possible NPVs, i.e. the present value of cash flows from the expiry date onwards, which
will arise at the expiry date of the option which we assumed to be t3. As we move from t0 to
t3, the spread of the expected distribution of the NPVs at t3 becomes smaller, as uncertainty
on the project outcome wanes (and the value of reversibility is reduced as a consequence).
By the time we reach the expiry date, t3, there is hardly any uncertainty left: the distribution
collapses to a single value of the net present value of the project, which we assume to be
known. As we described earlier, the decision rule is that, if at t3 the present value of cash
flows onwards (NPV) exceeds the strike price, then the investment is carried out; otherwise
the investment is waived for ever (see Figure 8).
Figure 8 -Some truncation effects
Strike Price Truncation
Strike Price Truncation
20
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