Question

Explain one type of stock or hybrid (something between debt and stock) debt/equity security that a company uses to generate capital (you are addressing stock from the standpoint of equity, not as an investment).  Do not include basic common or preferred stock.  Variants of these are permitted though.  Note no duplication is allowed.  If you post a similar security as another student, credit will be given to the person who first posts.  Be sure to indicate accounting treatment, advantages & disadvantages of the security to each the issuer and the investor. 

Answer 1

A payment-in-kind (PIK) loan is a loan characterized by the fact that the payment of interest is made by a borrower in a deferred manner via the issuance of additional securities in lieu of paying interest in cash. The PIK loan enables the debtor to borrow without having the burden of a cash repayment of interest until the loan term is ended. PIK loans are more commonly used in leveraged buyout (LBO) transactions.

Depending on the case, the payment of interest may be made by another debt security, by the borrowing of a company’s securities, or by the issuance of stock options.

Upon maturity or refinancing of the loan, the total amount of the original loan plus the PIK notes issued in lieu of interest is repaid.

Advantages:

PIK loans are taken if a company has a liquidity problem, but has the capability to pay interest without paying in cash form. This is attractive to companies that want to avoid making current cash outlays for debt interest, such as during a management or leveraged buyout, or during a growth phase of the business. In order to protect their liquid assets, companies pay their liabilities with the help of new liabilities.

Disadvantages:

Though this type of credit has high growth potential, it is also very expensive and risky. Its interest is higher than other loans which is charged on a compound basis. PIK loans do not generate any cash flow before term; they are subordinated to conventional debt and mezzanine debt; and they are generally not based on assets. In addition, PIK loans are usually treated as unsecured credit. They tend to lead to large losses in the event of a default.

Accounting Treatment:

Accounting for PIK interest is straightforward, as the following journal entry demonstrates. What you might miss is that because PIK interest is a non-cash expense, it must be added back to net income to compute cash flow from operations.
Accounting for PIK interest
dr. Interest expense – PIK
cr. Debt.