security types there, so this point is case-by-case.<\/p>\r\n\r\n\r\n\r\n<p>To assume that PIK Interest is <strong>not<\/strong> tax-deductible, you can add a Deferred Tax line in the cash flow projections and set it equal to the following in each period:<\/p>\r\n\r\n\r\n\r\n<p>= \u2013 PIK Interest * Tax Rate<\/p>\r\n\r\n\r\n\r\n<p>Here\u2019s an example in this simple model:<\/p>\r\n\r\n\r\n<div class=\"wp-block-image\">\r\n<figure class=\"aligncenter\"><img decoding=\"async\" width=\"1198\" height=\"679\" class=\"wp-image-28165\" title=\"PIK Interest and Tax Effects\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071104\/08-PIK-Interest-Tax-Deductible.jpg\" alt=\"PIK Interest and Tax Effects\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071104\/08-PIK-Interest-Tax-Deductible.jpg 1198w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071104\/08-PIK-Interest-Tax-Deductible-300x170.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071104\/08-PIK-Interest-Tax-Deductible-1024x580.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/02\/07071104\/08-PIK-Interest-Tax-Deductible-768x435.jpg 768w\" sizes=\"(max-width: 1198px) 100vw, 1198px\" \/><\/figure>\r\n<\/div>\r\n\r\n\r\n<p>&nbsp;<\/p>\r\n\r\n\r\n\r\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"PIK_Interest_Conclusions\"><\/span><strong>PIK Interest: Conclusions<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\r\n\r\n\r\n\r\n<p>In short, PIK Interest is not a &#8220;make or break&#8221; topic in deals or <a href=\"https:\/\/mergersandinquisitions.com\/financial-modeling\/\" target=\"_blank\" rel=\"noopener\">financial models<\/a>; it affects the output, but not enough to shift an investment recommendation from &#8220;no&#8221; to &#8220;yes&#8221; (or vice versa).<\/p>\r\n\r\n\r\n\r\n<p>You should be familiar with this concept for <a href=\"https:\/\/mergersandinquisitions.com\/lbo-modeling-test\/\" target=\"_blank\" rel=\"noopener\">LBO modeling tests<\/a>, <a href=\"https:\/\/mergersandinquisitions.com\/private-equity-case-study\/\" target=\"_blank\" rel=\"noopener\">private equity case studies<\/a>, and credit case studies, but it&#8217;s much less important than understanding how to model Debt repayments, calculate the IRR, and other basic topics.<\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>Unlike normal Interest on Debt, PIK Interest (PIK = \u201cPaid-in-Kind\u201d) accrues to the loan principal rather than being paid in cash, which results in an increasing loan balance and higher interest payments in the future.<\/p>\n","protected":false},"featured_media":0,"template":"","class_list":["post-28157","biws_kb","type-biws_kb","status-publish","hentry","kb_category-leveraged-buyouts-and-lbo-models"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/28157","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=28157"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}