Managers at the Physicians' Bone and Joint (PB&J) Clinic are considering whether to purchase a newly developed MRI machine that the manufacturer tells them will provide the basis for better diagnoses of foot and knee problems. The new machine is quite expensive but should last for a number of years. The clinic's CFO asked an analyst to work up estimates of the NPV of the investment under three different assumptions about the level of demand for its use (high, medium, and low). To carry out the analysis, the CFO assigned a 60 percent probability to the medium-demand state, a 25 percent probability to the high-demand state, and the remaining 15 percent to the low-demand state. After forecasting the demand for the machine based on the CFO's judgment and past utilization rates for MRI scans, the analyst made the following NPV estimates:
Demand State ______________ Probability of State _______ NPV Estimate
Low .................................. 15% ...........................$(300,000)
Medium .............................. 60% ............................$200,000
High .................................. 25% ............................$400,000
a. What is the expected NPV for the MRI machine based on the above estimates? How would you interpret the meaning of the expected NPV? Does this look like a good investment to you?
b. Assuming that the probability of the medium-demand state remains 60 percent, calculate the maximum probability you can assign to the low-demand state and still have an expected NPV of zero or higher.
c. How does knowing the maximum probability of realizing the low-demand state help you assess the project? (No calculations required.)