How does interest calculation differ for PIK debt versus cash-pay debt?
PIK debt (payment-in-kind) pays no cash interest — the interest expense is added to the principal and the balance grows. Cash-pay debt pays the interest out annually and the balance stays constant.
PIK preserves cash flow (no cash out), but costs at exit because the sponsor has to repay a larger balance. Compounding is significant — over 5 years at 5% PIK the balance grows by 27.6%, not the naive 25%.
PIK interest is just as deductible as cash interest — the interest deductibility limit (~30% of EBITDA in many jurisdictions) applies to both.
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| Year | Year-Begin | PIK | Year-End |
|---|---|---|---|
| 1 | $100.0m | $5.0m | $105.0m |
| 2 | $105.0m | $5.25m | $110.25m |
| 3 | $110.25m | $5.51m | $115.76m |
| 4 | $115.76m | $5.79m | $121.55m |
| 5 | $121.55m | $6.08m | $127.63m |
Compounding: (1.05)^5 − 1 = 27.6%. After 5 years the sponsor repays $127.63m instead of $100m — that is meaningfully less equity value at exit.
Calculating PIK wrongly as a simple multiplication (5% × 5 = 25%) instead of compound (27.6%) — over several years and at higher PIK rates (10–12%) the difference becomes significant.
Question: "Why would you choose PIK?"
Answer: "In years 1–2, when cash flow is still tight for servicing the senior. PIK is a cash-flow boost with a trade-off: higher total yield at exit. Standard in mezzanine, because the mezz coupon is high anyway (12–15%) and the PIK portion limits the cash burden in the early years"