Bill of Exchange Example & Calculation

What is a Bill of Exchange?

A bill of exchange is a formal, negotiable instrument that orders one party (called the drawee) to pay a specified sum of money to another party (called the payee) at a future date or on demand. It is typically drawn by the seller (the drawer) on the buyer (the drawee) in the context of a commercial transaction. The bill is often used in international trade to ensure payment for goods or services delivered, providing a mechanism to guarantee that the seller will receive payment.

The fundamental elements of a bill of exchange include:

1. Drawer: The person or entity that creates and issues the bill of exchange, often the seller or creditor, who requests the payment.

2. Drawee: The party who is ordered to pay the specified sum of money. This is typically the buyer or debtor.

3. Payee: The person or entity who is entitled to receive the payment. The payee is often the drawer themselves, or it may be a third party designated by the drawer.

4. Amount: The specific sum of money to be paid by the drawee to the payee.

5. Due Date: The date on which the payment must be made, which could either be a fixed date or a specified period after the bill is presented.

6. Acceptance: Acknowledgment by the drawee that they agree to pay the specified amount as per the terms of the bill.

A bill of exchange is legally enforceable once it is signed by the drawer, and it represents a formal contract between the involved parties. The drawee’s acceptance or refusal of the bill, and the subsequent payment or non-payment, will determine how the transaction is completed.

How a Bill of Exchange Works

The process of a bill of exchange is relatively simple but requires precise steps to ensure it serves its purpose effectively. Here’s how a typical bill of exchange transaction works:

1. Creation and Issuance: The seller (drawer) creates the bill of exchange and issues it to the buyer (drawee), requesting payment for goods or services provided. The bill specifies the amount to be paid, the due date for payment, and the payee (who may be the seller or a third party).

2. Acceptance: Upon receiving the bill, the drawee either accepts or rejects it. If the drawee accepts the bill, they signify their agreement to pay the specified sum by signing the document. This act is called acceptance, and it legally binds the drawee to fulfill the terms of the bill.

3. Payment: On the due date, the drawee must make the payment either directly to the payee or, if the bill has been transferred, to the party holding the bill. If payment is made before the due date, it may be considered discounted or settled early.

4. Transfer of the Bill: In many cases, the payee (or the holder of the bill) may choose to transfer the bill to a third party, either through endorsement or negotiation. In this way, the bill becomes a transferable instrument, allowing businesses to use it as a form of payment or as collateral for a loan.

5. Settlement: Once the payment is made, the bill is considered settled, and the transaction is complete. If the drawee fails to make payment on the specified due date, the payee may have the right to take legal action for recovery of the debt.

Formula:
P = A / (1 + rt)
where:
P = Present value or principal
A = Face value of the bill
r = simple interest rate
t = time period (in years)

Example 1:
Calculate the present value of a bill of exchange for $35,500 drawn on 1 August 2011 for six months, given that the rate of simple interest is 10% per annum.
Solution:
t = 6 / 12 = 0.5 years
r = 10% = 0.1
P = A / (1 + rt) = 35,500 / (1 + 0.1 * 0.5) = 35,500 / 1.05 = $33,809. 52
Thus, the present value was $33,809. 52

Example 2:
A $20,000 bill of exchange has 73 days to run and the rate of simple interest is 8.25 percent per annum. What is the present value of the bill?
Solution:
t = 73 / 365 = 0.2 years
r = 8.25% = 0.0825
P = A / (1 + rt) = 20,000 / (1 + 0.0825 * 0.2) = 20,000 / 1.0165 = $19,675.36
Thus, the present value is $19,675.36

Next: Find the Principal in Simple Interest