Pik Interest Definition Example Top 4 Types Of Pik Loans

PIK Interest Definition

Types of PIK Loans

Below are the various forms of PIK loans according to the situations and financial goals:

True PIK –The obligation to pay interest in kind is predefined and compulsory in debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more.Pay if you can – In this type of debt, the borrower is supposed to pay interest in cash if certain predefined conditions are met. Still, if the predefined conditions are not fulfilled due to some situations, the borrower needs to pay interest in kind at a higher rate than payment in cash.Holdco PIK – HoldcoHoldcoA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary’s directions and policies.read more debts are usually unsecured obligations with a final maturity date. In case of default by the borrower, lenders do not have many options to recover these loans because of their unsecured nature. However, lenders can claim equity of the borrower’s business. These types of debts come behind the other priority debt claims like trade creditorsTrade CreditorsThe term “trade credit” refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front.read more, which means debtors can pay Holdco PIK debt after payment of senior/priority debts.Pay if you like – In this form of PIK debt, the borrower can make Payment of interest by cash or kind or a mix of money and style. This type of debt gives a choice to the borrower that they can make Payment in cash if they have surplus money, or at the same time, if a borrower wants to use this surplus cash to invest in business operationBusiness OperationBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company’s goals like profit generation.read more, he can opt for Payment in kind option. The interest rate will change according to their choice of Payment. This option is also known as PIK Toggle.

Calculation Example of PIK Interest

In this type of loan option, because a company is not paying interest on cash, therefore till maturity, every year, the interest gets added in debt, i.e., in principle. Therefore, more debt means the principal amount grows until the loan matures.

In the below example, M/s Stark Inc has taken PIK Notes of $ 10000 on 01.01.2013. These notes have a 10% PIK interest rate, which will mature at the end of 5 years.

In standard debt instrumentsDebt InstrumentsDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more each year, these notes will incur interests of $ 1000, which the company has to pay every year.

However, in PIK debt, instead of being required to repay the interest amount, the interest is added to the debt in kind that will increase the debt amount as a result in below example at the end of the first year, i.e., on 31.12.2013, the loan amount will increase to $ 11000, and this will continue to grow till maturity.

Features of PIK Debt/Interest

These loans are unsecured; it means no need to give any assets as collateral againstthese loans.The Maturity of the Payment in the kind loan is 5 years or more.RefinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more of payment in kind loans is not possible except for the initial year of the loan.These loans give some rights to lenders, which means the lender has a right to take a certain number of shares/securities in place of the loan at the time of maturity of the loan, or lenders can take Assets of the company if the company is not performing well.

Advantages of PIK Interest

PIK loans are taken if the company has a liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more problem but can pay interest. It means it is suitable for companies with a long operating cycleOperating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company’s inventories into cash.read more.In this option, there is no need to pay interest or dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more in the form of cash.PIK loans are usually for five years or more.PIK loans are generally unsecured loanUnsecured LoanAn unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more; there is no need for collateral.Such loans come with a warrant that gives the lenders a right to purchase a set number of securities at a fixed price.In this option, a company can invest the cash for other capital expendituresCapital ExpendituresCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more, acquisitionsAcquisitionsAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more, or growth.

Disadvantages of PIK Interest

The interest rate on PIK loans is higher than that of Non-PIK loans.Lenders do not get any cash inflow before maturity.Since no collateral is required, lenders may face massive losses in case of default of payment.

Conclusion

Despite the high-interest rate, payment in kind debt is always in demand because it is blood for companies with a cash crunch and companies in the growth phase. It gives an option to the borrower not to pay interest on cash immediately, which means they can utilize this cash amount for their business operation. Deferring cash interest payments looks attractive, but it increases the company’s principal paymentPrincipal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan’s original amount is directly reduced.read more at the end of maturity.

From the lenders’ point of view, PIK is the most suitable strategy when they believe that they are giving loans to the company, which will grow because lenders will get equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company’s balance sheet.read more in place of interest. Therefore, they do not require to expend any additional cash. Similarly, if there is a loss to the borrower, then the lender will get assets of the business.