An LBO capital structure includes a $150M PIK toggle note with a 9% coupon and a $300M TLB with a 6% cash interest rate and 2% mandatory amortization on the original $300M. In Year 1, the company elects to pay 4% cash interest on the PIK note and 5% via PIK. Free cash flow before debt service is $110M. Calculate the Year 1 end balance of the TLB under (a) this partial-PIK election and (b) a scenario where the company pays the full 9% in cash. Explain why the net debt at year-end is the same under both scenarios, but the composition of debt differs, and why a sponsor might prefer one over the other.
EliteModel answer
Answer:
TLB mandatory amortization = $300M × 2% = $6M.
(a) Partial-PIK election:
- Cash interest: TLB $18M (300×6%) + PIK cash $6M (150×4%) = $24M.
- FCF after cash interest = $110M - $24M = $86M.
- After mandatory $6M, sweep = $80M.
- Total TLB paydown = $86M.
- End TLB = $300M - $86M = $214M.
- PIK balance: $150M × 1.05 = $157.5M.
- Total net debt = $214M + $157.5M = $371.5M.
(b) Full cash election:
- Cash interest: $18M + $13.5M (150×9%) = $31.5M.
- FCF after interest = $110M - $31.5M = $78.5M.
- After mandatory $6M, sweep = $72.5M.
- Total TLB paydown = $78.5M.
- End TLB = $300M - $78.5M = $221.5M.
- PIK balance unchanged = $150M.
- Total net debt = $221.5M + $150M = $371.5M.
Net debt is identical because the cash flow saved by PIKing ($7.5M) exactly equals the increase in PIK principal, leaving total leverage unchanged. However, the composition shifts: the PIK election reduces the senior TLB balance faster, improving senior credit metrics, but increases the junior PIK obligation that will accrue further or be paid at exit. A sponsor may prefer the PIK election to preserve cash for operations or to accelerate paydown of a more restrictive senior tranche, but must weigh the growing PIK claim and its ultimate cost.
Follow-up pressure:
- "Under what circumstances would a sponsor be forced to pay the PIK in cash rather than toggle? What might the credit agreement specify?"
- "How would the presence of the PIK toggle affect the model's ability to handle the circular reference? Does the PIK interest create a new loop?"
- "If the PIK note has a call protection schedule similar to high-yield bonds, how would that influence the sponsor's decision to PIK versus pay cash in the early years?"
This is an advanced Superday-level question with a full model answer, part of IB Atlas's practice bank.
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