SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549



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FORM 20-F

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005
Commission File No. 0-11456



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ELRON ELECTRONIC INDUSTRIES LTD.(Exact name of Registrant as specified in its charter and
translation of Registrants name into English)



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ISRAEL
(Jurisdiction of incorporation or organization)

3 Azrieli Center, 42nd Floor,
Tel-Aviv, Israel 67023
(Address of principal executive offices)



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Securities registered or to be registered pursuant to
Section 12(b) of the Act:

Not Applicable
(Title of Class)


Securities registered or to be registered pursuant to
Section 12(g) of the Act:


Ordinary Shares, nominal value 0.003
New Israeli Shekels per share
(Title of Class)


Securities for which there is a reporting obligation
pursuant to Section 15(d) of the Act:


Not Applicable
(Title of Class)




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Indicate the number of outstanding shares of each of the
issuers classes
of capital or common stock as of the close of the period covered by the Annual
Report: 29,483,455

Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.

Yes o   No
x

If
this report is an annual or transition report, indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934.

Yes o   No
x

Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing requirements
for the past 90 days:

Yesx   Noo

Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of accelerated
filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check
one):

|                            |                     |                        
|--------------------------- | ------------------- | -----------------------
|Large accelerated filer
  o | Accelerated filer x | Non-accelerated filer o

Indicate
by check mark which financial statements the registrant has elected to follow:

Item 17oItem 18x

If
this is an annual report, indicate by check mark whether the registrant is a
shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o   No
x

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TABLE
OF CONTENTS

|          |                                                                                |       
|--------- | ------------------------------------------------------------------------------ | ------
|          |                                                                                | Page  
|          |                                                                                |       
|PART I    |                                                                                |       
|          |                                                                                |       
|Item 1.   | Identity of Directors, Senior
  Management and Advisers                        | 3     
|          |                                                                                |       
|Item 2.   | Offer Statistics and Expected
  Timetable                                      | 3     
|          |                                                                                |       
|Item 3.   | Key Information                                                                | 3-21  
|          |                                                                                |       
|Item 4.   | Information on the Company                                                     | 21-47 
|          |                                                                                |       
|Item 4A.  | Unresolved Staff Comments                                                      | 48    
|          |                                                                                |       
|Item 5.   | Operating and Financial Review and
  Prospects                                 | 48-73 
|          |                                                                                |       
|Item 6.   | Directors, Senior Management and
  Employees                                   | 73-86 
|          |                                                                                |       
|Item 7.   | Major Shareholders and Related Party
  Transactions                            | 86-90 
|          |                                                                                |       
|Item 8.   | Financial Information                                                          | 91-92 
|          |                                                                                |       
|Item 9.   | The Offer and Listing                                                          | 92-93 
|          |                                                                                |       
|Item 10.  | Additional Information                                                         | 94-113
|          |                                                                                |       
|Item 11.  | Quantitative and Qualitative
  Disclosures about Market Risk                   | 113   
|          |                                                                                |       
|Item 12.  | Description of Securities Other than
  Equity Securities                       | 113   
|          |                                                                                |       
|PART II   |                                                                                | 113   
|          |                                                                                |       
|Item 13.  | Defaults, Dividend Arrearages and
  Delinquencies                              | 113   
|          |                                                                                |       
|Item 14.  | Material Modifications to the Rights
  of Security Holders and Use of Proceeds | 113   
|          |                                                                                |       
|Item 15.  | Controls and Procedures                                                        | 113   
|          |                                                                                |       
|Item 16.  | [Reserved]                                                                     | 114   
|          |                                                                                |       
|Item 16A. | Audit Committee Financial Expert                                               | 114   
|          |                                                                                |       
|Item 16B. | Code of Ethics                                                                 | 114   
|          |                                                                                |       
|Item 16C. | Principal Accountants Fees and
  Services                                     | 114   
|          |                                                                                |       
|Item 16D. | Exemptions from the Listing
  Standards for Audit Committees                   | 115   
|          |                                                                                |       
|Item 16E. | Purchases of Equity Securities by
  the Issuer and Affiliated Purchasers       | 115   
|          |                                                                                |       
|PART III  |                                                                                |       
|          |                                                                                |       
|Item 17.  | Financial Statements                                                           | 115   
|          |                                                                                |       
|Item 18.  | Financial Statements                                                           | 115   
|          |                                                                                |       
|Item 19.  | Exhibits                                                                       | 116   

2

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For
  the purpose of this Annual Report on Form 20-F, the terms group companies
  and companies in our group collectively refer to subsidiaries, affiliated
  and other companies in which we have direct or indirect holdings through our
  wholly-owned subsidiaries, Elbit Ltd., or Elbit, and DEP Technology Holdings
  Ltd., or DEP, including DEPs subsidiary, RDC Rafael Development Corporation
  Ltd., or RDC. Our ownership interests in our group companies reflected in this
  Annual Report represent our beneficial ownership interests in the outstanding
  shares of these companies as of May 31, 2006 unless otherwise expressly indicated.
  Our beneficial ownership interests in the preferred shares of these companies
  are represented on an as-converted-basis. We have also indicated our direct
  holding and our share in the holding of RDC in a group company where applicable.
  The references in this Annual Report to balance sheet items are as of December
  31, 2005, unless otherwise indicated.

Throughout
this report we discuss certain information regarding Given Imaging Ltd. and
Partner Communications Ltd., companies in our group which have securities
registered with the Securities and Exchange Commission in the United States
(the SEC). Our discussions of these Companies are qualified in their entirety
by the reports these companies file with the SEC which are posted on the SECs
website at www.sec.gov. Please see these reports for additional information on
these companies.

Forward-Looking
Statements

This
Annual Report on Form 20-F includes certain forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended.
The use of the words projects, expects, may, plans or intends, or
words of similar import, identifies a statement as forward-looking. There can
be no assurance, however, that actual results will not differ materially from
our expectations or projections. Factors that could cause actual results to
differ from our expectations or projections include the risks and uncertainties
described in this Annual Report under Item 3 titled Risk Factors as well as
those discussed elsewhere in this Annual Report and in our other filings with
the SEC. Any forward-looking statements contained in this Annual Report speak
only as of the date of this Annual Report, and we caution investors and
potential investors not to place undue reliance on these statements. We
undertake no obligation to update or revise any forward-looking statements. All
subsequent written or oral forward-looking statements attributable to us or
persons acting on our behalf are expressly qualified in their entirety by the
Risk Factors.

PART I

|                  |                                                        
|----------------- | -------------------------------------------------------
|Item 1.           | Identity of Directors, Senior
  Management and Advisers
|                  |                                                        
|Not
  Applicable.
|                  |                                                        
|Item 2.           | Offer Statistics and Expected
  Timetable              
|                  |                                                        
|Not
  Applicable.
|                  |                                                        
|Item 3.           | Key Information                                        

3

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|   |                        
|-- | -----------------------
|A. | Selected Financial Data

The
following selected financial data for the years ended December 31, 2001,
2002, 2003, 2004 and 2005 are derived from our audited consolidated financial
statements of which the financial statements as of December 31, 2004 and 2005,
and for each of the years ended December 31, 2003, 2004 and 2005 appear later
in this Form 20-F. The audited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles in the
United States, or U.S. GAAP.

CONSOLIDATED
STATEMENTS OF OPERATIONS(In thousands of U.S.
Dollars, except per share data)

|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|------------------------------------------------------------------------------------------------------------------ |  | ---------------------- | ------- | ---- | - | ------- | - | ---- | ------- | ---- | - | ------- | - | - | ------- | -
|                                                                                                                   |  | Year ended December 31 |        
|                                                                                                                   |  |                        |        
|                                                                                                                   |  | 2001                   |         | 2002 |   | 2003    |   | 2004 |         | 2005 |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |  
|Income:                                                                                                            |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Net revenues                                                                                                       |  | $                      |        |      | $ | 5,110   |   | $    | 9,157   |      | $ | 11,265  |   | $ | 12,646  |  
|Equity in losses
  of affiliated companies                                                                         |  |                        | (28,787 | )    |   | (24,189 | ) |      | (8,698  | )    |   | (10,492 | ) |   | (17,522 | )
|Gain from
  disposal of businesses and affiliated companies and changes in holdings in
  affiliated companies, net |  |                        | 3,179   |      |   | 6,888   |   |      | 25,754  |      |   | 132,396 |   |   | 23,328  |  
|Other income
  (expenses), net                                                                                     |  |                        | (4,666  | )    |   | (747    | ) |      | 14,637  |      |   | 4,749   |   |   | 58,648  |  
|Financial
  income, net                                                                                            |  |                        | 4,538   |      |   | 1,480   |   |      | 751     |      |   | 1,433   |   |   | 5,483   |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|                                                                                                                   |  |                        | (25,736 | )    |   | (11,458 | ) |      | 41,601  |      |   | 139,351 |   |   | 82,583  |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Costs and
  Expenses:                                                                                              |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Cost of revenues                                                                                                   |  |                        |        |      |   | 2,903   |   |      | 5,862   |      |   | 6,791   |   |   | 7,907   |  
|Research and
  development costs, net                                                                              |  |                        | 55      |      |   | 2,265   |   |      | 3,263   |      |   | 2,889   |   |   | 6,163   |  
|Marketing and
  selling expenses, net                                                                              |  |                        |        |      |   | 5,268   |   |      | 6,498   |      |   | 1,311   |   |   | 2,386   |  
|General and
  administrative expenses                                                                              |  |                        | 5,100   |      |   | 7,568   |   |      | 12,872  |      |   | 12,292  |   |   | 9,249   |  
|Restructuring
  costs                                                                                              |  |                        |        |      |   | 396     |   |      |        |      |   |        |   |   |        |  
|Amortization of
  intangible assets                                                                                |  |                        |        |      |   | 269     |   |      | 299     |      |   | 142     |   |   | 392     |  
|Impairment of
  intangible assets                                                                                  |  |                        |        |      |   |        |   |      |        |      |   | 4,192   |   |   |        |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|                                                                                                                   |  |                        | 5,155   |      |   | (18,670 | ) |      | 28,794  |      |   | 27,617  |   |   | 26,097  |  
|Income (loss)
  before tax benefit (taxes on income)                                                               |  |                        | (30,891 | )    |   | (30,128 | ) |      | 12,807  |      |   | 111,734 |   |   | 56,486  |  
|Tax benefit
  (taxes on income)                                                                                    |  |                        | 3,786   |      |   | 2,961   |   |      | (6,796  | )    |   | (15,101 | ) |   | (10,461 | )
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Income (loss)
  after taxes on income                                                                              |  |                        | (27,105 | )    |   | (27,167 | ) |      | 6,011   |      |   | 96,633  |   |   | 46,025  |  
|Minority
  interest in losses (income) of subsidiaries                                                             |  |                        | 438     |      |   | 2,823   |   |      | (10,907 | )    |   | (4,135  | ) |   | 5,160   |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Income (loss)
  from continuing operations                                                                         |  |                        | (26,667 | )    |   | (24,344 | ) |      | (4,896  | )    |   | 92,498  |   |   | 51,185  |  
|Loss from
  discontinued operations                                                                                |  |                        | (25,692 | )    |   | (17,235 | ) |      | (2,309  | )    |   | (8,365  | ) |   | (3,850  | )
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Net Income
  (loss)                                                                                                |  | $                      | (52,359 | )    | $ | (41,579 | ) | $    | (7,205  | )    | $ | 84,133  |   | $ | 47,335  |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Income (loss)
  per share:                                                                                         |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Basic -                                                                                                            |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Income (loss)
  from continuing operations                                                                         |  | $                      | (1.26   | )    | $ | (0.93   | ) | $    | (0.17   | )    | $ | 3.26    |   | $ | 1.74    |  
|Loss from
  discontinued operations                                                                                |  |                        | (1.21   | )    |   | (0.65   | ) |      | (0.08   | )    |   | (0.39   | ) |   | (0.13   | )
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  
|Net income
  (loss)                                                                                                |  | $                      | (2.47   | )    | $ | (1.58   | ) | $    | (0.25   | )    | $ | 2.86    |   | $ | 1.61    |  
|Weighted average
  number of ordinary shares used in computing basic net income (loss) per share
  (thousands)     |  |                        | 21,191  |      |   | 26,272  |   |      | 29,194  |      |   | 29,266  |   |   | 29,437  |  
|                                                                                                                   |  |                        |         |      |   |         |   |      |         |      |   |         |   |   |         |  

4

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|                                                                                                                |  |                        |        |      |   |        |   |      |        |      |   |        |   |   |        |  
|--------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ------ | ---- | - | ------ | - | ---- | ------ | ---- | - | ------ | - | - | ------ | -
|                                                                                                                |  | Year ended December 31 |       
|                                                                                                                |  |                        |       
|                                                                                                                |  | 2001                   |        | 2002 |   | 2003   |   | 2004 |        | 2005 |  
|                                                                                                                |  |                        |        |      |   |        |   |      |        |      |  
|Diluted -                                                                                                       |  |                        |        |      |   |        |   |      |        |      |   |        |   |   |        |  
|Income (loss)
  from continuing operations                                                                      |  | $                      | (1.27  | )    | $ | (0.93  | ) | $    | (0.17  | )    | $ | 3.25   |   | $ | 1.73   |  
|Loss from
  discontinued operations                                                                             |  |                        | (1.21  | )    |   | (0.65  | ) |      | (0.08  | )    |   | (0.39  | ) |   | (0.13  | )
|                                                                                                                |  |                        |        |      |   |        |   |      |        |      |   |        |   |   |        |  
|Net income
  (loss)                                                                                             |  | $                      | (2.48  | )    | $ | (1.58  | ) | $    | (0.25  | )    | $ | 2.86   |   | $ | 1.60   |  
|Weighted average
  number of ordinary shares used in computing diluted net income (loss) per
  share thousands) |  |                        | 21,191 |      |   | 26,272 |   |      | 29,194 |      |   | 29,385 |   |   | 29,550 |  
|                                                                                                                |  |                        |        |      |   |        |   |      |        |      |   |        |   |   |        |  
|Dividend paid
  per share                                                                                       |  | $                      |        |      | $ |       |   | $    |       |      | $ |       |   | $ | 3.0    |  
|                                                                                                                |  |                        |        |      |   |        |   |      |        |      |   |        |   |   |        |  

|                                                                                       |  |                             |         |      |   |         |  |      |         |      |   |         |  |   |         | 
|-------------------------------------------------------------------------------------- |  | --------------------------- | ------- | ---- | - | ------- |  | ---- | ------- | ---- | - | ------- |  | - | ------- | 
|                                                                                       |  | As of December 31,          |        
|                                                                                       |  |                             |        
|                                                                                       |  | 2001                        |         | 2002 |   | 2003    |  | 2004 |         | 2005 |  
|                                                                                       |  |                             |         |      |   |         |  |      |         |      |  
|                                                                                       |  | (U.S. Dollars in thousands) |        
|Balance Sheet Data                                                                     |  |                             |         |      |   |         |  |      |         |      |   |         |  |   |         | 
|Cash, cash
  equivalents and short-term and long term investments                      |  | $                           | 111,896 |      | $ | 99,735  |  | $    | 119,769 |      | $ | 188,106 |  | $ | 143,798 | 
|Investments in
  affiliated companies and in other companies and long term receivables |  |                             | 164,967 |      |   | 221,338 |  |      | 285,618 |      |   | 273,053 |  |   | 176711  | 
|Total assets                                                                           |  |                             | 321,512 |      |   | 394,253 |  |      | 450,704 |      |   | 501,156 |  |   | 353,773 | 
|Shareholders
  equity                                                                 |  |                             | 233,915 |      |   | 259,441 |  |      | 296,130 |      |   | 389,080 |  |   | 302,116 | 
|Capital stock                                                                          |  |                             | 217,478 |      |   | 284,583 |  |      | 328,477 |      |   | 337,294 |  |   | 291,445 | 

|                |                                            
|--------------- | -------------------------------------------
|B.              | Capitalization and Indebtedness            
|                |                                            
|Not Applicable.
|                |                                            
|C.              | Reasons for the Offer and Use of
  Proceeds
|                |                                            
|Not Applicable.
|                |                                            
|D.              | Risk Factors                               

Risks Affecting us and the Companies in our Group

Our
financial results and financial condition are principally impacted by the
results of, and the value of our holdings in, our group companies.For the year ended December 31, 2005, our share in the results of
operations of our group companies and gain upon the sale of shares in our group
companies accounted for substantially all of our income. In addition, as of
December 31, 2005, our holdings in group companies represented approximately
50% of our total assets. If our group companies experience difficulties in the
future, or if there are adverse changes in their market price or fair value,
our financial results and/or the value of our assets will be adversely
affected, and we may need to write-down or write-off the carrying value of our
holding or record the share in our group companys loss. In particular, as of
December 31, 2005, the carrying value of our holdings in Given Imaging Ltd., or
Given Imaging (Nasdaq:GIVN), represented approximately 19% of our total assets,
the carrying value of our holdings in Partner

5

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Communications Ltd., or Partner (Nasdaq: PTNR), represented approximately
  7% of our total assets and the carrying value of our holdings in Oncura, Inc.,
  or Oncura, through our subsidiary Galil Medical Ltd., or Galil Medical, represented
  approximately 6% of our total assets. Any adverse change in the results of operations
  or financial condition of Given Imaging, Oncura or other of our group companies
  whose results we consolidate or account for on an equity basis, or any substantial
  adverse change in the market value of shares in Given Imaging or Partner, may
  have a substantial negative impact on our results of operations or financial
  condition.

Our
performance significantly depends on the results of operations of our group
companies.Our results of operations are directly
impacted by the results of operations of our group companies accounted for
under the equity or consolidation method. To the extent any of these companies
have poor financial results or encounter difficulties in their operations, our
financial results will be negatively impacted. Many of these companies have not
yet generated significant revenues, have incurred losses and have invested
heavily in research, development and marketing of their products. We anticipate
that the majority of these companies will continue to record losses in the
future.

Our
financial results are directly impacted by our ability to conclude profitable
exit transactions. Our financial results are directly
impacted by our ability to conclude profitable exit transactions regarding
certain of the companies in our group. If worldwide market conditions in the
technology industry or other factors do not permit us to conclude these types
of transactions, our results will be adversely affected.

We
may face difficulties in our ability to dispose of our shares in publicly
traded companies in our group. Due to the limitations of
U.S. securities laws, material non-public information to which we may become
exposed due to our representation on the boards of directors of companies in
our group, and contractual and legal limits on the tradability of the shares,
we may face difficulties in our ability to dispose of our shares in publicly
traded companies in our group at a time and in a manner we deem suitable.

Our
market value significantly depends on the market values of publicly-traded
companies in our group.Our market value is directly
impacted by the market values of Given Imaging and Partner, each of whose
shares are traded in the public markets. To the extent that the share prices of
either of these companies decline, our market value will be negatively
impacted. In particular, we are affected by the price of shares of Given
Imaging,. If the share prices of either of these companies decline, our market
value could be adversely affected.

The
market price of our ordinary shares is subject to fluctuations.
The market value of our ordinary shares has fluctuated over time. The following
factors, among others, may significantly impact the market price of our
ordinary shares:

| |   |                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------
| |  | the market price of our group companies which are
  publicly traded, in particular, Given Imaging;                                            
| |   |                                                                                                                                               
| |  | our group companies, their competitors or other
  third parties announcing technological innovations, new products or earnings
  or losses;   
| |   |                                                                                                                                               
| |  | periodic variations in results of operations of our
  group companies;                                                                        
| |   |                                                                                                                                               
| |  | factors that generally affect the market for stocks
  of medical device, telecommunications, semiconductor and advanced materials
  companies;

6

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| |   |                                                              
| | - | -------------------------------------------------------------
| |  | political, economic or other developments affecting
  Israel;
| |   |                                                              
| |  | global economic and other external factors; and              
| |   |                                                              
| |  | quarter-to-quarter fluctuations in our financial
  results.  

Many
of our group companies may face difficulties in obtaining future financing on
favorable terms or at all.Many of our group companies
have extensive research and development and marketing costs and limited
revenues, if any. In order to succeed, these companies may require additional
capital to fund these costs. If these companies have difficulties in obtaining
financing from their current shareholders, which may also include additional
investments by us in these companies, or from new financing sources, their
continued operations may be at risk. This would adversely affect our financial
performance and results of operations.

Bank
of Israel regulations limit our and our group companies ability to borrow from
Israeli banks.Bank
of Israel regulations stipulate lending limits of Israeli banks to companies
and individuals considered to be in an affiliated group, which limits the
amount available to such affiliated group to borrow from such banks. We and our
group companies are part of the IDB affiliated group of companies, which is one
of the largest groups of affiliated companies in Israel. The IDB group includes
many Israeli companies, which require, or which hold ownership interests in
companies which require, extensive credit facilities from Israeli banks for the
operation of their businesses. These regulations may result in difficulties for
us and our group companies to obtain bank financing, if required.

Our
results may be affected by volatility in the securities markets.
Securities markets in general are volatile, and are particularly volatile with
respect to high-technology companies, including companies that have a
significant presence in Israel. Although the volatility of these companies
securities is not necessarily related to their operating performance, these
companies may experience difficulties in raising additional financing required
to effectively operate and grow their businesses. These difficulties and the
volatility of the securities markets in general may also affect our and our
group companies ability to realize investments.

The
downturn experienced by the technology markets in which our group companies
operate may re-occur.Our group companies are affected by the demand for the
technologies and technology products they develop and produce. The technology
sector has previously experienced a prolonged and severe downturn, reflected in
a steep decline in technology spending resulting in revenue declines for our
more mature companies and difficulties in raising financing for our early stage
companies. There is no assurance that a downturn will not re-occur or that the
technology sector will continue to grow. If a downturn re-occurs, our and our
group companies operations will be adversely affected.

We
compete with other entities for acquisition and investment opportunities.As
part of our overall strategy, we pursue acquisitions of, and investments in,
Israeli companies and Israel-related technology companies. The success of a
number of Israeli companies, particularly in information and communications technology
and medical devices, has prompted potential investors to seek investment
opportunities in Israel, which has allowed many Israeli high-technology
companies to gain direct access to Israeli and foreign public securities
markets. We compete for acquisition and investment opportunities with other
established and well-capitalized entities. There can be no assurance that we
will be able to locate acquisition or investment opportunities upon favorable
terms. Our failure to consummate further acquisitions or

7

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investments in the future may hinder our ability to
grow and could harm our business, financial condition and results of
operations.

There
  is no assurance that our subsidiary RDC will be able to continue to develop
  successful technologies and /or group companies.Our wholly-owned subsidiary
  DEP holds 50.1% of the outstanding shares and voting rights of RDC, established
  by DEP together with Rafael Armaments Development Authority Ltd., or Rafael
  pursuant to an agreement entered into between DEP and Rafael in 1993. RDC has
  first rights to exploit commercially technologies of Rafael for the development
  of products for use in non-military markets, which rights are dependent primarily
  upon RDCs or Rafaels identification of existing technologies for
  commercial uses, or the development by Rafael of new technologies, Rafaels
  willingness to transfer the necessary human or other resources to develop and
  exploit commercially its technology in non-military markets, and RDC reaching
  agreement with Rafael on the terms of any commercial exploitation. RDC is currently
  involved in a dispute with Rafael regarding Rafaels request to limit the
  scope of RDCs rights under the agreement to certain fields or applications
  and to limit the period of the agreement even though the agreement is unlimited
  in time. Our ability to continue to grow and develop RDC could be harmed, and
  our business, financial condition and results of operations could be adversely
  affected, if we are unable to realize the full potential value of RDCs
  agreement with Rafael as a result of any of the following:

| |   |                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Rafael and RDC do not reach consensus on Rafaels requests
        regarding limiting the scope and period of RDCs rights under the
        agreement,      
| |   |                                                                                                                                                              
| |  | Rafael does not cooperate with RDC in the
  realization of RDCs rights under the agreement,                                                                 
| |   |                                                                                                                                                              
| |  | Rafael or RDC do not identify existing technology,
  or Rafael does not develop new technology, that can be commercially exploited
  in non-military markets,
| |   |                                                                                                                                                              
| |  | Rafael does not transfer the necessary human or
  other resources to develop and exploit commercially this technology in
  non-military markets,             
| |   |                                                                                                                                                              
| |  | RDC does not reach agreement with Rafael on the
  terms of any commercial exploitation, or                                                                   
| |   |                                                                                                                                                              
| |  | the continued financing of RDC by its shareholders.                                                                                                          

Most
of our group companies are dependent upon proprietary technology which may be
infringed upon or may infringe upon the proprietary technology of others. Most
of our group companies greatly depend on their proprietary technology for their
success. Like many other technology companies, most of these companies rely on
a combination of patent, trade secret, copyright and trademark laws, together
with non-disclosure agreements, confidentiality clauses in their agreements,
including employment agreements, and technical measures to establish and
protect proprietary rights in their products. These companies may not be able
to enforce their proprietary rights under the laws of certain jurisdictions.
Our group companies may not successfully protect their technology because,
among other reasons:

| |   |                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------
| |  | some foreign countries may not protect their
  proprietary rights as fully as do the laws of the United States;

8

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| |   |                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | enforcing their rights may be time consuming and
  costly, diverting managements attention and company resources;                                                       
| |   |                                                                                                                                                                          
| |  | measures such as entering into non-disclosure
  agreements afford only limited protection;                                                                               
| |   |                                                                                                                                                                          
| |  | unauthorized parties may attempt to copy aspects of
  their products and develop similar software or to obtain and use information
  that they regard as proprietary; and
| |   |                                                                                                                                                                          
| |  | competitors may independently develop products that
  are substantially equivalent or superior to their products or circumvent
  intellectual property rights.           

In
addition, others may assert infringement claims against our group companies.
The cost of responding to infringement claims could be significant, regardless
of whether the claims are valid.

Many
of our group companies experience intense competition.
Many of our group companies experience competition from companies with
significantly greater financial, technical, marketing and public relations
resources, who have easier market access, better operational infrastructure,
longer operating histories, larger installed client bases, greater name
recognition, more established relationships and alliances in their industries
and offer a broader range of products and services. As a result, these
competitors may be able to respond more quickly to new or emerging technologies
or changes in clients requirements, benefit from greater purchasing economies,
offer more aggressive product and services pricing or devote greater resources
to the promotion of their products and services. If our group companies are unable
to successfully compete, their businesses, financial condition and results of
operations could be seriously harmed, which would in turn negatively affect our
financial condition and results of operations.

Our
group companies may experience delays in product development.Companies
in our group involved in technology product development may experience delays
in development which may result in loss of, or delay in, market acceptance.
Delays and difficulties associated with new product introductions or product
enhancements could negatively impact the business, financial condition,
prospects and results of operations of these companies and, as a result, our
financial results.

Israeli
government programs in which certain of our group companies participate may be
terminated or reduced in the future. In addition, the terms of such programs restrict the ability
of our group companies to manufacture products and/or transfer technologies
outside of Israel.Certain of our group companies participate in
programs of the Office of the Israeli Chief Scientist, or the OCS and the
Israel Investment Center, for which they receive grants and tax related and
other benefits. The benefits available under these programs depend on our group
companies meeting specified conditions. If our group companies fail to comply
with these conditions, they may be required to pay additional taxes and
penalties and be denied future benefits. We cannot assure you that these
benefits will be available in the future at their current levels or at all.

Under the Israeli Law for the
Encouragement of Industrial Research and Development, 1984, and related
regulations, the discretionary approval of an OCS committee is required for any
transfer of technology developed with OCS funding. There is no assurance that
our group

9

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companies will receive the
required approvals for any proposed transfer. Such approvals, if granted, may
be subject to the following additional restrictions:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| |  | our group companies could be
  required to pay the OCS a portion of the consideration received upon any sale
  of such technology or group company to an entity that is not Israeli. The
  scope of the support received, the royalties that were paid, the amount of
  time that elapsed between the date on which the technology was transferred
  and the date on which the grants were received, as well as the sale price,
  will be taken into account in order to calculate the amount of the payment;
  and | 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | 
| |  | the transfer of
  manufacturing rights could be conditioned upon an increase in the royalty
  rate and payment of increased aggregate royalties (up to 300% of the amount
  of the grant plus interest, depending on the percentage of the manufacturing
  transferred outside of Israel).                                                                                                                                                                                                                          | 

These restrictions may limit
the ability of our group companies to conclude transactions with international
companies, including exit transactions.

We
and our group companies may have difficulty retaining key employees.
Our success and the success of our group companies depend, in large part, on a
limited number of key management, scientific and technical personnel. In
addition, future success will depend upon, in part, attracting and retaining
highly qualified personnel. There can be no assurance that we or our group
companies will be able to either retain present personnel or acquire additional
qualified personnel as and when needed. The loss of the services of our key
personnel or those of our group companies and the failure to attract highly
qualified personnel may have a negative impact on our business.

Many
of our group companies depend on international operations.Many
of our group companies depend on sales to customers outside Israel. We expect
that international sales will continue to account for a significant portion of
these companies revenues for the foreseeable future. As a result, changes in
international, political, economic or geographic events could result in
significant shortfalls in orders or revenues. These shortfalls could cause the
business, financial condition and results of operations of these companies to
be harmed. Some of the risks of doing business internationally include:

| |   |                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------
| |  | unexpected changes in regulatory requirements;                                                          
| |   |                                                                                                         
| |  | the fluctuation of the New Israeli Shekel/U.S. Dollar representative
        rate of exchange;          
| |   |                                                                                                         
| |  | the inability of our group companies, their
  subsidiaries and subcontractors to obtain export licenses;
| |   |                                                                                                         
| |  | imposition of tariffs and other barriers and
  restrictions;                                            
| |   |                                                                                                         
| |  | burdens of complying with a variety of foreign laws;                                                    
| |   |                                                                                                         
| |  | political and economic instability;                                                                     

10

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| |   |                                                   
| | - | --------------------------------------------------
| |  | changes in diplomatic and trade relationships; and
| |   |                                                   
| |  | acts of terror.                                   

Some
of these factors, such as the ability to obtain export licenses and changes in
diplomatic relations, may be affected by Israels overall political situation.
See Conditions in Israel may affect our operations and the operations of our
group companies. In addition, the economic and political stability of the
countries of the major customers and suppliers of our group companies may also
impact their business.

Conditions
in Israel may affect our operations and the operations of our group companies.We
and most of our group companies conduct our principal operations in Israel, and
therefore are directly affected by the political, economic, and military
conditions affecting Israel and the Middle East. In particular, we could be
adversely affected by:

| |   |                                                                                            
| | - | -------------------------------------------------------------------------------------------
| |  | any major hostilities involving Israel;                                                    
| |   |                                                                                            
| |  | a full or partial mobilization of the reserve forces
  of the Israeli army;                
| |   |                                                                                            
| |  | the interruption or curtailment of trade between
  Israel and its present trading partners;
| |   |                                                                                            
| |  | a significant increase in inflation;                                                       
| |   |                                                                                            
| |  | a significant downturn in the economic or financial
  condition of Israel;                 
| |   |                                                                                            
| |  | a significant downgrading of Israels international
  credit rating;                       
| |   |                                                                                            
| |  | labor disputes and strike actions; and                                                     
| |   |                                                                                            
| |  | political instability                                                                      

Since
September 2000, there has been a significant increase in violence, civil unrest
and hostility, including armed clashes, between the State of Israel and the
Palestinians, and acts of terror have been committed inside Israel and against
Israeli targets in the West Bank and Gaza including armed hostilities between
Israel, the Palestinian Authority and other groups in the West Bank and Gaza
Strip. Israel has responded with military action and is building a security
fence, the route of which has been the subject of a great deal of controversy.
Despite Israels unilateral withdrawal from part of the territories, there is
an impasse in the entire peace process. No predictions can be made as to
whether or when a final resolution of the areas problems will be achieved or
the nature thereof and to what extent the situation will impact Israels
economic development. Any further escalation in these hostilities or any future
armed conflict, political instability or violence in the region could have a
negative effect on our and our group companies business and financial
condition, harm our and our group companies results of operations and
adversely affect our share price or the share prices of our group companies
that are publicly traded.

Our
and our group companies operations could be disrupted as a result of the
obligation of key personnel in Israel to perform military service.
All non-exempt male adult permanent residents of Israel under a specified age,
as a general rule, are obligated to perform military reserve duty and may be
called to active duty under emergency circumstances. Our operations and those
of our group companies could be disrupted by the absence for a significant
period of one or more of our or our group companies officers or employees. While we and our
group

11

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companies have operated effectively despite these conditions in the past,
we cannot assess what impact these conditions may have in the future,
particularly if emergency circumstances arise.

The
results of operations of our group companies may be harmed by foreign currency
exchange rate fluctuations. To the extent that our group
companies are based in Israel and have international operations, or operate
only in Israel but conduct their business in different currencies, their
revenues, expenses, assets and liabilities, are not necessarily in the same
currency and therefore they are exposed to foreign exchange rate fluctuations.
These fluctuations may negatively affect their results of operations. Some of
our group companies may attempt to hedge their foreign currency exposure from
time to time; however, we cannot assure you that if they do so they will be
successful.

Our
group companies may not be able to enforce covenants not to compete.Some
of our group companies currently have non-competition agreements with
substantial numbers of their employees who are involved in research and
development. In many cases, these employees are located primarily in Israel.
These agreements prohibit the companys employees, if they cease working for
the company, from directly competing with the company or working for its competitors.
Israeli courts have required employers seeking to enforce non-compete
undertakings of a former employee to demonstrate that the competitive
activities of the former employee will harm one of a limited number of material
interests of the employer which have been recognized by the courts, such as the
secrecy of a companys confidential commercial information or its intellectual
property. If any of our group companies cannot demonstrate that harm would be
caused to it, the company may be unable to prevent its competitors from
benefiting from the expertise of its former employees.

Product
liability claims could adversely affect the business results of our group
companies operating in the medical device industry.
Product liability is an inherent risk for our group companies operating in the
medical device industry. A product liability claim, regardless of its merit or
eventual outcome, could result in substantial costs to a group company and a
substantial diversion of management attention. A product liability claim or any
product recalls could also harm a group companys reputation and result in a
decline in revenues. Substantial damages awards have been made in some
jurisdictions against medical device companies based upon claims for injuries
allegedly caused by the use of their products. There can be no assurance that a
future product liability claim or series of claims brought against our group
companies would not have an adverse effect on their business or the results of
operations, or that product liability insurance would be adequate.

Product
regulation may adversely affect the ability of our medical device group
companies to bring new products to market or to continue to supply existing
products to the market.Our medical device group
companies are subject to strict government controls on the development,
manufacture, labeling, distribution and marketing of products. They must obtain
and maintain regulatory approval for their products from regulatory agencies
before products may be sold in a particular jurisdiction. Each regulatory
authority may impose its own requirements and delay or refuse to grant
approval, even though a product has been approved in another country.
Regulatory delays, the inability to successfully complete clinical trials,
claims and concerns about safety and efficacy, new discoveries, patents and
products of competitors and related patent disputes and claims about adverse
side effects are only a few of the factors that could adversely affect the
realization of product registration. Noncompliance with applicable regulatory
requirements can result in enforcement action which may include recalling
products,

12

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ceasing product marketing, paying significant fines
and penalties, and similar regulatory actions which could limit product sales,
delay or halt product shipment, delay new product clearance or approval, and
adversely affect such group companies results of operations.

Because
the medical device industry is litigious, our medical device group companies
are susceptible to intellectual property suits that could cause our group
companies to incur substantial costs or pay substantial damages or prohibit
them from selling their products. There is a substantial
amount of litigation over patent and other intellectual property rights in the
medical device industry. Whether a product infringes a patent involves complex
legal and factual issues, the determination of which is often uncertain.
Infringement and other intellectual property claims, with or without merit, can
be expensive and time-consuming to litigate and can divert managements
attention from the companys core business. See below under Risks Affecting
Our Holdings in Given Imaging.

If
our medical device group companies are unable to obtain reimbursement coverage
from third-party healthcare payors for procedures using their products, or if
reimbursement is insufficient to cover the costs of purchasing their products,
demand for their products may be adversely affected.If
physicians, hospitals and other healthcare providers are unable to obtain
sufficient coverage and reimbursement from third-party payors for products
produced by our medical device group companies, or if reimbursement is
insufficient to cover the costs of purchasing our medical device group
companies products or does not adequately compensate physicians and health
care providers as compared to alternative procedures, our medical device group
companies may be unable to generate sufficient sales to support their
businesses. In addition, our medical device group companies could be adversely
affected by changes in reimbursement policies of governmental or private
healthcare payors to the extent any such changes affect reimbursement amounts
or methods for procedures in which their products are used.

Our
telecommunications group companies operate in a highly regulated
telecommunications market which limits their flexibility to manage their
businesses.The telecommunications market is subject to
government regulation regarding licensing, competition, frequency allocation
and costs and arrangements pertaining to interconnection and leased lines. The
business and operations of our group companies which operate in this market,
primarily Partner and NetVision, could be adversely affected by changes in
laws, regulations or government policy affecting its business activities. These
could include decisions by the regulator increasing the rate of royalties to be
paid to the State of Israel, enlarging the types of revenues which the royalties
apply to, setting policies and imposing new regulations governing electronic
trade and mobile commerce, or further reducing call or Short Message Service,
or SMS, termination tariffs, as well as the amendment or revocation of their
licenses.

Certain
of our telecommunications group companies can only operate their businesses for
as long as they have a license from the Ministry of Communications.Partner
and NetVision Ltd., or NetVision, conduct their respective operations pursuant
to their respective licenses granted to each of them by the Ministry of
Communications. These licenses are subject to revocation in accordance with
their terms, and the terms of the licenses are subject to change by the
Ministry of Communications (including by imposing additional requirements).

13

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The
semiconductor industry in which certain of our group companies operate is
cyclical in nature and is characterized by ongoing changes.The semiconductor
industry has historically been a highly cyclical industry. Companies in the
semiconductor industry have expanded aggressively during periods of increased
demand. This expansion has frequently resulted in overcapacity and excess
inventories during periods of downturn, thereby adversely impacting upon the results
of operations of our group companies operating in the semiconductor field.

In
addition, the semiconductor industry is characterized by rapid ongoing changes,
including: (1) changes in customers capacity requirements and capital
spending, which depend in part on customers inventory levels relative to
demand for their products; (2) the importance of driving down cost of
ownership of systems; (3) more complex technology requirements;
(4) the increasing significance of consumer electronics as a driver for
chip demand and the related focus on lower prices; (5) varying levels of
business information technology spending; (6) the growing types and
varieties of integrated circuits and applications; (7) a rising percentage
of business from customers in Asia and emergence of customers and competitors
in new geographical regions; (8) customer demands for shorter lead times
for the manufacture and installation of semiconductor manufacturing equipment;
and (9) higher capital requirements for new semiconductor fabrication
plants. If our semiconductor companies do not successfully manage the risks
resulting from the ongoing changes occurring in the semiconductor industry,
their businesses, financial condition and results of operation could be
materially and adversely affected.

Specific Risks Affecting Elron

We
  may be deemed to be an investment company under the Investment Company Act of
  1940. Generally, a company must register under the Investment Company
  Act of 1940, or the 1940 Act, and comply with significant restrictions on operations
  and transactions with affiliates if its investment securities exceed 40% of
  the companys total assets, or if it holds itself out as being primarily
  engaged in the business of investing in, owning or holding securities. The 1940
  Act provides for various exemptions from the obligation to register thereunder,
  and in 1980 we received an order from the SEC, declaring that we are not an
  investment company under the 1940 Act. If certain of our investments were to
  adversely affect our status under the 1940 Act, we might need to dispose of
  or acquire other investments to avoid the requirement to register as an investment
  company on terms that may not be favorable to us. In addition, if we were deemed
  to be an investment company and therefore required to register as such under
  the 1940 Act, we would be unable to continue operating as we currently do, as
  a result of which our market value would be severely harmed.

If
we are characterized as a passive foreign investment company for U.S. federal
income tax purposes, our U.S. shareholders may suffer adverse tax consequences.Generally, if for any taxable year 75% or more of our
gross income is passive income, or at least 50% of our assets are held for the
production of, or produce, passive income, we may be characterized as a passive
foreign investment company, or PFIC, for U.S. federal income tax purposes.

If
we are characterized as a PFIC, our U.S. shareholders may suffer adverse tax
consequences, including having gains realized on the sale of our shares taxed
at ordinary income rates, rather than the capital gain rate. In addition, both
gains upon disposition and amounts

14

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received as distributions could be subject to an
additional interest charge by the Internal Revenue Service. If we are
determined to be a PFIC for any given year, then dividends paid in that year
and in the next year cannot qualify as qualified dividends which are eligible
for the capital gains rate for certain U.S. Shareholders. A determination that
we are a PFIC could also have an adverse effect on the price and marketability
of our shares.

Following
the sale of our shares in Elbit Systems in 2004, we announced that, as a result
of the transaction, we may be characterized as a PFIC for 2004. Following a
review of our position and consulting with our advisors on this matter in 2004,
and based on certain assumptions and facts known at that time (which we believe
have not changed), we believe there is substantial authority for the position
that we can rely on the change of business exception to PFIC status provided
under Section 1298(b)(3) of the U.S. Internal Revenue Code of 1986, as amended.
Substantial authority is generally sufficient to support a return reporting
position. Pursuant to this exception, in order to avoid PFIC status in 2004,
among other requirements, we cannot be a PFIC in 2005 or 2006 (which cannot be
determined at this time with respect to 2006) or in any year prior to 2004
(which we believe was not the case).

We
believe that in 2005 we were not a PFIC. However, since the determination of
whether we are a PFIC is based upon such factual matters as the valuation of our
assets and, in certain cases, the assets of companies held by us, there can be
no assurance with respect to the position of the Internal Revenue Service or a
court of law as to our status as a PFIC. Our analysis related to 2005 is based,
among others, upon certain assumptions and methodologies with respect to the
values that we have used; our percentage ownership (by value), and the
appropriate value of our ownership interest, in companies we held; and the
manner in which we have allocated the aggregate value of our assets among our
active assets and passive assets.

We
cannot assure you that the Internal Revenue Service will not challenge our
assumptions and methodologies. If the IRS were to challenge successfully such
assumptions or methodologies, we would potentially be classified as a PFIC for
2005 or prior years.

With
respect to 2006, the ultimate determination of our PFIC status will depend on
the composition of our gross income and assets for the entire year, and the
values of those assets, which are difficult to predict at this time and the
appropriate value of our ownership interest in our group companies.

In
view of the above, it is unclear whether the change of business exception
would ultimately be satisfied for 2004. We cannot assure shareholders that the
Internal Revenue Service will not challenge our reliance on the change of
business exception or our assumptions used in determining our percentage of
passive assets and income. If there are such challenges, we could be classified
as a PFIC for 2004, even if we are not a PFIC in 2005 and 2006. Furthermore,
there can be no assurance that we will not become a PFIC in the future. See
Item 10. Additional Information  Taxation  U.S. Federal Income Tax
Considerations - Tax Consequences if We are a Passive Foreign Investment
Company.

U.S.
holders of our shares are urged to consult their tax advisors regarding the
application of the passive foreign investment company rules.

15

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One
of our shareholders beneficially owns a substantial amount of our ordinary
shares and may therefore influence our affairs.As of May
31, 2006, Discount Investment Corporation Ltd., or DIC, beneficially owned an
aggregate of approximately 47.6% of our ordinary shares and has the ability, in
effect, to elect the members of our board of directors and to significantly
influence our business. A majority of the members of our board of directors are
officers or directors of DIC or its parent company, IDB Development Corporation
Ltd., or IDBD, or its parent company, IDB Holding Corporation Ltd., or IDBH.

It
may be difficult to serve process or to enforce a U.S. judgment against us, our
directors and our officers.Since all of our directors
and officers reside outside the United States, it may be difficult to effect
service of process on us, our directors or officers within the United States.
Furthermore, because most of our assets are located outside the United States,
it may not be possible to enforce any judgment obtained in the United States
against us or the aforementioned individuals in the United States. There is
doubt as to the enforceability of civil liabilities under the U.S. Securities
Act of 1933 and U.S. Securities Exchange Act of 1934 in original actions instituted
in Israel.

Risks
Affecting Our Holdings in Given Imaging

The
following risk factor sections have been condensed for the purposes of this
Annual Report. The risks associated with Given Imaging are more fully described
in documents filed by Given Imaging with the SEC.

The
price of Given Imagings shares could fluctuate significantly as a result of a
number of factors, including varying quarterly financial performance or its
failure to meet its guidance or the expectations of analysts or investors,
which may lead to additional volatility in its share price.Given
Imagings ordinary shares are traded on the Nasdaq National Market and on the
Tel Aviv Stock Exchange. In 2005, the closing price of its shares has ranged
from $20.39 to $36.04 per share on the Nasdaq National Market and NIS 95.79 to
NIS155.3 on the Tel Aviv Stock Exchange. The price of Given Imagings shares
could fluctuate significantly for, among other things, the following reasons:
future announcements concerning Given Imaging or its competitors, the existence
of litigation concerning Given Imagings intellectual property assets, changes
in third-party reimbursement practices, regulatory developments, and new
clinical or economic data regarding Given Imagings current or future products.
In addition, it is Given Imagings practice to provide guidance to the market
as to its expected revenues and earnings per share based on information
available to Given Imaging at the time of the guidance. If Given Imagings quarterly
operating results do not meet its guidance or the expectations of securities
analysts or investors, the price of Given Imagings shares would likely
decline. Therefore, revenues from system sales may be concentrated at the end
of each fiscal quarter making it difficult for Given Imaging to determine the
success of each quarter until its end and resulting in lower than expected
quarterly revenues if external or other events cause a large number of
potential customers to defer their purchasing decisions even for a short period
of time. Furthermore, Given Imaging believes that demand for systems and
capsules may be materially affected by seasonal factors during the summer
months which may result in slower
sales during the summer. Share price fluctuations may be exaggerated by low
trading volume of Given Imagings ordinary shares and changes in trading
practices in Given Imagings ordinary shares, such as short buying and selling.
Securities class action litigation has often been brought against

16

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companies following periods of volatility. Any
securities litigation claims brought against Given Imaging could result in
substantial expense and divert managements attention from its business.

Given
Imaging may be unable to maintain or increase its profitability.
Given Imaging was formed in 1998 and recorded initial sales of its principal
product, the Given System, in the third quarter of 2001. Given Imaging incurred
losses until the second quarter of 2004 and has maintained profitability until
the quarter ended December 31, 2005. Given Imaging has significant operating
expenses and must continue increasing its revenues from sales of the Given
System and of the PillCam capsules at a higher rate than the increase in its
expenses in order to maintain and grow its profits.

If
Given Imaging is unable to achieve broader penetration of the Given System
among gastroenterologists, it may not be able to maintain its current growth
rate.Given Imagings principal product is the Given System, consisting of a line
of PillCam capsules and the related data recorder and computer workstation. As
of December 31, 2005, Given Imaging had sold over 2,860 systems worldwide.
Growth in Given Imagings installed base has contributed to its revenue growth.
If Given Imaging is unable to continue to achieve broad penetration among
gastroenterologists, Given Imaging may be unable to maintain its current growth
rate.

Given
Imaging currently depends on sales of the PillCam SB for a substantial majority
of its revenues.A substantial portion of Given Imagings annual
revenue growth to date has resulted from increased sales of the PillCam SB
capsule. Given Imaging expects that a substantial majority of its revenues for
the foreseeable future will come from sales of the PillCam SB capsule and other
PillCam capsules. Sales of the PillCam SB capsule contributed $22.9 million, or
56.4%, in 2003, $41.6 million, or 64%, in 2004 and $62.5 million, or 72% in
2005 of Given Imagings total revenues. Given Imaging believes that the usage
rate of the PillCam capsules is an important factor in growing revenues.
Increasing the usage rate of customers is also important to attracting new
customers to purchase and use the Given System. If Given Imaging is unable to
increase the usage rate of the Given System, Given Imaging may not be able to
achieve the revenues necessary to maintain its revenue growth.

Given
Imagings future growth also depends in part on the success of Ethicon
Endo-Surgery in marketing its new PillCam ESO video capsule, particularly in
the United States.In May 2004, Given Imaging entered into an exclusive
sales representation and co-promotion agreement with Ethicon Endo-Surgery, a
Johnson & Johnson company. InScope, a division of Ethicon Endo-Surgery established
to market products to the gastroenterology market, has exclusive rights to
market Given Imagings PillCam ESO capsule in the United States. Under the
agreement, InScope is responsible for marketing the PillCam ESO capsule and,
consequently, Given Imagings future growth depends in part on the success of
InScope in doing so. Sales of the PillCam ESO capsule in 2005 were lower than
expected and may continue to be lower than expected if InScope is not
successful in marketing the PillCam ESO capsule. This may negatively impact
Given Imagings revenue growth.

Given
Imaging faces direct competition from manufacturers of capsule endoscopy
systems and may lose market share if Given Imaging is unable to compete
effectively in the marketplace or utilize its patent portfolio.      In October 2005,
Olympus Corporation launched a competing capsule endoscopy system and began
sales in Europe and Australia. Based on publicly available information, Olympus
is also conducting clinical trials in the United States and intends to seek FDA
clearance to market its capsule endoscopy system in the United States. In

17

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addition, in April 2006, in response to a request made by Olympus in December
2003 to re-examine Given Imagings first U.S. Patent #5,604,531, the USPTO
issued an office action confirming the validity of 13 of the original 17 claims
of this patent. Given Imaging has the right to appeal the rejection of the four
other claims. On May 19, 2006, Olympus Corporation and its subsidiaries filed a
complaint in the U.S. District Court for the Eastern District of Pennsylvania
against Given Imaging for alleged infringement of U.S. Patent 5,010,412,
entitled High Frequency, Low Power Light Source for Video Camera. In
addition, other companies in Korea and China began selling capsule endoscopy
systems in these territories in 2005. If Given Imaging is unable to compete
effectively in the marketplace or utilize its patent portfolio against the
Olympus capsule endoscopy system and other competing systems, Given Imaging may
lose market share or experience delays in completing sales as a result of
longer decision making process among potential customers.

Given
Imaging may be unable to introduce other products for use in other parts of the
gastrointestinal tract.Given Imagings objective is to
expand the use of the Given System by developing and introducing new capsules
for visualizing other parts of the gastrointestinal tract, including the
stomach and the colon. There can be no assurance of widespread market acceptance
of the Given System as superior to existing technologies for detection of
abnormalities in other parts of the gastrointestinal tract or that Given
Imaging will succeed in marketing and selling capsules for use in other parts
of the gastrointestinal tract. In addition, Given Imaging will be required to
obtain FDA clearance in the United States and other regulatory approvals
outside of the United States before commercially distributing the Given System
for use in other parts of the gastrointestinal tract or introducing new
products for use in the gastrointestinal tract. If future clinical trials
indicate that the Given System is not as clinically or cost-effective in these
parts of the gastrointestinal tract as current methods, or that it causes unexpected
complications or other unforeseen negative effects, Given Imaging may not
obtain regulatory clearance to market and sell the Given System for use in
other parts of the gastrointestinal tract or obtain reimbursement coverage, and
its growth would be adversely affected.

Any
disruption in the United States market, the primary market for Given Imagings
products, may result in a material reduction in Given Imagings revenues and
negatively affect its results of operations.

Since
Given Imaging began selling the Given System in 2001, most of its revenues have
been generated from sales in the United States. Sales in the United States
accounted for, $26.2 million, or 65%, of its revenues in 2003, $46.7 million,
or 72%, of its revenues in 2004 and $63.9 million, or 74%, of its revenues in
2005. Any disruption to Given Imagings market in the United States resulting
from adverse changes in reimbursement policies, regulatory requirements,
competitors, macro-economic changes and other events, many of which are outside
Given Imagings control, may result in a material reduction in its revenues and
negatively affect its results of operations.

GivenImagings reliance on sole
source
suppliers could harm its ability to meet demand for the Given System in a
timely manner or within budget.Given Imaging depends on sole
source suppliers for some of the components necessary for the production of the
Given System. Specifically, Micron Technology, Inc., through its Micron Imaging
Group and other wholly-owned subsidiaries, is currently the sole supplier of
the imaging sensor and the packaging for the sensor, and Zarlink Semiconductors
is currently the sole supplier of the transmitter that is

18

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integrated into the PillCam capsules. If the supply of
these components is disrupted or terminated, or if these suppliers are unable
to supply the quantities of components that Given Imaging requires, it may not
be able to find alternative sources for these key components. If Given Imaging
is required to change the manufacturer of any of these key components of the
Given System, there may be a significant delay in locating and/or verifying a
suitable alternative manufacturer. Furthermore, in the event that the
manufacturer of a key component of Given Imagings product ceases operations or
otherwise ceases to do business with Given Imaging, Given Imaging may not have
access to the information necessary to enable another supplier to manufacture
the component. The occurrence of any of the above events could harm the ability
of Given Imaging to meet demand for its products in a timely manner or within
budget, which could harm its ability to generate revenues, lead to customer
dissatisfaction and damage its reputation.

Risks Affecting Our Holdings in
Partner

The
following risk factor sections have been condensed for the purposes of this
Annual Report. The risks associated with Partner are more fully described in
documents filed by Partner with the SEC.

We
are restricted in our ability to freely dispose of our holdings in Partner.
Almost all of our shares in Partner are subject to transfer restrictions
stipulated by Partners license which requires that at least 5% of the economic
and voting interest of Partner be owned by Israeli citizens and residents
(Minimum Israeli Percentage). Pursuant to the relationship agreement between
the founding shareholders of Partner, each Israeli party to the relationship
agreement, including us, has undertaken to maintain such portion of the shares
as is necessary to maintain the Minimum Israeli Percentage. These restrictions
limit our ability to freely dispose of our shares in Partner.

Partner
expects its subscriber growth rate, and consequently its revenue growth rate,
to slow because Israels mobile telephone services market is highly penetrated,
making it more difficult to obtain new subscribers than in the past.
Because the Israeli market for mobile telephones is highly penetrated, future
demand for Partners services will not grow at the same rate as it has in the
past, and Partners subscriber growth will not develop at the same rate as in
the past and will depend significantly on Partners ability to retain existing
subscribers in its network and to attract subscribers from the other mobile
telephone network operators. While Partners market share, based on internal
estimates, has increased from approximately 13% of Israeli mobile subscribers
at December 31, 1999 to approximately 32% at December 31, 2005. Partners
market share growth has slowed since 2003 and Partner expects this trend to
continue.

Competition
from existing competitors may require Partner to increase its subscriber
acquisition costs and customer retention costs and increase its churn rate. Partner
competes primarily with Cellcom (a company controlled by DIC) and Pelephone,
two of the other mobile telephone network operators in Israel. Because of the
ease of switching between cellular operators, Partner has already faced and may
continue to face an increase in its churn rate and may be forced to increase
its customer retention costs, including subsidies towards upgrades of
subscribers handsets, in order to retain subscribers. In 2005, Partner
experienced a higher churn rate than in 2004, primarily due to the prepaid
sector. Competition, including increased

19

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competition resulting from the introduction of number
portability, may further increase the churn rate.

Risks
Affecting Our Holdings in Oncura

Oncura
  may incur future losses and be unable to achieve profitability. Oncura
  was formed in 2003 and has generated net losses from the commencement of its
  operations in July 2003 through December 31, 2005. Oncura has significant operating
  expenses and there is no assurance that Oncura will be able to achieve profitability
  in the future.

Oncura
expects to derive a significant portion of its future revenues from its
cryotherapy products, which could fail to achieve broad market acceptance or
generate significant revenue growth. Oncura expects that revenues from its
cryotherapy products will grow significantly over time. Accordingly, Oncuras
success is in large part dependent on acceptance by physicians and patients of
its cryotherapy products. Although cryotherapy has existed for many years, it
has not been widely accepted due to a variety of factors including concerns
over the safety and efficacy of the technology and the availability of
alternative therapies. If Oncuras cryotherapy products do not achieve broad
market acceptance, Oncura may not be able to achieve the revenue growth necessary
to achieve and maintain profitability.

Oncura
  is dependent on its two shareholders, GE Healthcare and Galil Medical and there
  is no assurance that they will continue to support Oncura. Oncura depends
  primarily on GE Healthcare and Galil Medical, for manufacturing its products.
  Although Oncura has long-term supply agreements with each of GE Healthcare and
  Galil Medical, its business could be seriously harmed if it were unable to maintain
  these relationships or if GE Healthcare or Galil Medical were unable to continue
  to manufacture the companys products. In addition, Oncuras operations
  from inception through December 31, 2005 have not generated positive cash flows
  and its corresponding working capital deficits have been financed by loans from
  its shareholders. If Oncura is not able to secure suitable third-party financing
  to fund its working capital deficits, the company will continue to need to rely
  on its shareholders to provide necessary funding until such time as the company
  becomes cash flow positive or can obtain necessary financing from a third-party.
  Each of Oncuras shareholders provided to Oncura a letter in which they
  confirmed their intention to continue providing financial support to Oncura
  through May 31, 2007 or such later date as may be agreed by them. There is no
  assurance that Oncuras shareholders, including Galil Medical, of which
  we beneficially own, as of May 31, 2006, 60% of the shares directly and indirectly,
  will continue to fund Oncuras working capital deficit after May 31, 2007
  or maintain their respective holdings in Oncura, which may adversely affect
  Oncura's business and results of operations.

Risk
  Affecting Our Holdings in NetVision

The
market for the supply of Internet access services and value added services in
Israel is very competitive. The supply of Internet
access services requires a special license from the Israeli Ministry of
Communications whose policy is to encourage competition and therefore does

20

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not place any material
barriers to entry into the market. Since the beginning of 2004, competition in
the market has focused on broadband Internet services. NetVision continues to
experience increased competition in gaining broadband communication market
share, mainly from companies such as Internet Gold (Nasdaq:IGLD), Bezeq
International, Barak I.T.C. (1995) Ltd., or Barak, and 012 Golden Lines Ltd.,
or Golden Lines. As of December 31, 2005, NetVision estimates that it held
approximately 25% of the broadband Internet communication market in Israel.
Competition from existing and new competitors may require NetVision to reduce
its tariffs and increase its subscriber acquisition and retention costs as a
result of which NetVisions results of operations could be adversely
impacted. Due to the intense competition, there has been a slow down in
the increase of NetVisions subscriber base. NetVision is currently engaged in merger
discussions with Barak. There is no assurance that the proposed merger will
take place.

The
market for the supply of international telephone services in Israel is very
competitiveThe market for international telephony
services, which NetVision entered in November 2004, is very competitive. The
three major competitors are Bezek International, Golden Lines and Barak. Such
competition may result in a decrease in prices to a level which will make
penetration for NetVision more difficult, decrease NetVisions profits or even
result in losses for NetVision, from these activities. In such event,
NetVisions investment in its international telephone activities will be
negatively impacted which in turn will negatively affect NetVisions results of
operations.

NetVision
relies on certain third-parties for leased lines. NetVision relies on certain third-party service
providers including local and long distance telecommunications companies, such
as Bezeq and Med Nautilus, for leased lines. Internet access by NetVisions
customers is dependent on the telecommunications infrastructure owned and
maintained by Bezeq and the local cable companies. If NetVisions subscribers
access to Israels fixed-line telecommunications infrastructure is disrupted,
it would significantly impact the services that NetVision provides to its
subscribers and could result in a substantial reduction in Internet access
volume and revenue. Furthermore an increase in the cost of access to Israels
fixed-line telecommunications infrastructure could also adversely impact
NetVisions results of operations.

Item 4. Information on the Company

A.      History
and Development of the Company

We
are a high technology operational holding company that operates through our
group companies. Our group companies include both publicly traded and privately
held companies.

Founded
in 1962, we have been a major force in the development of the Israeli high
technology industry by building Israeli and Israel-related companies with
technologies in the fields of medical devices, advanced defense electronics,
telecommunications, semiconductors, software products and services and advanced
materials. Historically, most of our group companies were established together
with entrepreneurs or started as activities within Elron and were subsequently
spun-off. In addition, some of our group companies grew out of our subsidiary,
RDC, established by us (through our subsidiary, DEP) together with Rafael, the

21

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largest research and development organization of Israels
  Ministry of Defense, pursuant to an agreement entered into in July 1993 for
  the purposes of exploiting Rafaels technology in non-military markets.
  RDC has first rights to exploit commercially technologies of Rafael in non-military
  markets, which rights are dependent primarily upon RDCs identification
  of new and existing military technology developed by Rafael, for commercial
  exploitation in non-military markets. Potential projects and opportunities are
  identified through mutual cooperation and ongoing liaison between RDC and their
  professional advisors and members of Rafaels research and development
  team. Following the identification of a project, RDC commercially exploits the
  project, initially using its own finance and management resources and thereafter
  obtains external financing. Given Imaging and Galil Medical are examples of
  companies that grew out from this cooperation with Rafael. RDC is currently
  involved in a dispute with Rafael regarding Rafael's request to limit the scope
  and period of their agreement. See Item 3 Risks Affecting Us and the Companies
  in our Group.

We
expect to continue to build and realize value for our shareholders through the
sale of a portion or all of our holdings in, or the issuance of shares by any
of our group companies to third parties, while simultaneously pursuing the
acquisition of, or investment in, new and existing companies at different
stages of development including early stage and more mature companies, and
building our group companies. We believe that this strategy provides the
ability to increase shareholder value as well as capital to support the growth
of our group companies.

Our
primary activity is our involvement in the management of our group companies,
in which we maintain controlling or significant holdings, and, in a limited
number of cases, minority holdings. We participate in the management of most of
our group companies by means of active membership on their boards of directors
and board committees. As a result, we are involved in matters of policy,
strategic planning, marketing, selecting and manning senior management
positions, approving investments and budgets, financing and the overall ongoing
monitoring of our group companies performance. In addition to our
representation on the boards of directors of our group companies, we provide
hands-on assistance to our group companies management in support of their
growth. We view our hands-on involvement in the operations of our group
companies as a key element of our business. Our group companies therefore
benefit from the experience of our management team in various areas in which
they need support and leadership, including, but not limited to, market
analysis, risk management, identifying joint venture opportunities,
introductions to potential customers and investors, business plan preparation,
budgetary control and strategic planning and research and development guidance.

Both
our legal name and our commercial name is Elron Electronic Industries Ltd. We
were incorporated in Israel in 1962 under the name of Elron Electronic
Industries Ltd. The principal legislation under which we operate is the Israeli
Companies Law, 1999. Our shares are publicly traded on Nasdaq National Market
under the symbol ELRN and on the Tel Aviv Stock Exchange. Elrons corporate
headquarters and registered office is located at 3 Azrieli Center, 42nd Floor,
Tel-Aviv 67023, Israel, Tel. 972-3-607-5555, Fax. 972-3-607-5556, e-mail:
elron@elron.net. Our web site address is www.elron.com. Information contained
on our web site is not part of this Annual Report.

The
following are significant transactions and events which we and our group
companies have completed or which took place since January 1, 2005:

22

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Sale of Partner shares                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On April 20, 2005 we completed the sale to Partner of 12,765,190
        Partner shares for approximately $94 million, as part of the sale together
        with the other Israeli founding shareholders of Partner of an aggregate
        of approximately 33.3 million Partner shares to Partner for an aggregate
        consideration of approximately $245 million. As a result of the sale,
        we recorded in 2005 a gain of $45.4 million, net of tax.                                                                                                                                                                   
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | In April 2006, we purchased an additional 0.6% of
  Partners outstanding shares from Polar Communications Ltd., one of the other
  founding shareholders of Partner, for approximately $5.3 million, at a 15%
  discount to the then market price. Following this transaction, our beneficial
  holding in Partner is approximately 2.6%. Almost all of our holding is
  subject to certain transfer restrictions under Partners Israeli
  communications license.                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | Investment in NuLens Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On April 21, 2005, we invested approximately $1.7
  million in NuLens Ltd., or NuLens, an Israeli medical device company
  operating in the field of intra-ocular lenses, mainly for cataract and
  presbyopia procedures. The investment was the first of two installments. The
  second installment of approximately $1.1 million was invested in March 2006
  simultaneously with the closing of a new investment round of approximately
  $6.0 million, led by Warburg Pincus, a leading global private equity fund, in
  which we also invested an additional $1.5 million. Following these
  investments, we hold 29% of NuLens.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | Investment of $16 million in
  Teledata Networks Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On May 8, 2005, we completed an investment of $16
  million in Teledata Networks Ltd., or Teledata. The investment was part of an
  aggregate round of financing of $19 million, in which FBR Infinity II
  Ventures, a related venture capital fund, or Infinity, invested $3 million,
  for approximately 4% of Teledata, and with whom we entered into a voting
  agreement. (See Item 7b-Related Party Transactions). Teledata provides
  innovative access products and solutions for both traditional and next generation
  networks to telecom operators and service providers. We hold approximately
  21% of Teledata.     
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | Sale of Oren Semiconductor                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On June 10, 2005, Zoran Corporation, or Zoran (NASDAQ: ZRAN),
        acquired Oren Semiconductor, Inc., or Oren, in which we held a 41% interest.
        Elron received approximately $12.5 million in cash in the acquisition
        (of which approximately $2 million was escrowed under the terms of the
        agreement, of which we already received approximately $1 million) and
        approximately $7.7 million of Zoran shares (based on Zorans share
        price on the completion date of the acquisition). As a result of the transaction
        we                                                          

23

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | recorded a gain in 2005, net of taxes, of
  approximately $17.2 million. In July 2005, we sold Zorans shares for $8.8
  million, resulting in a gain net of tax, of $0.7 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | NetVision Initial Public Offering                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On May 19, 2005, NetVision completed its initial
  public offering on the Tel Aviv Stock Exchange, or TASE, in Israel for net
  proceeds of approximately NIS135 million (approximately $31 million). In
  addition, future proceeds from the exercise of options sold in the offering
  may amount to approximately NIS28.8 million (approximately $6.6 million). DIC
  is the other major shareholder of NetVision. We and DIC each converted
  approximately $3.1 million of loans into equity of NetVision immediately
  prior to the offering and $2.2 million in loans was repaid to each of us from
  the proceeds of the offering. As a result of the initial public offering our
  holding in NetVision decreased from 45.7% to approximately 39% (27.4% on a
  fully diluted basis taking into account the possible exercise of the
  convertible securities) resulting in a gain for Elron of approximately $3.0
  million.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | Investment in BrainsGate Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On
  August 8, 2005, we completed an investment of approximately $6.9 million in
  BrainsGate Ltd., or BrainsGate, for approximately 22% of the equity of
  BrainsGate, as part of an aggregate investment of approximately $17.0
  million. Infinity, with whom we have a voting agreement, holds approximately
  5% of the equity of BrainsGate. See Item 7b - Related Party Transactions.
  BrainsGate is an Israeli company that is developing innovative technologies
  for neurostimulation treatments of brain diseases.                                                                                                                                                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | Dividend distribution.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On
  September 5, 2005, we declared a cash dividend of $3.00 per share, totaling
  approximately $88.5 million. The dividend was paid on September 27, 2005, to
  shareholders of record on September 15, 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | Investment in Enure Networks Ltd. (formerly known as Gaia Broadband Services Management
  Ltd.).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | On
  October 2, 2005, we completed an investment of approximately $4.0 million in
  Enure Networks Ltd., or Enure, for approximately 57% of the equity of Enure.
  Enure is an Israeli software company engaged in developing solutions in the
  field of broadband services management and home networks.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  | Establishment of Medingo.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   | In
  November 2005, RDC established Medingo Ltd., or Medingo. Medingo is
  developing a disposable insulin dispenser for diabetic patients. We
  beneficially own 100% of the outstanding shares of Medingo through our
  holding of RDC, which holds directly all the shares of Medingo.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

24

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|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|---------------------------------------------------------------------------------------------------------------------------------------------------------- | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                           |  | Sale of holdings in Elron Telesoft Ltd. and Elron Telesoft
  Export Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |   | On
  December 29, 2005, we completed the sale of all of our shares of Elron
  Telesoft Ltd. and Elron Telesoft Export Ltd. (together, the ET Group), to
  ECtel Ltd. (Nasdaq: ECTX) for $2.5 million, of which $0.4 million shall be
  paid if certain milestones will be achieved during 2006. The transaction did
  not materially affect our results of operations                                                                                                                                                                     
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |  | Investment in Safend Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |   | On
  January 2, 2006, we completed an investment of approximately $3.7 million in
  preferred shares of Safend Ltd., or Safend, for approximately 26% of the
  equity of Safend. Safend is an Israeli company which develops comprehensive
  desktop and laptop endpoint security solutions.                                                                                                                                                                                                                                                
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |  | $14
  million Investment in AMT. On June 8, 2006, A.M.T. Advanced Metal Technologies,
  or AMT, completed a $14 million financing led by Shamrock Israel Growth Fund,
  an Israeli private equity fund. We committed to invest an aggregate of $5
  million (of which we invested $2.5 million immediately) in the financing
  round in which other existing shareholders also participated. Following the
  transaction, we hold approximately 34% of AMT.                                                                                 
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|The following are the significant investments and
  divestitures which we and companies in our group completed in 2003 and 2004,
  in chronological order:
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |  | Investment
  in Notal Vision, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |   | In January 2003, we completed an investment of $2.0
  million in Notal Vision, Inc., or Notal, an Israeli related medical device
  company operating in the field of early detection of Age Related Macular
  Deterioration (AMD). Our investment formed part of an aggregate investment by
  other investors in Notal of approximately $4.5 million, including an
  investment by an existing shareholder, Innomed Ventures (Israel) L.P., or
  Innomed, in which we also hold an interest. We currently hold 23% of the
  equity of Notal.
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |  | Galil
  Medical and Amersham Health Plc (now GE Healthcare) merge urology therapy
  units                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                           |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                           |   | On July 1, 2003, the merger between the urology
  business of our subsidiary, Galil Medical, and the brachytherapy business of
  Amersham plc, now a subsidiary of GE Healthcare, was completed and a new
  company, Oncura, was incorporated. Oncura provides minimally invasive
  treatment options for prostate cancer using brachytherapy (radio-active
  seeds) and cryotherapy (hyper-cooling) technologies. Amersham Health Plc (now
  GE Healthcare) and Galil Medical each contributed the related operations                      

25

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | and assets necessary for Oncura to conduct the
  brachytherapy business and the cryotherapy business, respectively, in the
  urology field. In exchange for such assets, GE Healthcare received 78% and
  Galil Medical received 22% of the outstanding shares of Oncura. In addition,
  at the closing, Galil Medical purchased 3% of Oncura from GE Healthcare for
  $4.5 million in cash, which was paid in full as of April 26, 2004, resulting
  in Galil Medicals aggregate ownership interest of 25% of Oncura. Galil Medical has
  an option to purchase an additional 3% of Oncura from GE Healthcare for $5.4 million,
  exercisable until 45 days following the closing of an initial public offering
  of Oncura. As a result of the transaction, a gain in the amount of
  $21.2 million was recorded by Galil Medical in 2003. Our share in this gain (net of minority interest and
  income taxes) amounted to $4.4 million.                                                                                                                                                   
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Sale
  of Shares of Given Imaging by RDC                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |   | In 2003, RDC sold, in a series of transactions,
  753,600 shares of Given Imaging for approximately $7.8 million, resulting in
  a gain of approximately $4.4 million ($0.1 million net of tax and minority interest).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Purchase
  of Shares of Given Imaging from RDC                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |   | In May 2003, a Share Purchase Agreement was signed
  between RDC, Elron and Rafael, according to which RDC sold two million shares
  of Given Imaging, representing 7.9% of Given Imagings then outstanding
  shares, to Elron and Rafael (one million or 3.95% each) for total
  consideration of $12.2 million. RDC used $5.0 million of the proceeds to
  repay shareholders loans to Rafael and Elron. This transaction did not have
  any effect on our consolidated results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Sale
  of approximately 6.3 million Shares of Partner                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |   | In the second and third quarters of 2003, we sold,
  in a series of transactions, an aggregate of approximately 6.3 million shares
  of Partner, representing approximately 3% of Partners then outstanding
  shares, to Israeli institutional investors for approximately $29.3 million,
  as a result of which we recorded in 2003 an aggregate gain, net of tax, of
  approximately $7.1 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Sale
  of Elron SW, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |   | On September 2, 2003, our
  subsidiary, Elron SW Inc., or ESW, sold substantially all of its
  assets and business to Zix Corporation, or Zix (Nasdaq: ZIXI), a global
  provider of e-messaging protection and transaction services, in consideration
  for 1,709,402 shares of Zixs common stock, then with a market value of
  approximately $6.0 million and a 5.75% convertible note (the Note) of $1.0
  million. ESW granted a beneficial interest in approximately 85,000 common
  shares it received to certain of its former employees in recognition of
  services rendered to ESW. In addition, Zix assumed certain liabilities of ESW
  in the net amount of approximately $1.0 million. The transaction resulted in
  a gain of approximately $4.1 million. Simultaneously with the closing of the sale,
  we purchased the 1,709,402 shares of Zix common stock and the Note from ESW
  for approximately $6.2 million, based on the principal amount of the Note and
  the closing sale price of Zix shares on the Nasdaq National Market on the day
  prior to the closing.

26

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | As of December 31, 2004, we had sold all our shares
  of Zix (including 262,454 shares resulting from the conversion of the Note)
  for approximately $17 million, and recognized an aggregate gain of
  approximately $10.2 million ($6.8 million net of tax). In December 2004, ESW was voluntarily dissolved.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Purchase of shares of 3DV Systems
  Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   | On February 1, 2004, we and our subsidiary, RDC
  purchased approximately 47% of the outstanding share capital of 3DV Systems
  Ltd., or 3DV, in which we and RDC previously together held 48%, from the
  majority of the other shareholders of 3DV in consideration for an option,
  which has since expired, to receive up to 40% of the share capital of a new
  company to be established. We and RDC together currently hold 89% of 3DV.                                                                                                                                                                                                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Sale
  of KIT eLearning Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   | In March 2004, KIT eLearning Ltd., or KIT, a
  provider of online academic programs, in which we held a 45% ownership
  interest, was sold to Online Higher Education, a subsidiary of Laureate
  Education, Inc., or Laureate (Nasdaq: LAUR) (formerly known as Sylvan
  Learning Systems, Inc.), a global leader in higher education, for an
  immediate cash payment of $9.4 million and a future payment of up to an
  additional $10.0 million based on earnings of KIT in 2006 and 2007 (of which
  our share will be up to $5.7 million). The other selling shareholders of KIT
  were DIC, our largest shareholder, and Kidum IT Ltd., a privately held
  Israeli company. From the $9.4 million immediate proceeds of the sale, we
  received approximately $5.7 million and we recorded a gain of approximately
  $5.3 million.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Given
  Imaging secondary offering                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   | On
  June 23, 2004, Given Imaging completed a secondary public offering of
  2,880,750 ordinary shares at $32.00 per share, of which 1,500,000 shares were
  sold by Given Imaging
  and 1,380,750 shares were sold by selling shareholders, including 300,000
  shares sold by our subsidiary, RDC. Given Imaging received net proceeds from
  the offering of approximately $44.3 million. We also hold a direct interest
  in Given Imaging, but did not participate in the offering.                                                                                                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   | As a result of the sale of Given Imagings shares by
  RDC and the decrease in our direct and indirect interest (through our
  holdings in RDC) in Given Imaging to approximately 15%, we recorded a gain in
  2004, net of tax and minority interest, of approximately $6.7 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Sale of all of our holdings in
  Elbit Systems Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   | On July 28, 2004, we sold all of our holdings in
  Elbit Systems Ltd., or Elbit Systems, (Nasdaq: ESLT), constituting
  approximately 19.6% of the then outstanding share capital of Elbit Systems,
  to the Federmann group, following the exercise of its right of                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

27

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | first refusal, for approximately $196.6 million. As
  a result, we recorded in 2004 a gain, net of tax, of approximately $91.5
  million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | Purchase of additional shares of
  Given Imaging                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |   | In August and November 2004, we purchased
  approximately 1.4 million additional shares of Given Imaging in various
  transactions for an aggregate amount of approximately $44 million. As a
  result of these purchases, our direct and indirect ownership interest in
  Given Imaging (through our holdings in RDC) increased from approximately 15%
  to approximately 20% and our beneficial ownership increased to approximately
  25%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | Tender offer by DIC to purchase
  7.5% of our shares                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |   | On August 22, 2004, DIC completed a tender offer to
  purchase 2,203,425 of our ordinary shares for $15 per share, net to the
  seller in cash, less any required withholding taxes and without interest.
  Following consummation of the tender offer, DIC owned approximately 46% of
  our outstanding shares. DIC has purchased additional shares from time to time
  and as of May 31, 2006, holds approximately 47.6% of our outstanding shares.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | Investment of $3 million in
  Starling Advanced Communications Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |   | On October 21, 2004, we completed an investment of
  $3 million in preferred shares of Starling Ltd., or Starling, of which $1.5
  million was invested immediately and $1.5 million was invested in April 2005.
  Following the investments our direct interest in Starling is approximately
  33% and our beneficial ownership (directly and through RDC) is approximately
  66%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | Investment of $6.7 million in
  Jordan Valley Semiconductor Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |   | On October 21, 2004, we invested approximately $6.7
  million in Jordan Valley Semiconductor Ltd., or Jordan Valley, for preferred
  shares constituting 28% of the equity of Jordan Valley, as part of an
  aggregate amount of approximately $9 million raised by Jordan Valley. Our
  holding was subject to adjustment based upon Jordan Valleys performance for
  the period July 1, 2004 until June 30, 2005 with an option to make an
  additional investment on the same terms as the original investment to enable
  us to hold 25% of Jordan Valleys equity, on a fully diluted basis, after the
  adjustment. In October 2005, we exercised this option and invested an
  additional amount of approximately $1.4 million, following which we hold
  approximately 28% of the equity of Jordan Valley. The balance of the
  aggregate investment in Jordan Valley was invested indirectly by Clal
  Industries and Investments Ltd., or Clal. Jordan Valley is an Israeli private
  company engaged in developing solutions for advanced in-line thin film
  metrology for the semiconductor industry. Jordan Valley is 40% owned
  (indirectly) by Clal, a subsidiary of IDBD, which then owned approximately
  67% of DIC. Clal, IDBD and DIC are publicly traded on the Tel Aviv Stock
  Exchange. Our investment in Jordan Valley was approved in accordance with
  Israeli law by the shareholders of Elron and Clal on October 21, 2004.

28

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Investment in Impliant                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |   | On December 28, 2004, we invested approximately $7.3
  million for preferred shares of Impliant constituting approximately 23% of
  the equity of Impliant, as part of a financing round of approximately $18
  million from new and existing investors of Impliant. In October 2005, we
  invested an additional $1 million as part of an extension of the initial
  financing round. Following this additional investment, we hold 21.5% of the
  equity of Impliant. Impliant is a privately held medical device company
  engaged in the development of a novel posterior motion preservation system
  for spine surgery.

B.       Business
Overview

Our
group companies are engaged in four main fields of advanced technology, namely:
(i) medical devices; (ii) information and communications technology; (iii)
semiconductors and (iv) advanced materials. The business overview is presented,
for the purposes of convenience only, according to the four main fields listed above,
none of which is considered a separate reportable segment.

1.       Medical
Devices

Our
activities in the field of medical devices consist mainly of our holdings in
the following companies:

| |   |                                                                                                                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Given Imaging, in which we beneficially own
  approximately 36% of the outstanding shares representing all shares owned by
  us, RDC and DIC (which we may be deemed to beneficially own as a result of
  the voting agreement between DIC and us), or approximately 19% representing
  our direct holding and our share in the holding of RDC;
| |   |                                                                                                                                                                                                                                                                                                                                                
| |  | Galil Medical, in which we beneficially own
  approximately 60% of the outstanding shares representing all shares owned by
  us and RDC, or approximately 40%, representing our direct holding and our
  share in the holding of RDC;                                                                                                          
| |   |                                                                                                                                                                                                                                                                                                                                                
| |  | Oncura, in which we beneficially own approximately
  25% of the outstanding shares representing shares owned by Galil Medical, or
  approximately 10%, representing our share in the holding of Galil Medical;                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                
| |  | Notal, in which we hold approximately 23% of the
  outstanding shares;                                                                                                                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                
| |  | Impliant, in which we hold approximately 21.5% of
  the outstanding shares;                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                
| |  | NuLens, in which we hold approximately 29% of the outstanding
  shares;                                                                                                                                                                                                                                                                        
| |   |                                                                                                                                                                                                                                                                                                                                                
| |  | BrainsGate, in which we hold approximately 22% of
  the outstanding shares; and                                                                                                                                                                                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                
| |  | Medingo, in which we beneficially own 100% of the
  outstanding shares representing all shares held by RDC which holds directly
  all the shares of Medingo.                                                                                                                                                                                   

29

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Given
Imaging

Given
Imaging is an Israeli company that develops, manufactures and markets
innovative diagnostic products for disorders of the gastrointestinal tract. It
pioneered capsule endoscopy, a proprietary approach to visual examination of
the gastrointestinal tract through the use of a miniaturized video camera
contained in a disposable capsule.

Given
Imaging was incorporated in Israel by our subsidiary, RDC, in
January 1998. Its initial public offering and listing on the Nasdaq
National Market occurred in October 2001. In March 2004, Given Imaging
also listed its shares on the TASE. In June 2004, Given Imaging completed its
secondary public offering raising $44.3 million.

Given
Imagings principal product, which incorporates its core technology, is the
Given System, a proprietary wireless imaging system which uses disposable video
capsules, referred to as the PillCam capsules. The PillCam video capsules are
easily ingested by the patient and move naturally through the gastrointestinal
tract without discomfort while wirelessly transmitting high quality color
images and data to a portable recorder, enabling gastroenterologists to view
high quality video, images and data on their workstations. Given Imaging believes
that capsule endoscopy provides a patient-friendly solution that addresses a
significant market opportunity and overcomes many of the shortcomings of
traditional diagnostic tools for gastrointestinal disorders.

As
of December 31, 2005, Given Imaging had an installed base of approximately
2,860 Given Systems and had sold approximately 307,000 PillCam SB capsules in
over 50 countries worldwide.

In
November 2004, Given Imaging received FDA marketing clearance for its second
PillCam capsule, the PillCam ESO capsule, for visualizing the esophagus. Given
Imaging markets the PillCam ESO video capsule through a strategic marketing and
sales alliance formed in May 2004 with InScope, a division of Ethicon
Endo-Surgery, a Johnson & Johnson company. Under the terms of the
agreement, InScope committed to pay Given Imaging $50 million subject to
achievement of certain milestones. Out of this amount, to date, Given Imaging
has received $25 million.

Given
Imaging has also developed the AGILE Patency Capsule and system, which is a
dissolvable capsule that enables physicians to determine whether there are
obstructions or strictures in the gastrointestinal tract. Given Imaging
launched the AGILE Patency Capsule and system in Europe in November 2003 and in
May 2006 received FDA clearance to market this system in the United States.

Given
Imagings research and development efforts are focused primarily on developing
improvements to its existing products and developing new capsules to be used in
the detection of abnormalities in other areas of the gastrointestinal tract.
For example, in the second half of 2005, Given Imaging began performing initial
clinical trials with the PillCam Colon capsule, which is still under development.
If initial results are favorable, Given Imaging intends to commence broader
studies during 2006 which will then be used to support a submission of the
PillCam Colon capsule for FDA clearance.

30

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In
April 2006, Given Imaging appointed Nachum (Homi) Shamir as its new President
and Chief Executive Officer, to replace Mr. Gavriel Meron, co-founder of Given
Imaging. At the same time Mr. Meron was appointed Executive Vice Chairman of
Given Imagings Board of Directors. Mr. Meron subsequently resigned in June
2006 following a transition period to pursue other interests.

Given
Imaging recorded revenues of $86.7 million in 2005, $65.0 million in 2004
and $40.5 million in 2003.

Third-party
payors in the United States began issuing coverage policies for capsule
endoscopy in early 2002. Initially, all reimbursement policies issued coverage
for capsule endoscopy of the small bowel only for the diagnosis of obscure
gastrointestinal bleeding. Subsequently, reimbursement coverage has been
expanded to include other indications and as of December 31, 2005, most
Medicare carriers and private payors, with a total insured population in the
United States of approximately 209 million individuals, also cover capsule
endoscopy of the small bowel for suspected Crohns disease, suspected small
bowel tumors and other small bowel pathologies. Almost all of the reimbursement
policies currently in effect require that a previous procedure, such as
endoscopy or radiology, be performed prior to using the Given System and some
may require prior authorization. In 2005, several third-party payors have
issued new or updated policies that do not require endoscopy or other procedure
prior to performing small bowel capsule endoscopy. As of December 31, 2005,
approximately 11.5 million individuals in the United States had coverage under
these new or updated policies.

As
of December 31, 2005, no third party payor had established published coverage
policy for capsule endoscopy of the esophagus using the PillCam ESO capsule.
Meanwhile, numerous payers are reimbursing this procedure on a case by case
basis. Given Imaging does not expect broad coverage for this procedure prior to
assignment of a CPT code, which Given Imaging does not expect to occur until
late 2006, effective January 2007.

Given
Imaging currently markets and sells the Given System through a combination of
direct sales through its subsidiaries, and through independent distributors in
over 50 jurisdictions. Currently, Given Imaging markets the Given System
directly in Australia, France, Germany, the United States and Israel through
approximately 80 sales and marketing personnel employed by Given Imaging and
its subsidiaries in those jurisdictions. In the United States, which accounted
for 72% of Given Imagings revenues in 2004, and 74% of its revenues in 2005,
Given Imaging markets its products through its wholly-owned subsidiary, Given
Imaging, Inc. As of December 31, 2005, Given Imaging had a direct sales
force in the United States of approximately 45 personnel. In the first quarter
of 2006, Given Imaging substantially increased its direct sales force in the
United States.

Sales
to Given Imagings local distributors worldwide accounted for approximately 15%
of its revenues in 2005. Under the terms of Given Imagings distribution
agreements, Given Imaging generally grants to one distributor in each
particular country or region the right to market the Given System for an
initial period of approximately three years. During this period, the
distributor is required to meet minimum sales targets set out in each
distribution agreement.

31

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Given Imaging
may, in its sole discretion, upon prior written notice, terminate a
distribution agreement with a distributor in the event that a distributor fails
to meet its minimum sales targets.

The
Given System consists of Pillcam capsules, a portable data recorder and sensor
array, and a dedicated computer workstation. Given Imaging manufactures the
PillCam capsules at its facilities in Yoqneam, Israel using three
semi-automated production lines. Two of these production lines are used to
manufacture the PillCam SB capsule and one to manufacture the PillCam ESO
capsule. Given Imaging has constructed a fourth semi-automated production line,
which it plans to use for manufacturing the PillCam ESO capsule.Each semi-automatic production line in
Yoqneam, Israel facility has a capacity to manufacture approximately 270,000
PillCam capsules per year. Given Imaging has also installed at Pemstars
facilities in Ireland, a semi-automated production line of the PillCam SB
capsule for backup purposes, which has a capacity to manufacture an additional
270,000 PillCam capsules per year. Current production capacity is sufficient to
support sales in the foreseeable future.

The
portable data recorders are manufactured externally and assembled and tested at
Given Imagings facilities. The sensor arrays are manufactured and assembled
externally and are tested at Given Imagings facilities. The computer
workstation is an off-the-shelf computer workstation pre-loaded with Given
Imagings RAPID software. Given Imagings research and development activities
are conducted internally by its research and development staff, primarily at
its facilities in Yoqneam, Israel.

Given
Imagings first issued patents in the United States and Israel are on an in
vivo video camera system. Given Imaging acquired the rights to these issued
U.S. and Israeli patents in January 1998 under a technology purchase and
license agreement with Rafael. These issued patents in the United States and
Israel expire in January 2014 and January 2015, respectively. As of
December 31, 2005, Given Imaging held 36 additional issued patents in
Australia, France, South Korea, Israel and the United States covering different
elements of its technology and expiring between July 2014 and August 2022. As
of December 31, 2005, Given Imaging had 421 patent applications worldwide based
on 120 priority applications relating to various elements and functions of its
product and enhancements.In April 2006, in response to a request made by
Olympus in December 2003 to re-examine Given Imagings first U.S. Patent
#5,604,531, the USPTO issued an office action confirming the validity of 13 of
the original 17 claims of this patent. Given Imaging has the right to appeal
the rejection of the four other claims. On May 19, 2006, Olympus and its
subsidiaries filed a complaint in the U.S. District Court for the Eastern
District of Pennsylvania against Given Imaging for alleged infringement of U.S.
Patent 5,010,412, entitled High Frequency, Low Power Light Source for Video
Camera. In response to this law suit, Given Imaging announced that it believes
the complaint filed by Olympus has no merit and that it intends to take all
necessary steps to protect its interests.

For
additional information on Given Imagings business, including additional
products, manufacturing and suppliers and regulatory approvals, see Given
Imagings filings with the SEC.

32

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Galil Medical

Galil
Medical, an Israeli company established by RDC in 1997, is a provider of
minimally invasive temperature based therapies for the treatment of benign and
malignant diseases. Since 1999, Galil was focused on developing products to
address specific urologic diseases including prostate and kidney cancer. In
July 2003, Galil Medical completed the merger of its urology related
cryotherapy business with Amersham Healths brachytherapy business, which
created Oncura. Galil Medical holds 25% of Oncura. Galil Medical has entered
into supply and R&D services agreements with Oncura, pursuant to which
Galil Medical provides Oncura with certain exclusive supply, manufacturing and
R&D services in the urology field, upon a cost plus basis.

In
addition to its urology activities for Oncura, Galil Medical is now focusing on
developing minimally invasive cryotherapy solutions for womans health
conditions such as uterine fibroids and breast fibroadenoma. In 2005, Galil Medical received FDA
approval for breast fibroadenoma and the CE Mark for uterine fibroids.

Galil
Medicals intellectual property consists of intellectual property, which was
received from Rafael, and intellectual property developed by Galil Medicals research
and development team. Galil Medical has 15 patents and 23 pending applications.

As
of December 31, 2005, Galil Medical had 320 SeedNet machines installed
worldwide. Galil Medical recorded revenues of $8.3 million in 2005, $7.6
million in 2004 and $7.6 million in 2003. Revenues for the first half 2003
represented sales to the end user customer, while the majority of the revenues
for the second half of 2003 and for the years 2004 and 2005 represented sales
and services to Oncura.

Galil
Medicals research and development and manufacturing facilities are based in
Yoqneam, Israel.

As
of May 31, 2006, Galil Medical had approximately 52 employees.

Oncura

Oncura,
a Delaware corporation, markets and sells therapeutic device systems and
related consumables used primarily in the performance of minimally-invasive,
urologic cancer treatment. Oncuras products include implantable radioactive
seeds and cryotherapy devices and related disposable kits used in the treatment
of prostate and other urologic cancers.

Oncuras
formation was the result of a merger, completed July 1, 2003, between the
urology business of
Galil Medical, and the brachytherapy business of Amersham plc, now a subsidiary
of General Electric Company (GE Healthcare), as a result of which Galil
Medical and GE Healthcare acquired 78% and 22% of the issued and outstanding
shares of Oncura, respectively. Galil Medical purchased an additional 3% of
Oncura from GE Healthcare for $4.5 million, resulting in Galil Medical owning
an aggregate interest of 25% in Oncura. In addition, Galil Medical has an option to purchase an additional 3% of
Oncura from GE Healthcare for $5.4 million, exercisable until 45 days following
the closing of an initial public offering of Oncura.

33

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Oncura
is headquartered in Plymouth Meeting, Pennsylvania. In addition, Oncura has an
international management office located in Amersham, United Kingdom.

Oncura
does not manufacture any of the products it sells. A majority of Oncuras
products are manufactured by its two shareholders, GE Healthcare and Galil
Medical, and sold to Oncura under long-term supply agreements. Oncura also
purchases certain products, principally a type of radioactive seed not
manufactured by GE Healthcare, from a third-party supplier.

Oncura
markets and distributes its products directly and indirectly to numerous
international markets, including, the United States, Canada, Europe, Russia,
Israel, Greece, Korea, Philippines, Hong Kong, Australia, New Zealand, and
portions of South America. In the United States, Oncura sells principally
through its direct sales force. Outside of the United States, Oncura sells
through its direct sales force along with a network of affiliated and
independent distributors and agents. In certain markets outside the United
States Oncuras products are distributed under long-term distribution agreements
with affiliates of GE Healthcare.

Oncura
has also entered into services and research and development agreements with its
shareholders and affiliates for the provision of certain administrative and
research and development services.

Oncura
terminated most of its existing service and distributor arrangements with its
shareholders in 2004 and 2005. Oncura expects to terminate two additional
distributor arrangements with GE Healthcare in 2006. Subsequent to 2006 and for
the foreseeable future Oncura expects to continue its remaining distribution
agreements with GE Healthcare in Scandinavia, Austria, Portugal and New
Zealand.

Oncuras
intellectual property consists primarily of product brand names and product
patented technology that it either owns or is licensed to Oncura by GE
Healthcare and Galil Medical under exclusive licensing agreements.

As
of May 31, 2006, Oncura had approximately 99 employees.

Oncuras
activities in the marketing and distribution of cancer therapy products are
subject to extensive laws, regulations, regulatory approvals and guidelines.
Within the United States, the Companys products must comply with the U.S.
Federal Food Drug and Cosmetic Act, which is enforced by the FDA. Oncura must
also comply with the regulations of the Competent Authorities of the European
Union for any products sold in the member nations of the European Union. Oncura
is also subject to various other regulations, regulatory approvals and
guidelines in other markets in which it distributes its products. Oncuras
radioactive seeds are manufactured by GE Healthcare and third-party vendors and
physical handling and delivery of all radioactive seeds to customers, including
those manufactured by third parties, is the exclusive responsibility of these
affiliated and other non-affiliated vendors.

Oncuras
revenues were approximately $72.1 million in 2005 and $68.8 million in 2004,
and approximately $31.4 million for the period from commencement of operations
in July 1, 2003 through December 31, 2003.

34

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Notal

Notal
is a medical device company founded in 2000, operating mainly in the field of
early detection of Age Related Macular Degeneration (AMD). AMD is a common eye
disease that gradually destroys central visual function, manifested in two
forms: dry AMD, a mild form of the disease, and wet AMD, a progression of dry
AMD, which often leads to rapid, severe visual deterioration and blindness. To
address the growing need for early detection of wet AMD and for the continuous
monitoring of patients with dry AMD, Notal Vision has developed the patented
Preferential Hyperacuity Perimetry (PHP), designed to detect and monitor the
progression of the disease in a non-invasive manner. Notal launched, together with
Carl Zeiss Meditec, or Zeiss, the Preview PHP device, intended for professional
use by ophthalmologists and optometrists in their clinics. The current
diagnostic device enables early detection of wet AMD among the at-risk
population, those already diagnosed with the dry form of the disease. Future
versions may also target for screening purposes the full population at risk
(e.g., anyone over the age of 55) who may be unaware that they may have dry
AMD, as well as patients already treated for wet AMD for post-treatment
follow-up. Post treatment follow-up is intended to identify the recurrence of
the disease and confirm the stage of the disease. Sales of the Preview PHP
device to end-users started in the third quarter of 2004.

Based
on the PHP technology, Notal is also developing the Home Device, a monitoring
device intended for home use. The monitoring device will enable patients with
dry AMD to monitor themselves at home on a more frequent basis, ensuring timely
intervention by a physician should the disease progress to the wet form. In May
2005, Notal appointed TLC Vision Corporation, or TLC, as it exclusive
distributor for the sale and distribution of the Home Device in North
America. TLC also signed an investment agreement with Notal, pursuant to which
TLC committed to invest $4.25 million in Notal (of which $2.8 million has
already been invested) subject to achievement of milestones, primarily for the
purpose of funding the development of the Home Device.

Notal
commenced sales in 2003 and recorded revenues of $0.1 million in 2005, $1.0
million in 2004 and $0.9 million in 2003.

The
decrease in Notals revenues in 2005 resulted primarily from Zeiss
non-compliance with Notals exclusive distribution agreement with Zeiss. Notal
and Zeiss are in the process of negotiating their disputes through arbitration
or mediation.

Notals
headquarters are located in Tel Aviv, Israel and as of May 31, 2006, had 25
employees. Notal has one patent and three pending patent applications.

Innomed,
14% held by us, is also a 29% shareholder of Notal (see below, Other Holdings
in Medical Devices).

Impliant

Impliant
is a developer of posterior motion preservation spine implants. The companys
TOPS SystemTotal Posterior Spine System, is a mobile spine implant that
addresses the major degenerative spine diseases of the posterior spinal column.
The TOPS System

35

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reestablishes
a full range of motion, including axial rotation, lateral bending, flexion and
extension. Impliant began clinical trials on the device in January 2005.

In
  March 2006, Impliant received a CE Mark to sell its products in Europe.

Impliants
  headquarters are located in Milford, Connecticut, with research and development
  activities taking place in Ramat Poleg, Israel. As of May 31, 2006, Impliant
  had 26 employees.

Impliant
has 10 pending patent applications.

Innomed,
  14% held by us, is also a 11% shareholder of Impliant (see below, Other
  Holdings in Medical Devices).

Impliant
is currently in the development stage and has not commenced sales.

NuLens

NuLens,
established in September 2002, operates in the field of intra-ocular lenses or
IOLs mainly for treatment of cataracts and presbyopia. NuLens is focused on
exploiting the novel technologies in its patents and developing a real
accommodative IOL (RA-IOL) with the capacity of providing over 10 Diopters in
real accommodative power to the cataract and presbyopia markets. NuLens is
currently in the process of pre-clinical trials. In May 2006, NuLens received
approval from the Ministry of Health in Spain to commence clinical trials and
is expected to commence a clinical pilot study in the second half of 2006.

NuLens
has two patents and nine pending patent applications.

NuLens
offices are located in Herzliya, Israel and Alicante, Spain. As of May 31,
2006, NuLens had 10 employees.

NuLens is
currently in the development stage and accordingly has not commenced sales.

BrainsGate

Established
in 2000, BrainsGate is a medical device company developing innovative therapies
for patients suffering from Central Nervous System (CNS) diseases. BrainsGates
platform technology involves electrical stimulation of the spheno-palatine
ganglion (SPG) to increase cerebral blood flow and to increase the permeability
of the blood-brain barrier (BBB).

BrainsGate
is exploring several applications for its technology, and is currently focusing
on two directions, drug delivery into the CNS, and treatment of acute ischemic
stroke.

BrainsGate
has developed the NeuroPath System, based on a miniature electrode implanted
at the roof of the mouth using a minimally invasive surgery.

BrainsGate
has eight pending patent applications and 24 patents.

36

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BrainsGate
initiated clinical feasibility trials in Europe, treating patients with
Grade-IV Astrocytoma (GBM). Clinical trials for the ischemic stroke application
are planned to commence in the second half of 2006.

BrainsGate
is headquartered in Raanana, Israel. As of May 31, 2006, BrainsGate had 21
employees.

BrainsGate
is currently in the development stage and accordingly has not commenced sales.

Medingo

Medingo,
wholly-owned by RDC, was established in November 2005. Medingo develops
solutions specifically to the needs of insulin-dependent diabetic patients.
Medingos device is a miniature dispensing patch, which is convenient, easy to
use, discreet and more cost-effective than standard insulin pumps.

Medingo
has five pending patent applications.

Medingos
offices are located in Yokneam, Israel. As of May 31, 2006, Medingo had 15
employees.

Medingo
is currently in the development stage and accordingly has not commenced sales.

Other Holdings in
Medical Devices

Our
other holding in the medical devices field is in Innomed, which is a seed stage
fund that initiates and invests in Israeli and Israeli related companies in the
field of medical devices and life sciences. We hold, through our subsidiary
DEP, approximately 14% of the partnership interest in Innomed. Innomed is a
member of the Jerusalem Global Ventures Group of venture capital funds.

|   |                                                                                                 |                                                                                                                                                                                                                                 
|-- | ----------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2. | Information, Communications & Technology, or ICT.                                              
|   |                                                                                                
|   | Our
  activities in the field of ICT consist of our holdings in the following main
  companies:
|   |                                                                                                
|   |                                                                                                | Partner, in
  which we hold approximately 2.6% of the outstanding shares;                                                                                                                                                       
|   |                                                                                                 |                                                                                                                                                                                                                                 
|   |                                                                                                | NetVision,
  in which we hold approximately 39% of the outstanding shares;                                                                                                                                                      
|   |                                                                                                 |                                                                                                                                                                                                                                 
|   |                                                                                                | Teledata, in
  which we hold approximately 21% of the outstanding shares and Infinity, a
  related venture capital fund, holds approximately 4% of the outstanding
  shares;                                                    
|   |                                                                                                 |                                                                                                                                                                                                                                 
|   |                                                                                                | Wavion, in
  which we hold approximately 38% of the outstanding shares;                                                                                                                                                         
|   |                                                                                                 |                                                                                                                                                                                                                                 
|   |                                                                                                | Starling, in
  which we beneficially own approximately 72% of the outstanding shares
  representing all shares owned by us and RDC, or approximately 50%,
  representing our direct holding and our share in the holding of RDC;
|   |                                                                                                 |                                                                                                                                                                                                                                 
|   |                                                                                                | Enure, in
  which we hold approximately 57% of the outstanding shares;                                                                                                                                                          

37

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| |   |                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------
| |  | Safend, in
  which we hold approximately 26% of the outstanding shares;                                              
| |   |                                                                                                                      
| |  | Pulsicom
  Israel Technologies Ltd., or Pulsicom, in which we hold approximately 18% of
  the outstanding shares; and
| |   |                                                                                                                      
| |  | CellAct
  Ltd., or CellAct, in which we hold approximately 45% of the outstanding
  shares.                          

Partner

Partner
is a publicly traded, Israel-based company. Its shares are traded on the Tel
Aviv Stock Exchange under the symbol PTNR. American Depositary Shares, or
ADSs, each representing one of the Companys ordinary shares, are quoted on the
Nasdaq National Market under the symbol PTNR and are traded on the London
Stock Exchange under the symbol PCCD. Partner was the first Global System for
Mobile Communications, or GSM, mobile telephone network operator in Israel and
is one of four cellular service providers in Israel.

On
April 20, 2005, we completed the sale to Partner of most of our Partner shares
for approximately $94 million, as part of the sale together with the other
Israeli founding shareholders of Partner of an aggregate of approximately 33.3
million Partner shares to Partner for an aggregate consideration of
approximately $245 million, following which we held approximately 2% of
Partners outstanding shares. On March 21, 2006, we purchased an additional
0.6% of Partners outstanding shares from one of the other Israeli founding
shareholders of Partner for approximately $5.3 million.

Our
remaining shares, constituting approximately 2.6% of Partners outstanding
shares, are no longer pledged to the banks providing financing to Partner.
However, almost all Partner shares held by us are subject to certain transfer
restrictions under Partners Israeli communications license. Under Partners
Israeli communications license, the Israeli founding shareholders are required
to maintain such amount of shares to ensure that at least 5% of Partners
shares are held by Israeli citizens and residents. In addition, the Israeli
founding shareholders are required to appoint, generally, 10% of Partners
board of directors. On April 20, 2005, the Israeli founding shareholders,
including us, entered into a Restated Relationship Agreement among themselves
and Partners controlling shareholders, Hutchison BV and Advent Investments Pte
Ltd., and a shareholders agreement among themselves to regulate the above
issues as between them. For a description of the material terms of these
agreements, See Item 10C - Material Contracts.

Partners
principal business is the provision of mobile telephone services in Israel.
Partner currently operates in the 900 MHz and 1800 MHz bands. Its GSM network
covers approximately 97% of the Israeli population. Its services include
standard and enhanced GSM services, as well as value added services and
products such as voice mail, voice messaging, color picture messaging, icon,
ringtone and game downloads, information services, High Speed Circuit Switched
Data or HSCSD, General Packet Radio Services, or GPRS, which enables the packet
transfer of data in an always on mode at a speed of up to 20-30 Kbps,
personal numbering and data and fax transmission services. Partner also offers
its subscribers the ability to roam using their mobile phones outside Israel.

Partners
3G network, which as of the end of 2005 covered approximately 92%, of the
Israeli population, offers a wide range of new services, such as video calls, a
new portal of

38

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content services including a broad selection
of video-based services under the obox live brand, and the transmission of
data at speeds of up to 384 Kbps.

Partner
distributes its services primarily through direct sales through Partner-owned
sales centers and business sales representatives and indirect sales through
traditional networks of specialist dealers and non-traditional networks of
retail chains and stores, which account for a majority of Partners sales.
Partner also offers 24-hour, seven days a week customer service, as well as
handset repair and replacement services, to subscribers who acquire these
services.

Partner
is subject to extensive regulation related to the spectrum and its ability to
operate mobile telephone service in Israel. The Israeli Ministry of
Communications controls the granting of licenses to operate mobile telephone
service in Israel. It has granted licenses to several companies to operate such
mobile networks, and may grant additional licenses in the future. Additionally,
Partner must erect antennae that carry its network transmissions in order to
maintain the coverage of the Israeli population required in its license. The
erection and operation of these antennae must comply with local, regional and
national regulations.

Partner
is also dependent on a number of licenses and agreements to operate its mobile
telephone network, and Partner maintains contracts with a number of dealers
through which its products are sold and has contracts with Nortel, Nokia and
Ericsson to provide it with equipment to run its network. Such equipment is
available only through a limited number of suppliers. Partner also leases most
of its transmission capacity from Bezeq. Partner maintains agreements with
mobile telephone network operators in foreign countries through which it
provides its customers with international service.

As
of December 31, 2005, Partner had approximately 2.529 million subscribers,
representing approximately 32% of the total Israeli cellular market. Partners
revenues were approximately NIS5.12 billion ($1.11 billion) in 2005, NIS 5.14
billion ($1.12 billion) in 2004 and NIS 4.47 billion ($0.97 billion in
2003) The dollar amounts are based on the shekel-dollar representative rate of
exchange on December 31, 2005 of NIS4.603 equal to $1.00.

In
  the third quarter of 2005, Partners Board of Directors and shareholders
  approved the distribution of its first cash dividend, in the amount of NIS 0.57
  per share, totaling approximately NIS 86.4 million to its shareholders of record
  as of September 26, 2005. In the first quarter of 2006, Partners Board
  of Directors and shareholders approved the distribution of an additional cash
  dividend in the amount of NIS 0.65 per share (totaling approximately NIS 100
  million) to its shareholders of record as of April 10, 2006. In the second quarter
  of 2006, Partners Board of Directors approved the distribution of an additional
  cash dividend in the amount of NIS 0.45 per share (totaling approximately NIS70
  million) to its shareholders of record as of June 6, 2006.

NetVision

NetVision
provides Internet services and solutions in Israel and international telephony
services through Voice over IP technology (VoIP). On May 19, 2005, NetVision
completed its initial public offering on the TASE of shares and convertible
securities in consideration for aggregate immediate net proceeds of
approximately NIS135 million (approximately $31 million). In addition, future
proceeds from the exercise of options sold in the offering may amount up to
approximately NIS28.8 million (approximately $6.6 million). NetVisions total
revenues were $74.3 million in 2005, $66 million in 2004 and $61.3 million in
2003 based on the

39

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shekel-dollar
representative rate of exchange as of December 31, 2005 of NIS 4.603 equal to
$1.00.

NetVisions
activities in the Internet area focus on providing Internet connectivity and
related services and products, content and electronic commerce services and the
establishment and supply of Internet-based applications. NetVision provides
international telephone services through 017 prefix, which are provided using
Voice Over Internet Protocol (VOIP) technology, a technology that enables
voice transmission over the Internet infrastructure.

NetVision
estimates that as of December 31, 2005, its share of the Internet connectivity
market in Israel was approximately 25%, with 425,000 customers receiving
Internet connectivity services from NetVision (of which
approximately 272,000 were broadband).

NetVision
also provides various content and electronic commerce services. NetVision
maintains Nana, a portal which provides a variety of content and e-commerce
services, such as search engines and mail boxes, chat rooms, forums and blogs,
Web site indexing for both local and international sites, shopping and
advertising.

NetVision
is involved in e-commerce activity and currently operates through Nanashops
website (previously called Netaction), which enable e-commerce through
various sale methods - auction, public sale and group purchases.

NetVision
is dependent on the communication services provided by Bezeq which has a
monopoly for domestic telecommunications in Israel. NetVision is also dependent
on maintaining its operating license granted by the Israeli Ministry of
Communications

On
May 1, 2006, NetVision announced that it will be entering into merger
discussions with Barak, a subsidiary of Clal Industries and Investments Ltd.,
or Clal. Elron, Clal and DIC, the other major shareholder of NetVision, are all
part of the IDB group of companies. Barak engages mainly in the provision of
international telecommunication services. The transaction, if it takes place,
will be subject to the signing of a definitive agreement as well as corporate
and regulatory approvals. There is no assurance that the transaction will take
place.

NetVisions
headquarters are located in Haifa, Israel. As of May 31, 2006, NetVision had
1,195 employees.

Teledata

Teledata
provides innovative access products and solutions for both traditional and Next
Generation Networks, or NGN, to telecom operators and service providers which
allow operators to provide a large variety of wireline services, including
Voice, Data and Video (Triple Play) for business and residential customers.
Teledatas solutions provide a smooth migration path from existing legacy
networks into NGN based on IP and soft switches. Teledata has two families of
products: BroadAccess which is a carrier-class Integrated Multiservice Access
Platform (IMAP) providing integration into both ATM and IP networks and
HighPGate, an access gateway for voice, data and protocol conversion into NGN.

40

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Teledata
sells its products directly and through distributors in Europe, Asia, Africa
and South America. Teledatas revenues were $55.9 million in 2005, $38.9
million in 2004, and $20.8 million in 2003. Teledatas revenues depend to a
large extent on being awarded large projects with new customers mainly in third
world countries. There is no assurance that Teledata will be able to maintain
its revenues at the same level as in the past.

Teledata
was established in 1981 and maintains its headquarters in Herzliya, Israel.
Teledata also operates through subsidiaries in the Netherlands, Australia and
Brazil. As of May 31, 2006, Teledata had 161 employees worldwide.

Teledata
has 14 patents and 26 pending patent applications, primarily in the United
States.

Wavion

Wavion
develops and delivers access points for outdoor metro applications. Wavion
commenced development of its products in the second quarter of 2000. Wavions
proprietary signal processing algorithms for digital beam forming utilize
multipath to provide significant performance gains in system capacity,
operating range, data rate and interference mitigation. The modular technology
can be customized to meet the requirements of most equipment vendors and
integrates easily into any wireless communication system.

In
May 2006, Wavion launched its product and expects to commence product sales in
the second half of 2006.

Wavion
is a Delaware corporation with research and development facilities in Yoqneam,
Israel.

Wavion
has two pending patent applications and as of May 31, 2006, Wavion had 64
employees.

Starling

Founded
at the end of 2003, Starling is a provider of innovative connectivity solutions
for the broadband access market for mobile platforms, currently focusing on aircraft.
Its antenna and SATCOM (satellite communications) systems are based on proven
technology developed at Rafael and Elbit Systems Ltd. Starling provides a
unique connectivity solution that makes possible the delivery of advanced
Internet services and applications for VOIP, security, entertainment and
operations on all three major categories of aircraft, namely, business jets,
narrow-body and wide-body. The Starling MIJET product line incorporates a
two-way Ku-band low profile antenna with a proprietary SATCOM resource
allocation system that effectively utilizes satellite transponder capacity. The
solution enables the delivery of high-speed Internet services on a broadband
connection.

Starling
does not expect to receive purchase orders prior to the end of 2006.

Starling
has its headquarters in Yoqneam, Israel.

Starling
has two pending patent applications. As of May 31, 2006, Starling had 26
employees.

41

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Enure

Enure,
established in 2003, develops software that automates the operation of
broadband services in the home. Enures software is intended to ensure that the
home network and applications work reliably, problems are automatically fixed
and installations, upgrades, and policies management by service providers, are
all executed automatically.

Enures
main target market is broadband service providers, a rapidly growing arena with
major technology investments. For service providers, such as telecommunication
companies and Multi Service Organizations, or MSOs, typically cable companies,
Enures software drives operating expense reduction and establishes the solid
basis for future advanced services, such as VoIP, IPTV and Triple and Quadruple
Play.

Enures
software uses patent-pending core technology. Enures home-residing software is
sold under the brand ServiceShield, and its optional service-provider-residing
server under the brands ServiceShield Concentrator and TIC.

As
of December 31, 2005, Enure had not yet generated revenues.

Enure
operates from Herzelia, Israel and as of May 31, 2006, Enure had 25 employees.
Enure has two pending patent applications.

42

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Safend

Safend,
established in 2003, develops comprehensive endpoint security solutions that
enable organizations to adopt new communication technologies without
sacrificing security. Safend products focus on securing enterprise desktops and
laptops by providing visibility and control over wired and wireless
commuinication ports.

Safends
end-point security solutions provide the enterprise with granular visibility
and control over the myriad of devices users connect to their desktops and
laptops.

In
2005 Safend recorded revenues in the amount of $0.4 million.

Safend
is headquartered in Tel Aviv, Israel with a subsidiary in Philadelphia,
Pennsylvania. As of May 31, 2006, Safend had 44 employees worldwide.

Safend
has filed two Patent Cooperation Treaty or PCT applications and three
additional provisional patent applications.

Pulsicom

Pulsicom
Israel Technologies Ltd. develops high accuracy, real time locating and
tracking systems for confined spaces. Pulsicoms technology employs short-pulse
technologies, including very-and ultra-wideband and sophisticated
position-determination algorithms.

Pulsicom
is an early stage development company, which has not yet completed its
commercial product development. In order to generate revenues, Pulsicom
provides development services to different customers. Pulsicom has limited
resources and its continued operations depend on its ability to raise
additional capital. There is no assurance that Pulsicom will be successful in
its efforts to raise additional capital. As of May 31, 2006, Pulsicom had 6
employees.

Cellact

Cellact
Ltd. is a developer of cellular messaging platforms and applications, based on
proprietary technology. Cellacts main product, Large Account gateway, was
first commercially released in July 2001. The Large Account gateway is a
product aimed at mobile operator, virtual mobile operators and mobile service
providers. The Large Account gateway provides the operator with the ability to
easily connect and manage content providers and enterprises to its SMS and MMS
systems. Cellacts customers come from a variety of industries, including
telecom, finance and call centers

43

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|   |               
|-- | --------------
|3. | Semiconductors

Our
activities in the field of semiconductors consist of our holdings in the
following companies:

| |   |                                                                                                                                                                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | ChipX, in
  which we hold approximately 29% of the outstanding shares.                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                              
| |  | Jordan
  Valley, in which we hold approximately 28% of the outstanding shares;                                                                                                                                                                                                               
| |   |                                                                                                                                                                                                                                                                                              
| |  | Sela 
  Semiconductor Engineering Laboratories Ltd., or SELA, in which we
  beneficially own approximately 66% of the outstanding shares representing all
  the shares owned by us and RDC, or approximately 39%, representing our direct
  holding and our share in the holding of RDC; and
| |   |                                                                                                                                                                                                                                                                                              
| |  | 3DV, in
  which we beneficially own approximately 89% of the outstanding shares
  representing all shares owned by us and RDC, or approximately 62%,
  representing our direct holding and our share in the holding of RDC.                                                                  

ChipX

ChipX
is a manufacturer of late stage programmable structured ASICs (Application
Specific Integrated Circuits). ChipXs innovative, patented technology
consolidates wafer manufacture tooling, reduces time-to-market and minimizes
the cost of initial production. In 2004, ChipX discontinued the low volume
OneMask business to focus on specific higher volume vertical markets with its
future products, which were introduced during the second half of 2005. Initial
customer purchases of these products are expected to commence in late 2006.
ChipX also discontinued the back end production processes relating to low
volume production, in effect becoming a totally fabless operation.

ChipXs
Structured ASIC solution specifically addresses applications with medium to
high production volumes. Along with standard cell ASIC vendors, ChipX primarily
addresses the hard-wired ASIC market serving a wide variety of end markets,
including automotive, computer, consumer, industrial and communications
markets.

ChipX
depends upon third-party manufacturers to manufacture its products. ChipX uses
a wide range of parts and raw materials in the production of its
semi-conductors, including silicon wafers, and electronic and mechanical
components.

ChipX
generally does not have guaranteed supply arrangements with its suppliers and
does not maintain an extensive inventory of parts and materials for
manufacturing.

ChipXs
  patented structured ASIC technology is protected by several core patents on
  its basic architecture, special logic cell and metal configurable memory. In
  addition, ChipX has internally developed routing software and metal programmable
  input/output cells to take advantage of its proprietary technology. ChipX has
  19 U.S. patents and 2 pending applications.

ChipXs
total revenues were $14.7 million in 2005, $16.2 million in 2004 and $13.7
million in 2003.

ChipXs
headquarters are located in Santa Clara, California with research and
development operations taking place in Haifa, Israel. As of May 31, 2006, ChipX
had 73 employees.

44

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Jordan Valley

Jordan
  Valley offers inline metrology solutions with ultra thin film measurement capability
  and wide range of application coverage based on X-ray technology. The companys
  JVX® platform exploits various X-ray-based schemes to provide a broad range
  of measurement capabilities including thickness, density, roughness, and composition
  of metals and dielectric films. The platform features small spot size, non-destructive,
  enabling product wafer metrologies.

Jordan
Valley operates two business divisions: analytic division and semiconductor
division. Jordan Valley focuses in the semiconductor industry, selling,
directly in the United States and via distributors in Japan, Europe, Taiwan,
Korea and China.

Jordan
Valleys revenues were $10.4 million in 2005, $8.2 million in 2004 and $3.2
million in 2003.

Jordan
Valleys headquarters, manufacturing, and R&D facilities are located in
Migdal Haemek, Israel. Marketing offices are located in the United States. As
of May 31, 2006, Jordan Valley had 90 employees.

In
the field of X-Ray metrology, Jordan Valley holds 19 U.S. patents with 15
applications pending, as well as five patents with 24 applications pending in
foreign jurisdictions.

SELA

SELA
develops and manufactures yield enhancing and automation equipment for the
semiconductor and optical component industries. SELA is dedicated to the
development and marketing of solutions for failure analysis and process
monitoring in the semiconductor industry. SELAs automated sample preparation
systems are used primarily by semiconductor manufacturers to prepare samples
for scanning electron microscopy and transmission electron microscopy. SELA has
six patents and two pending patent applications. SELAs revenues were $4.2
million in 2005, $5.1 million in 2004 and $4.3 million in 2003. SELAs
headquarters are located in Yoqneam, Israel and it maintains a marketing office
in Sunnyvale, California. As of May 31, 2006, SELA had 36 employees.

3DV

3DV
designs and develops three dimensional image sensors chip sets that generate
both color and depth information, for each object captured by a camera, in real
time. 3DVs business is currently focused on applications in the video gaming field
and ceased engaging in applications in the medical field.

3DV
  has not yet generated significant revenues and its ability to continue to operate
  is dependent upon financial support from its shareholders and its ability to
  raise financing from external investors. 3DV is headquartered in Yoqneam, Israel
  and as of May 31, 2006, 3DV had 19 employees.

45

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|   |                   
|-- | ------------------
|4. | Advanced Materials

Our
activities in the field of amorphous metals consist of our holding in AMT, in
which we hold approximately 34% of the outstanding shares on an as converted
basis as of June 8, 2006.

AMT
operates through its group companies in developing, marketing and licensing
technologies for amorphous and nano-crystalline advance materials, as a
solution for a wide range of commercial applications. AMTs thin ribbons,
microwires and nano powder amorphous materials exhibit magnetic, electrical,
mechanical and chemical properties that enable the enhancement of existing
products and applications, as well as the introduction of new products and
solutions for various industrial and high-tech applications and markets. AMT
operates in four fields: heating, sensoring (authentication and anti-shop
lifting), micro wires and electronic elements. AMTs current main focus is in
the field of heating through A.H.T. Advanced Heating Technology Ltd., or AHT,
and in the sensoring field (authentication and anti-shop lifting) through
A.C.S. Advanced Coding Systems Ltd, or ACS. The continued operations of AMTs group
companies are largely dependent upon their ability to generate sufficient
revenues. There is no assurance that AMTs group companies will be able to
successfully market their respective products in the worldwide market.

AHT,
in which AMT holds approximately 93% of the outstanding shares, is engaged in
the development and production of heating applications based on thin ribbon,
amorphous materials. AHT holds a global patent on using amorphous ribbons for
heating products. AHT has developed a variety of heating products for domestic,
outdoor, agricultural and pipe heating markets. AHTs electrical heating
element enables the heating of very large surface areas at lower temperatures
and higher efficiency and therefore at a lower cost and presents competitive
advantages over other electrical and non-electrical heating alternatives. AHT
currently focuses on two principal markets: under floor indoor heating and
outdoor heating.

AHT
has agreements with distributors in various countries, including most recently,
a distribution agreement with Mohawk Carpet Distribution, L.P signed in 2005
for distribution of its products in the United States.

AHTs
revenues were $2.6 million in 2005, $1.2 million in 2004, and $0.8 million in
2003.

AHT
has five patents.

AHT
is headquatered in Netanya, Israel and as of May 31, 2006, AHT had 21
employees.

ACS

ACS,
in which AMT holds directly and indirectly approximately 89% of the outstanding
shares, develops, markets and sells products using microwires amorphous
material for brand protection against counterfeiting and theft and electronic
article surveillance tags for anti-shoplifting. ACS competes in the electronic
article surveillance tags, data and authentication tags markets. ACSs revenues
were $1.0 million in 2005, $0.8 million in 2004 and $0.6 million in 2003.

ACS
has 3 patents and 5 patents pending.

ACS
is headquatered in Even Yehuda, Israel and as of May 31, 2006, ACS had 12
employees.

46

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Other Holdings

Elbit
Vision Systems Ltd., or EVS, [OTCBB: EVSNF.OB], in which we beneficially hold
approximately 9.3% of the outstanding shares (not including 1,512,939 warrants
to purchase ordinary shares of EVS), designs, develops, manufactures, markets
and supports automatic visual inspection and quality monitoring systems for a
broad range of industries. EVS automatic in-line inspection and quality
monitoring systems are designed to increase the accuracy, consistency and speed
of detection of defects in the manufacturing process in order to reduce labor
costs, improve product quality and increase manufacturing efficiency. EVS
Microelectronic Division primarily provides optical inspection and correction
systems for the manufacture of liquid crystal displays, flat panel displays.
EVSs, Industrial Division provides automatic optical inspection (AOI) and
non-destructive ultrasound inspection systems for heavy manufacturing
industries (automotive, aeronautics, steel and others) and industrial materials
(textiles, non-wovens, plastic, paper and others).

EVS
maintains a global sales force and service coverage with over 850 inspection
systems installed in 25 countries and has more than 100 customers.

EVSs
revenues were $20.8 million in 2005, $11.0 million in 2004 and $6.3 million in
2003.

EVS
is headquartered in Yoqneam, Israel, with offices in the United States and
Korea, and as of May 31, 2006, had 118 employees.

|   |                         
|-- | ------------------------
|C. | Organizational Structure

As
of May 31, 2006, DIC, an Israeli company, holds approximately 47.6% of our
total outstanding shares. For additional information about DIC, see Major
Shareholders in Item 7 below. For our holdings in our group companies, see
above.

|   |                               
|-- | ------------------------------
|D. | Property, plants and equipment

Our
corporate headquarters and executive offices are located in Tel-Aviv, Israel.
These offices, which measure approximately 980 square meters, are leased at an
annual rent of approximately $0.3 million.

We
believe that the above facilities are adequate for our operations as currently
conducted. In the event that additional facilities are required, we believe
that we could obtain such additional facilities at commercially reasonable
prices.

In
addition, we have contractual rights to long-term leases in property located in
Karmiel, in northern Israel, totaling approximately 15,760 square meters,
consisting of building facilities. These premises are currently leased to Elbit
Systems Ltd., or Elbit Systems.

47

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Item 4A. Unresolved Staff Comments

Not
applicable.

Item 5. Operating and Financial Review and
Prospects

OVERVIEW

We
are a high technology operational holding company that operates through
subsidiaries and affiliated companies, referred to as our group companies.
Founded in 1962, we have been a major force in the development of the Israeli
high technology industry by building Israeli and Israel-related companies with
technologies in the fields of medical devices, advanced defense electronics,
communications, semiconductors, software products and services and advanced
materials. Some of our group companies grew out of our subsidiary, RDC. Our
group companies include both publicly traded and privately held companies.

Our
primary activity is our involvement in the management of our group companies in
which we maintain controlling or significant holdings, and, in a limited number
of cases, non-significant holdings. We participate in the management of most of
our group companies by means of active membership on their boards of directors
and board committees. As a result, we are involved in matters of policy,
strategic planning, marketing, selecting and manning senior management
positions, approving investments and budgets, financing and the overall ongoing
monitoring of our group companies performance. In addition to our
representation on the boards of directors of our group companies, we provide
hands-on assistance to the group companies management in support of their
growth. We view our hands-on involvement in the operations of our group
companies as a key element of our business. Our group companies therefore
benefit from the experience of our management team in various areas in which
they need support and leadership, including, but not limited to, strategic
planning, research and development guidance, identifying joint venture
opportunities, introductions to potential customers and investors, risk
management, market analysis, business plan preparation, budgetary control, and
legal support.

Technology
industries are characterized by the high degree of risk inherent in their
products, their continuous technological innovation and their penetration into
world markets, which requires investment of considerable resources and
continuous development efforts. The future success of our group companies is
dependent upon their technological quality, the prices and nature of their
products in comparison to their competitors and their ability to introduce new
products to the markets at the right time, while offering cost effective
solutions suitable to their customers needs as well as their ability to raise
financing and the condition of the capital markets.

We
expect to continue to build and realize value for our shareholders through the
sale to third parties of a portion or all of our holdings in, or the issuance
of shares by, our group companies, while simultaneously pursuing the
acquisition of, or investment in, new and existing companies at different
stages of development including early stage and more mature companies. We
believe that this strategy provides the ability to increase shareholder value
as well as to create capital to support the growth of our group companies and
to invest in new opportunities.

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The nature of
our business, therefore, will result in some volatility in our results of
operations, depending on the transactions that occur within a particular
period.

Our
net income (or loss) in any given period is due, for the most part, to the
results of operations of those of our group companies which are accounted by us
under the consolidation or equity method of accounting and dispositions and
changes in our holdings of group companies. As most of our group companies are
technology companies which have not yet generated significant revenues and
which invest considerable resources in research and development and in
marketing activities, we have experienced, and expect to continue to
experience, losses in respect of these companies. However, as a result of
recent accounting pronouncements described below under CRITICAL ACCOUNTING
POLICIES, some of our group companies and new companies in which we may invest
may be accounted for at cost, thereby not affecting our results of operation.

Our
capital resources in any given period are primarily affected by the extent of
our investment in existing and new companies and the realization of certain
holdings as well as the impact of any dividends or distributions to our
shareholders. The results of operations of our group companies, and
consequently, our results of operations and capital resources, are affected by
general economic conditions as well as by factors specifically related to the
technology markets, which also affect the ability of our group companies to
raise financing and our ability to dispose of holdings and realize gains from
our holdings.

TREND INFORMATION

Technology
industries are affected by economic trends and the condition of the capital
markets. Since the second half of 2003, there has been a recovery in the
technology sectors and capital markets from the downturn which commenced in
2001. This trend was reflected in the improvement in the results of operations
of most of our group companies as well as the raising of funds from new
strategic and other investors in private placements completed by some of our
group companies. In addition, we recorded significant gains from realizing
certain of our holdings, mainly in 2004 as a result of the sale of our holdings
in Elbit Systems Ltd. and in the second quarter of 2005 from the sale of most
of our shares in Partner and the sale of all of our shares in Oren (see ITEM 4
Information on the Company). Should the improvement in the technology sectors
and capital markets continue, we anticipate that it will have a positive effect
on our group companies and their ability to raise additional capital. In
addition, during 2004 and 2005 we invested approximately $48.3 million in new
companies (see Item 4 Information on the Company for more information
regarding new investments in 2005) and an additional $64.8 million in existing
group companies (mainly in Given Imaging) including an amount of $12.4 million
in consolidated subsidiaries.

CRITICAL ACCOUNTING POLICIES

We prepare
our consolidated financial statements in conformity with accounting principles
generally accepted in the United States (US GAAP). Our significant accounting
policies are more fully described in Note 2 to our Consolidated Financial
Statements included elsewhere in this report. Certain accounting principles
require us to make certain estimates, judgments and assumptions. We believe
that the estimates, judgments and assumptions upon which we rely are

49

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reasonable based upon information available to us at the time that
these estimates, judgments and assumptions are made. These estimates, judgments
and assumptions can affect the reported amounts of assets and liabilities as of
the date of the financial statements, as well as the reported amounts of
revenues and expenses during the periods presented. To the extent there are
material differences between these estimates, judgments or assumptions and
actual results, our financial statements will be affected. The significant
accounting policies that we believe are the most critical to aid in fully
understanding and evaluating our reported financial results include the
following:

| |   |                                                                               
| | - | ------------------------------------------------------------------------------
| |  | Principles of accounting for holdings in group companies;                     
| |   |                                                                               
| |  | Business combinations and purchase price allocation;                          
| |   |                                                                               
| |  | Impairment of goodwill and other intangible assets;                           
| |   |                                                                               
| |  | Other-than-temporary decline in value of investments in group
  companies; and
| |   |                                                                               
| |  | Accounting for income taxes.                                                  

Principles of
Accounting for Holdings in Group Companies

The various
holdings that we have in our group companies are accounted for under several
methods, based among others, on our level of ownership and the type and form of
our holdings in our group companies, as described below.

Consolidation. Companies over which we have control are
accounted for under the consolidation method of accounting. Control is usually
assumed when we own directly or through our subsidiaries, more than 50% of the
outstanding voting securities of a company. However, whether or not we control
a group company also depends on an evaluation of several factors, including,
among others, our representation on the board of directors and any minority
participating rights and other factors which require management to make
judgment and involve the use of significant estimates and assumptions.

Under the
consolidation method, a controlled companys assets and liabilities are
included within our consolidated balance sheet and its income and expense items
are included within our consolidated statements of operations. The share of
other shareholders in the net assets and in the net income or losses of a
consolidated company is reflected in minority interest in our consolidated
balance sheet and in our consolidated statements of operations, respectively.
The minority interest amount adjusts our consolidated net income (loss) to
reflect only our share in the earnings or losses of any consolidated company.

Notwithstanding
the above, in January 2003, the Financial Accounting Standards Board
(FASB) issued Interpretation No. 46, Consolidation of Variable
Interest Entities  An Interpretation of Accounting Research Bulletin
No. 51 (FIN 46), relating to certain entities in which equity investors
do not have the characteristics of a controlling financial interest or do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support. In December 2003, the FASB
issued FASB Interpretation No. 46 (revised December 2003) (FIN 46R), which
replaced FIN 46. FIN 46R defines the provisions under which a Variable Interest
Entity (VIE) should be consolidated. In general, a VIE is a corporation,
partnership, limited-liability corporation, trust, or any other legal structure
used to conduct activities or hold assets that either (1) has an insufficient
amount of equity to carry out

50

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its principal activities without additional subordinated financial
support, (2) has a group of equity owners that is unable to make significant
decisions about its activities, or (3) has a group of equity owners that does
not have the obligation to absorb losses or the right to receive returns
generated by its operations. FIN 46R provides several exceptions to its scope,
such as that an entity that is deemed to be a business need not be evaluated to
determine if it is a VIE unless one of the conditions specified in FIN 46R
exists. FIN 46R requires a VIE to be consolidated by the party with an
ownership, contractual or other pecuniary interest in the VIE (a variable
interest holder) that will absorb a majority of the risk of loss from the VIEs
activities, is entitled to receive a majority of the VIEs residual returns (if
no other variable interests absorb a majority of the VIEs losses), or both. A
variable interest holder that consolidates the VIE is called the primary
beneficiary.

As an
operational holding company, we have made investments in and granted loans to
companies that are engaged in various fields of high technology. Some of these
companies are in their early stages of development and will require substantial
external investments until they can finance their activities, they are
currently engaged in, without additional support from other parties and may be
considered VIEs. These companies are currently primarily funded with financing
from venture capital funds, other holding companies and private investors.

Our
assessment of whether a group company is within the scope of FIN 46R, whether a
group company is a VIE and the determination of the primary beneficiary is
judgmental in nature and involves the use of significant estimates and
assumptions regarding the fair value of certain entities and their variable
interests. The estimates and assumptions include, among others, forecasted cash
flows, their respective probabilities and the economic value of certain
preference rights.

As of
December 31, 2005, Wavion, in which we hold approximately 37.8% is considered
to be a VIE, but Elron is not its primary beneficiary. As of December 31, 2005,
our maximum exposure to loss as a result of our involvement in Wavion does not
exceed the carrying value of our investment in Wavion in the amount of
approximately $0.8 million.

Equity Method. Group companies which we do not control, but
over whom we exercise significant influence over the operating and financial
policies and in which we hold common stock or in-substance common stock as
defined in EITF 02-14 Whether an Investor Should Apply the Equity Method of
Accounting to Investments Other Than Common Stock (EITF 02-14) (which is further
described below), are accounted for under the equity method of accounting.
Significant influence is usually assumed when we hold 20% or more of a group
companys voting securities, however, whether or not we exercise significant
influence with respect to a group company also depends on an evaluation of
several additional factors, including, among others, our representation on the
board of directors, agreements with other shareholders, our participation in
policy making processes, the existence of material intercompany transactions
and technological dependency, the extent of ownership by an investor in
relation to the concentration of other shareholdings, and other factors which
may require management to make certain judgmental decisions regarding significant
influence.

EITF 02-14,
which became effective at the beginning of the fourth quarter of 2004, defines
in-substance common stock as an investment with similar risk and reward
characteristics to common stock. In certain holdings we invested, among others,
in preferred shares which include rights, among others, such as cumulative and
participating dividends, dividend preferences and

51

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liquidation preferences. Based on EITF 02-14, new companies in which we invested in
the fourth quarter of 2004 and in 2005, namely Jordan Valley, Impliant,
Teledata, NuLens and BrainsGate, are being accounted for at cost
notwithstanding our significant influence in such companies, as the investment
in these companies is not considered to be in-substance-common stock. Any
assessment of whether we hold in substance common stock in a group company is
judgmental in nature and involves the use of significant estimates and
assumptions such as assessing the fair value of the subordinated equity of the
group company.

We also
account for our interests in private equity funds under the equity method of
accounting, based on our holding percentage.

Under the
equity method of accounting, a group companys assets and liabilities are not
included within our consolidated balance sheet and their results of operations
are not reflected within our consolidated statements of operations. However,
our share in the net income or losses of the group company is reflected as an
equity income (loss) in our consolidated statements of operations. The share of
income or losses is generally based upon our ownership level of the outstanding
share capital of the group company. In circumstances where the equity method is
being applied, our ownership in an investee is in the form of a preferred
security or other senior security which is considered to be in-substance common
stock and the investment in common stock is zero, we recognize equity method
losses based on our ownership level in the particular investee security or loan
held by us to which the equity method losses are being applied.

Other Methods. Our holdings in companies that we do not account
for under either the consolidation or the equity method of accounting are
accounted for under three different methods:

| |   |                                                                                                                                                                                                                                                                                             
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Non-marketable securities are presented at cost. Under this method,
  our share in the income or losses of these entities is not included in our
  consolidated statements of operations.                                                                                                   
| |   |                                                                                                                                                                                                                                                                                             
| |  | Marketable
  securities which are classified as available-for-sale are presented at fair
  market value and the effect of any unrealized change in market value is
  reflected in other comprehensive income (loss). When realized, gain or loss
  is included in our results of operations.

See below for a discussion of Other-Than-Temporary Decline in Value of
Investments in Group Companies.

Business Combinations
and Purchase Price Allocation

Business
combinations are accounted for using the purchase method of accounting, under
which the total purchase price is allocated to proportional interest in the
acquired companys assets and liabilities based on their estimated fair values,
and the remainder, if any, is attributed to goodwill.

The
aggregate purchase price of any investment accounted for under either the consolidation
or the equity method of accounting is being allocated to identifiable net
assets, intangible assets other than goodwill, in-process research and
development (IPR&D) activities, and to goodwill. The amount allocated to
IPR&D is being charged immediately to our results of operations in
accordance with FASB Interpretation No. 4, Applicability of FASB Statement No.

52

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2 to Business Combinations Accounted for by the Purchase Method (FIN
4). The amounts allocated to finite-lived intangible assets other than
goodwill are amortized on a straight-line basis over their weighted average
expected useful life. In 2005 and 2004, IPR&D charges amounted to $1.1
million and $2.3 million (which are part of our share in the net income or loss
of affiliated companies). IPR&D in 2004 resulted mainly from the purchase
of Given Imaging shares for approximately $43.9 million.

Estimating
the fair value of certain assets acquired and liabilities assumed is judgmental
in nature and often involves the use of significant estimates and assumptions,
mainly with respect to intangible assets. While there are a number of different
methods for estimating the value of intangibles acquired, the primary method we
use is the discounted cash flow approach. Some of the more significant
estimates and assumptions inherent in the discounted cash flow approach include
projected future cash flows, including their timing, a discount rate reflecting
the risk inherent in the future cash flows and a terminal growth rate. Another
area which requires judgment which can impact our results of operations is
estimating the expected useful lives of the intangible assets. To the extent
intangible assets are ascribed with longer useful lives, there may be less
amortization expenses recorded in any given period. As we and our group
companies operate in industries which are rapidly evolving and extremely
competitive, the value of the intangible assets, including goodwill, their
respective useful lives and the investments in companies is exposed to future
adverse changes which can result in a charge to our results of operations (See
also Other-Than-Temporary Decline in Investments in Group Companies under
this section).

Impairment of
Goodwill and Other Intangible Assets

We conduct
a goodwill impairment review at least annually and on an interim basis whenever
events or changes in circumstances indicate that the carrying value may not be
recoverable. Factors that we consider important which could trigger an
impairment review include significant underperformance relative to historical
or expected future operating results and significant negative industry or
economic trends. We test for impairment at a level referred to as a reporting
unit. Determining fair value involves the use of significant estimates and
assumptions. These estimates and assumptions could have an impact on whether or
not an impairment charge is recognized. To determine fair value, we may use a
number of valuation methods including quoted market prices, discounted cash flows
and revenue multipliers. As mentioned above, these approaches use estimates and
assumptions including projected future cash flows, discount rate and terminal
growth rate. Using different assumptions could result in different results. In
2005 and 2004, a goodwill impairment charge in the amount of $1.3 million and
$2.0 million, respectively, was recorded with respect to the operation of the
ET group in light of its results of operation (following the sale of this
business, these charges are presented as part of the loss from discontinued
operations in the statements of operations). At December 31, 2005, consolidated
goodwill amounted to approximately $2.7 million.

Other
intangible assets with definite useful lives are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an
asset may not be recoverable. Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset to the future
undiscounted cash flows expected to be generated by the asset. If an asset is
considered to be impaired, the impairment to be recognized is measured by the
amount by which the carrying amount of the asset exceeds its fair value. In the
evaluation

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of fair value,
we use significant estimates and assumptions such as projected future cash
flows which are subject to high degree of judgment. In 2004 we recorded
impairment charges of other intangible assets of $2.9 million with respect to
the ET group in light of its results of operation (following the sale of this
business, this charge is presented as part of the loss from discontinued
operations in the statements of operations). In addition in 2004 we recorded
impairment charges of other intangible assets of $4.2 million with respect to
MediaGate due to our revised estimate about future proceeds from the sale of
its technology. Intangible assets with an indefinite useful life are tested for
impairment at least annually by comparing the fair value of the intangible
asset to its carrying value. If the carrying value of the intangible asset
exceeds its fair value, an impairment loss is recognized in an amount equal to
that excess. In the valuation of fair value we use judgment as to which is the
most appropriate method to use for measuring fair value and as to what
assumptions to use in implementing the methodology chosen. As we operate in
industries which are rapidly evolving and extremely competitive, changes in the
assumptions and estimates may affect the carrying value of the intangible
assets, and could result in an additional impairment charge to our results of
operations. At December 31, 2005, consolidated intangible assets, other than
goodwill, amounted to approximately $2.8 million.

Other-Than-Temporary
Decline in Value of Investments in Group Companies

At the end
of each reported period we evaluate whether an other-than-temporary decline in
the value of an investment in a group company has been sustained. This
evaluation is judgmental in nature. If it has been determined that an
investment has sustained an other-than-temporary decline in its fair value
relative to its carrying value, the investment is written down to its fair
value by a charge to our results of operations.

An
evaluation of fair value is dependent upon specific facts and circumstances.
Factors that are considered by us in this determination include financial
information (including, among others, budgets, business plans and financial
statements) and the value at which independent third parties have invested or
have committed to invest and independent appraisals, if available. Factors
indicative of an other-than-temporary decline include recurring operating
losses, credit defaults, specific conditions affecting the investment, such as
in the industry or in geographic area, and subsequent rounds of financing at an
amount below the cost basis of the investment. This list is not all inclusive
and we weigh all quantitative and qualitative factors in determining if an
other-than-temporary decline in value of an investment has occurred. As we
operate in industries which are rapidly evolving and extremely competitive, it
is possible that our estimates could change in the near term and there can be
no assurance that an additional write-down or write-off of the carrying value
will not be required in the future. In 2005 and 2004 we recorded write-downs in
the amounts of $6.0 million and $1.5 million, respectively, with respect to
certain group companies (in 2005 mainly with respect to Oncura and Avantry Ltd.,
and in 2004 mainly with respect to Textology Inc., 3DV and Ingeneo Ltd.).

Accounting for Income Taxes

At
the end of each reported period, we are required to estimate our income taxes.
This process requires us to estimate our actual current tax liabilities and
make an assessment of temporary differences resulting from differing treatment
of items for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within our consolidated balance
sheet. We must then assess the likelihood that our net deferred tax

54

---



assets will be
realized through future taxable income and, to the extent we believe that
realization is not likely, we must establish a valuation allowance. Management
judgment is required in determining our provision for income taxes, our
deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. Our judgment as to the likelihood to
realize our net deferred tax assets is largely based upon interpretations of
certain tax laws and estimates and assumptions mainly with respect to our
ability to realize investments in our group companies. Our ability to realize
investments is mainly dependent upon factors such as the condition of the
securities markets and other general economic conditions. As the securities
markets for our group companies are highly volatile, changes in our assumptions
and estimates may require us to increase the valuation allowance and therefore
we may be required to include an expense within the tax provision in our
statement of operations.

As
of December 31, 2005, deferred tax assets with respect to the corporate
carryforward losses that are more likely than not to be realized in future
years amounted to approximately $6.5 million ($10.6 million as of December 31,
2004). In 2005, we reduced our previous valuation allowance by $19.6 million,
which included $13.3 million as a result of Elbits receipt of final tax
assessment (of which $3.9 million was recorded as a reduction of goodwill since
the deferred tax assets related to carryforward losses of Elbit incurred in
periods prior to our acquisition of Elbit) and $5.0 million as a result of the
sale of the ET group. In 2004, we reduced our previous valuation allowance by
$28.7 million in respect of losses incurred in prior periods mainly due to the
sale of our shares in Elbit Systems and due to final tax assessments for
previous years.

Deferred
tax liabilities as of December 31, 2005 amounted to $9.5 million, mainly with
respect to our investment in Partner which is accounted for as
available-for-sale securities and with respect to our investment in Given
Imaging which is accounted under the equity method.

As
of December 31, 2005 Elron had carryforward losses of approximately $69.0
million.

|   |                  
|-- | -----------------
|A. | Operating Results

Basis of
Presentation

Consolidation.
Our consolidated financial statements include the accounts of Elron and all of
our direct or indirect (through Elbit, DEP and RDC) controlled subsidiaries.
The following are our main subsidiaries:

|                  |  |                  |  |                 
|----------------- |  | ---------------- |  | ----------------
|2005              |  | 2004             |  | 2003            
|                 
|Elron
  TeleSoft1 |  | Elron
  TeleSoft |  | Elron
  Telesoft
|RDC               |  | RDC              |  | RDC             
|Galil
  Medical   |  | Galil
  Medical  |  | Galil
  Medical 
|SELA              |  | SELA6            |  | MediaGate       
|MediaGate         |  | MediaGate        |  | ESW             
|3DV               |  | 3DV4             |  |                 
|Starling          |  | Starling         |  |                 
|Medingo2          |  | ESW5             |  |                 
|Enure3            |  |                  |  |                 

55

---



| |                                                                                                        | 
| | ------------------------------------------------------------------------------------------------------ | 
| | 1 Sold on
  December 29, 2005.                                                                        
| | 2 Established
  by RDC in the fourth quarter of 2005.                                                 
| | 3 Consolidated
  since the beginning of the fourth quarter of 2005.                                   
| | 4 Consolidated
  following the purchase of a controlling interest during the first quarter of
  2004  
| | 5 Liquidated
  as of December 31, 2004 following the sale of all of its assets and business
  in 2003.
| | 6 Consolidated
  since the end of the second quarter of 2004.                                         

Equity Method.
Our main group companies held by us or through Elbit, DEP, Galil Medical and/or
RDC accounted for under the equity method of accounting include:

|                      |  |                      |  |                              
|--------------------- |  | -------------------- |  | -----------------------------
|2005                  |  | 2004                 |  | 2003                         
|                     
|Given
  Imaging       |  | Elbit
  Systems2     |  | Elbit
  Systems              
|Oren
  Semiconductor1 |  | Given
  Imaging      |  | Given
  Imaging              
|NetVision             |  | Oren
  Semiconductor |  | Oren
  Semiconductor         
|ChipX                 |  | NetVision            |  | NetVision                    
|Wavion                |  | ChipX                |  | ChipX                        
|Notal Vision          |  | Wavion               |  | Wavion                       
|AMT                   |  | Notal Vision         |  | Notal Vision                 
|Oncura                |  | AMT                  |  | AMT                          
|Pulsicom              |  | Oncura               |  | Oncura3                      
|CellAct               |  | Pulsicom             |  | Pulsicom                     
|                      |  | CellAct              |  | CellAct                      
|                      |  | SELA3                |  | KIT4                         
|                      |  |                      |  | 3DV                          
|                      |  |                      |  | Avantry
  (formerly: Witcom)5

1 Sold on June 10,
2005.


2 Sold on July 28,
2004.


3 Through the end
of the second quarter of 2004.


4 Sold on March
31, 2004


5 Through December
31, 2003, following a merger with another Israeli company.


Cost.
Our main group companies held by us accounted for under the cost method of
accounting include:


|              |  |                 |  |     
|------------- |  | --------------- |  | ----
|2005          |  | 2004            |  | 2003
|             
|Jordan Valley |  | Jordan
  Valley |  | -   
|Impliant      |  | Impliant        |  |     
|Teledata      |  | Avantry         |  |     
|BrainsGate    |  |                 |  |     
|NuLens        |  |                 |  |     
|              |  |                 |  |     

Available for Sale. Investments in Partner and EVS were accounted for by us as securities
available for sale as of December 31, 2005, 2004 and 2003. Our investment in
Zix was accounted for by us as securities available for sale as of December
31, 2004 and 2003.

56

---



Results of
Operations

The following
tables set forth our results of operations in the reported periods:

|                            |  |                                        |      |      |  |      |  |  |       |  
|--------------------------- |  | -------------------------------------- | ---- | ---- |  | ---- |  |  | ----- | -
|                            |  | Year ended December 31,                |     
|                            |  |                                        |     
|                            |  | 2005                                   |      | 2004 |  | 2003 | 
|                            |  |                                        |     
|                            |  | (millions of $, except per share data) |     
|Net income (loss)           |  |                                        | 47.3 |      |  | 84.1 |  |  | (7.2  | )
|Net income (loss) per share |  |                                        | 1.61 |      |  | 2.87 |  |  | (0.25 | )

The net income
we reported in 2005 was mainly due to the following gains from changes in
holding and dispositions of affiliated and other group companies:

|      |                                                                                                                                                                                                                                                                                                                                                                         
|----- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(i)   | a gain, net
  of tax, of approximately $45.4 million resulting from the sale of Partners
  shares. The tax expense relating to the aforementioned gain was decreased by
  approximately $9.4 million resulting from a decrease in our previous valuation
  allowance in respect of losses incurred in prior periods, following our
  receipt of a final tax assessment;
|      |                                                                                                                                                                                                                                                                                                                                                                         
|(ii)  | a gain, net
  of tax, of approximately $17.2 million resulting from the sale of Oren
  shares;                                                                                                                                                                                                                                                                          
|      |                                                                                                                                                                                                                                                                                                                                                                         
|(iii) | a gain of
  approximately $3.0 million from the decrease in our interest in NetVision
  following its initial public offering; and                                                                                                                                                                                                                                      
|      |                                                                                                                                                                                                                                                                                                                                                                         
|(iv)  | a tax
  benefit of $5 million, resulting from a decrease in our previous valuation
  allowance in respect of losses incurred on our investment in the ET group.                                                                                                                                                                                                         

The above
gains were offset by losses, net, which we recorded with respect to our group
companies in the amount of $23.0 million in 2005.

The net income
we reported in 2004 included the following gains from changes in holding and
dispositions of group companies:

|      |                                                                                                                                                                                                                                                                                                                                                                                      
|----- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(i)   | a gain, net
  of tax, of approximately $91.5 million resulting from the sale of our
  holdings in Elbit Systems. The tax expense relating to the aforementioned
  gain was decreased by approximately $21.6 million resulting from a decrease
  in our previous valuation allowance in respect of losses incurred in prior
  periods following our receipt of a final tax assessment;
|      |                                                                                                                                                                                                                                                                                                                                                                                      
|(ii)  | a gain, net
  of tax and minority interest, of approximately $6.7 million resulting from
  the sale of Given Imaging shares by RDC and the decrease in our direct and
  indirect interest in Given Imaging following the completion of Given
  Imagings secondary public offering;                                                                                                  
|      |                                                                                                                                                                                                                                                                                                                                                                                      
|(iii) | a gain of
  approximately $5.3 million resulting from the sale of our shares in KIT
  eLearning; and                                                                                                                                                                                                                                                                                 
|      |                                                                                                                                                                                                                                                                                                                                                                                      
|(iv)  | a gain, net
  after tax, of approximately $3.6 million resulting from the sale of Zix
  shares (which were received as consideration for the sale of the ESW business
  in 2003) for aggregate consideration of $8.1 million.                                                                                                                                                        

The above
gains were offset by losses, net, which we recorded with respect to our group
companies in the amount of $23.3 million in 2004.

The net loss
we reported in 2003 included the following gains from changes in holding and
dispositions of group companies:

|    |                                                                                                             
|--- | ------------------------------------------------------------------------------------------------------------
|(i) | a gain, net
  after tax, of approximately $7.1 million, resulting from the sale of Partner
  shares in 2003;

57

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|      |                                                                                                                                                                                                                                  
|----- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(ii)  | our share in
  the gain resulting from the merger in 2003 of the urology therapy units of
  Galil Medical and Amersham (later acquired by GE Healthcare) in the amount of
  approximately $4.4 million; and                      
|      |                                                                                                                                                                                                                                  
|(iii) | a gain of
  approximately $4.1 million resulting from the sale of substantially all of
  ESW assets and business to Zix and a gain, net of tax, of approximately $3.2
  million resulting from the subsequent sale of Zix shares.

The above
gains were offset by losses, net, which we recorded with respect to our group
companies in the amount of $24.2 million in 2003.

Subsequent to
the sale of the ET group in 2005 and ESW in 2003 we operate in one segment. The
following table summarizes our operating results in the reported periods:

|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|---------------------------------------------------------------------------------------------------------- |  | ----------------------- | ----- | ---- |  | ----- | - |  | ----- | -
|                                                                                                           |  | Year ended December 31, |      
|                                                                                                           |  |                         |      
|                                                                                                           |  | 2005                    |       | 2004 |  | 2003  |  
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|                                                                                                           |  | (millions of $)         |      
|Net revenues                                                                                               |  |                         | 12.6  |      |  | 11.3  |   |  | 9.1   |  
|Net loss from equity investments                                                                           |  |                         | (17.5 | )    |  | (10.5 | ) |  | (8.7  | )
|Gains from disposal of business and  affiliated companies and
changes in  holdings in affiliated companies |  |                         | 23.3  |      |  | 132.4 |   |  | 25.8  |  
|Other income, net                                                                                          |  |                         | 58.6  |      |  | 4.7   |   |  | 14.6  |  
|Finance income, net                                                                                        |  |                         | 5.5   |      |  | 1.4   |   |  | 0.8   |  
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|Total income                                                                                               |  |                         | 82.5  |      |  | 139.3 |   |  | 41.6  |  
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|Cost of revenues                                                                                           |  |                         | 7.9   |      |  | 6.8   |   |  | 5.9   |  
|Operating expenses*                                                                                        |  |                         | 17.8  |      |  | 16.5  |   |  | 22.6  |  
|Amortization of intangible assets                                                                          |  |                         | 0.4   |      |  | 0.1   |   |  | 0.3   |  
|Impairment of long-lived assets                                                                            |  |                         |      |      |  | 4.2   |   |  |      |  
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|Total costs and expenses                                                                                   |  |                         | 26.1  |      |  | 27.6  |   |  | 28.8  |  
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|Gain from continuing operations  before income taxes                                                       |  |                         | 56.5  |      |  | 111.7 |   |  | 12.8  |  
|Taxes on income                                                                                            |  |                         | (10.5 | )    |  | (15.1 | ) |  | (6.8  | )
|Minority interest                                                                                          |  |                         | 5.2   |      |  | (4.1  | ) |  | (10.9 | )
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|Net income (loss) from continuing
  operations                                                             |  |                         | 51.2  |      |  | 92.5  |   |  | (4.9  | )
|Discontinued operations of the ET group
  (**)                                                             |  |                         | (3.9  | )    |  | (7.9  | ) |  | (2.1  | )
|Discontinued operations of ESW and others                                                                  |  |                         |      |      |  | (0.5  | ) |  | (0.2  | )
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  
|Net income (loss)                                                                                          |  |                         | 47.3  |      |  | 84.1  |   |  | (7.2  | )
|                                                                                                           |  |                         |       |      |  |       |   |  |       |  

* Excluding
amortization of intangible assets and impairment of long lived assets which are
presented as a separate line item.

** As
described under ITEM 4, Information on the Company, in December 2005, we
sold all our holdings in the ET group and accordingly the current period
results of operations and the gain on the sale have been classified as
discontinued operations, and prior periods results have been reclassified
accordingly. The following table sets forth the composition of the discontinued
operating results of the ET group for the reported periods:

58

---



|                                    |  |                         |      |      |  |      |   |  |      |  
|----------------------------------- |  | ----------------------- | ---- | ---- |  | ---- | - |  | ---- | -
|                                    |  | Year ended December 31, |     
|                                    |  |                         |     
|                                    |  | 2005                    |      | 2004 |  | 2003 |  
|                                    |  |                         |      |      |  |      |   |  |      |  
|                                    |  | (millions of $)         |     
|Loss from
  operations              |  |                         | (4.1 | )    |  | (7.9 | ) |  | (2.1 | )
|Gain on
  disposal                  |  |                         | 0.2  |      |  |     |   |  |     |  
|                                    |  |                         |      |      |  |      |   |  |      |  
|Loss from
  discontinued operations |  |                         | (3.9 | )    |  | (7.9 | ) |  | (2.1 | )
|                                    |  |                         |      |      |  |      |   |  |      |  

The loss from
operations in 2004 was primarily due to an impairment charge of long lived
assets and goodwill in the aggregate amount of $4.9 million. In 2005, a
goodwill impairment in the amount of $1.3 million was recorded.

Year Ended December
31, 2005 compared to Year Ended December 31, 2004.

Income

Net revenues.
Net revenues consisted of sales of products and services by our subsidiaries,
mainly Galil Medical and SELA. The following table sets forth these revenues:

| |                 |  |                         |      |      |  |      | 
| | --------------- |  | ----------------------- | ---- | ---- |  | ---- | 
| |                 |  | Year ended December 31, |     
| |                 |  |                         |      |      |  |      | 
| |                 |  | 2005                    |      | 2004 | 
| |                 |  |                         |      |      |  |      | 
| |                 |  | (millions of $)         |     
| | Galil
  Medical |  |                         | 8.3  |      |  | 7.6  | 
| | SELA1           |  |                         | 4.2  |      |  | 3.3  | 
| | Other           |  |                         | 0.1  |      |  | 0.4  | 
| |                 |  |                         |      |      |  |      | 
| |                 |  |                         | 12.6 |      |  | 11.3 | 
| |                 |  |                         |      |      |  |      | 

1
SELAs results have been consolidated since July 1, 2004

In 2005, Galil
Medical recorded revenues of $8.3 million, compared to $7.6 million in 2004.
Galil Medicals revenues derived mainly from the supply of cryo products and
R&D services to Oncura, in which it has a 25% ownership interest.

SELA recorded
revenues of $4.2 million in 2005, compared to $5.1 million in 2004 (of which
$3.3 million were in the second half of 2004 and was consolidated in our
financial statements of 2004).

Share in net losses
of affiliated companies. Our share in net losses
of affiliated companies resulted from our holdings in certain investments that
are accounted for under the equity method (see above under Basis of
Presentation). Our share in net losses of affiliated companies amounted to
$17.5 million in 2005, compared to $10.5 million in 2004. The increase in our
share in net losses of our affiliated companies is primarily due to the sale of
our holding in Elbit Systems in the third quarter of 2004, which positively
contributed $4.7 million in the first half of 2004, and due to impairment
charges of $5.1 million, with respect to our investment in Oncura (through
Galil Medical) in 2005.

59

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Highlights of the
Results of Operations of Our Major Affiliates:

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Given Imaging (Nasdaq: GIVN) (a 19.4%
  holding directly and indirectly through RDC as of December 31, 2005).Given
  Imaging, a medical device company that develops, manufactures and markets
  innovative diagnostic systems for visualizing the gastrointestinal tract,
  using a disposable miniature swallowable video capsules, recorded revenues of
  $86.8 million in 2005, an increase of approximately 35% over the revenues
  recorded in 2004 of $65.0 million. The increase in revenues resulted
  primarily from the increase in sales of Given PillCam video capsule for the
  small bowel. Given Imagings net income in 2005 was $6.3 million, compared to
  $2.9 million in 2004. Given Imagings net income in 2005 included a special
  provision recorded in the second quarterof $1.8 million, before tax effect,
  for uncollectable sales tax related to its U.S. subsidiary.                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Oncura (a 25% holding by Galil Medical as
  of December 31, 2005). Oncura, which markets and
  sells therapeutic device systems and related consumables used primarily in
  the performance of minimally-invasive, urologic cancer treatment, recorded
  revenues in 2005 of approximately $72.1 million compared to $68.8 million in
  2004 and its net loss amounted to $6.2 million compared to $2.2 million in
  2004. The increase in the net loss resulted primarily due to the increase in
  operating expenses, mainly selling and marketing expenses. In light of
  Oncuras results of operations, we recorded an impairment charge of $5.1
  million in 2005 ($2.1 million after minority interest). Each of Galil Medical
  and GE Healthcare have confirmed their intention to continue providing
  financial support to Oncura through May 31, 2007 or such later date as may be
  agreed by them.                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | NetVision (a 39% holding as of December 31,
  2005) (TASE: NTSN). NetVision provides internet
  services and solutions in Israel and commencing in the fourth quarter of
  2004, international telephone services through voice over IP (VOIP).
  NetVisions revenues increased in 2005 by 12.6% to $74.3 million (of which
  $3.3 million were derived from international telephony services) from $66.0
  million in 2004 and its customer base at December 31, 2005 reached
  approximately 425,000 (of which approximately 272,000 were broadband)
  compared to 390,000 at the end of 2004 (of which approximately 225,000 were
  broadband). NetVisions operating income in 2005 increased by 43.3% to $9.5
  million, compared to $6.6 million in 2004 and its net income amounted to $5.4
  million compared to $3.9 million in 2004. NetVisions operating currency is
  the New Israeli Shekel (NIS) and accordingly, all figures above are
  translations for convenience purposes of NetVisions NIS figures into US
  dollars at the representative rate of exchange prevailing at December 31,
  2005 according to which $1.00 equaled NIS 4.603.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Wavion (a 38% holding as of December 31,
  2005). Wavion is a developer of broadband wireless access systems
  for Wi-Fi networks. Wavions net loss amounted to $6.3 million in 2005,
  approximately the same as in 2004, which consists primarily of expenses
  relating to the development of its product.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | ChipX (a 27% holding as of December 31,
  2005). ChipX is a manufacturer of late stage
  programmable application-specific integrated circuits, or structured ASICs.
  ChipXs revenues in 2005 amounted to $14.7 million, compared to $16.2 million
  in 2004, and its net loss amounted to $6.3 million, compared to $5.6 million
  in 2004. Revenues decreased as ChipX shifted from its previous product to the
  new structured ASIC products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

60

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | AMT (a 42% holding as of December 31,
  2005). The AMT group develops technologies and
  products based on amorphous metals. AMTs consolidated revenues in 2005
  amounted to $3.6 million, compared to $2.6 million in 2004, and its
  consolidated net loss amounted to $3.9 million, compared to $3.0 million in
  2004. AMTs main subsidiary, AHT, which uses amorphous metals for heating
  products, recorded revenues of $2.6 million in 2005, compared to $1.2 million
  in 2004, and recorded a net loss of $1.9 million in 2005, the same as in
  2004.

We expect that
most of our group companies as well as new companies in which we will invest
will continue to recognize losses in future periods, as they invest significant
resources in research and development and sales and marketing activities and
have not yet generated significant revenues. Our results of operations will
therefore be affected by the extent of our share in their net losses (to the
extent they are reported under the equity or consolidation method of
accounting).

Results of
operations of significant group companies which are accounted for other than
under the equity method of accounting and whose results do not affect our
results of operations.

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Partner (Nasdaq: PTNR) (a 2% holding as of
  December 31, 2005). Partner is a
  Global System for Mobile Communications, or GSM, mobile telephone network
  operator in Israel. Our investment in Partner is accounted for as
  available-for-sale securities. The market value of our investment in Partner
  as of December 31, 2005 amounted to $26.0 million. Almost all of the
  remaining Partner shares held by us as of December 31, 2005, amounting to
  approximately 3.1 million shares, are subject to certain transfer
  restrictions under Partners Israeli communications license but are no longer
  pledged to Partners lending banks.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | In 2005,
  Partner recorded revenues of $1,113 million compared to $1,117 million in
  2004 and its net income amounted to $77 million, compared to $102.4 million
  in 2004. Partners subscriber base as of December 31, 2005 was 2,529,000
  compared to 2,340,000 at the end of 2004. Partners operating currency is the
  NIS and accordingly, all figures above are translations for convenience
  purposes of Partners NIS figures into U.S. dollars at the representative
  rate of exchange prevailing at December 31, 2005 according to which $1.00
  equaled NIS 4.603.                                                                     
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Teledata (a 21% holding as of December 31,
  2005). Teledata provides innovative access
  products and solutions for both traditional and next generation networks to
  telecom operators and service providers. Teledatas revenues in 2005 amounted
  to $55.9 million compared to $38.9 million in 2004 and its net income amounted
  to $1.8 million in 2005 compared to a net loss of $2.5 million in 2004. The
  increase in revenues resulted mainly from an increase in revenues from
  existing customers.                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Jordan Valley (a 28% holding as of December
  31, 2005). Jordan Valley is engaged in
  developing solutions for advanced in-line thin film metrology for the
  semiconductor industry. Jordan Valleys revenues in 2005 increased to $10.4
  million from $8.3 million in 2004, primarily due to the launch of new
  products. Jordan Valleys net loss in 2005 was $0.1 million, compared to $0.7
  million in 2004.                                                                                                                                                                                                                                    

61

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Gains from Disposal
of Business and Affiliated Companies and Changes in Holdings in Affiliated
Companies. Gains from disposal of businesses and affiliated
companies and changes in our holdings in affiliated companies in 2005 amounted
to $23.3 million, compared to $132.4 million in 2004. The gain in 2005 resulted
primarily from the following: (i) a gain of approximately $19.7 million (which
after income taxes amounted to $17.2 million) resulting from the sale of Orens
shares in consideration for $20.3 million; (ii) a gain of approximately $3.0
million from the decrease in our interest in NetVision following its initial
public offering; and (iii) a gain of $1.2 million (which after minority
interest and income taxes amounted to $0.5 million) resulting from the exercise
of a call option granted to a former senior executive of RDC to purchase 70,200
shares of Given Imaging for the aggregate exercise price of approximately
$12,000.

The gain recorded in 2004 resulted primarily from the following: (i) a
$104.6 million gain (which after income taxes amounted to $91.5 million)
resulting from the sale of our holding in Elbit Systems; (ii) a $15.2 million
gain (which after minority interest and income taxes amounted to $6.7 million)
resulting from the sale of shares of Given Imaging by RDC and the decrease in
our direct and indirect interest in Given Imaging following Given Imagings
secondary public offering; and (iii) a gain of $5.8 million (which after
minority interest and income taxes amounted to $1.4 million) resulting from the
purchase by RDC of treasury shares amounting to approximately 3% of its
outstanding shares from one of its shareholders (a former senior executive of
RDC) in consideration for distribution of 200,000 shares of Given Imaging; and
(iv) a $5.3 million gain from the sale of our share of KIT eLearning, for an
immediate cash payment of $9.4 million (from which we received $5.7 million).
Based on future earnings of KIT in 2006 and 2007, there may be an additional
payment of up to $10 million, of which our share will be up to $5.7 million. If
we receive this additional payment, we will record an additional gain.

Other Income, net.
Other income, net, amounted to $58.6 million in 2005 compared to $4.7 million
in 2004. The gain in 2005 was primarily due to the following (i) a $56.4
million gain (which after income taxes amounted to $45.4 million) from the sale
of shares of Partner for approximately $94.0 million; (ii) a gain of $1.1 million
($0.7 million net of tax) from the sale of Zorans shares received as part of
the consideration for Orens shares; and (iii) a gain from a dividend received
from Partner in the amount of $0.4 million. The gain in 2004 resulted mainly
from a $5.4 million gain, before tax, from the sale of shares of Zix received
in consideration for ESWs assets and business sold to Zix in 2003.

Expenses

Cost of revenues.Cost of revenues consisted primarily of
expenses related to salaries and hardware associated with delivering products
and services of our subsidiaries, mainly Galil Medical and SELA (whose results
have been consolidated since July 1, 2004). Cost of revenues in 2005 amounted
to $7.2 million, compared to $6.3 million in 2004.

Operating expenses. Operating expenses
are comprised of research and development expenses, sales and marketing and
general and administrative expenses of our and RDCs corporate operations and
of our subsidiaries, mainly Galil Medical, SELA, Starling and 3DV. The
following table sets forth operating expenses (excluding amortization of
intangible assets which is presented as a separate line item and amounted to
$0.4 million in 2005 and $0.1 million in

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2004, which
also constitute part of operating expenses under US GAAP but for presentation
purposes are included as a separate line item):

| |                      |  |                         |      |      |  |      | 
| | -------------------- |  | ----------------------- | ---- | ---- |  | ---- | 
| |                      |  | Year ended December 31, |     
| |                      |  |                         |      |      |  |      | 
| |                      |  | 2005                    |      | 2004 | 
| |                      |  |                         |      |      |  |      | 
| |                      |  | (millions of $)         |     
| | Corporate            |  |                         | 6.9  |      |  | 7.3  | 
| | Galil
  Medical      |  |                         | 2.8  |      |  | 2.3  | 
| | SELA1                |  |                         | 3.1  |      |  | 1.6  | 
| | Starling             |  |                         | 2.4  |      |  | 1.6  | 
| | 3DV                  |  |                         | 1.9  |      |  | 1.2  | 
| | Other
  (mainly RDC) |  |                         | 0.7  |      |  | 2.5  | 
| |                      |  |                         |      |      |  |      | 
| |                      |  |                         | 17.8 |      |  | 16.5 | 
| |                      |  |                         |      |      |  |      | 

1SELAs results have been consolidated since July 1, 2004

Operating
expenses of Galil Medical in 2005 amounted to $2.8 million, as compared to $2.3
million in 2004, and its operating results amounted to an operating loss of
$0.5 million compared to operating income of $0.1 million in 2004. The change
in Galil Medicals operating results was due to the commencement of the
development of its cryotherapy technology for application in the womens health
field at the end of 2004. In November 2005, Galil Medicals cryo products
received FDA clearance for the treatment of breast fibroadenoma (non cancerous
breast lumps).

SELAs
operating expenses amounted to $3.1 million in 2005, compared to $2.9 million
in 2004 (of which $1.6 million was incurred in the second half of 2004 and was
consolidated in our financial statements of 2004) and its operating loss
amounted to $0.7 million compared to an operating income of $0.4 million in
2004 (of which $0.5 million was incurred in the second half of 2004 and was
consolidated in our financial statements of 2004), resulting from the decrease
in revenues recognized in 2005.

The decrease
in operating expenses of the other companies resulted mainly from income
recorded by RDC in 2005 with respect to the decrease in the fair value of call
options held by RDCs employees to purchase shares of affiliated companies.

Finance
income, net. Finance income, net, amounted in 2005 to $5.5
million, compared to $1.4 million in 2004. The increase is mainly due to higher
cash resources during the period as a result of the sale of our holding in
Elbit Systems in 2004 for approximately $197 million and from the sale of
Partner shares in the second quarter of 2005 for approximately $94.0 million.
Income from interest in future periods is expected to decrease due to a
decrease in cash resources mainly as a result of a cash dividend payment to our
shareholders on September 27, 2005.

Income
Taxes. Income taxes, net, amounted to $10.5 million in
2005 which included mainly $11.0 million of income taxes with respect to the
gain from the sale of Partner shares (which includes an offset of $9.4 million
due to the reduction in our previous valuation allowance with respect to losses
incurred in prior periods following our receipt of a final tax assessment) and
$2.4 million from the sale of Oren shares and approximately $3.0 million in
respect of financing income. These were partially offset mainly by a tax benefit
of $5.0 million, resulting from a

63

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decrease in our previous valuation allowance due to the sale of the ET
group and an approximately $1.2 million adjustment of a prior year tax
provision in Elbit. Income taxes, net, in 2004 were $15.1 million resulting
mainly from the sale of our holding in Elbit Systems, the secondary public
offering of Given Imaging, the purchase of treasury stock in RDC in
consideration for distribution of Given Imagings shares and the sale of Zix
shares. Income taxes were partially offset by a tax benefit in the amount of
$2.9 million due to the change in the Israeli tax rate enacted in 2004 and a
$1.5 million tax benefit related to the impairment of future royalties to be
received by MediaGate.

Year Ended December
31, 2004 compared to Year Ended December 31, 2003.

Income

Net revenues.Net
revenues consisted of sales of products and services by our subsidiaries,
mainly Galil Medical and SELA (which results have been consolidated since July
1, 2004). The following table sets forth revenues:

| |                 |  |                         |      |      |  |     | 
| | --------------- |  | ----------------------- | ---- | ---- |  | --- | 
| |                 |  | Year ended December 31, |     
| |                 |  |                         |      |      |  |     | 
| |                 |  | 2004                    |      | 2003 | 
| |                 |  |                         |      |      |  |     | 
| |                 |  | (millions of $)         |     
| | Galil
  Medical |  |                         | 7.6  |      |  | 7.6 | 
| | SELA            |  |                         | 3.3  |      |  |    | 
| | MediaGate       |  |                         |     |      |  | 1.5 | 
| | Other           |  |                         | 0.4  |      |  | 0.1 | 
| |                 |  |                         |      |      |  |     | 
| |                 |  |                         | 11.3 |      |  | 9.2 | 
| |                 |  |                         |      |      |  |     | 

| |                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Galil Medicals
  revenues in 2004 and in 2003 (from July 1, 2003) were derived mainly from the
  supply of cryo products and R&D services to Oncura, in which it has a 25%
  ownership interest.
| |                                                                                                                                                                                                  
| | SELA recorded
  revenues of $5.1 million in 2004 (of which $3.3 million were in the second
  half of 2004) compared to $4.3 million in 2003.                                                     

Share in net losses
of affiliated companies. The share in net losses
of affiliated companies amounted to $10.5 million in 2004, as compared to $8.7
million in 2003. As a result of the completion of the sale of our holding in
Elbit Systems during the third quarter of 2004, our share in net income of
Elbit Systems was included through the end of the second quarter of 2004 based
on Elbit Systems unaudited financial report as of June 30, 2004 and amounted
to $4.7 million. Our share in the net income of Elbit Systems in 2003 amounted
to $9.1 million. Elbit Systems revenues in 2004 through the end of the second
quarter amounted to $445.3 million as compared to $420.9 million in the first
half of 2003 and its net income amounted to $24.0 million as compared to $21.5
million in the same period of 2003.

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Highlights of the
Results of Operations of Our Major Affiliates:

Given
Imaging (a 20% holding directly and indirectly through RDC as of December 31,
2004). Given Imagings revenues in 2004 were $65.0
million, an increase of 60.4% over 2003 revenues of $40.5 million. As of
December 31, 2004, cumulative unit sales of Given Imaging capsule for the small
intestine had reached 171,800 and its installed base reached more than 1,300
workstations in the United States and approximately 2,300 worldwide. Given
Imagings gross profit increased to 72.7% of revenues in 2004 compared to 66.6%
in 2003 and it reported net income of $2.9 million in 2004, compared to a net
loss of $9.6 million in 2003.

During
the second quarter of 2004, Given Imaging completed a secondary offering to the
public in which it raised net proceeds of $44.3 million. In addition, Given
Imaging entered into an exclusive sales representation and co-promotion
agreement with Ethicon Endo-Surgery, Inc., a Johnson & Johnson company,
according to which Ethicon has exclusive rights to market Given Imagings
Pillcam ESO video capsule for visualization of the esophagus. Following FDA
clearance to market the PillCam ESO in late November and through December 31,
2004, more than 3,400 PillCam ESO capsules were sold.

Oncura
(a 25% holding through Galil as of December 31, 2004).
Oncuras revenues in 2004 amounted to $68.8 million and its net loss amounted
to $2.2 million. Oncuras revenues in the period since commencing operation on
July 1, 2003 and through December 31, 2003 amounted to $31.4 million and its
net loss amounted to $0.9 million.

NetVision
(a 46% holding as of December 31, 2004). In 2004 NetVision
continued to experience increased competition in gaining broadband Internet
services market share, resulting from the transition of customers to broadband
Internet services. Nonetheless, NetVision revenues increased in 2004 by 7.6% to
$70.5 million from $65.5 million in 2003 and its customer base at December 31,
2004 reached approximately 390,000 (of which approximately 225,000 were
connected through broadband) compared to 341,000 at December 31, 2003 (of which
approximately 146,000 were connected through broadband). NetVisions operating
income increased by 47.2% to $7.3 million in 2004 compared to $5.0 million in
2003 and its net income increased to $4.3 million in 2004 compared to $1.0
million in 2003. NetVisions operating currency is the New Israeli Shekel (NIS)
and accordingly, all figures above are translations for convenience purposes of
NetVisions NIS figures into US dollars at the representative rate of exchange
prevailing December 31, 2004 according to which $1.00 equaled NIS 4.308.

During
2004, we and DIC each granted NetVision a $5.3 million loan, in order to enable
NetVision to repay its line of credit to one of its lending banks and to set up
its international telephony services. As a result of the extension of the
original repayment period of the loans and in accordance with EITF 02-18, we
recorded a portion of the loan, in the amount of $2.0 million, as a loss,
representing the funding of NetVisions previous years losses.

Wavion
(a 38% holding as of December 31, 2004).Following
a financing round in which Wavion raised $12.5 million in the second half of
2003, Wavion directed resources away from its subcontracting activities to
R&D activities, resulting in a decrease in revenues from

65

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subcontracting
services in 2004 to $0.1 million compared to $1.8 million in 2003 and an
increase in its net loss which amounted to $6.3 million in 2004 compared to $1.7
million in 2003.

ChipX
(a 27% holding as of December 31, 2004). ChipXs
revenues in 2004 increased by 18% to $16.2 million from $13.7 million in 2003,
primarily due to the launch of new products and the recovery in the
semiconductor industry, and its net loss in 2004 decreased to $5.6 million from
$7.8 million in 2003. In March 2004, ChipX raised $12.0 million in a private
placement, the proceeds of which were being used to finance its sales and
marketing efforts and development investments in its structured ASIC
technology.

AMT
(a 40% holding as of December 31, 2004).During
2004 AMT completed a private placement of $6.0 million, in which we invested an
additional $3.0 million. AMTs consolidated revenues in 2004 amounted to $2.6
million, compared to $1.3 million in 2003 and its net loss in 2004 amounted to
$3.0 million, compared to $3.5 million in 2003.

Results of
operations of significant group companies which are accounted for other than
under the equity method of accounting.

Partner
(an 8.6% holding as of December 31,
2004). At December 31, 2004, the market value of our investment
in Partner amounted to approximately $136.2 million. The following are
highlights of the results of operations of Partner for 2004 (all figures below
are convenience translations of Partners nominal New Israeli Shekel (NIS)
figures into US dollars at the rate of the exchange prevailing at December 31,
2004 according to which $1.00 equaled NIS 4.308). Partners revenues in 2004
increased to $1,193.3 million, up 15.1% from $1,037.1 million in 2003. Partners
subscriber base at the end of 2004 was 2,340,000 as compared to 2,103,000 at
the end of 2003. Partners net income in 2004 was $109.5 million, as compared
to $269.9 million in 2003. The decrease in Partners net income in 2004
resulted primarily from the utilization of its accumulated tax loss carry
forward and the creation of deferred tax asset in 2003 in the amount of $146.9
million.

Jordan
Valley (a 28% holding as of December 31, 2004).
Jordan Valleys revenues in 2004 increased to $8.3 million from $3.2 million in
2003, primarily due to the launch of new products for the semiconductor
industry, and its net loss in 2004 decreased to $0.7 million from $2.5 million
in 2003.

Impliant
(a 23% holding as of December 31, 2004). Impliants
net loss in 2004 amounted to $3.3 million, compared to $2.3 million in 2003,
mainly as a result of increase in research and development expenses.

Gains from Disposals
of Businesses and Affiliated companies and Changes in Holdings in Affiliated
Companies.Our gains from disposals of businesses
and affiliated companies and changes in holdings in affiliated companies
amounted to $132.4 million in 2004 compared to $25.8 million in 2003.

The
gain in 2004 consisted primarily from the following: (i) a $104.6 million gain
(which after income taxes amounted to $91.5 million) resulting from the sale of
our holding in Elbit Systems (we used Elbit Systems unaudited financial report
as of June 30, 2004 in order to record

66

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the carrying
value of our investment in Elbit Systems as of the date of sale and to
determine the gain resulting from the sale); (ii) a $15.2 million gain (which
after minority interest and income taxes amounted to $6.7 million) resulting
from the sale of shares of Given Imaging by RDC and the decrease in our direct
and indirect interest in Given Imaging following Given Imagings secondary
public offering; (iii) a $5.3 million gain from the sale of our share of KIT to
a subsidiary of Laureate for a cash payment of $9.4 million (from which we
received $5.7 million)
(based on future earnings of KIT in 2006 and 2007, there may be an additional
payment of up to $10 million, of which our share will be up to $5.7 million;.
If we receive this additional payment, we will record an additional gain);
(iv) a gain of $5.8 million (which after minority interest and income taxes
amounted to $1.4 million) resulting from the sale of shares of Given Imaging in
connection with the purchase by RDC of treasury shares amounting to
approximately 3% of its outstanding shares from one of its shareholders (a
former senior executive of RDC); and (v) a gain of $0.6 million resulting from
the exercise of a call option granted to the chairman of our board of directors
to purchase 21,751 shares of Given Imaging from us for the aggregate exercise
price of approximately $49,000.

The
gain in 2003 was mainly due to the gain from the merger of the urology therapy
business of Galil Medical and GE Healthcare in the amount of approximately
$21.2 million (which after minority interest and income taxes amounted to $4.4
million) and the $4.5 million gain from the sale of 753,600 shares of Given
Imaging held by RDC for approximately $7.8 million and changes in our holding
in Given Imaging as a result of exercise of options.

Other
Income (expenses), net. Other income, net,
amounted to $4.7 million in 2004 compared to $14.6 million in 2003. The gain in
2004 included mainly a $5.4 million gain, before tax, from the sale of shares
of Zix received in consideration for ESWs assets and business sold to Zix in
2003, a $0.5 million loss representing the funding of 3DVs previous years
losses and $0.8 million write down of investment, mainly with respect to
Textology.

The
gain in 2003 resulted primarily from the following: (i) the sale of Partner
shares for approximately $29.3 million which resulted in a $11.1 million gain
before tax; (ii) the sale of shares of Zix for approximately $9.0 million which
resulted in a $4.8 million gain before tax; and (iii) a $2.0 million gain,
before tax, from the sale of all of our shares of 24/7 Real Media shares
(Nasdaq: TFSM) for approximately $5.2 million. These gains were partially
offset by $3.7 million of write-downs mainly with respect to Cellenium and
Textology.

Finance
income, net. Finance income, net, amounted to $1.4
million in 2004 compared to $0.8 million in 2003. The increase in finance
income was primarily due to the increase in cash balances following the
completion of the sale of our holding in Elbit Systems for $196.6 million.

Expenses

Cost
of revenues.Cost of revenues amounted to $6.3
million, compared to $5.6 million in 2003, which consisted primarily of
expenses related to salaries, materials, subcontractors and hardware associated
with delivering products and services of our subsidiaries, mainly Galil
Medical, MediaGate, 3DV (the results of which have been consolidated since
January 1, 2004) and SELA (the results of which have been consolidated since
July 1, 2004).

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Operating
expenses. Operating expenses are comprised of
research and development expenses, sales and marketing and general and
administrative expenses of our subsidiaries, mainly Galil Medical, MediaGate,
3DV (the results of which have been consolidated since January 1, 2004) and
SELA (the results of which have been consolidated since July 1, 2004), and of our
and RDCs corporate operations. The following table sets forth operating
expenses. The operating expenses presented below for 2004 exclude impairment
and amortization of intangible assets in the amount of $0.1 million ($0.3
million in 2003), which also constitute part of operating expenses under US
GAAP but for presentation purposes is included as a separate line item:

| |                      |  |                         |      |      |  |      | 
| | -------------------- |  | ----------------------- | ---- | ---- |  | ---- | 
| |                      |  | Year ended December 31, |     
| |                      |  |                         |      |      |  |      | 
| |                      |  | 2004                    |      | 2003 | 
| |                      |  |                         |      |      |  |      | 
| |                      |  | (millions of $)         |     
| | Corporate            |  |                         | 7.3  |      |  | 7.1  | 
| | Galil
  Medical      |  |                         | 2.3  |      |  | 10.4 | 
| | SELA                 |  |                         | 1.6  |      |  |     | 
| | MediaGate            |  |                         |     |      |  | 3.1  | 
| | Starling             |  |                         | 1.6  |      |  |     | 
| | 3DV                  |  |                         | 1.2  |      |  |     | 
| | Other
  (mainly RDC) |  |                         | 2.5  |      |  | 2.0  | 
| |                      |  |                         |      |      |  |      | 
| |                      |  |                         | 16.5 |      |  | 22.6 | 
| |                      |  |                         |      |      |  |      | 

Operating
expenses of Galil Medical in 2004 decreased to $2.3 million from $10.4 million
in 2003, resulting in operating loss of $0.1 million, compared to $7.6 million
in 2003. The decrease in Galil Medicals operating expenses and operating loss
was mainly due to the merger of the urology therapy units of Galil Medical and
GE Healthcare which resulted in a significant decrease in Galil Medicals
marketing and selling expenses. Galil Medical started at the end of 2004 to
develop its cryotherapy technology for application in the womens health field.

The
decrease in MediaGates operating expenses resulted from the sale of its assets
and business to Telrad in January 2004, following which MediaGate ceased its
operations.

SELAs
operating expenses amounted to $2.9 million in 2004 (of which $1.6 million were
incurred in the second half of 2004 and the amount was consolidated in our
financial statements of 2004), compared to $2.4 million in 2003 and its net
income amounted to $0.2 million, compared to $0.1 million.

Impairment.
An impairment charge of $4.2 million ($2.7 million net of tax) was recorded
with respect to future royalties to be received by MediaGate in connection with
the sale of MediaGates business in January 2004 to Telrad. The write-off was
due to our revised estimate about the realizability of future royalties.
However, MediaGates bank loan in the amount of approximately $2.6 million,
which was secured by a first ranking pledge over these future royalties and
which was not guaranteed by us, was not written-off even though it could only
be repaid from royalties to be received. This is in accordance with SFAS 140
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities - A Replacement of FASB Statement 125, which allows
derecognition of a liability only if it has been extinguished, either through
payment or when the debtor is legally released from being the

68

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primary
obligor under the liability. In the first quarter 2006, we recorded a gain of
approximately $2.7 million resulting from the extinguishment of the loan as a
result of an agreement signed with the bank.

Income
Taxes. Income taxes, net, in 2004 were $15.1
million, which included mainly $13.1 million of income taxes with respect to
the gain resulted from the sale of our holdings in Elbit Systems (which
includes an offset of $21.6 million due to the reduction in our valuation
allowance with respect to previous years losses), $6.7 million resulting from
the secondary public offering of Given Imaging and the purchase of treasury
stock in RDC in consideration for distribution of Given Imagings shares and
$1.8 million resulting from the sale of Zix shares. These amounts were offset
primarily by a tax benefit in the amount of $2.9 million due to the change in
the Israeli tax rate enacted in 2004, which gradually reduces the corporate tax
rate in Israel from 36% in 2003 to 30% in 2007, a $2.4 million tax benefit with
respect to corporate expenses, net and $1.5 million tax benefit related to the
impairment of future royalties to be received by MediaGate from Telrad.

Income
taxes, net, in 2003 were $6.8 million, which included mainly $7.0 million of
income taxes with respect to the sale of shares of Partner, Given Imaging and
24/7 Real Media as well as with respect to the merger of the urology therapy
units of Galil Medical and GE Healthcare and a tax benefit of $1.7 million
mainly with respect to corporate expenses, net.

|   |                                
|-- | -------------------------------
|B. | Liquidity and Capital Resources

Consolidated
cash, debentures and deposits at December 31, 2005, were approximately $143.8
million compared with $188.1 million at December 31, 2004. At December 31,
2005, corporate cash, debentures and deposits were $133.8 million compared with
$175.7 million at December 31, 2004.

The
main sources of corporate cash and other liquid instruments in 2005 were $94.0
million of proceeds from the sale of Partner shares, $10.5 million cash
proceeds from the sale of shares in Oren, $8.8 million from the sale of Zoran
shares received as part of the consideration for Orens shares, $2.2 million
repayment of loan by NetVision and $2.1 million proceeds from the sale of the
ET group.

The
main uses of corporate cash and other liquid instruments in 2005 were an $88.5
million dividend, income tax payments of approximately $27.1 million (mainly
with respect to the sale of Elbit Systems shares in 2004 and Partner shares in
2005) and $40.5 million of investments (including loans) in new and existing
group companies as detailed below (in millions of $):

|                           |  |    
|-------------------------- |  | ---
|Consolidated companies (*) |  |    
|                           |  |    
|Starling                   |  | 1.5
|Galil
  Medical            |  | 0.8
|3DV                        |  | 0.7
|Enure                      |  | 4.0
|Other                      |  | 2.1
|                           |  |    
|                           |  | 9.1

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| |                                                |  |  |      | 
| | ---------------------------------------------- |  |  | ---- | 
| | Affiliated
  companies
  and other investments |  |  |      | 
| |                                                |  |  |      | 
| | Wavion                                         |  |  | 1.4  | 
| | Teledata                                       |  |  | 16.0 | 
| | Brainsgate                                     |  |  | 6.9  | 
| | Nulens                                         |  |  | 1.7  | 
| | AMT                                            |  |  | 1.4  | 
| | Jordan
  Valley                                |  |  | 1.4  | 
| | Impliant                                       |  |  | 1.0  | 
| | Other                                          |  |  | 1.6  | 
| |                                                |  |  |      | 
| |                                                |  |  | 31.4 | 
| |                                                |  |  |      | 
| |                                                |  |  |      | 
| | Total
  corporate investments                  |  |  | 40.5 | 
| |                                                |  |  |      | 

*
These investments do not affect the cash included in the consolidated financial
statements.

In
addition, during 2005 RDC invested $6.1 million, which included $0.6 million in
a new company established at the end of 2005 (Medingo) which is developing a
miniature disposable insulin dispenser for insulin dependent diabetic patients.

Consolidated
working capital at December 31, 2005 amounted to $136.2 million compared to
$162.2 million at December 31, 2004. The decrease is mainly due to the decrease
in corporate cash and other liquid instruments.

Consolidated
loans at December 31, 2005, were approximately $7.3 million, compared to $7.5
million at December 31, 2004. In the first quarter of 2006 MediaGates bank
loan in the amount of approximately $2.8 million was settled in consideration
for $0.1 million. As a result, we recorded in the first quarter of 2006 a gain
of approximately $2.7 million.

Subsequent to
December 31, 2005 and through May 31, 2006, we invested an additional aggregate
amount of approximately $17.1 million in new and existing group companies as
detailed below:

|                       |  |  |     |  | 
|---------------------- |  |  | --- |  | 
|Consolidated companies |  |  |     | 
|(*)                    |  |  |     |  | 
|                       |  |  |     |  | 
|RDC                    |  |  | 2.0 | 
|                       |  |  |     | 
|                       |  |  |     | 
|Total                  |  |  | 2.0 | 

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|                                               |  |  |      | 
|---------------------------------------------- |  |  | ---- | 
|Affiliated
  companies
  and other investments |  |  |      | 
|                                               |  |  |      | 
|Wavion                                         |  |  | 1.4  | 
|NuLens                                         |  |  | 2.6  | 
|Partner                                        |  |  | 5.3  | 
|Safend                                         |  |  | 3.5  | 
|ChipX                                          |  |  | 2.3  | 
|                                               |  |  |      | 
|Total                                          |  |  | 15.1 | 
|                                               |  |  |      | 
|                                               |  |  |      | 
|Total
  corporate investments                  |  |  | 17.1 | 
|                                               |  |  |      | 



|  |                                                                                                
|- | -----------------------------------------------------------------------------------------------
|* | These
  investments do not affect the cash included in the consolidated financial
  statements.

On
June 8, 2006 we invested additional $2.5 million in AMT.

Our
investment policy for managing our funds is in general to invest in bank
deposits and U.S. government securities with high liquidity.

We
believe that our existing capital will be sufficient to fund our and our
subsidiaries operations and our investment plan in existing and new companies
for at least the next twelve months.

Shareholders
equity at December 31, 2005, was approximately $302.1 million, representing
approximately 85% of total assets, compared with $389.1 million, representing
approximately 78% of total assets at December 31, 2004. The decrease in
shareholders equity is mainly due to our dividend distribution in 2005.

Market Risk

Market risks
relating to our operations result primarily from changes in interest rates,
exchange rates and equity prices. In order to limit our exposure, we may enter,
from time to time, into various derivative transactions. Our objective is to
reduce exposure and fluctuations in earnings and cash flows associated with
changes in interest rates, foreign currency rates and equity prices. We do not
use financial instruments for trading purposes. It is our policy and practice
to use derivative financial instruments only to limit exposure. As part of this
policy, in 2005 we hedged the dollar value of the expected proceeds from the
sale of our shares in Partner by the purchase of call options and by selling
put options, at a dollar/NIS exchange rate ranging from $4.36 to $4.44 for a
period of 81 days. This transaction had no material effect on our results of
operations.

Interest Rate Risks

We are exposed
to market risks resulting from changes in interest rates, relating primarily to
our debentures and deposits. We do not use derivative financial instruments to
limit exposure to interest rate risk. As of December 31, 2005, we held U.S.
government debentures with a market value of approximately $62.6 million. The
market value of the debentures depends on changes and expectations of changes
in the interest rates in the United States and general market conditions in the
United States. At December 31, 2005, all of our debentures and short-term
deposits were fixed rate based with an average annual rate of 3.7% and a
weighted average maturity of approximately 1.7 years. In 2005, as a result of
increase in interest rates, we recorded

71

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an other than
temporary decline in value, net of tax, of approximately $0.6 million on
debentures held by us.

Exchange Rate Risk

Since most of
our group companies are Israeli-related, our main exposure, if any, results
from changes in the exchange rate between the New Israeli Shekel and the U.S.
dollar. Our functional currency, as well as that of our principal subsidiaries
and affiliated companies, is the U.S. dollar. Our policy is to reduce exposure
to exchange rate fluctuations by having most of our and our subsidiaries
assets and liabilities, as well as most of the revenues and expenditures in
U.S. dollars, or U.S. dollar linked. Therefore, we believe that the potential
loss that would result from an increase or decrease in the exchange rate is
immaterial to our business and net assets. See above regarding the hedging of
the dollar value of the proceeds from the sale of our shares in Partner.

Equity Price Risk

We are exposed
to fluctuations in the equity price of our holdings in publicly traded
companies. At December 31, 2005 we directly and indirectly held shares of
publicly traded companies, primarily Given Imaging, Partner, NetVision and EVS.
Stock prices in the industries of these companies, and of these companies
themselves, have historically experienced significant volatility. Changes in
the market value of our publicly traded holdings, including holdings through
our affiliates, which are accounted under the equity method of accounting or as
available-for-sale securities will not affect our results of operations but may
have a significant effect on our market value. We view the risks of reduction
in market price of these companies as part of our business risks and we
examine, from time to time, the possibility of having a partial hedge against
equity price risks. Based on closing market prices at December 31, 2005, the
market value of our holdings in public securities was approximately $197.0
million. At December 31, 2005, no instruments were used to hedge the risk of
equity price fluctuations.

Changes in the
market value of our available-for-sale securities (Partner and EVS) are
reported in other comprehensive income, which is included as a component of
shareholders equity, and not as part of our results of operations. The market
value of our available-for-sale securities as of December 31, 2005 amounted to
$27.85 million.

|   |                         
|-- | ------------------------
|C. | Research and Development

Since
we, through our group companies, engage in fields of high-technology, our group
companies invest significant resources in research and development (R&D)
activities.

The
combined R&D costs of all group companies amounted to approximately$43.5
million in 2005, $58.9 million in 2004 and $85.1 million in 2003 (including
R&D expenses of Elbit Systems which was sold in the second half of 2004 in
the amount of $0, $27.1 million and $54.9 million, in 2005, 2004 and 2003,
respectively). The decrease in R&D costs in 2005 as compared to 2004 was
primarily due to the sale of Elbit Systems. This decrease was offset by the
R&D expenses of our new affiliates and subsidiaries in which we invested at
the end of 2004 and during 2005, including Jordan Valley, Impliant, Teledata,
BrainsGate, NuLens, Enure and Medingo as well by the increase in the R&D
expenses of our group companies, mainly RDC, Given Imaging, Galil Medical,
Oncura, 3DV, Starling and SELA. The decrease in R&D costs in 2004 as compared
to 2003 was primarily due to the sale or discontinued operations of some of

72

---



our group
companies during 2003 and 2004 (mainly Elbit Systems in July 2004, ESW and
MediaGate), which was partially offset by an increase in R&D expenses in
some of our group companies (mainly Wavion, Starling and ChipX).

Our
consolidated research and development costs amounted to $6.2 million, $2.9
million and $3.3 million in 2005, 2004 and 2003, respectively. The increase in
the consolidated R&D costs resulted mainly from the increase in R&D
expenses of our subsidiaries RDC, Galil Medical, Starling and 3DV as well as
from our new consolidated companies, Medingo and Enure (both consolidated since
the fourth quarter of 2005) and SELA (consolidated since the second half of
2004).

|D. | Trend Information
|-- | -----------------
|   |                  

Trend
  Information pertaining to our group companies and us is incorporated by
  reference to Item 4, Information on the Company of this Report and
  this Item 5 under Results of Operations.

|   |                               
|-- | ------------------------------
|E. | Off Balance Sheet Arrangements

There is no
principal amount of off balance sheet transactions.

|   |                                            
|-- | -------------------------------------------
|F. | Tabular Disclosure of Financial Obligations

At
December 31, 2005, we and our subsidiaries had no material contractual
obligations which are expected to affect our consolidated cash flow in future
periods, except for lease obligations and payments of bank credits, bank loans
and loans from others, including short term loans taken by our subsidiaries, in
each case due in future periods as set forth in the table below (in million of
$):

|                    |  |      |  |      |  |      |     |      |  |      |  |       |   |  |     | 
|------------------- |  | ---- |  | ---- |  | ---- | --- | ---- |  | ---- |  | ----- | - |  | --- | 
|Type of Obligation* |  | 2006 |  | 2007 |  | 2008 |     | 2009 |  | 2010 |  | Total |  
|                    |  |      |  |      |  |      |     |      |  |      |  |       |  
|Loans from
  banks  |  | 3.8  |  |     |  |      |    |      |  |     |  |       |  |  | 3.8 | 
|Loans from
  other  |  | 2.1  |  | 1.4  |  |      |    |      |  |     |  |       |  |  | 3.5 | 
|Operating
  leases  |  | 0.8  |  | 0.7  |  |      | 0.4 |      |  | 0.2  |  |       |  |  | 2.1 | 

* Does not
include accrued severance pay and retirement obligation of $2.6 million at
December 31, 2005.

Item 6. Directors, Senior Management and
Employees

|   |                                
|-- | -------------------------------
|A. | Directors and Senior Management

As of May 31,
2006, our executive officers and directors are as follows:

73

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|                                |      |    |  |                                            |  |  |          | 
|------------------------------- | ---- | -- |  | ------------------------------------------ |  |  | -------- | 
|                                | Name |    |  | Age                                        |  |  | Position | 
|                                |      |    |  |                                            |  |  |          | 
|Ami Erel (5)                    |      | 59 |  | Chairman of
  the Board of Directors      
|Avraham
  Asheri (1)(4)         |      | 68 |  | Director                                  
|Prof. Gabi
  Barbash            |      | 56 |  | Director                                  
|Prof. Yair
  Beery             |      | 49 |  | Director                                  
|Nochi
  Dankner(5) (6)          |      | 51 |  | Director                                  
|Avraham
  Fischer(5)            |      | 49 |  | Director                                  
|Yaacov
  Goldman (1)(2)(3) (4)  |      | 50 |  | External
  Director                       
|Ari
  Bronshtein(5)             |      | 36 |  | Director                                  
|Shay Livnat(5)
  (6)            |      | 47 |  | Director                                  
|Dori Manor(5)
  (6)             |      | 39 |  | Director                                  
|Professor
  Daniel Sipper(1)(2) |      | 73 |  | External
  Director                       
|Doron Birger                    |      | 55 |  | President
  and CEO                       
|Moshe
  Fourier                 |      | 58 |  | Vice
  President, Chief Technology Officer
|Rinat Remler                    |      | 34 |  | Vice
  President, Chief Financial Officer 
|Yair Cohen                      |      | 51 |  | Vice
  President                          
|Assaf Topaz (7)                 |      | 35 |  | Vice
  President                          



|   |                                                                                                                      
|-- | ---------------------------------------------------------------------------------------------------------------------
|1. | Member of
  our audit committee.                                                                                     
|   |                                                                                                                      
|2. | External
  director under the Israeli Companies Law.                                                                 
|   |                                                                                                                      
|3. | Designated
  Financial Expert under Sarbanes-Oxley Act of 2002.                                                      
|   |                                                                                                                      
|4. | Designated
  Financial Expert under Israeli Companies Law.                                                           
|   |                                                                                                                      
|5. | Director or
  Officer of IDBH, IDBD and/or DIC.                                                                      
|   |                                                                                                                      
|6. | See Item 7A
   Major Shareholders.                                                                                
|   |                                                                                                                      
|7. | Assaf Topaz
  is the husband of Michal Topaz, daughter of Ruth and Isaac Manor. See Item 7A
   Major Shareholders.

Ami
Erelhas served as the Chairman of our Board of
Directors of Elron since November 1999 and served as our Chief Executive
Officer from November 1999 to December 2001. Mr. Erel has served as President
and Chief Executive Officer of DIC since June 1, 2001. Mr. Erel is also
Chairman of the board of directors of Cellcom Israel Ltd., NetVision and
Scailex Corporation (formerly Scitex Corporation) and serves as a director of
Property and Building Corporation Ltd. and Super-Sol Ltd. Mr. Erel also serves
as the Chairman or a member of the boards of various other subsidiaries and
affiliates of DIC and Elron. From 1997 to 1999, Mr. Erel served as President
and Chief Executive Officer of Bezeq-The Israel Telecommunications Corp. Ltd.
(Bezeq). From 1997 to 1998, he was Chairman of the board of directors of
PelePhone Communications Ltd. As of January 2005, Mr. Erel serves as Chairman
of the Executive Committee of the Manufacturers Association of Israel. From
January 2000 to January 2004, Mr. Erel served as Chairman of the Board of
Israel Association of Electronics & Information Industries. Mr. Erel holds
a B.Sc. in electrical engineering from the Technion, Israel Institute of
Technology.

74

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AvrahamAsheri
joined Elron as a director in December 1999. He serves as the Chairman of our
Audit Committee. He is an economic and financial advisor. Mr. Asheri is a
member of the boards of directors of Discount Mortgage Bank Ltd., Africa Israel
Investments Ltd., Elbit Systems Ltd. and Scailex Corporation Ltd. (formerly
Scitex Corporation Ltd.) Mr. Asheri was the President and Chief Executive Officer
of Israel Discount Bank from November 1991 until July 1998. Prior to joining
Israel Discount Bank in 1983 as Senior Executive Vice President and a member of
its management committee, Mr. Asheri held the position of Director General of
the Ministry of Industry and Trade. During his 23 years at the Ministry of
Industry and Trade and at the Ministry of Finance, Mr. Asheri held several key
offices in Israel and abroad, including Managing Director of the Investment
Center in Israel, and Trade Commissioner of Israel to the United States. Mr.
Asheri holds a bachelors degree in economics and political science from the
Hebrew University in Jerusalem.

Prof.
Gabi Barbashjoined Elron as a director in May 2003.
Since 1999, Prof. Barbash has been Director General of the Tel-Aviv Sourasky
Medical Center and between 2000 and 2003 he served as Chairman of the Board of
Directors of Teuza Venture Capital Fund. Between 1998 and 2000, Prof. Barbash
was the Chairman of the Israeli National Transplant Center. Between 1996 and
1999, Prof. Barbash was the Director General of the Israeli Ministry of Health.
Between 1995 and 1998, Prof. Barbash was a member of the Scientific Committee
of the Interdisciplinary Center for Technological Analysis and Forecasting at
Tel-Aviv University. Between 1993 and 1996, Prof. Barbash was the Director
General of the Sourasky Medical Center. Between 1986 and 1993, Prof. Barbash
was the Deputy Director of the Sheba Medical Center and from 1990 to 1993, he
was Director of the Rehabilitation Hospital of the Sheba Medical Center. Prof.
Barbash holds an M.D. degree from the Hebrew University, Jerusalem, Hadassah
Medical School and a masters degree in public health from Harvard University.

Prof.
Yair Beery joined Elron as a director in January
2004. Since 1985, Prof. Beery has been with the Department of Electrical
Engineering at Tel Aviv University and served as its Chairman from 1999 until
2003. From 1998 until 2005, Prof. Beery worked with Benny Steinmetzs Group
and co-founded STI Ventures, a high technology venture investment company. From
1989 until 1996, Prof. Beery served as Vice President of Advanced Technology
of the DSP Group Inc. Prof. Beery serves as a member of the board of directors
of Teledata, one of our group companies. Prof. Beery is also a member of the
advisory boards of ChipX, also one of our group companies, and Mplicity Ltd.
Prof. Beery served previously on the boards of directors and advisory boards
of numerous Israel-related technology companies. Prof. Beery holds B.Sc.,
M.Sc. and Ph.D. degrees (Electrical Engineering) from Tel Aviv University,
Israel.

Ari
Bronshtein joined Elron as a director in March 2006.
In January 2006, Mr. Bronshtein joined DIC as Vice-President. From 2004 to
2005, Mr. Bronshtein served as Vice President and head of the Economics and
Business Development division of Bezeq. From 2000 to 2003, Mr. Bronshtein
served as Director of Finance and Investments at Bezeq. From 1999 to 2000, Mr.
Bronshtein served as Manager of business analysis at Comverse Technologies,
Inc. From 1996 to 1999, Mr. Bronshtein served in various positions at Tadiran
Ltd., his last position being Director of the Finance and Investments division.
Mr. Bronshtein serves as a director of American Israeli Paper Mills Ltd., and
as an external director and chairman of the investment committee of Koor -
Tadiran Gemel. Mr. Bronshtein has previously served as a director of
Bezeq International Ltd., Xpert Systems Ltd. and Simcha Urieli & Sons
Engineering & Construction Company Ltd. In

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addition, Mr.
Bronshtein has served as an external director and member of the investment
committee of Dash Mutual Fund Management Ltd. Mr. Bronshtein has also served as
chairman of the investment committee of Stage One and as a member of the
investment committee of Eurofund, both venture capital funds. Mr. Bronshtein
holds a Bachelors Degree in Finance and Management and Masters Degree in
Finance and Accounting, both from Tel Aviv University.

Nochi
  Dankner joined Elron as a director in June 2005. Mr. Dankner is the Chief
  Executive Officer and Chairman of the board of directors of IDBH and serves
  as Chairman of the board of directors of IDBD, DIC and Clal Industries and Investments
  Ltd. Mr. Dankner is the founder of the Ganden Group and serves as a director
  of companies in the Ganden Group which holds investments in companies operating
  primarily in the fields of real estate and tourism, including
  as Chairman of Ganden Holdings Ltd. and Ganden Investments (2000) Ltd. and as
  Co-Chairman of Ganden Tourism and Aviation Ltd. and Israir Ltd. In addition,
  Mr. Dankner serves as a director of Cellcom Israel Ltd., Clal Insurance Company
  Ltd., Nesher-Israeli Cement Enterprises Ltd., Property and Building Corporation
  Ltd., Azorim Investments, Development and Construction Company Ltd., Super-Sol
  Ltd. and other public and private companies in the IDB group. Mr. Dankner is
  Chairman of the IDB Fund For the Community and is a member of Matan
  - Your Way to Give, a non-profit organization. Mr. Dankner also serves
  as a member of the Management Committee of the Association of Friends of the
  Tel Aviv Sourasky Medical Center, and as a member of the Board of Trustees of
  the Tel Aviv University. Mr. Dankner holds an LL.B. degree from the Tel Aviv
  University and a Bachelor of Arts degree in Political Science from Tel Aviv
  University.

Avraham
Fischer joined Elron as a director in August 2003. He
is the Executive Vice President of IDBH, the deputy Chairman of IDBD, Co-Chief
Executive Officer of Clal Industries and Investments Ltd. and Chairman of Clal
Biotechnology Industries Ltd. In addition, he is a partner of Fischer, Behar,
Chen & Co., a leading Israeli law firm. Mr. Fischer is the co-founder and
co-Chairman of Ganden Tourism and Aviation Ltd., a company holding investments
in Israeli companies, operating primarily in the field of tourism, and is the
co-founder and Vice-Chairman of Ganden Holdings Ltd., which is the principal
shareholder of IDB Holding Ltd. He serves as a director of Clal Industries
& Investments Ltd., IDBH, DIC, Scailex Corporation (formerly Scitex
Corporation Ltd.), ECI Telecom Ltd., American Israeli Paper Mills Ltd., Vyyo
Inc. and several other companies. Mr. Fischer is a co-chairman of Matan  Your
Way to Give, a non-profit organization. Mr. Fischer holds an LL.B. degree from
the Tel Aviv University and is a member of the Israeli bar association.

Yaacov
Goldman joined Elron as an external director in March
2003 and was reappointed as an external director for a second three year term
in March 2006. He serves as a member of our Audit Committee and is our
designated financial expert on the audit committee. Mr. Goldman also serves as
a director of Bank Leumi LeIsrael B.M., Mer Telemanagement Solutions Ltd.,
Golden House Ltd. and Renewable Resources Ltd. Mr. Goldman serves as the
Professional Secretary of the Peer Review Institute of the Certified Public
Accountants Institute in Israel. Commencing in 1981 Mr. Goldman worked for
Kesselman & Kesselman (member firm of PriceWaterhouseCoopers) for 19 years,
and from 1991 until 2000, as a partner and then senior partner of such firm.
From September 2000 until November 2001, Mr. Goldman served as managing
director of Argoquest Holdings, LLC. From March 2002 until October 2002,
Mr. Goldman acted as a consultant to a private equity initiative with
Poalim Capital Markets &

76

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Investments
Ltd. Mr. Goldman is a certified public accountant in Israel, having
received his Bachelor of Economics and Accounting from the Tel Aviv University.

Shay
Livnat joined Elron as a director in June 2005 and is
the founder, President & Chief Executive Officer of Zoe Holdings Ltd. He is
also the founder and co-chairman of UPS Israel and UTI (Isuzu) Israel. Since
2004, Mr. Livnat has been a director of IDBD, Clal Industries and Investments
Ltd., Clal, Scaelix Corporation and Scitex Vision Ltd. Since 1992, Mr Livnat
has been a director of Taavura Holdings Ltd. Between 1988 and 1998, Mr. Livnat
was the Managing Director of Tashtit Ltd (DAF, Liebherr) and Vice-President of
the Taavura Group. Mr. Livnat holds a Bachelor of Science in Electrical
Engineering, Fairleigh Dickinson University, New Jersey, USA.

Dori
Manor joined Elron as a director in August 2003. He
has served as Chief Executive Officer of David Lubinski Ltd., a group of automotive
companies, since 2000, and was the Vice President from 1997 until 2000 and
Assistant Director from 1994 until 1996. During 1994 and 1995, he served as a
director of Morasco Ltd. During 1992 and 1993, he was engaged as an Industrial
Engineering consultant for Factory Design Ltd. Mr. Manor serves as a director
of IDBH, IDBD, DIC and Clal Industries and Investments Ltd. Mr. Manor received
an MBA degree from the European Institute of Business Administration (INSEAD)
in Fontainebleau, France, in 1996 and a Bachelor of Science degree in
Industrial Engineering from Tel Aviv University in 1993.

Professor
Daniel Sipper joined Elron as an external director in
February 2001. Professor Sipper serves on our Audit Committee. Professor Sipper
serves in the faculty of the Department of Industrial Engineering at Tel-Aviv
University. He received his bachelor of science from the Technion, Israel
Institute of Technology, a masters of science degree from Columbia University
and a Ph.D. in Industrial Engineering from the Georgia Institute of Technology.

Doron
Birger joined Elron in 1994 as Vice President of
Finance. Mr. Birger has served as President and Chief Executive Officer of
Elron since August 2002, President since September 2001, Chief Financial
Officer from 1994 to May 2002 and Corporate Secretary from 1994 to September
2001. Mr. Birger is Chairman of Given Imaging and ChipX Corporation as well as
a director of RDC, NetVision, Teledata and various others of our group
companies. From 1991 to 1994, Mr. Birger was Vice President-Finance at North
Hills Electronics Ltd., an advanced electronics company. From 1990 to 1991, Mr.
Birger served as Chief Financial Officer of Middle-East Pipes Ltd., a
manufacturer in the metal industry. From 1988 to 1990, Mr. Birger served as
Chief Financial Officer of Maquette Ltd., a manufacturer and exporter of
fashion items. From 1981 to 1988, Mr. Birger was Chief Financial Officer and
director at Bateman Engineering Ltd. and I.D.C. Industrial Development Company
Ltd. From 1979 to 1981, Mr. Birger was the Chief Financial Officer of Fibronics
Ltd. Mr. Birger is a member of Young Entrepeneurs, a non-profit organization,
and a director of the National Science & Technology Museum in Haifa. Mr.
Birger holds a B.A. and an M.A. in economics from the Hebrew University,
Jerusalem.

Moshe
Fourier joined Elron as Vice-President and Chief
Technical Officer on June 1, 2000. Mr. Fourier serves as a director of Wavion,
Starling and other Elron group companies. From 1999 to 2000, he served as the
Chief Operations Officer for Terayon Communications

77

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broadband
voice division, one of the leading companies that provides cable modems and
telecommunications solutions over the cable television infrastructure. From
December 1993 until 1999, he joined the founder of Telegate and jointly
initiated this start-up providing telecommunications equipment for delivering
voice, data and video over cable television infrastructure, and served as
Deputy Chief Executive Officer and Vice President of Research and Development
and Technology. In June 1992, he joined RADA Electronic Industries as Vice
President of Engineering. In August 1975, Mr. Fourier joined Astronautics
Corporation of America - the Israeli division, as the first engineer and was promoted
in 1978 to Vice President of Engineering. Mr. Fourier holds a bachelor of
science degree in electrical engineering (BSEE) and an associated electrical
engineering degree from the Technion, Israel Institute of Technology.

Rinat
Remler joined Elron in April 2000 as Director of
Finance and in November 2005 was appointed as Vice President & Chief
Financial Officer. From 1997 to 2000, Ms. Remler worked for Luboshitz
Kasierer, a leading Israeli auditing firm, now part of Ernst & Young
International. Ms. Remler serves on the boards of directors of NetVision, RDC
and other Elron group companies. Ms. Remler was a lecturer in accounting and
economics at the University of Haifa from to 1997 to 1998 and at the Technion,
Israel Institute of Technology, from 1995 to 1997. Ms. Remler holds a BA degree
in Economics from the Haifa University (summa cum laude) and a M.A. degree in
Business Administration from the Technion, Israel Institute of Technology. Ms.
Remler has been a licensed CPA in Israel since 1997.

Yair
Cohen joined Elron in July 2005 as Vice President.
Prior to joining Elron, Mr. Cohen served since 2000 as Brigadier General of the
special Unit 8200, the central military intelligence unit of the Israeli
Defense Force, engaged in the development of state of the art technology. Mr.
Cohen serves on the Boards of Directors of RDC, Galil Medical and other Elron
group companies. Mr. Cohen holds a BA degree in History and Arabic (summa cum
laude) from Bar-Ilan University, Israel, and a M.A. degree in Management of
National Resources (summa cum laude) from Industrial College (NDU), Washington
D.C.

Assaf
Topaz joined Elron in April 2004 as Director of
Business Development and in April 2005, was appointed as Vice President. Mr.
Topaz serves as director of Enure Networks and Jordan Valley Semiconductor.
Prior to joining Elron, from 1998 to 2002, Mr. Topaz was co-founder and Chief
Operations Officer of Gilian Technologies, Inc, a technology company engaged in
the web security market. From 1996 to 1998, Mr. Topaz was a business
development executive for Euro Tel Aviv, an advertising agency. From 1995 to
1996, Mr. Topaz was an account executive at McCann Erickson-Kesher Advertising
Ltd. Mr. Topaz holds a B.A., Economics and Geography from the Hebrew University
of Jerusalem, Israel and a Masters Degree in Business from Stanford University.

|   |             
|-- | ------------
|B. | Compensation

During
the year ended December 31, 2005, we paid aggregate remuneration to our
directors and officers as a group who served in the capacity of director or
executive officer during such year of approximately $2,192,000. This amount
does not include amounts expended by us for automobiles made available to our
officers in the aggregate amount of $38,000.

78

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The
following table sets forth the approximate aggregate compensation paid by us
during the fiscal year ended on December 31, 2005 to all of our directors and
officers.

| |                 |  |                                                                           |  |                                                                                                 | 
| | --------------- |  | ------------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------- | 
| |                 |  | Cash and Cash-Equivalent Forms of Compensation
  (in thousands of U.S. $) | 
| |                 |  |                                                                           | 
| | 2005(1)         |  | Salaries, Fees, Directors
  Fees, Commissions and
  Bonuses              |  | Securities(2) or Property,
  Insurance
  Benefits or
  Reimbursements
  and Personal
  Benefits | 
| |                 |  |                                                                           |  |                                                                                                 | 
| | All
  Directors |  | 245                                                                       |  |                                                                                                | 
| | All Officers    |  | 1,734                                                                     |  | 213                                                                                             | 



|    |                                                                                                                        
|--- | -----------------------------------------------------------------------------------------------------------------------
|(1) | Does not
  include an increase in provision for vacation in the amount of approximately
  $30,000.                     
|(2) | See Share
  Ownership under this Item 6 and Compensation of the Chairman under Item 7-
  Related Party Transactions.
|    |                                                                                                                        
|C.  | Board Practices                                                                                                        

None
of our directors have service contracts with us or any of our group companies
providing for benefits upon termination of employment. Two of our directors
have consulting agreements with us pursuant to which they provide services to
us. See Item 7  Related Party Transactions. Compensation of our officers is
recommended by our senior management and approved by the board of directors or
a committee of the board of directors. Compensation of all other employees is
determined by our senior management.

Board of Directors

Our
Articles of Association provide for a board of directors of not less than five
members and no more than fifteen members, including external directors. Each
director, other than external directors, is elected to serve until the end of
the first annual meeting following their appointment. However, if no directors
are elected at such annual meeting, the then present directors shall continue
in office. The board of directors may appoint additional directors, provided
that the total number of directors does not exceed the maximum number of
fifteen as mentioned above. A director appointed as such shall serve until the
end of the next annual meeting held following his or her appointment and he or
she shall be eligible for re-appointment. Notwithstanding any of the above, any
director, other than external directors, may be removed from office by an
ordinary resolution of a general shareholders meeting or by two thirds of the
directors. A director need not hold any of our shares to qualify as one of our
directors. Our Articles provide that our board of directors may delegate its
powers to its committees, subject to limitations determined by the Israeli
Companies Law.

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Substitute Directors

Our
Articles of Association provide that any director may, by written notice to us,
appoint another person to serve as a substitute director and may cancel such
appointment. The identity of a substitute director requires the approval of the
board of directors. Under the Israeli Companies Law, there shall not be
appointed as a substitute director, any person who is not himself qualified to
be appointed as a director or a person who is already serving as a director or
a person who is already serving as a substitute director for another director.
Nevertheless, a director may be appointed as a substitute director for a
committee of the board of directors if he or she is not already serving as a
member of the committee. Under the Israeli Companies Law, there shall not be
appointed a substitute director for an external director.

The
term of appointment of a substitute director may be for one meeting of the
board of directors or for a specified period or until notice is given of the
cancellation of the appointment. To our knowledge, no director currently
intends to appoint any other person as a substitute director, except if the
director is unable to attend a meeting of the board of directors.

External Directors

The
Israeli Companies Law requires Israeli companies with shares that have been
offered to the public in or outside of Israel (public companies) to appoint two
external directors. No person may be appointed as an external director if the
person or the persons spouse, siblings, parents, grandparents, descendants,
spouses descendants and the spouses of any of the foregoing (referred to as a
relative), partner, employer or any entity under the persons control, has or
had, within the two years preceding the date of the persons appointment to
serve as external director, any affiliation with the company or any entity
controlling, controlled by or under common control with the company. The term
affiliation includes:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | an
  employment relationship;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | a business
  or professional relationship maintained on a regular basis;                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | control; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | service as
  an office holder, as defined below in Item 10, excluding service as a
  director who was appointed to serve as an external director in a company
  which is going to initially offer its shares to the public.                                                                                                                                                                                                                                                                                   
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | No person
  may serve as an external director if the persons position or other business
  activities create, or may create, a conflict of interest with the persons
  responsibilities as an external director or may otherwise interfere with the
  persons ability to serve as an external director. If, at the time external
  directors are to be appointed, all current members of the board of directors
  are of the same gender, then at least one external director must be of the
  other gender.

Pursuant
to a 2005 amendment to the Companies Law, a public company is required to
appoint as an external director a person, who has professional capability or
a person, who has financial and accounting expertise, provided that at least
one of the external directors shall have financial and accounting expertise.
In addition, pursuant to the same amendment to the Companies Law, the board of
directors of a public company is required to determine the minimum number of
directors with financial and accounting expertise serving on the board of

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directors. The
qualifications for professional capability and financial and accounting
expertise are determined by regulations. In March 2006, we determined the
minimum number of directors with financial and accounting expertise serving
on our board of directors to be two. Mr. Goldman and Mr. Asheri are designated
as our two directors with financial and accounting expertise.

External
directors are to be elected by a majority vote at a shareholders meeting,
provided that either:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the majority
  of shares voted at the meeting, including at least one-third of the shares
  held by non-controlling shareholders, or their representatives, which voted
  at the meeting, vote in favor of election of the director without taking
  abstentions into account. According to the Israeli Companies Law, a
  controlling shareholder is defined as a person who has the ability to direct
  the activities of a company, other than if this power derives solely from its
  position on the board of directors or any other position with the company. A
  person is presumed to be a controlling shareholder if he holds half or more
  of the following: (1) voting rights in the general meeting, or (2) rights to
  appoint directors or the Chief Executive Officer; or
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | the total
  number of shares held by non-controlling shareholders voted against the
  election of the director does not exceed one percent of the aggregate voting
  rights in the company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

The
initial term of an external director is three years and may be extended for an
additional three years. Both of our external directors are currently serving
their respective additional terms, which end in 2007 and 2009, respectively.
External directors may be removed only in a general meeting, by the same
percentage of shareholders as is required for their election, or by a court,
and in both cases only if the external directors cease to meet the statutory
qualifications for their appointment or if they violate their duty of loyalty
to the company. Each committee of a companys board of directors must include
at least one external director and all of the external directors must be
members of the audit committee.

An
external director is entitled to compensation in accordance with the
regulations adopted under the Israeli Companies Law and is otherwise prohibited
from receiving any other compensation, directly or indirectly, in connection
with service provided as an external director.

Audit Committee

The
Israeli Companies Law requires public companies to appoint an audit committee.
The responsibilities of the audit committee include identifying irregularities
in the management of the companys business and approving related party
transactions as required by law. An audit committee must consist of at least
three directors, including, as mentioned, all of the external directors of the
company. The Chairman of the board of directors, any director employed by or
otherwise providing services to the company, and a controlling shareholder or
any relative of a controlling shareholder, may not be a member of the audit
committee.

Our
two external directors serve on the audit committee of the board of directors.
All members of our audit committee meet the definition of independent directors
under the Sarbanes Oxley Act of 2002 and the Nasdaq Marketplace Rules. None of
them is an affiliated person of us

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or has
received any consulting, advisory or other compensatory fee from us, other than
in their capacity as directors. Yaacov Goldman is our designated financial
expert under the Sarbanes-Oxley Act of 2002.

Internal Auditor

Under
the Israeli Companies Law, the board of directors of public companies must
appoint an internal auditor, nominated by the proposal of the audit committee.
The role of the internal auditor is to examine, among other matters, whether
the companys actions comply with the law and orderly business procedure. Under
the Israeli Companies Law, the internal auditor may be an employee of the
company but not an office holder (as defined below in Item 10), an interested
party, a relative of an office holder or an interested party, and he may not be
the companys independent accountant or its representative. According the
Israeli Companies Law, an interested party is defined as a shareholder who holds
5% or more of the outstanding share capital or the voting power, a director, a
general manager or a shareholder who has the right to appoint at least one
director or the general manager. Doron Cohen of Fahn Kane, a member of Grant
Thornton International, is our internal auditor.

Nasdaq Listing
Standards

Our
ordinary shares are currently listed on the Nasdaq National Market and are
subject to the rules and regulations established by Nasdaq as being applicable
to listed companies. Rule 4350 imposes various corporate governance
requirements on listed securities. Section (a)(1) of Rule 4350 provides that
foreign private issuers are required to comply with certain specific
requirements of Rule 4350, but, as to the balance of Rule 4350, foreign private
issuers may comply with the laws of their home jurisdiction in lieu of the
requirements of such sections of Rule 4350.

We
have chosen to follow the rules of our home jurisdiction, the Israeli Companies
Law, in lieu of the requirements of Section 4350(c) relating to:

| |   |                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | independence
  of the board of directors;                                                                                                                                          
| |   |                                                                                                                                                                                    
| |  | executive
  sessions of independent directors;                                                                                                                                     
| |   |                                                                                                                                                                                    
| |  | the
  requirement that compensation of executive officers is to be determined by an
  independent committee of the board or by the independent members of the board
  of directors;
| |   |                                                                                                                                                                                    
| |  | the
  requirement that director nominees must be selected by an independent
  committee of the board or by the independent members of the board of
  directors.                    

The above
requirements of Rule 4350 are not required under the Israeli Companies Law.

|   |          
|-- | ---------
|D. | Employees

All
of our employees are located in Israel. The following table sets forth, for the
last three financial years, the number of our employees.

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| |                                 |  |      |  |      |  |      | 
| | ------------------------------- |  | ---- |  | ---- |  | ---- | 
| | Period
  ended December 31,     |  | 2005 |  | 2004 |  | 2003 | 
| |                                 |  |      |  |      |  |      | 
| | Management
  and Administration |  | 22   |  | 22   |  | 22   | 

Certain
provisions of Israeli employment laws and of Extension Orders based upon
provisions of the collective bargaining agreements between the Histadrut
(General Federation of Labor in Israel) and the Coordination Bureau of Economic
Organizations (including the Industrialists Associations) are applicable to
employees in Israel by order of the Israeli Ministry of Labor. These provisions
concern principally the length of the work day, minimum daily wages for
professional workers, insurance for work-related accidents, procedures for
dismissing employees, determination of severance pay, and other conditions of
employment. We generally provide employees with benefits and working conditions
beyond the minimum requirements.

Israeli
law generally requires severance pay, which may be funded by Managers
Insurance described below, upon the retirement or death of an employee or
termination of employment without cause (as defined in the law). The payments
thereto amount to approximately 8.33% of wages. Furthermore, Israeli employees
and employers are required to pay predetermined sums to the National Insurance
Institute, which is similar to the United States Social Security Administration.
Such amounts also include payments for national health insurance. The payments
to the National Insurance Institute are equal to approximately 16.3% of the
wages, of which the employee contributes approximately 66% and the employer
contributes approximately 34%.

A
general practice followed by us and some of our group companies although not
legally required, is the contribution of additional funds on behalf of most of
the employees to a fund known as Managers Insurance. This fund provides a
combination of savings plan, insurance and severance pay benefits to the
employee, giving the employee a lump sum payment upon retirement and securing
the severance pay, if legally entitled, upon termination of employment. The
employer decides which employees are entitled to participate in the plan, and
each employee who agrees to participate contributes an amount equal to 5% of
his or her salary and the employer contributes between 13.3% and 15.8% of the
employees salary.

Share
Ownership

The number of
our ordinary shares beneficially owned by each of our directors, and by our
directors and officers as a group, as of May 31, 2006, is as follows:

| |                                         |  |                   |     | 
| | --------------------------------------- |  | ----------------- | --- | 
| | Director                                |  | Ordinary
  Shares |     | 
| |                                         |  |                   |     | 
| | Ami Erel,
  Chairman(1)                 |  | 10,376            | (2) | 
| | Avraham Asheri                          |  | 0                 |     | 
| | Prof. Gabi
  Barbash                    |  | 0                 |     | 
| | Ari
  Bronshtein(1)                     |  | 0                 |     | 
| | Prof. Yair
  Beery                     |  | 0                 |     | 
| | Nochi
  Dankner(1)                      |  | 0                 |     | 
| | Avraham
  Fischer(1)                    |  | 0                 |     | 
| | Yaacov
  Goldman                        |  | 0                 |     | 
| | Shay Livnat(1)                          |  | 0                 |     | 
| | Dori Manor(1)                           |  | 0                 |     | 
| | Prof. Daniel
  Sipper                   |  | 0                 |     | 
| | All officers
  and directors as a group |  | 171,866           | (3) | 

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|    |                                                                                                                                                                            
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Director or officer of DIC, IDBD or IDBH. Ownership excludes shares
        beneficially owned by these companies.                                                         
|    |                                                                                                                                                                            
|(2) | Consists
  solely of options to purchase our ordinary shares, based on our share price
  as of May 31, 2006. See below Series 9 and Series 11 under Stock Option
  Plans.
|    |                                                                                                                                                                            
|(3) | Includes
  options to purchase 170,626 of our ordinary shares currently exercisable or
  exercisable within 60 days of May 31, 2006.                                       

Stock Option Plans

As of May 31,
2006, 451,551 options to purchase our ordinary shares granted to our officers
and employees were outstanding. Details concerning these options are as
follows:

Series 9 Options

The
Chairman of our board of directors was granted options to purchase 58,154 of
our ordinary shares (the Series 9 Options). The Series 9 Options were granted
ratably over a period of three years commencing on February 2000 and are
exercisable for a period of three years, commencing two years after the date of
grant. Series 9 Options to purchase 38,768 of our ordinary shares, granted in
February 2000 and 2001, have since expired.

The
per share exercise price of the Series 9 Options granted in February 2002 is
$10.01. Upon exercise of the Series 9 Options, the option holder is granted a
number of shares reflecting the benefit component of the options exercised, as
calculated at the exercise date.

Series 10 Options

There
are outstanding options to purchase an aggregate of 25,000 of our ordinary
shares which are held by two of our officers (the Series 10 Options). The
Series 10 Options are exercisable at a price of $29.38 per share. The
optionholders are entitled to exercise 25% of the amount granted, each year,
starting in October 2001. The Series 10 Options will expire in October 2007.

Series 11 Options

The
Chairman of our board of directors was granted options to purchase 58,000 of
our ordinary shares (the Series 11 Options). The Series 11 Options were
granted ratably over a period of three years commencing in June 2001 and are
exercisable for a period of three years, commencing two years after the date of
grant. The first amount of 19,333 Series 11 Options was granted in June 2001
and expired in June 2006. The second amount of 19,333 Series 11 Options was
granted in June 2002 and were exercised in December 2004 into 8,623 shares
based upon a per share exercise price of $8.337. The third amount of 19,334
Series 11 Options was granted in June 2003. The per share exercise price of the
Series 11 Options granted in June 2003 is $5.437.

Upon
exercise of the Series 11 Options, the option holder is granted a number of
shares reflecting the benefit component of the options exercised, as calculated
at the exercise date.

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Series 12 Options

There
are outstanding options to purchase an aggregate of 24,000 of our ordinary
shares held by one of our officers (the Series 12 Options). The Series 12
Options are exercisable at a price per share of $18.87 per share. The officer
is entitled to exercise 25% of the amount granted each year, starting in
February 2002. The Series 12 Options will expire in June 2008.

2003 Option Plan

During
May 2003, our Board of Directors adopted the 2003 Option Plan which was
subsequently ratified by our shareholders on November 30, 2003. Under this
plan, options to purchase an aggregate of up to 500,000 ordinary shares may be
granted. The 2003 Option Plan provides that the exercise price per share shall
be reduced by an amount equal to the amount of any dividend per share
distributed. The optionees are entitled to exercise 25% of the amount granted,
each year, commencing on the date of grant and expiring five years later. In
granting the options, the Board of Directors selected the capital gains tax
track pursuant to the new tax reform legislation which came into effect on
January 1, 2003. For more details see Item 10  Taxation  Employee Stock
Options.

The
following options were granted by during the period May 2003 to March 2006 and
remain outstanding:

|                |  |                          |         |                                                                     |  |                |      |   |      |    
|--------------- |  | ------------------------ | ------- | ------------------------------------------------------------------- |  | -------------- | ---- | - | ---- | ---
|Date of Grant   |  | Aggregate No. of Options |         | Aggregate No. of Options Granted to Officers (or former
  Officers) |  | Exercise Price |     
|                |  |                          |         |                                                                     |  |                |     
|May 2003        |  |                          | 199,500 |                                                                     |  | 175,000        |      | $ | 5.00 | (i)
|December
  2004 |  |                          | 20,000  |                                                                     |  | 20,000         |      | $ | 9.41 | (i)
|July 2005       |  |                          | 40,000  |                                                                     |  | 40,000         |      | $ | 7.84 | (i)
|November
  2005 |  |                          | 80,000  |                                                                     |  | 55,000         | (ii) | $ | 9.12 |    
|March 2006      |  |                          | 5,000   |                                                                     |  |               |      | $ | 9.05 |    

| |      |                                                                                                                                                                                                                                                                                                                                  
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i)  | Exercise
  price reduced as a result of $3.00 dividend per share distributed in
  September 2005.                                                                                                                                                                                                                                
| |      |                                                                                                                                                                                                                                                                                                                                  
| | (ii) | 30,000
  options were issued under Section 3(i) of the Israeli Income Tax Ordinance
  due to the classification of the optionee as a controlling person under the
  Income Tax Ordinance. These options are still subject to shareholder
  approval. (For more details  see Item 10  Taxation  Employee Stock
  Options.)

Options of certain officers to acquire shares
in our private group companies

During
2001, the Board of Directors approved the grant of options to certain of our
officers to acquire between 1% and 2% of our investments in certain private
companies. The options are exercisable at the weighted average price of our
investments. The options vest ratably over a three year period and are
exercisable for an additional three years. These options are in addition

85

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to those
granted to our Chairman, Mr. Ami Erel. See Item 7  Major Shareholders and
Related Party Transactions - Compensation of Chairman.

Item 7. Major Shareholders and Related
Party Transactions

|   |                     
|-- | --------------------
|A. | Major
  Shareholders

The
following table sets forth, as of May 31, 2006, unless otherwise specified, the
number of ordinary shares beneficially owned by all shareholders known to us to
beneficially own more than 5% of our ordinary shares. The voting rights of our
major shareholders do not differ from the voting rights of other holders of our
ordinary shares. As of May 12, 2006, there were a total of 526 holders of
record of our ordinary shares, of which 416 were registered with addresses in
the United States. We believe that the number of beneficial owners is
substantially greater than the number of record holders, because a large
portion of our common stock is held of record in broker street names. United
States holders of record held approximately 11% of our then outstanding
ordinary shares.

|                                                         |  |                             |  |                              |      |   | 
|-------------------------------------------------------- |  | --------------------------- |  | ---------------------------- | ---- | - | 
|Name and Address                                         |  | Number of
  Ordinary Shares |  | Percent of
  Ordinary Shares |     
|                                                         |  |                             |  |                              |     
|Discount Investment Corporation Ltd. (1)Tel Aviv, Israel |  | 14,048,613                  |  |                              | 47.6 | % | 
|                                                         |  |                             |  |                              |      |   | 
|Clal Insurance Group (2) Tel Aviv, Israel                |  | 109,972                     |  |                              | 0.4  | % | 
|All Officers and Directors as a group (3)                |  | 171,866                     |  |                              | 0.6  | % | 

(1) IDBH is
the parent of IDBD, which, in turn, is the parent of DIC and Clal Insurance
Enterprise Holdings Ltd. (Clal). IDBH, IDBD, DIC and Clal are public
companies traded on the Tel Aviv Stock Exchange.

As of May 31,
2006, approximately 51.7% of the outstanding share capital of IDBH was owned by
a group comprised of: (i) Ganden Investments I.D.B. Ltd. (Ganden
Investments), a private Israeli company controlled by Nochi Dankner and his
sister, Shelly Bergman, which held 31.02% of the equity of and voting power in
IDBH; (ii) Manor Investments-IDB Ltd. (Manor Investments), a private Israeli
company controlled by Ruth Manor, which held 10.37% of the equity of and voting
power in IDBH; and (iii) Avraham Livnat Investments (2002) Ltd. (Livnat
Investments), a private Israeli company controlled by Avraham Livnat, which
held 10.34% of the equity of and voting power in IDBH. Ganden Investments,
Manor Investments and Livnat Investments, owning in the aggregate approximately
51.7% of the equity of and voting power in IDBH, entered into a Shareholders
Agreement relating, among other things, to their joint control of IDBH, the
term of which is until May 19, 2023 (IDB Shareholders Agreement). Ganden
Investments, Manor Investments and Livnat Investments pledged their shares of
IDBH to a financial institution as collateral for the repayment of loans
borrowed to purchase such shares.

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In addition,
as of May 31, 2006, (i) Ganden Holdings Ltd. (Ganden Holdings), another
private Israeli company controlled by Nochi Dankner and his sister, Shelly
Bergman, which is the parent company of Ganden Investments, held directly
approximately 11.38% of the equity and voting power of IDBH, (ii) Ganden
Investments additionally held directly approximately 6.71% of the equity in IDBH,
(iii) Shelly Bergman held, though a wholly owned company, approximately 7.23%
of the equity of and voting power in IDBH, (iv) another private Israeli company
controlled by Ruth Manor, which is the parent company of Manor Investments,
held approximately 0.03% of the equity and voting power in IDBH and (v) another
private Israeli company controlled by Avraham Livnat, which is the parent
company of Livnat Investments, held approximately 0.04% of the equity and
voting power in IDBH. Substantially all of the additional shares of IDBH set
forth in (i) and (ii) above held directly by Ganden Holdings and Shelly
Bergmans wholly owned company, were acquired with borrowed funds and are
pledged to each respective shareholders lending institution. None of the
shares set forth in (i) (v) above are subject to the IDB Shareholders
Agreement.

Ganden
Investments, Manor Investments and Livnat Investments have pledged their shares
of IDBH in favor of certain financial institutions as collateral for the
repayment of certain loans borrowed by them in order to finance part of the
consideration paid for the shares of IDBH purchased by them. The lenders may
realize these pledges in certain events described in the agreements with such
financial institutions.

Nochi Dankner
is Chairman of IDBH, IDBD and DIC and a director of Clal and Elron. Zehava
Dankner (the mother of Nochi Dankner) is a director of IDBH, IDBD and DIC and
Clal. Zvi Livnat (a son of Avraham Livnat) is a director of IDBH, IDBD and DIC.
Shay Livnat (a son of Avraham Livnat) is a director of IDBD and Elron. Isaac
Manor (the husband of Ruth Manor) is a director of IDBH, IDBD, DIC and Clal and
Dori Manor (the son of Isaac and Ruth Manor) is a director of IDBH, IDBD, DIC
and Elron.

DICs
address is 3 Azrieli Center, 44th floor, Tel Aviv 67023, Israel.

(2) The Clal Insurance Group is comprised of Clal and its subsidiary
  companies, which are deemed to be major shareholders of the Company. Clal is
  majority owned by IDBD, the parent company of DIC, which in turn is a controlling
  shareholder of the Company. As of May 31 2006, the other major shareholder of
  Clal was Bank Hapoalim, which held approximately 17.53% of Clals shares
  (including holdings of mutual and provident funds that are controlled by Bank
  Hapoalim B.M.). None of the remaining shareholders of Clal held more than 5%
  of its shares.

The
Clal Insurance Groups address is 48 Menachem Begin Rd., Clal Development
Bldg., Tel Aviv, Israel.

(3) This
amount includes 170,626 shares underlying options that are currently
exercisable or that will become exercisable within 60 days of May 31, 2006.
This amount does not include any shares that may be deemed to be beneficially
owned by directors by virtue of their affiliation with DIC.

87

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|   |                           
|-- | --------------------------
|B. | Related Party Transactions

Directors Compensation

In
2006, we agreed to grant compensation to each of our external directors and to
one of our other directors not employed by DIC or IDBH equal to the maximum
compensation permitted under the Companies Law and Regulations for a dual
listed company, namely NIS112,008 (approximately $25,000) per director and up
to NIS3,360 (approximately $750) per director for participation in each meeting
of the board of directors or any committee thereof, in each case, adjusted to
the Israeli Consumer Price Index from time to time. With respect to the
remaining directors, in 2006, and with respect to all the directors, in each of
the fiscal years 2004 and 2005 respectively, we agreed to grant compensation,
according to the amount then permitted according to the Israeli Companies
Regulations (Rules Regarding Compensation and Expenses for an External
Director), 2000 (the External Director Regulations), for companies of the
same classification in relation to its shareholders equity, which were as of
May 31, 2006, in addition to reimbursement of expenses, approximately NIS
47,320 (approximately $10,500) per director for one year and in addition
approximately NIS 1,820 (approximately $400) per director for participation in
each meeting of the board of directors or any committee thereof.

Consulting Agreements with Directors

On
March 12, 2006, following the approval of the Audit Committee and the Board of
Directors, our shareholders approved a consulting agreement with Prof. Yair
Beery with effect from January 1, 2005 until December 31, 2006 pursuant to
which Prof. Beery provides services to us and our group companies in
consideration for $5,000 per month.

In
May 2006, the Audit Committee and the Board of Directors approved a consulting
agreement with Prof. Gabi Barbash with effect from January 1, 2006 until
December 31, 2006 pursuant to which Prof. Barbash provides services to us and
our group companies in consideration for $5,000 per month. The agreement with
Prof. Barbash is subject to shareholders approval. The matter will be presented
to shareholders at our annual meeting to be held later this year.

Compensation of the Chairman

Mr.
Ami Erel has options to acquire up to 1.5% of any shares or other securities
acquired by us in Wavion, Inc. and up to 0.75% of any shares or other
securities acquired by us and through DEP in Galil Medical Ltd. (each an
Invested Company) (together, the Option). The Option shall be exercisable
at the weighted average price of investments made by us with respect to any
such Invested Company until the date of exercise of the Option. The Option
shall be exercisable for a period of three years commencing on the later of
January 1, 2000 or the date of the latest investment by us in the relevant
Invested Company, provided that at the time of the Option exercise
Mr. Erel is a director or an employee of ours and that we have not sold or
otherwise transferred to a third party our securities in the relevant Invested
Company.

Mr.
Erel shall be entitled to participate in a sale by us of shares which were, or
are, subject to Mr. Erels Option hereunder, by selling the same
proportion of his shares along with us. We may require Mr. Erel to sell
such shares together with a sale of shares by us. Sales by Mr. Erel of

88

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shares
acquired upon exercise of the foregoing Options, which are not publicly traded,
will require our approval. To date, none of the foregoing options have been
exercised.

Investments in and
loans to Galil Medical Ltd.

From
January 1, 2005 through May 31, 2006, we, our subsidiary RDC, and DIC invested
in and provided loans to Galil Medical.

These
transactions were approved by our Audit Committee and our Board of Directors
due to DICs participation in the transactions.

Grant of Letters of
Exemption and Indemnification

In
2001, following the approval of our audit committee, board of directors and
shareholders, and in accordance with the provisions of the Companies Law, we
granted letters of indemnification to our directors and officers. The aggregate
indemnification shall not exceed 25% of our shareholders equity according to
our consolidated financial statements for the year ended December 31, 2000, for
all persons and cases to be indemnified. In addition, we undertook to exempt
our directors and officers, to the extent permitted by law, from any liability
towards us for any damage caused or that may be caused to us by them, if caused
or that may be caused following a breach of their duty of care towards us. We
continue to grant letters of indemnification and exemption to our directors and
officers in accordance with the above terms.

Directors and
Officers Insurance Policy

In
April 2005, following the resolution and recommendation of our Audit Committee
and Board of Directors, our shareholders approved and ratified the purchase of
a directors and officers liability insurance policy (the Policy) for our
directors and officers from Clal Insurance Company Ltd., a related party and
separately approved the application of the Policy to Dori Manor, one of our
directors, and any future director or officer of the Company who may currently
be considered a Controlling Shareholder under the Companies Law, 1999. The
principal terms of the Policy are as follows:

| |     |                                                                                                                      
| | --- | ---------------------------------------------------------------------------------------------------------------------
| | (1) | The Policy
  was for a period beginning on January 1, 2005 and ending on June 30, 2006.                              
| |     |                                                                                                                      
| | (2) | The coverage
  under the Policy was limited to $30 million per claim and in the aggregate
  during the Policy period.
| |     |                                                                                                                      
| | (3) | The annual
  premium to be paid with respect to the Policy was approximately $475,000.                               

In
addition, our shareholders approved: (i) any renewal and/or extension of the
Policy for all our directors and officers; and (ii) the purchase of any other
directors and officers liability insurance policy for our directors and
officers upon the expiration of the Policy; provided that any such renewal,
extension or purchase referred to in clauses (i) and (ii) above is for the
benefit of our previous and/or current and/or future directors and officers and
on terms substantially similar to those of the Policy; and that the premium
will not increase by more than 25% in any year, as compared to the previous
year.

We
expect to renew the Policy by June 30, 2006.

89

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Voting Agreement with DIC regarding Given
Imaging

On
September 29, 2003, we and DIC entered into a voting agreement pursuant to
which, among other things, DIC agreed to vote all of its ordinary shares in
favor of nominees to the board of directors of Given Imaging proposed by us.
The voting agreement is for a term of one year and renews automatically each
year thereafter unless terminated by notice of either party to the other party
no later than August 30 in each year. By virtue of this agreement, we may be
deemed to beneficially own the shares held by DIC in Given Imaging, which
together with the shares of Given Imaging which we hold directly as well as
those held by RDC, represents approximately 36% of the outstanding shares of
Given Imaging. This agreement was approved by our Audit Committee and our Board
of Directors.

Voting Agreement
with Infinity regarding Teledata

On
May 8, 2005, as part of our investment in Teledata, we and Infinity, a related
venture capital fund, entered into a voting agreement pursuant to which we
agreed to vote in concert with each other at meetings of shareholders of
Teledata. Clal, a subsidiary of IDBD, is the largest limited partner of
Infinity. DIC, our largest shareholder, is also a subsidiary of IDBD. This
agreement was approved by our Audit Committee and our Board of Directors as
part of our investment in Teledata.

Voting Agreement
with Infinity regarding Brainsgate

On
July, 2005, as part of our investment in BrainsGate, we and Infinity entered
into a voting agreement pursuant to which we agreed to vote in concert with
each other at meetings of shareholders of BrainsGate. This agreement was
approved by our Audit Committee and our Board of Directors as part of our
investment in BrainsGate.

Shareholders
Agreement with DIC regarding NetVision

On
May 10, 2005, immediately prior to the NetVision initial public offering, we
and DIC entered into a shareholders agreement pursuant to which we and DIC
agreed to vote all of our shares in favor of our respective nominees to the
board of directors of NetVision. In addition, under the agreement, we and DIC
have rights of first refusal and co-sale rights on the sale of our respective
shares subject to and in accordance with the mechanisms set forth in the
agreement. The agreement shall terminate upon the earlier of our mutual consent
or either us or DIC holding less than 10% of NetVision. This agreement was
approved by our Audit Committee and our Board of Directors.

|   |                                 
|-- | --------------------------------
|C. | Interests of Experts and Counsel

Not
Applicable.

90

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Item 8. Financial Information

|   |                                                        
|-- | -------------------------------------------------------
|A. | Consolidated Statements and Other Financial Information

Our
consolidated financial statements and other financial information are
incorporated herein by reference to Item 18 below.

Legal Proceedings

Gesser Claim

On
September 8, 1999, we received a copy of a statement of claim, along with a
court order requiring a motion to approve this claim as a class action,
submitted by David Gesser, a shareholder of Elscint Ltd., or Elscint, The
motion requests that this claim be approved as class action instead of the
previous claim submitted by Yonatan Aderet. This claim names as defendants
Elscint, Elbit, our company, and Emmanuel Gill, Uzia Galil, Dov Tadmor, Micha
Angel and Yigal Baruchi, former directors of Elscint, and Yonatan Aderet, the
former President and director of Elscint. The motion was submitted by the
applicant on behalf of all existing shareholders of Elscint who held Elscints
shares on February 18, 1999. The plaintiff seeks damages of approximately
$158.0 million.

The
claim alleges that the defendants, by their decisions regarding the sale of
Elscints assets, caused damage to Elscint and its minority shareholders. The
plaintiff seeks a court order requiring Elscint, or the other defendants, to
purchase from each of the members of the represented class all shares held by
them at a price of $27.46 per share. The lawsuit has been suspended pursuant to
an arrangement reached by the parties pending the outcome of the appeal in the
Investors claim described below. The arrangement provides that if the appeal as
described in the Investors Claim immediately below is accepted, then the
proceedings to recognize the lawsuit as a class action will proceed. Otherwise,
the application to recognize the claim as a class action suit will be
dismissed.

Investors Claim

On
November 2, 1999, we received a statement of claim and an application to claim
as a class action against Europe Israel (M.M.S.) Ltd. (EIL), Elbit Medical
Imaging, Elscint, Control Centers Ltd. (the controlling shareholder of EIL),
Marina Herzliya Limited Partnership 1988 (which is controlled by Control
Centers) and against us and 25 past and present officers of the above
companies, including our officers.

The
claim was submitted by a number of investors and others, who hold shares in
Elscint, while the application to approve the claim as a class action was
submitted on behalf of shareholders who held shares in Elscint on September 6,
1999 and continued to hold such shares on the date of application, excluding
the respondents.

The
allegations, which the claimants raised against us and our officers, relate to
the period prior to the sale of our holdings in Elbit Medical Imaging to EIL.
These allegations include, among others, that (i) we and our officers gave
preference to the interests of our company and the personal interests of our
officers over the interests of Elscint and its minority shareholders; (ii) we
and our officers did not act in order to enable the minority shareholders of
Elscint to participate in the proceeds of the sale of Elscints assets; and
(iii) general allegations against the

91

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transactions
whereby we sold our holdings in Elbit Medical Imaging to EIL. Further
allegations were raised against the other respondents.

The
plaintiffs seek a court order pursuant to which Elbit Medical Imaging would be
compelled to execute the alleged buy-out of shares at $14 per share.
Alternatively, the claimants have requested additional remedies set forth in
the statement of claim, including a remedy requested also from us and our
officers regarding compensation for the damages that they allege were suffered
by them and/or by Elscint. Certain of the remedies have been requested also as
derivative claims on behalf of Elscint. The maximum liability in this claim is
not specified by the plaintiffs.

On
August 16, 2000, the Haifa District Court dismissed the application to
recognize the claim as a class action. Some of the claimants requested and were
granted permission to appeal to the Supreme Court of Israel. The appeal to the
Supreme Court is still pending. In addition, the claimants submitted an amended
claim in February 2001, which was not recognized as a class action suit. The
allegations are similar to those in the previous claim. It has not yet been
determined when the defendants are required to file their statements of defense
to the claim. The claimants and the defendants are currently involved in
various proceedings, primarily involving a disagreement concerning the court
fees.

We
deny all the allegations set forth in the above claims and are defending and
intend to continue defending against such claims.

Other than the
above matters, we are not a party to any material litigation.

Dividend Policy

Currently
we do not have any fixed dividend policy. The declaration of dividends is
determined by the board of directors taking into consideration our financial
status, profitability, realization of assets and our investment requirements.
In September 2005, we distributed a dividend of $3.00 per share, or
approximately $88.5 million in the aggregate.

|   |                    
|-- | -------------------
|B. | Significant Changes

Except
as otherwise disclosed in this Annual Report, no significant change has
occurred since December 31, 2005.

Item 9. The Offer and Listing

|   |                          
|-- | -------------------------
|A. | Offer and Listing Details

Markets and Share Price History

Our
ordinary shares are traded on the Nasdaq National Market, where our shares are
listed and traded under the symbol ELRN. Our shares are also traded on the
Tel Aviv Stock Exchange (TASE) in Israel. The following table sets forth, for
the periods indicated, the high and low reported sales prices of our Ordinary
Shares on the Nasdaq National Market and, in New Israeli Shekels (NIS), on the
Tel Aviv Stock Exchange, which reflect the distribution of a dividend of $3.00
per share in 2005:

92

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| |                       |  |                     |  |                    |  |                |  |               | 
| | --------------------- |  | ------------------- |  | ------------------ |  | -------------- |  | ------------- | 
| |                       |  | NASDAQ              |  | NASDAQ             |  |                |  |               | 
| | Period                |  | High
  (US dollars) |  | Low
  (US dollars) |  | TASEHigh (NIS) |  | TASELow (NIS) | 
| |                       |  |                     |  |                    |  |                |  |               | 
| | 2001                  |  | 20.44               |  | 8.37               |  | 86.26          |  | 41.12         | 
| | 2002                  |  | 11.77               |  | 4.37               |  | 54.24          |  | 23.40         | 
| | 2003                  |  | 9.06                |  | 3.91               |  | 42.53          |  | 20.09         | 
| | First
  Quarter 2004  |  | 11.23               |  | 9.2                |  | 53.59          |  | 43.55         | 
| | Second
  Quarter 2004 |  | 11.64               |  | 9.86               |  | 55.70          |  | 48.86         | 
| | Third
  Quarter 2004  |  | 11.85               |  | 10.57              |  | 56.82          |  | 51.46         | 
| | Fourth
  Quarter 2004 |  | 12.09               |  | 9.875              |  | 56.30          |  | 46.94         | 
| | First
  Quarter 2005  |  | 13.09               |  | 11.51              |  | 60.05          |  | 54.11         | 
| | Second
  Quarter 2005 |  | 12.82               |  | 9.92               |  | 58.68          |  | 47.93         | 
| | Third
  Quarter 2005  |  | 11.55               |  | 9.61               |  | 55.04          |  | 46.52         | 
| | Fourth
  Quarter 2005 |  | 11.74               |  | 9.8                |  | 54.01          |  | 46.41         | 
| | December
  2005       |  | 11.74               |  | 10.63              |  | 54.01          |  | 48.72         | 
| | January 2006          |  | 11.64               |  | 10.79              |  | 54.19          |  | 48.77         | 
| | February
  2006       |  | 11.47               |  | 10.55              |  | 52.37          |  | 49.42         | 
| | March 2006            |  | 11.09               |  | 10.4               |  | 52.01          |  | 49.33         | 
| | April 2006            |  | 11.25               |  | 10.76              |  | 50.81          |  | 49.30         | 
| | May 2006              |  | 12.2                |  | 10.39              |  | 54.04          |  | 46.38         | 

B.          Plan
of Distribution

Not Applicable.

C.          Markets

As noted
above, our Ordinary Shares are traded on the Nasdaq National Market under the
symbol ELRN. Our shares are also traded on the Tel Aviv Stock Exchange in
Israel.

D.          Selling
Shareholders

Not Applicable.

E.          Dilution

Not Applicable.

F.          Expenses
of the Issue

Not
Applicable.

93

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Item 10. Additional Information

A Share Capital

Not Applicable

B.        Memorandum
and Articles of Association

Articles of Association; Israel Companies Law

Our
shareholders approved the adoption of our Articles of Association in March
2001. The objective of Elron as stated in our Articles and in our Memorandum of
Association is to engage in any lawful activity.

We
have currently outstanding only one class of securities, our ordinary shares,
par value NIS 0.003 per share. No preferred shares are currently authorized.

Holders
of ordinary shares have one vote per share, and are entitled to participate
equally in the payment of dividends and share distributions and, in the event
of our liquidation, in the distribution of assets after satisfaction of
liabilities to creditors. According to our Articles, any modification of the
Articles requires the approval of a special majority at a general meeting. A
special majority is defined in our Articles as at least a majority of 67% of
the shareholders who voted at the general meeting, without taking abstaining
votes into account.

The
Israeli Companies Law and our Articles require that we hold our annual general
meeting of shareholders each year no later than 15 months from the last annual
meeting, at a time and place determined by the board of directors, upon at
least 21 days prior notice to our shareholders. Under the Israeli law and
regulations and our Articles of Association, notice of the meeting is required
to be published in two widely distributed daily newspapers published in Hebrew
and to be sent to shareholders whose names appear in the shareholders register
if their registered shares are not in Israel. Commencing April 2, 2006, The
Companies Law requires us to issue a voting instrument in order to enable
shareholders to vote through a voting instrument, if certain matters are on the
agenda of the meeting. No business may be commenced until a quorum of two or
more shareholders holding at least one third of the voting rights are present
in person or by proxy. The Israeli Companies Law provides that the record date
for the participation of shareholders of a company whose shares are traded or
registered outside of Israel such as us may be no more than 40 but no less than
4 days prior to the meeting, provided that notice for said meeting is given
prior to the record date. Resolutions regarding the following matters must be
passed at a general meeting of shareholders:

| |   |                                                                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | amendments
  to our Articles and Memorandum of Association;                                                                                                          
| |   |                                                                                                                                                                      
| |  | appointment
  or termination of our auditors;                                                                                                                        
| |   |                                                                                                                                                                      
| |  | appointment
  and dismissal of directors;                                                                                                                            
| |   |                                                                                                                                                                      
| |  | approval of interested
  party actions and transactions requiring general meeting approval as provided
  in sections 255 and 268 to 275 of the Israeli Companies Law;
| |   |                                                                                                                                                                      
| |  | increase or
  reduction of our authorized share capital and alterations of our share
  capital;                                                                      

94

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| |   |                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a merger as
  provided in section 320 of the Israeli Companies Law;                                                                                                                                                                                                             
| |   |                                                                                                                                                                                                                                                                                 
| |  | the exercise
  of the board of directors powers by a general meeting, if the board of
  directors is unable to exercise its powers and the exercise of any of its
  powers is vital for our proper management, as provided in section 52(a) of
  the Israeli Companies Law; and
| |   |                                                                                                                                                                                                                                                                                 
| |  | any matter
  that is required to be adopted by resolution of a general meeting pursuant to
  the Israeli Companies Law or in accordance with our Articles.                                                                                                                      

An
extraordinary meeting of our shareholders shall be convened by the decision of
the board, or at the request of any two directors or one quarter of the
officiating directors, or by request of one or more shareholders holding at least
5% of the voting rights in our company. Shareholders requesting an
extraordinary meeting must submit their proposed resolution with their request.
Within 21 days of receipt of the request, the board must convene an
extraordinary meeting and send out notices setting forth the date, time and
place of the meeting. Such notice must be given at least 21 days, but not more
than 35 days, prior to the extraordinary meeting.

The
Israeli Companies Law codifies the fiduciary duties and duty of care that
office holders owe to a company. An office holder, is defined in the Israeli
Companies Law, as a (i) director, (ii) general manager, (iii) chief business
manager, (iv) deputy general manager, (v) vice general manager, (vi) executive
vice president, (vii) vice president, (viii) another manager directly
subordinate to the general manager or (ix) any other person assuming the
responsibilities of any of the forgoing positions without regard to such
persons title. Each person listed in the table under Directors and Senior
Management in Item 6 above is an office holder.

The
Israeli Companies Law requires that an office holder of a company promptly
disclose, and no later than the first board meeting in which such transaction
is discussed, any personal interest that he or she may have and all related
material information known to him or her, in connection with any existing or
proposed transaction by the company. In addition, if the transaction is an
extraordinary transaction, the office holder must also disclose any personal
interest held by the office holders relative. An extraordinary transaction is
defined as a transaction not in the ordinary course of business, not on market
terms, or that is likely to have a material impact on the companys
profitability, assets or liabilities.

In
the case of a transaction in which an officer has a personal interest that is
not an extraordinary transaction, after the office holder complies with the
above disclosure requirement, board approval is required unless the Articles of
Association of the company provide otherwise. Our Articles of Association
provide that a transaction with one of our office holders or a transaction, in
which an office holder has a personal interest which, in each case, is not
regarded as an extraordinary transaction, requires the approval of the board or
the audit committee or by such other organ empowered by the board for such
purpose. If the transaction in which an officer has a personal interest is an
extraordinary transaction, then, it must also be approved by the audit
committee and by the board of directors.

Agreements
regarding directors terms of employment require the approval of audit
committee, the board of directors and the shareholders. In all matters in which
a director has a personal interest, including matters of his/her terms of
employment, he/she shall not be permitted to vote on the matter or be present
in the meeting in which the matter is considered. However,

95

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should a
majority of the audit committee or of the board of directors have a personal
interest in the matter then:

| |    |                                                                                                                                
| | -- | -------------------------------------------------------------------------------------------------------------------------------
| | a) | all of the
  directors shall be permitted to vote on the matter and attend the meeting in
  which the matter is considered; and
| |    |                                                                                                                                
| | b) | the matter
  requires approval of the shareholders at a general meeting.                                                       

According
to the Israeli Companies Law, the disclosure requirements discussed above also
apply to a controlling shareholder of a public company. The term controlling
shareholder for these purposes also includes shareholders that hold 25% or
more of the voting rights if no other shareholder owns more than 50% of the
voting rights in the company. In general, extraordinary transactions with a
controlling shareholder or in which a controlling shareholder or his relative
has a personal interest, and agreements relating to employment and compensation
terms of a controlling shareholder require the approval of the audit committee,
the board of directors and the shareholders of the company.

Such
shareholder approval must either include at least one-third of the shares held
by disinterested shareholders who participate in the vote (without taking
abstaining votes into account), or, alternatively, the total shareholdings of
the disinterested shareholders who vote against the transaction must not
represent more than one percent of the voting rights in the company. Under
specified circumstances, such shareholder approval is not required.

Under
the Israeli Companies Law, if a private placement: (1) will entail 20% or more
of the voting rights of a company prior to the placement, and all or part of
the private placement consideration is not in cash or in public traded
securities or is not upon market terms and if as a result of the private
placement the holdings of substantial shareholder shall increase or result in a
person becoming a substantial shareholder, or (2) result in a person becoming a
controlling shareholder, then the allotment must be approved by the board of directors
and by the shareholders of the company. A substantial shareholder is defined
as a shareholder that holds 5% or more of the companys outstanding share
capital, assuming the exercise of all of the securities convertible into shares
held by that person. In order for the private placement to be on market terms
the board of directors has to determine, on the basis of a detailed
examination, that the private placement is on market terms, unless proved
otherwise. Any placement of securities that does not fall within the above
description may be issued at the discretion of the board of directors.

Under
the Israeli Companies Law, a shareholder has a duty to act in good faith
towards the company and other shareholders when exercising his rights and
refrain from abusing his power in the company, including, among other things,
voting in the general meeting of shareholders on the following matters:

| |   |                                                                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | any
  amendment to the Articles of Association;                                                                                                                      
| |   |                                                                                                                                                                      
| |  | an increase
  of the companys authorized share capital;                                                                                                             
| |   |                                                                                                                                                                      
| |  | a merger; or                                                                                                                                                         
| |   |                                                                                                                                                                      
| |  | approval of
  interested party acts and transactions that require general meeting approval
  as provided in sections 255 and 268 to 275 of the Israeli Companies Law.

96

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In
addition, any controlling shareholder, any shareholder who knows that it
possesses power to determine the outcome of a shareholder vote and any
shareholder who has the power to appoint or prevent the appointment office
holder in the company is under a duty to act with fairness towards the company.
The Israeli Companies Law does not describe the substance of this duty. The
Israeli Companies Law requires that specified types of transactions, actions
and arrangements be approved as provided for in a companys articles of
association and in some circumstances by the audit committee, by the board of
directors and by the general meeting of the shareholders. The vote required by
the audit committee and the board of directors for approval of these matters,
in each case, is a majority of the directors participating in a duly convened
meeting.

|   |                                                                                                                                                                                                                                                    |                                                       
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------
|C. | Material Contracts                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                   
|   | 1.                                                                                                                                                                                                                                                 | Deed of Transfer for Sale of
  Shares of Elbit Systems
|   |                                                                                                                                                                                                                                                    |                                                       
|   | On
  July 28, 2004, we signed a deed of transfer to sell all of our holdings in
  Elbit Systems, constituting approximately 19.6% of the outstanding share
  capital of Elbit Systems, to the Federmann group, for approximately $196.6
  million.
|   |                                                                                                                                                                                                                                                    |                                                       
|   | 2.                                                                                                                                                                                                                                                 | Sale of shares of Partner                             
|   |                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                    | Buyback                                               
|   |                                                                                                                                                                                                                                                   

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On
  April 20, 2005 we completed the sale to Partner of 12,765,190 Partner shares
  for approximately $94 million, as part of the sale together with the other
  Israeli founding shareholders of Partner of an aggregate of approximately
  33.3 million Partner shares to Partner for an aggregate consideration of
  approximately $245 million, pursuant to the terms of an irrevocable offer
  letter February 7, 2005. Under the terms of the offer letter, we, Polar
  Communications Ltd. (Polar) and Eurocom Communications Ltd. (Eurocom),
  offered to sell to Partner, severally and not jointly, all of our respective
  Ordinary Shares, for aggregate consideration of between NIS 984.6 million
  ($225.2 million) and NIS 1.02 billion ($233.6 million) (the Buyback). Matav
  Investments Ltd. (Matav), the remaining Israeli founding shareholder, had the
  option to participate in the Buyback which it exercised. The sale price
  formula of the Buyback reflected a 10% discount from the 20-trading
  day volume weighted average market price of the Partner ordinary shares
  on the Tel Aviv Stock Exchange prior to the meeting of Partner shareholders
  in which the Buyback is approved, up to a maximum price of NIS 32.22 per
  share ($7.37 based on the applicable exchange rate of NIS 4.372 per
  $1.00) but not below NIS 31.04 per share ($7.10 based on such exchange rate).
  The sale was completed at the maximum price per share.

Restatement
of Relationship Agreement

On
April 20, 2005, in connection with the completion of the Buyback, we, the other
Israeli founding shareholders, Eurocom, Polar and Matav (the Israeli
Shareholders) together with Advent Investments Pte Ltd. and Hutchison
Telecommunications International (Netherlands) B.V., entered into the Restated
Relationship Agreement, which replaced the Relationship Agreement dated October
10, 1999 among the parties.

97

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The
Restated Relationship Agreement requires the Israeli Shareholders, severally
but not jointly, based on their respective holdings in Partner as of April 20,
2005, to hold a sufficient number of Partner ordinary shares to comply with the
minimum aggregate holdings by Israeli entities required under Partners license
and articles of association (the Required Israeli Percentage). The Required
Israeli Percentage is currently 5% of the outstanding share capital of Partner.
The number of Partner ordinary shares required to be held by the Israeli
Shareholders to maintain the Required Israeli Percentage is calculated based on
the number of Partner ordinary shares outstanding from time to time up to a
maximum of 160,922,344 ordinary shares outstanding, as adjusted to reflect
stock splits, stock dividends and similar changes that apply to all the
ordinary shares.

The
Restated Relationship Agreement also requires the Israeli Shareholders to
transfer such ordinary shares that are subject to the holding requirement of
Required Israeli Percentage (the Restricted Shares) only in accordance with
the transfer limitations provided by Partners license and articles of
association.

In
addition, pursuant to the Restated Relationship Agreement, the Israeli
Shareholders undertook to appoint and retain the number of Israeli directors of
Partner that are required pursuant to applicable law (including its license and
articles of association) to be appointed and retained by Israeli Shareholders
(the Israeli Director(s)). Partners license currently requires that at least
10% of its directors be Israeli Directors, but one Israeli director is
sufficient so long as there are fewer than 15 directors. Based on the current
size of Partners board of directors, which is comprised of 13 directors, one
Israeli Director is currently required.

On
March 21, 2006, pursuant to our purchase of Polars shares in Partner, we
joined the Restated Relationship Agreement in place of Polar.

Shareholders
Agreement

On
April 20, 2005, we together with the other Israeli Shareholders also entered
into a shareholders agreement. The shareholders agreement sets forth the
mechanism for appointing the Israeli Director(s). Specifically, the Israeli
Director(s) will be appointed on a rotation basis. Subsequently, this agreement
was amended to provide that we will not participate in the rotation. On March
21, 2006, pursuant to our purchase of Polars shares in Partner, we joined the
shareholders agreement in place of Polar.

|   |                  
|-- | -----------------
|D. | Exchange Controls

The
Israeli Currency Control Law, 1978 imposes certain limitations concerning
foreign currency transactions and transactions between Israeli and non-Israeli
residents, which limitations may be regulated or waived by the Controller of
Foreign Exchange at the Bank of Israel, through general and special
permits. In May 1998, a new general permit was issued pursuant to which
substantially all transactions in foreign currency are permitted. Any dividends
or other distributions paid in respect of ordinary shares and any amounts
payable upon our dissolution, liquidation or winding up, as well as the
proceeds of any sale in Israel of our securities to an Israeli resident are
freely repatriable into non-Israeli currencies at the rate of exchange
prevailing at the time of conversion, provided that Israeli income tax has been
paid on (or withheld from) such payments.

98

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|   |         
|-- | --------
|E. | Taxation

General

The
following is a summary of the material provisions of the current tax law
applicable to companies in Israel, with special reference to its effect on us
and our group companies. The following also contains a discussion of material
Israeli tax consequences to our shareholders and government programs from which
we and some of our group companies benefit. To the extent that the discussion
is based on tax legislation that has not been subject to judicial or
administrative interpretation, we cannot assure you that the views expressed in
the discussion will be accepted by the tax authorities in question.

The discussion
is not intended, and should not be construed, as legal or professional tax
advice and is not exhaustive of all possible tax considerations.

Israeli Tax
Reform

In
July 2002, the Israeli Parliament approved a law enacting extensive changes to
Israels tax law (the Tax Reform Legislation) generally effective
January 1, 2003. Among the key provisions of the Tax Reform Legislation
are (i) changes which may result in the imposition of taxes on dividends
received by an Israeli company from its foreign subsidiaries; and (ii) the
introduction of the controlled foreign corporation concept according to which
an Israeli company may become subject to Israeli taxes on certain income of a
non-Israeli subsidiary if the subsidiarys primary source of income is passive
income (such as interest, dividends, royalties, rental income or capital
gains). An Israeli company that is subject to Israeli taxes on the income of
its non-Israeli subsidiaries will receive a credit for income taxes
paid/withheld or will be paid/withheld by the subsidiary in its country of
residence, according to the terms and conditions determined in the Israeli Tax
Ordinance.

On July 25, 2005, the
Israeli Knesset (Parliament) approved a significant amendment which came into
effect on January 1, 2006. This amendment includes, among others, changes in
the capital markets tax rate.

General Corporate
Tax Structure

Israeli
companies are generally subject to company tax at the rate of 34% (31% in 2006,
29% in 2007 and 27% in 2008, 26% in 2009 and 25% in 2010 and thereafter) of
taxable income. However, the effective tax rate payable by a company that
derives income from an Approved Enterprise (as further discussed below) may be
considerably less, or the same in 2010.

Law for the
Encouragement of Capital Investments, 1959

From
time to time, certain operations of our group companies have been granted
Approved Enterprise status under the Law for the Encouragement of Capital
Investments, 1959, as amended, or the Investment Law.

The
Investment Law provides that a capital investment in eligible facilities may,
upon application to the Investment Center of the Ministry of Industry and Trade
of the State of Israel, or the Investment Center, be designated as an Approved
Enterprise. Each certificate of approval

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for an
Approved Enterprise relates to a specific investment program delineated both by
its financial scope, including its capital sources, and by its physical
characteristics, e.g., the equipment to be purchased and utilized pursuant to
the program. The tax benefits derived from any such certificate of approval
relate only to taxable income attributable to the specific Approved Enterprise.

Taxable
income of a company derived from an Approved Enterprise is subject to company
tax at the rate of up to 25% (rather than 34%, in 2005, as stated above) for a
period of time termed the benefit period. The benefit period is a period of
seven years commencing with the year in which the Approved Enterprise first
generated taxable income. The benefits may be shorter as it is limited to 12
years from the commencement of production of the Approved Enterprise or 14
years from the date of approval, whichever is earlier. Under certain
circumstances (as further detailed below), the benefit period may extend to a
maximum of ten years from the commencement of the benefit period. A company
which operates under more than one approval or that has capital investments which
are only partly approved (such a company being designated as a Mixed
Enterprise), may have an effective company tax rate that is the result of a
weighted combination of the various applicable rates.

A
company owning an Approved Enterprise may elect to forego certain government
grants extended to Approved Enterprises in return for what is termed an
alternative package of tax benefits (referred to as the Alternative Package).
Under the Alternative Package, a companys undistributed income derived from an
Approved Enterprise will be exempt from company tax for a period of between two
and ten years, depending on the geographic location of the Approved Enterprise
within Israel. Such company will be eligible for the tax benefits under the
Investment Law for the remainder of the benefit period.

Should
the percentage of share capital of the companies having Approved Enterprises
held by foreign shareholders exceed 25%, future Approved Enterprises of such
companies would qualify for reduced tax rates for an additional three years,
after the seven years mentioned above.

The
company tax rate applicable to income earned from Approved Enterprise programs
(currently, for programs on which an application for an approved enterprise
status was submitted before December 31, 2004) in the benefit period by a
company meeting these qualifications is as follows:

| |                                 |  |          |     | 
| | ------------------------------- |  | -------- | --- | 
| | % of Foreign 
  Ownership       |  | Tax Rate |    
| |                                 |  |          |    
| | Over 25% but
  less than 49%    |  |          | 25% | 
| | 49% or more
  but less than 74% |  |          | 20% | 
| | 74% or more
  but less than 90% |  |          | 15% | 
| | 90% or more                     |  |          | 10% | 

Entitlement
to these benefits is subject to the final ratification of the Investment
Center, and is conditioned upon fulfillment of all terms of the approved
program. However, there can be no assurance that our group companies which
enjoy Approved Enterprise benefits will obtain approval for additional Approved
Enterprises, or that the provisions of the Investment Law will not change with
respect to future approvals, or that the above-mentioned shareholding portion
will be reached for each subsequent year.

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A
company that pays a dividend out of income derived from the Approved
Enterprise(s) during the tax exemption period will be subject to deferred
company tax in respect of the amount distributed (including the recipients tax
thereon) at the rate which would have been applicable had such company not
elected the Alternative Package. This rate is generally 10% to 25%, depending
on the extent to which non-Israeli shareholders hold such companys shares.

The
dividend recipient is taxed at the reduced rate applicable to dividends from
Approved Enterprises (generally 15% as compared to 25% (or compared to 20% from
January 1, 2006 if the dividend recipient is not a substantial shareholder -
shareholders owning, directly or indirectly, 10% or more of our outstanding
voting capital) for individuals or an exemption for companies), if the dividend
is distributed during the tax benefit period or within 12 years after this
period. However, the limitation does not apply if the company qualifies as a
foreign investors company. This tax must be withheld by such company at
source, regardless of whether the dividend is converted into foreign currency.

Subject
to certain provisions concerning income subject to Mixed Enterprises, all
dividends are considered to be attributable to the entire enterprise and the
effective tax rate on the dividend is the result of a weighted combination of
the various applicable tax rates. However, such company is not obliged to
distribute exempt retained profits under the Alternative Package, and such
company may generally decide from which years profits to declare dividends.

Each
application to the Investment Center is reviewed separately, and a decision as
to whether or not to approve such application is based, among other things, on
the then prevailing criteria set forth in the Investment Law, on the specific
objectives of the applicant company set forth in such application and on
certain financial criteria of the applicant company. Accordingly, there can be
no assurance that any such application by any of our group companies will be
approved. In addition, the benefits available to an Approved Enterprise are
conditional upon the fulfillment of certain conditions stipulated in the
Investment Law and its regulations and the criteria set forth in the
certificate of approval, as described above. In the event that these conditions
are violated, in whole or in part, a company with an Approved Enterprise would
be required to refund the amount of tax benefits, with the addition of the
Israeli consumer price index linkage differences and interest

Reform (Amendment)
of the Encouragement of Capital Investment Law

On
March 29, 2005, the Israeli Knesset (Parliament) passed an amendment to the
Investment Law, that revamps the Israeli tax incentives for future industrial
and hotel investments (2005 amendment). A tax holiday package can now be
elected for up to 15 years for a Privileged Enterprise as defined in the 2005
amendment, if certain conditions are met, without needing to obtain approval.
The extent of the tax benefits available depends mainly upon the level of
foreign investment and the geographical location of the Privileged
Enterprise.

The 2005
amendment became effective on April 1, 2005. Taxpayers may, under certain
conditions, claim Privileged Enterprise status for new and expanded enterprises
with respect to 2004 or subsequent years, unless the Investment Center granted
such taxpayer Approved Enterprise status prior to December 31, 2004.

Subject to
certain conditions, various alternative tax-only benefit packages can now be
elected with respect to investments in a Privileged Enterprise. Companies in
industry or tourism in Israel may elect between:

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  Tax
  holiday package - for a Privileged Enterprise: a tax exemption applies to
  undistributed profits for 2 to 15 years depending on geographical location of
  the Privileged Enterprise and the level of foreign ownership. Company tax
  rates of between 10% and 25% apply to distributed exempt profits or profits
  derived subsequent to the exempt period. The total period of tax benefits is
  7 to 15 years, or
| |                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  Grant /
  Reduced tax package - for an Approved Enterprise: Fixed asset grants up to
  24% for enterprises in a development area and reduced company tax rates
  between 0% and 25% for 7 to 15 years.                                                                                                                                                                                                                          

Dividend
withholding tax also applies at a rate of 4% or 15% depending on the package
selected.

Taxation under
Inflationary Conditions

The
Income Tax Law (Inflationary Adjustments), 1985 (referred to as the
Inflationary Adjustments Law) is intended to neutralize the erosion of capital
investments in business and to prevent tax benefits resulting from deduction of
inflationary expenses. This law applies a supplementary set of inflationary
adjustments to the normal taxable profits computed under regular historical
cost principles. We and our group companies operating in Israel are taxed under
this law.

Under
the Inflationary Adjustments Law, results for tax purposes are measured in real
terms, in accordance with the changes in the consumer price index. In addition,
subject to certain limitations, depreciation of fixed assets and losses carried
forward are adjusted for inflation on the basis of changes in the consumer
price index.

The
salient features of the Inflationary Adjustments Law can be described generally
as follows:

A
special tax adjustment for the preservation of equity whereby certain corporate
assets are classified broadly into Fixed (inflation resistant) Assets and
Non-Fixed (soft) Assets. Where a companys equity, as defined in such law,
exceeds the depreciated cost of Fixed Assets, a deduction from taxable income
that takes into account the effect of the applicable annual rate of inflation
on such excess is allowed (up to a ceiling of 70% of taxable income in any
single tax year, with the unused portion permitted to be carried forward on a
linked basis to the following year and will be considered a business loss). If
the depreciated cost of Fixed Assets exceeds a companys equity, then such
excess multiplied by the applicable annual rate of inflation is added to
taxable income.

Subject
to certain limitations, depreciation deductions on Fixed Assets and losses
carried forward are adjusted for inflation based on the increase in the
consumer price index (from the beginning of the 1982 fiscal year, and as of the
1985 fiscal year, with respect to equipment).

Law for the
Encouragement of Industry (Taxes), 1969

Certain
of our group companies currently qualify as Industrial Companies within the
definition of the Law for the Encouragement of Industry (Taxes), 1969 (referred
to as the Industry Encouragement Law). According to the Industry Encouragement
Law, an Industrial Company is a company resident in Israel, at least 90% of the
income of which in any tax year (exclusive of income from defense loans,
capital gains, interest and dividends) is derived from an

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Industrial
Enterprise owned by it. An Industrial Enterprise is defined as an enterprise
whose major activity in a given tax year is industrial production activity.

The
following preferred corporate tax benefits are available to Industrial
Companies: (a) deduction of purchases of know-how and patents over an
eight-year period for tax purposes; (b) under certain interpretations,
deduction of expenses incurred in connection with a public issuance of
securities over a three-year period; and (c) an election under certain
conditions to file a consolidated tax return with additional related Israeli
Industrial Companies and/or with a company that controls an Industrial Company
and a specified percentage of its assets are invested in industrial companies;
and (d) accelerated depreciation rates on equipment and buildings.

Eligibility
for the benefits under the Industry Encouragement Law is not subject to receipt
of prior approval from any governmental authority. No assurance can be given
that any of our group companies will qualify and/or continue to qualify as an
Industrial Company or that the benefits described above will be available in
the future.

Capital Gains Tax

Israeli
law imposes a capital gains tax on the sale of capital assets. The law
distinguishes between the Real Gain and the Inflationary Surplus. The Real Gain
is the excess of the total capital gain over the Inflationary Surplus, computed
on the basis of the increase of the consumer price index between the date of
purchase and date of sale. The Inflationary Surplus accumulated until December
31, 1993 is taxed at a rate of 10% for residents of Israel (reduced to no tax
for non-residents if calculated according to the exchange rate of the foreign
currency lawfully invested in shares of an Israeli resident company, instead of
the consumer price index). Inflationary Surplus accumulated from and after
December 31, 1993 is exempt from any capital gains tax, while the Real Gain is
added to ordinary income, which effective until December 31 2002 is taxed at
the marginal rate of up to 49% for individuals and 34% for corporations (in
2005). Effective January 1, 2003, the capital gains tax rate imposed upon
sale of capital assets acquired after that date has been reduced to 25%;
capital gains accrued from assets acquired before that date are subject to a
blended tax rate based on the relative periods of time before and after that
date that the asset was held.

Under
current law, effective January 1, 2003 so long as our ordinary shares are
listed on a stock exchange the sale of these shares is subject to 15% tax (20%
tax from January 1,2006) in case the shares were purchased after December 31,
2002, and in case the shares were purchased before that date the sale will be
subject to a blended tax in which the portion of the gain accrued until
December 31, 2002 will be exempt from Israeli capital gains tax and the portion
of the real gain accrued from January 1, 2003 until the date of sale will be
subject to 15% tax (20% tax from January 1, 2006). Companies upon which the
provisions of the Income Tax Law (Inflationary Adjustments), 1985 were not
imposed before January 1, 2006 are subject to a 25% tax rate on real capital
gains derived on or after January 1, 2003 from the sale of the shares.
Notwithstanding the above, companies upon which the provisions of the Income
Tax law (Inflationary Adjustments), 1985 were imposed before January 1, 2006
are subject to regular corporate tax rate on real capital gains derived on the
sale of the shares prior to January 1, 2006.

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The taxable
real gain will be based on the difference between the adjusted average value of
the shares during the last three trading days before January 1, 2003 (or the
adjusted original cost if it is higher than the adjusted average value) and the
value of the shares at the date of sale. In the event the above mentioned
calculation creates a loss, such loss can only be offset against a capital gain
from other traded securities according to the provisions of the Israeli law.
The amount of the loss is limited to the difference between the adjusted
average value and the value of the shares at the date of sale.

Employee Stock
Options

Effective
from January 1, 2003, the Tax Reform Legislation enables a company to grant
options through one of three tax tracks:

(a)
the income tax track through a trustee pursuant to which the optionee pays
income tax rate (according to the marginal tax rate of the optionee- up to 49%
tax) plus payments to the National Insurance Institute and health tax on the
profit gained upon the earlier to occur of the transfer of the options or the
underlying shares from the trustee to the optionee or the sale of the options
or the underlying shares by the trustee, and the company may recognize expenses
pertaining to the options for tax purposes. The options (or upon their
exercise, the underlying shares), must be held by a trustee for a period of 12
months commencing from the end of the year in which the options were granted
(as of January 1, 2006, a period of 12 months commencing from the date of which
the options were granted; or

(b)
the capital gains tax track through a trustee pursuant to which the optionee
pays capital gains tax at a rate of 25% on the capital profit portion and
marginal tax rate ( including payments to the National Insurance Institute and
health tax) on the income portion (in general, the income portion is the profit
derived from the difference between the average market value of the share 30
days before the allotment date and the exercise price of the option) upon, the
earlier to occur of the transfer of the options or the underlying shares from
the trustee to the optionee or the sale of the options or the underlying shares
by the trustee. (On the capital profit the optionee is not required to make
payments to the National Insurance Institute and health tax). In this track, on
the capital profit, the Company may not recognize expenses pertaining to the options for tax purposes
but may do so on the income portion. The options (or upon their exercise, the
underlying shares), must be held by a trustee for a period of 24 months
commencing from the end of the year in which the options were granted (as of
January 1, 2006, a period of 24 months commencing from the date of which the
options were granted); or

(c)
the income tax track without a trustee pursuant to which the optionee pays
income tax rate (according to the marginal tax rate of the optionee- up to 49%
tax) plus payments to the National Insurance Institute and health tax on the
profit at the allotment date, and pays capital gains tax at a rate of 25% on
the capital profit upon the sale of the underlying shares, and the company may
not recognize expenses pertaining to the capital gain for tax purposes but may
recognize expenses pertaining to the profit at the allotment date.

In
accordance with the provisions of the Tax Reform Legislation, if a company has
selected the capital gains track, the company must continue granting options
under the selected capital gains track until the end of the year following the
year in which the first grant of options under that trustee track will be made.
Notwithstanding the above, the company may at any time also grant options under
the provisions of the income tax track without a trustee.

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The
above rules apply only to employees, including officer holders but excluding
controlling shareholders.

Controlling
shareholders will be taxable under section 3i to the tax ordinance, according
to which, the optionee pays income tax rate (according to the marginal tax rate
of the optionee- up to 49%) on the profit upon the sale of the underlying
shares.

U.S.-Israel Tax
Treaty

Pursuant
to the Convention Between the Government of the United States of America and
the Government of Israel with Respect to Taxes on Income (referred to as the
U.S.-Israel Tax Treaty), the sale, exchange or disposition of ordinary shares
by a person who qualifies as a resident of the United States within the meaning
of the U.S.-Israel Tax Treaty and who is entitled to claim the benefits
afforded to such resident by the U.S.-Israel Tax Treaty (called a Treaty U.S.
Resident) will not be subject to Israeli capital gains tax unless (a) such
Treaty U.S. Resident is an individual and was present in Israel for more than
183 days during the relevant taxable year or (b) such Treaty U.S. Resident
holds, directly or indirectly, shares representing 10% or more of the voting
power of a company during any part of the 12-month period preceding such sale,
exchange or disposition. A sale, exchange or disposition of shares by a Treaty
U.S. Resident who is an individual and was present in Israel for more than 183
days during the relevant taxable year or who holds, directly or indirectly,
shares representing 10% or more of the voting power of a company at any time
during such preceding 12-month period would be subject to such Israeli tax, to
the extent applicable, unless the aforementioned exemption from capital gain
tax for shares listed on the Tel-Aviv Stock Exchange applies; however, in case
under the U.S.-Israel Tax Treaty and the Israeli tax law a Treaty U.S. Resident
will be subject to capital gain tax in Israel, such Treaty U.S. Resident would
be permitted to claim a credit for such taxes against the U.S. income tax
imposed with respect to such sale, exchange or disposition, subject to the
limitations in U.S. laws applicable to foreign tax credits.

Taxation of
Non-Residents

Non-residents
of Israel are subject to income tax on income accrued or derived from sources
in Israel. Such sources of income include passive income such as dividends,
royalties and interest, as well as non-passive income from services rendered in
Israel and capital gain as mentioned above. On distributions of dividends other
than bonus shares (stock dividends), income tax at the rate of 20% is withheld
at source, unless a different rate is provided in a treaty between Israel and
the shareholders country of residence. For example, the tax rate would be
12.5% if the non-resident is a company which holds 10% or more of our voting
power (during the part of our tax year which precedes the date of payment of
the dividend and during the entire prior tax year) which pursuant to the
U.S.-Israel Tax Treaty. Under the U.S.-Israel Tax Treaty, the maximum tax on
dividends paid to a holder of ordinary shares who is a resident of the United
States will be 25%. However, under the Investment Law, dividends generated by
an Approved Enterprise in any case are taxed at the rate of 15%. In addition,
if our ordinary shares are traded on the Tel Aviv Stock Exchange (or listed on
a stock exchange recognized by the Israeli Ministry of Finance), gains on the
sale of ordinary shares held by non-Israeli tax resident investors will
generally be exempt from Israeli capital gains tax.

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U.S. Federal Income
Tax Considerations

Subject
to the limitations described herein, this discussion summarizes the material
U.S. federal income tax consequences of the purchase, ownership and disposition
of our ordinary shares to a U.S. holder. A U.S. holder is a holder of our
ordinary shares who is:

| |   |                                                                                                                                                                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | an
  individual citizen or resident of the U.S. for U.S. federal income tax
  purposes;                                                                                                                                                                                                                                            
| |   |                                                                                                                                                                                                                                                                                                                                    
| |  | a
  corporation or partnership (or another entity taxable as a corporation or partnership
  for U.S. federal income tax purposes) created or organized under the laws of
  the United States or any political subdivision thereof;                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                    
| |  | an estate,
  the income of which may be included in gross income for U.S. federal income
  tax purposes regardless of its source; or                                                                                                                                                                                               
| |   |                                                                                                                                                                                                                                                                                                                                    
| |  | a trust (i)
  if, in general, a U.S. court is able to exercise primary supervision over its
  administration and one or more U.S. persons have the authority to control all
  of its substantial decisions or (ii) that has in effect a valid election
  under applicable U.S. Treasury regulations to be treated as a U.S. person.

Unless
otherwise specifically indicated, this discussion does not consider the U.S.
tax consequences to a person that is not a U.S. holder and considers only U.S.
holders that will own the ordinary shares as capital assets.

This
discussion is based on current provisions of the Internal Revenue Code of 1986,
as amended (the Code), current and proposed Treasury regulations promulgated
under the Code and administrative and judicial interpretations of the Code, all
as currently in effect and all of which are subject to change, possibly with a
retroactive effect. This discussion does not address all aspects of U.S.
federal income taxation that may be relevant to any particular U.S. holder
based on the U.S. holders particular circumstances. In particular, this
discussion does not address the U.S. federal income tax consequences to U.S.
holders who are broker-dealers or who own, directly, indirectly or constructively,
10% or more of our outstanding voting shares, U.S. holders holding the ordinary
shares as part of a hedging, straddle or conversion transaction, U.S. holders
whose functional currency is not the U.S. dollar, insurance companies,
tax-exempt organizations, financial institutions and persons subject to the
alternative minimum tax, who may be subject to special rules not discussed
below. Additionally, the tax treatment of persons who are, or hold the ordinary
shares through, a partnership or other pass-through entity is not considered,
nor is the possible application of U.S. federal estate or gift taxes or any
aspect of state, local or non-U.S. tax laws.

You
are advised to consult your tax advisor with respect to the specific U.S. federal,
state, local and foreign income tax consequences to you of purchasing, holding
or disposing of our ordinary shares.

Taxation of
Distributions on Ordinary Shares

Subject
to the discussion below under Tax Consequences If we are a Passive Foreign
Investment Company, a distribution paid by us with respect to the ordinary
shares to a U.S. holder will be treated as dividend income to the extent that
the distribution does not exceed our current and accumulated earnings and
profits, as determined for U.S. federal income tax purposes. The amount of a
distribution with respect to the ordinary shares will equal the amount

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of cash and
the fair market value of any property distributed and will also include the
amount of any Israeli taxes withheld as described above under Taxation of
Non-Residents. Dividends that are received by U.S. holders that are
individuals, estates or trusts will be taxed at the rate applicable to
long-term capital gains (a maximum rate of 15%), provided that such dividends meet
the requirements of qualified dividend income. Dividends that fail to meet
such requirements, and dividends received by corporate U.S. holders are taxed
at ordinary income rates. No dividend received by a U.S. holder will be a
qualified dividend (1) if the U.S. holder held the ordinary share with
respect to which the dividend was paid for less than 61 days during the 121-day
period beginning on the date that is 60 days before the ex-dividend date with
respect to such dividend, excluding for this purpose, under the rules of Code
section 246(c), any period during which the U.S. holder has an option to sell,
is under a contractual obligation to sell, has made and not closed a short sale
of, is the grantor of a deep-in-the-money or otherwise nonqualified option to
buy, or has otherwise diminished its risk of loss by holding other positions
with respect to, such ordinary share (or substantially identical securities);
or (2) to the extent that the U.S. holder is under an obligation (pursuant
to a short sale or otherwise) to make related payments with respect to
positions in property substantially similar or related to the ordinary share
with respect to which the dividend is paid. If we were to be a passive foreign
investment company (as such term is defined in the Code) for any year,
dividends paid on our ordinary shares in such year or in the following year
would not be qualified dividends. In addition, a non-corporate U.S. holder will
be able to take a qualified dividend into account in determining its deductible
investment interest (which is generally limited to its net investment income)
only if it elects to do so; in such case the dividend will be taxed at ordinary
income rates.

The
amount of any distribution which exceeds the amount treated as a dividend will
be treated first as a non-taxable return of capital, reducing the U.S. holders
tax basis in its ordinary shares to the extent thereof, and then as capital
gain from the deemed disposition of the ordinary shares. Corporate holders will
not be allowed a deduction for dividends received in respect of the ordinary
shares.

Dividends
paid by us in NIS will be included in the income of U.S. holders at the dollar
amount of the dividend (including any Israeli taxes withheld therefrom), based
upon the spot rate of exchange in effect on the date the distribution is
included in income. U.S. holders will have a tax basis in the NIS for U.S.
federal income tax purposes equal to that dollar value. Any subsequent gain or
loss in respect of the NIS arising from exchange rate fluctuations will
generally be taxable as U.S. source ordinary income or loss.

Subject
to the limitations set forth in the Code and the Treasury regulations
thereunder, U.S. holders may elect to claim as a foreign tax credit against
their U.S. federal income tax liability the Israeli income tax withheld from
dividends received in respect of the ordinary shares. The limitations on
claiming a foreign tax credit include, among others, computation rules under
which foreign tax credits allowable with respect to specific classes of income
cannot exceed the U.S. federal income taxes otherwise payable with respect to
each such class of income. In this regard, dividends paid by us will be foreign
source passive income for U.S. foreign tax credit purposes or, in the case of
a financial services entity, financial services income (and, for tax years
beginning after December 31, 2006, as general category income). U.S. holders
that do not elect to claim a foreign tax credit may instead claim a deduction
for the Israeli income tax withheld if they itemize deductions. The rules
relating to foreign tax credits are complex, and you should consult your tax
advisor to determine whether and to what extent

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you would be
entitled to this credit. A U.S. holder will be denied a foreign tax credit for
Israeli income tax withheld from a dividend received on the ordinary shares (i)
if the U.S. holder has not held the ordinary shares for at least 16 days of the
31-day period beginning on the date which is 15 days before the ex-dividend
date with respect to such dividend or (ii) to the extent the U.S. holder is
under an obligation to make related payments with respect to positions in
substantially similar or related property. Any days during which a U.S. holder
has substantially diminished its risk of loss on the ordinary shares are not
counted toward meeting the required 16 day holding period. Distributions of
current or accumulated earnings and profits will be foreign source passive
income for U.S. foreign tax credit purposes.

Taxation of the
Disposition of Ordinary Shares

Subject
to the discussion below under Tax Consequences if We are a Passive Foreign
Investment Company, upon the sale, exchange or other disposition of our ordinary
shares, a U.S. holder will recognize capital gain or loss in an amount equal to
the difference between the amount realized on the disposition and the U.S.
holders tax basis in the ordinary shares. The gain or loss recognized on the
disposition of the ordinary shares will be long-term capital gain or loss if
the U.S. holder held the ordinary shares for more than one year at the time of
the disposition and is eligible for a maximum 15% rate of taxation for
individuals. Capital gain from the sale, exchange or other disposition of
ordinary shares held for one year or less is short-term capital gain and taxed
as ordinary income at a maximum rate of 35%. Gain or loss recognized by a U.S.
holder on a sale, exchange or other disposition of ordinary shares will be
treated as U.S. source income or loss for U.S. foreign tax credit purposes.

A
U.S. holder that uses the cash method of accounting calculates the dollar value
of the proceeds received on the sale as of the date that the sale settles.
However, a U.S. holder that uses the accrual method of accounting is required
to calculate the value of the proceeds of the sale as of the trade date and may
therefore realize foreign currency gain or loss. A U.S. holder may avoid
realizing foreign currency gain or loss by electing to use the settlement date
to determine the proceeds of sale for purposes of calculating the foreign
currency gain or loss. In addition, a U.S. holder that receives foreign
currency upon disposition of ordinary shares and converts the foreign currency
into dollars after the settlement date or trade date (whichever date the U.S.
holder is required to use to calculate the value of the proceeds of sale) will
have foreign exchange gain or loss based on any appreciation or depreciation in
the value of the foreign currency against the dollar, which will generally be
U.S. source ordinary income or loss.

Tax Consequences if
We are a Passive Foreign Investment Company

We
will be a passive foreign investment company, or PFIC, if either (1) 75% or
more of our gross income in a taxable year is passive income; or (2) the
average percentage (by value) in a taxable year of our assets that produce, or
are held for the protection of, passive income, is at least 50%. If we own
(directly or indirectly) at least 25% by value of the stock of another
corporation, we will be treated for purposes of the foregoing tests as owning
our proportionate share of the other corporations assets and as directly
earning our proportionate share of the other corporations income. If we are a
PFIC, a U.S. holder must determine under which of three alternative taxing
regimes it wishes to be taxed:

The
QEF regime applies (to the exclusion of the excess distribution regime,
described below) if the U.S. holder elects to treat us as a qualified electing
fund (QEF) for the first

108

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taxable year
in which the U.S. holder owns our ordinary shares during which we are a PFIC,
and if we comply with certain reporting requirements. If the QEF regime
applies, then each year that we are a PFIC such U.S. holder will include in its
gross income a proportionate share of our ordinary earnings (which is taxed as
ordinary income) and net capital gain (which is taxed as long-term capital
gain), subject to a separate election to defer payment of taxes, which deferral
is subject to an interest charge. These amounts would be included in income by
an electing U.S. holder for its taxable year in which our taxable year ends,
whether or not such amounts are actually distributed to the U.S. holder. A U.S.
holders basis in our ordinary shares for which a QEF election has been made
would be increased to reflect the amount of any taxed but undistributed income.
Generally, a QEF election allows an electing U.S. holder to treat any gain realized
on the disposition of his ordinary shares as capital gain.

Once
made, the QEF election applies to all subsequent taxable years of the U.S.
holder in which it holds our ordinary shares and for which we are a PFIC and
can be revoked only with the consent of the Internal Revenue Service. A
shareholder makes a QEF election by attaching a completed Internal Revenue
Service Form 8621, including the PFIC annual information statement, to a timely
filed United States federal income tax return. Even if a QEF election is not
made, a U.S. person who is a shareholder in a PFIC must file a completed
Internal Revenue Service Form 8621 every year.

If
a QEF election is made by the U.S. holder after the first taxable year in which
the U.S. holder holds our ordinary shares during which we are a PFIC, then both
the QEF regime and the excess distribution regime, defined below, will apply
simultaneously unless the U.S. holder makes a special election.

A
second regime, the mark-to-market regime, may be elected so long as our
ordinary shares are publicly traded. Pursuant to this regime, an electing U.S.
holders ordinary shares are marked-to-market each year in which we are a PFIC,
and the U.S. holder recognizes as ordinary income or loss an amount equal to
the difference as of the close of the taxable year between the fair market
value of our ordinary shares and the U.S. holders adjusted tax basis in our
ordinary shares. Losses are allowed only to the extent of net mark-to-market
gain previously included by the U.S. holder under the election for prior
taxable years. An electing U.S. holders adjusted basis in our ordinary shares
is increased by income recognized under the mark-to-market election and
decreased by the deductions allowed under the election.

Under
the mark-to-market election, as long as we are a PFIC, gain on the sale of our
ordinary shares is treated as ordinary income, and loss on the sale of our
ordinary shares, to the extent the amount of loss does not exceed the net mark-to-market
gain previously included, is treated as ordinary loss. The mark-to-market
election applies to the tax year for which the election is made and all later
tax years in which we are a PFIC, unless the ordinary shares cease to be
marketable or the Internal Revenue Service consents to the revocation of the
election.

If
the mark-to-market election is made after the first taxable year in which a
U.S. holder holds our ordinary shares and we are a PFIC, then special rules
would apply.

A
U.S. holder making neither the QEF election nor the mark-to-market election is
subject to the excess distribution regime. Under this regime, excess
distributions are subject to special tax rules. An excess distribution is
either (1) a distribution with respect to shares that is greater than 125% of
the average distributions received by the U.S. holder from us over the shorter
of either the preceding three years or such U.S. holders holding period for
our shares, or

109

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(2) 100% of the gain from the disposition of our
shares (including gain deemed recognized if the ordinary shares are used as
security for a loan).

Excess
distributions must be allocated ratably to each day that a U.S. holder has held
our ordinary shares. A U.S. holder must include amounts allocated to the
current taxable year, as well as amounts allocated to taxable years prior to
the first year in which we were a PFIC, in its gross income as ordinary income
for that year. All amounts allocated to prior years of the U.S. holder during
which we were a PFIC would be taxed at the highest tax rate applicable to
ordinary income for each such prior year. The U.S. holder also would be liable
for interest on the deferred tax liability for each such prior year calculated
as if such liability had been due with respect to each such prior year. A U.S.
holder that is an individual is not allowed a deduction for interest on the
deferred tax liability. The portions of gains and distributions that are not
characterized as excess distributions are subject to tax in the current year
under the normal tax rules of the Code.

A
U.S. person who inherits shares in a foreign corporation that was a PFIC in the
hands of the decedent (who was not a nonresident alien and did not make either
of the elections described above), is denied the otherwise available step-up in
the tax basis of such shares to fair market value at the date of death. The
U.S. person steps into the shoes of the decedent and will be subject to the
rules described above.

If
we are determined to be a PFIC for any given year, then dividends in that year
and in the next year cannot qualify as qualified dividends which are eligible
for the capital gains rate.

Following
the sale of our shares in Elbit Systems in 2004, we announced that, as a result
of the transaction, we may be characterized as a PFIC for U.S. federal income
tax purposes for 2004. Following a review of our position and consulting with
our advisors on this matter in 2004, and based on certain assumptions and facts
known at that time (which we believe have not changed), we believe there is
substantial authority for the position that we can rely on the change of
business exception to PFIC status provided under Section 1298(b)(3) of the
U.S. Internal Revenue Code of 1986, as amended. Substantial authority is
generally sufficient to support a return reporting position. Pursuant to this
exception, in order to avoid PFIC status in 2004, among other requirements, we
cannot be a PFIC in 2005 or 2006 (which cannot be determined at this time with
respect to 2006) or in any year prior to 2004 (which we believe was not the
case).

We
believe that in 2005 we were not a PFIC. However, since the determination of
whether we are a PFIC is based upon such factual matters as the valuation of
our assets and, in certain cases, the assets of companies held by us, there can
be no assurance with respect to the position of the Internal Revenue Service or
a court of law as to our status as a PFIC. Our analysis related to 2005 is
based, among others, upon certain assumptions and methodologies with respect to
the values that we have used; our percentage ownership (by value), and the
appropriate value of our ownership interest, in companies we held; and the
manner in which we have allocated the aggregate value of our assets among our
active assets and passive assets.

We
cannot assure you that the Internal Revenue Service will not challenge our
assumptions and methodologies. If the IRS were to challenge successfully such
assumptions or methodologies, we would potentially be classified as a PFIC for
2005 or prior years.

110

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With
respect to 2006, the ultimate determination of our PFIC status will depend on
the composition of our gross income and assets for the entire year, and the
values of those assets, which are difficult to predict at this time and the
appropriate value of our ownership interest in our group companies.

In
view of the above, it is unclear whether the change of business exception
would ultimately be satisfied for 2004. We cannot assure shareholders that the
Internal Revenue Service will not challenge our reliance on the change of
business exception or our assumptions used in determining our percentage of
passive assets and income. If there are such challenges, we could be classified
as a PFIC for 2004, even if we are not a PFIC in 2005 and 2006. Furthermore,
there can be no assurance that we will not become a PFIC in the future.

With
respect to subsequent years, the tests for determining passive foreign
investment company status are applied annually and it is difficult to make
accurate predictions of future income and assets, which are relevant to this
determination. As described above, the tests are impacted, by, among other
factors, changes in value of our group companies which are difficult to predict
at this time and the appropriate value of our ownership interest in our group
companies. Accordingly, there can be no assurance that we will not become a
PFIC for the current fiscal year ending December 31, 2006 or in a future year.
We will notify U.S. holders in the event we conclude that we will be treated as
a PFIC for any taxable year to enable U.S. holders to consider whether or not
to elect to treat us as a QEF for U.S. federal income tax purposes or to mark
to market the ordinary shares or to become subject to the excess
distribution regime.

U.S.
holders are urged to consult their tax advisors regarding the application of
the PFIC rules, including eligibility for and the manner and advisability of
making, the QEF election or the mark-to-market election.

Information Reporting and Backup Withholding

A
U.S. holder generally is subject to information reporting and may be subject to
backup withholding at a rate of up to 28% with respect to dividend payments and
receipt of the proceeds from the disposition of the ordinary shares. Backup
withholding will not apply with respect to payments made to exempt recipients,
including corporations and tax-exempt organizations, or if a U.S. holder
provides a correct taxpayer identification number (or certifies that he has
applied for a taxpayer identification number), certifies that such holder is
not subject to backup withholding or otherwise establishes an exemption. Backup
withholding is not an additional tax and may be claimed as a credit against the
U.S. federal income tax liability of a U.S. holder, or alternatively, the U.S.
holder may be eligible for a refund of any excess amounts withheld under the
backup withholding rules, in either case, provided that the required
information is furnished to the Internal Revenue Service.

Non-U.S. holders of Ordinary Shares

Except
as provided below, a non-U.S. holder of ordinary shares (except certain former
U.S. citizens and long-term residents of the United States) will not be subject
to U.S. federal income or withholding tax on the receipt of dividends on, and
the proceeds from the disposition of, an ordinary share, unless that item is
effectively connected with the conduct by the non-U.S. holder

111

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of a trade or business in the United States and, in
the case of a resident of a country which has an income tax treaty with the
United States, that item is attributable to a permanent establishment in the
United States or, in the case of an individual, a fixed place of business in
the United States. In addition, gain recognized by an individual non-U.S.
holder will be subject to tax in the United States if the non-U.S. holder is
present in the United States for 183 days or more in the taxable year of the
sale and other conditions are met.

Non-U.S.
holders will not be subject to information reporting or backup withholding with
respect to the payment of dividends on ordinary shares unless the payment is
made through a paying agent, or an office of a paying agent, in the United
States. Non-U.S. holders will be subject to information reporting and backup
withholding at a rate of up to 28% with respect to the payment within the
United States of dividends on the ordinary shares unless the holder provides
its taxpayer identification number, certifies to its foreign status, or
otherwise establishes an exemption.

Non-U.S.
holders will be subject to information reporting and backup withholding at a
rate of up to 28% on the receipt of the proceeds from the disposition of the
ordinary shares to, or through, the United States office of a broker, whether
domestic or foreign, unless the holder provides a taxpayer identification
number, certifies to its foreign status or otherwise establishes an exemption.
Non-U.S. holders will not be subject to information reporting or backup
withholding with respect to the receipt of proceeds from the disposition of the
ordinary shares by a foreign office of a broker; provided, however, that if the
broker is a U.S. person or a U.S. related person, information reporting (but
not backup withholding) will apply unless the broker has documentary evidence
in its records of the non-U.S. holders foreign status or the non-U.S. holder
certifies to its foreign status under penalties of perjury or otherwise
establishes an exemption. For this purpose, a U.S. related person is a broker
or other intermediary that maintains one or more enumerated U.S. relationships.
Backup withholding is not an additional tax and may be claimed as a credit
against the U.S. federal income tax liability of a non-U.S. holder, or
alternatively, the non-U.S. holder may be eligible for a refund of any excess
amounts withheld under the backup withholding rules, in either case, provided
that the required information is furnished to the Internal Revenue Service.

|   |                            
|-- | ---------------------------
|F. | Dividends and Paying Agents

Not Applicable.

|   |                     
|-- | --------------------
|G. | Statement by Experts

Not Applicable.

|   |                     
|-- | --------------------
|H. | Documents on Display

We
are required to file reports and other information with the Securities and
Exchange Commission, or SEC, under the Securities Exchange Act of 1934 and the
regulations thereunder applicable to foreign private issuers. Reports and other
information filed by us with the SEC may be inspected and copied at the SECs
public reference facilities described below. Although as a foreign private
issuer we are not required to file periodic information as frequently or as
promptly as United States companies, we generally do publicly announce our
quarterly and year-end results promptly and file periodic information with the
SEC under cover of Form 6-K. As a

112

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foreign private issuer, we are also exempt from the
rules under the Exchange Act prescribing the furnishing and content of proxy
statements and our officers, directors and principal shareholders are exempt
from the reporting and other provisions in Section 16 of the Exchange Act.

You
may review a copy of our filings with the SEC, including any exhibits and
schedules, at the SECs public reference facilities in Room 1024, Judiciary
Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the regional
offices of the SEC. You may also obtain copies of such materials from the
Public Reference Section of the SEC, Room 1024, Judiciary Plaza, 450 Fifth
Street, N.W., Washington, D.C. 20549, at prescribed rates. You may call the SEC
at 1-800-SEC-0330 for further information on the public reference rooms. You
may read and copy any reports, statements or other information that we file
with the Securities and Exchange Commission at the facilities listed above. In
addition, certain of our filings are available to the public at the SECs
website at http://www.sec.gov. We also generally make available on our own web
site (www.elron.com) all our quarterly and year-end financial statements as
well as other information. Our website is not part of this Annual Report.

Any
statement in this Annual Report about any of our contracts or other documents
is not necessarily complete. If the contract or document is filed as an exhibit
to this Annual Report, the contract or document is deemed to modify the
description contained in this Annual Report. We urge you to review the exhibits
themselves for a complete description of the contract or document.

|   |                       
|-- | ----------------------
|I. | Subsidiary Information

Not Applicable.

Item 11.
Quantitative and Qualitative Disclosures About Market Risk

For
disclosures regarding our market risk exposures, see Item 5, Operating and
Financial Review and Prospects above.

Item 12.
Descriptions of Securities Other than Equity Securities

Not Applicable.

PART II

Item 13.
Defaults, Dividend Arrearages and Delinquencies

Not Applicable.

Item 14.
Material Modifications to the Rights of Security Holders and Use of Proceeds

Not Applicable.

Item 15.
Controls and Procedures

Our
Chief Executive Officer and Chief Financial Officer, after evaluating the
effectiveness of our disclosure controls and procedures (as defined in Rule
13a-15(e)of the Securities Exchange Act of 1934, as amended), have concluded
that, as of December 31, 2005, our disclosure controls and procedures were
effective to ensure that information required to be

113

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disclosed by us in reports
that we file or submit under the Exchange Act is accumulated and communicated
to our management, including our Chief Executive Officer and Chief Financial
Officer, to allow timely decisions regarding required disclosure and is
recorded, processed, and reported within the periods specified by the SECs
rules and forms. There were no changes in our internal controls over financial
reporting identified with the evaluation thereof that occurred during the
period covered by this annual report that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.

Item 16. [Reserved]

Item16A.Audit Committee Financial Expert

The
board of directors has determined that Mr. Yaacov Goldman is the audit
committee financial expert serving on its audit committee. Mr. Goldman is
independent as defined in Rule 4200 of the NASDAQ Marketplace Rules.

Item
16B. Code of Ethics

We
have adopted a code of ethics applicable to our employees, officers and
directors A copy of the code of ethics was filed as an Exhibit 11.1 to our
Annual Report on Form 20F filed with the Securities Exchange Commission on June
29, 2004, and is also available on our website, www.elron.com.

Item
16C. Principal Accountant Fees and Services

The following table sets forth the total remuneration
that was paid by us and our subsidiaries to our principal accountants Kost
Forer Gabbay & Kasierer (a member of Ernst & Young Global) in each of
our previous two fiscal years:

| |                      |  |                  |     |      |  |     | 
| | -------------------- |  | ---------------- | --- | ---- |  | --- | 
| |                      |  | 2004             |     | 2005 | 
| |                      |  |                  |     |      | 
| |                      |  | (in
  thousands) |    
| |                      |  |                  |     |      |  |     | 
| | Audit fees (1)       |  |                  | 250 |      |  | 269 | 
| | Tax fees (2)         |  |                  | 109 |      |  | 144 | 
| | All other fees
  (3) |  |                  | 100 |      |  | 20  | 
| |                      |  |                  |     |      |  |     | 
| | Total                |  |                  | 459 |      |  | 433 | 

No audit  related fees were
paid in 2004 or 2005.

| |                                                                                                                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) Audit Fees consist of fees billed for the annual
  audit services engagement and other audit services, which are those services
  that only the external auditor can reasonably provide, and include statutory
  audits; consents; and assistance with and review of documents filed with the
  SEC.                                                         
| |                                                                                                                                                                                                                                                                                                                                                                  
| | (2) Tax Fees include fees billed for tax compliance
  services, including the preparation of original and amended tax returns and
  claims for tax refund; tax consultations, such as assistance and
  representation in connection with tax audits and appeals, and requests for
  rulings or technical advice from taxing authority; and tax planning services.

114

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| |                                                                
| | ---------------------------------------------------------------
| | (3) Services relating to Elrons status under the
  PFIC rules.

| |                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our audit committees policy
  is to pre-approve each audit and non-audit service to be performed by our
  independent auditors for us and our subsidiaries.

Item
16D. Exemptions from the Listing Standards for Audit Committees

Not Applicable

Item
16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers

During 2005 and 2006 to date, DIC purchased an additional
aggregate of 604,955 of our ordinary shares on the TASE as set forth in the
table below, thereby increasing its shareholding to approximately 47.6%. Except
for these purchases, neither we nor any
affiliated purchaser purchased any of our equity securities during the period
covered by this Annual Report.

|                         |  |  |                                                      |  |  |                                                |  |  |                                                                                                                |  |  |                                                                                                                                                | 
|------------------------ |  |  | ---------------------------------------------------- |  |  | ---------------------------------------------- |  |  | -------------------------------------------------------------------------------------------------------------- |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------- | 
|Period                   |  |  | (a)Total number
  of shares (or
  units
  purchased) |  |  | (b)Average price
  paid per share
  (or units) |  |  | (c)Total number
  of shares (or
  units)
  purchased as
  part of
  publicly
  announced
  plans or
  programs |  |  | (d)Maximum
  number (or
  approximate
  dollar value) of
  shares (or
  units) that may
  yet be
  purchased
  under the
  plans or
  programs | 
|                         |  |  |                                                      |  |  |                                                |  |  |                                                                                                                |  |  |                                                                                                                                                | 
|June 19 to June 30, 2005 |  |  | 565,111                                              |  |  | NIS58.40                                       |  |  |                                                                                                               |  |  |                                                                                                                                               | 
|                         |  |  |                                                      |  |  |                                                |  |  |                                                                                                                |  |  |                                                                                                                                                | 
|March 29, 2006           |  |  | 39,844                                               |  |  | NIS49.76                                       |  |  |                                                                                                               |  |  |                                                                                                                                               | 

PART III

Item 17. Financial
Statements

Not Applicable.

Item 18.
Financial Statements

115

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Our
financial statements follow the certifications following the signature page of
this Annual Report.

|                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|----------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Item 19. Exhibits
|                 
|1.1               | Articles of Association (English translation)
  approved by the registrants shareholders on March 19, 2000, incorporated by
  reference to Exhibit 1.1 to the registrants Form 20-F for the year ended
  December 31, 2000, filed with the Commission on June 8, 2001.                                                                                                                                                                                                         
|1.2               | Memorandum of Association of Elron Electronic
  Industries Ltd., incorporated by reference to Exhibit 1.2 to the registrants
  Form 20-F for the year ended December 31, 2000, filed with the Commission on
  June 8, 2001.                                                                                                                                                                                                                                                     
|4.1               | Agreement dated as of April 1993 among Discount Investment Corporation
        Ltd., PEC Israel Economic Corporation, Rafael Armament Development Authority
        Ltd., Galram Technology Industries Limited, incorporated by reference
        to Exhibit 10.4 to Amendment No. 5 to the registrants Registration
        Statement on Form F-4, filed with the Commission on March 14, 2002.                                                                                
|4.2               | License from the Israeli Ministry of Communications
  issued to Partner Communications Company Ltd. on April 8, 1998, incorporated
  by reference to Exhibit 4.5 to the Annual Report on Form 20-F/A of Elbit
  Ltd., filed with the Commission on March 15, 2002 as may be amended from time
  to time and incorporated in subsequent filings by Partner with the
  Commission.                                                                                                 
|4.3               | Addendum to Agreement dated June 16, 2003 among DEP
  Technology Holdings Ltd., Rafael Armament Development Authority Ltd., Galram
  Technologies Industries Ltd. and RDC Rafael Development Corporation Ltd.
  incorporated by reference to Exhibit 4.17 of the registrants Form 20-F, filed
  with the Commission on June 30, 2003.                                                                                                                                           
|4.4               | Restatement of Relationship Agreement dated April
  20, 2005 by and among Hutchison Telecommunications International
  (Netherlands) B.V., Advent Investments Pte Ltd., Elbit Ltd., Eurocom
  Communications Ltd. Polar Comunications Ltd., Matav Investments Ltd., Matav
  Cable Systems Media Ltd. and Tapuz Cellular Systems Ltd. incorporated by
  reference to Exhibit 1 to amendment no. 3 to registrants filing on Form 13 D
  filed with the Commission on May 16, 2005.
|4.5               | Shareholders Agreement dated April 20, 2005 by and
  among Elbit Ltd., Eurocom Communications Ltd. Polar Comunications Ltd., Matav
  Investments Ltd. and Matav Cable Systems Media Ltd. incorporated by reference
  to Exhibit 2 to amendment no.3 to registrants filing on Form 13 D filed with
  the Commission on May 16, 2005.                                                                                                                                             
|8.1               | List of subsidiaries                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|11.1              | Code of Ethics incorporated by reference to Exhibit
  11.1 to the registrants Annual Report on Form 20-F filed with the Commission
  on June 30, 2004.                                                                                                                                                                                                                                                                                                                          
|12.1              | Certification of Chief Executive Officer of the
  Registrant pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                          
|12.2              | Certification of Chief Financial Officer of the
  Registrant pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                          
|13.1              | Certification of Chief Executive Officer of the
  Registrant pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*                                                                                                                                                                                                                                                                                                                                                         
|13.2              | Certification of Chief Financial Officer of the
  Registrant pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*                                                                                                                                                                                                                                                                                                                                                         

116

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|      |                                                                                                                                              
|----- | ---------------------------------------------------------------------------------------------------------------------------------------------
|15.1  | Consent of Kost Forer Gabbay & Kasierer, a member of Ernst
  & Young Global, for Elron Electronic Industries Ltd.                            
|15.2  | Consent of Kost Forer Gabbay & Kasierer, a member of Ernst
  & Young Global, for Elbit Systems Ltd.                                          
|15.3  | Consents of Brightman Almagor & Co., a member of
  Deloitte Touche Tohmatsu, for A.M.T. Advanced Metal Technologies Ltd.                     
|15.4  | Consent of Somekh Chaikin, a member firm of KPMG
  International, for Given Imaging Ltd.                                                     
|15.5  | Consent of PricewaterhouseCoopers LLP for ChipX
  Incorporated.                                                                              
|15.6  | Consent of Kost Forer Gabbay & Kasierer, a member of Ernst
  & Young Global, for ChipX (Israel) Ltd.                                         
|15.7  | Consent of Kesselman & Kesselman CPA(Isr.) a
  member of PricewaterhouseCoopers International Limited for Notal Vision, Inc.                 
|15.8  | Consents of PriceWaterhouseCoopers LLP for Oncura, Inc.                                                                                      
|15.9  | Consent of Kesselman & Kesselman CPA(Isr.) a
  member of PricewaterhouseCoopers International Limited for Pulsicom Israel
  Technologies Ltd.
|15.10 | Consent of Kesselman & Kesselman CPA(Isr.) a
  member of PricewaterhouseCoopers International Limited for Ingenio
  Technologies Ltd.        

|  |                                                                                            
|- | -------------------------------------------------------------------------------------------
|* | This document is being furnished in accordance with
  SEC Release No. 33-8212 and 34-47551.

117

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SIGNATURES

The
registrant hereby certifies that it meets all of the requirements for filing on
Form 20-F and that it has duly caused and authorized the undersigned to sign
this Annual Report on its behalf.

|                     |                                    |        |                                         
|-------------------- | ---------------------------------- | ------ | ----------------------------------------
|Dated: June 27, 2006 | ELRON
  ELECTRONIC INDUSTRIES LTD.
|                     |                                    |        |                                         
|                     |                                    | By:    | /s/ Doron Birger                        
|                     |                                    |        |                                         
|                     |                                    | Name:  | Doron Birger                            
|                     |                                    |        |                                         
|                     |                                    | Title: | President & Chief Executive Officer     
|                     |                                    |        |                                         
|                     |                                    | By:    | /s/ Rinat Remler                        
|                     |                                    |        |                                         
|                     |                                    | Name:  | Rinat Remler                            
|                     |                                    |        |                                         
|                     |                                    | Title: | Vice President & Chief Financial Officer

118

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ELRON ELECTRONIC INDUSTRIES LTD.AND
ITS SUBSIDIARIES

CONSOLIDATED

FINANCIAL STATEMENTS

As of December 31,
2005

---



ELRON ELECTRONIC
INDUSTRIES LTD. AND ITS SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31,
2005

INDEX

|                                                          |     
|--------------------------------------------------------- | ----
|                                                          | Page
|                                                          |     
|                                                          |     
|Report of Independent Registered Public
  Accounting Firm | 2   
|                                                          |     
|Consolidated Balance Sheets                               | 3-4 
|                                                          |     
|Consolidated Statements of Operations                     | 5   
|                                                          |     
|Statements of Shareholders Equity                        | 6   
|                                                          |     
|Consolidated Statements of Cash Flows                     | 7-8 
|                                                          |     
|Notes to the Consolidated Financial
  Statements          | 9-52
|                                                          |     
|Annex to the Consolidated Financial
  Statements          | 53  



---

---



|                |  |   |                              |  |   |                     
|--------------- |  | - | ---------------------------- |  | - | --------------------
|ERNST
  & YOUNG |  | n | Kost Forer Gabbay & Kasierer |  | n | Phone: 972-3-6232525
|                |  |   | 21 Aminadav St.              |  |   | Fax: 972-3-5622555  
|                |  |   | Tel-Aviv 67067, Israel       |  |   |                     

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders ofELRON ELECTRONIC INDUSTRIES LTD

We have
audited the accompanying consolidated balance sheets of Elron Electronic
Industries Ltd. (the Company) and its subsidiaries as of December 31, 2005
and 2004, and the related consolidated statements of operations, changes in
shareholders equity and cash flows for each of the three years in the period
ended December 31, 2005. These financial statements are the responsibility of
the Companys management. Our responsibility is to express an opinion on these
financial statements based on our audits. We did not audit the financial
statements of certain affiliates, the investment in which, at equity, amounted
to $ 46.2 million and $ 56.7 million as of December 31, 2005 and
2004, respectively, and the Companys equity in their income (losses) amounted
to $ (9.1) million, $ 1.2 million and $ (9.7) million for the years ended
December 31, 2005, 2004 and 2003, respectively. Those financial statements were
audited by other auditors whose reports have been furnished to us, and our
opinion, insofar as it relates to the amounts included for those companies, is
based solely on the reports of other auditors.

We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. We were not engaged to
perform an audit of the Companys internal control over financial reporting. Our
audit included consideration of internal control over financial reporting as a
basis for designing audit procedures that are appropriate in the circumstances,
but not for the purpose of expressing an opinion on the effectiveness of the
Companys internal control over financial reporting. Accordingly, we express no
such opinion. An audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits and the reports of other auditors provide a reasonable basis for our
opinion.

In our
opinion, based on our audits and the reports of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of the Company and its
subsidiaries as of December 31, 2005 and 2004, and the consolidated results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2005, in conformity with U.S. generally accepted accounting
principles.

As
discussed in Note 2(s) to the consolidated financial statements, effective
January 1, 2003, the Company adopted the full provisions of SFAS 123,
Accounting for Stock  Based Compensation with respect to all employee awards
granted, modified or settled after January 1, 2003. As discussed in Note 2(i)
to the consolidated financial statements, effective October 1, 2004, the
Company adopted the provisions of EITF 02-14 Whether an Investor Should Apply
the Equity Method of Accounting to Investments Other than Common Stock.

|                   |                                 
|------------------ | --------------------------------
|Tel-Aviv,
  Israel | KOST FORER GABBAY & KASIERER    
|March 14,
  2006   | A Member of Ernst & Young Global

2

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|CONSOLIDATED BALANCE SHEETS                               
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                                          |  |      |  |              |         |          |   |         | 
|------------------------------------------------------------------------------------------------------------------------- |  | ---- |  | ------------ | ------- | -------- | - | ------- | 
|                                                                                                                          |  |      |  | December 31, |        
|                                                                                                                          |  |      |  |              |        
|                                                                                                                          |  | Note |  | 2005         |         | 2004 *** |  
|                                                                                                                          |  |      |  |              |         |          |  
|ASSETS                                                                                                                    |  |      |  |              |         |          |   |         | 
|CURRENT ASSETS                                                                                                            |  |      |  |              |         |          |   |         | 
|Cash and cash equivalents                                                                                                 |  | 4    |  | $            | 26,520  |          | $ | 42,097  | 
|Short-term investments                                                                                                    |  | 5    |  |              | 54,661  |          |   | 101,024 | 
|Available for sale marketable
securities                                                                                  |  | 6    |  |              | 62,617  |          |   | 44,985  | 
|Trade receivables(net of allowance of
  doubtful accounts of $426 and $463 at December 31, 2005 and 2004
  respectively)* |  |      |  |              | 6,440   |          |   | 3,698   | 
|Other receivables and prepaid expenses
*                                                                                  |  |      |  |              | 2,846   |          |   | 1,505   | 
|Inventories                                                                                                               |  |      |  |              | 2,117   |          |   | 1,961   | 
|Total assets attributed to discontinued
  operations**                                                                    |  | 22   |  |              |        |          |   | 7,652   | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|Total current assets                                                                                                      |  |      |  |              | 155,201 |          |   | 202,922 | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|INVESTMENTS AND LONG-TERM
  RECEIVABLES                                                                                   |  |      |  |              |         |          |   |         | 
|Investments in affiliated companies                                                                                       |  | 7    |  |              | 102,780 |          |   | 117,124 | 
|Investments in other companies and
  long-term receivables *                                                              |  | 8    |  |              | 73,931  |          |   | 155,929 | 
|Deferred taxes                                                                                                            |  | 14   |  |              | 6,521   |          |   | 5,493   | 
|Severance pay deposits                                                                                                    |  |      |  |              | 1,971   |          |   | 2,136   | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|Total investments and long-term receivables                                                                               |  |      |  |              | 185,203 |          |   | 280,682 | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|PROPERTY AND EQUIPMENT, NET                                                                                               |  | 9    |  |              | 7,809   |          |   | 8,057   | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|INTANGIBLE ASSETS                                                                                                         |  | 10   |  |              |         |          |   |         | 
|Goodwill                                                                                                                  |  |      |  |              | 2,742   |          |   | 6,657   | 
|Other intangible assets                                                                                                   |  |      |  |              | 2,818   |          |   | 2,838   | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|Total intangible assets                                                                                                   |  |      |  |              | 5,560   |          |   | 9,495   | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 
|Total assets                                                                                                              |  |      |  | $            | 353,773 |          | $ | 501,156 | 
|                                                                                                                          |  |      |  |              |         |          |   |         | 

|    |                                                                                                                                                                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*   | Includes short-term receivables from related parties in the aggregate
  amount of $5,043 and $2,292 as of December 31, 2005 and 2004, respectively,
  and long-term receivables from related parties in the aggregate amount of
  $434 and $405 as of December 31, 2005 and 2004, respectively.
|**  | Includes short-term receivables from related parties in the aggregate
  amount of $663 as of December 31, 2004.                                                                                                                                                                                
|*** | Reclassified  see Note 3(d) and Note 22.                                                                                                                                                                                                                                                      

The accompanying notes are an integral part
of the consolidated
financial statements.

3

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|CONSOLIDATED BALANCE SHEETS                               
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- |  | ------------ | ------- | ------- | - | ------- | 
|                                                                                                                                                                                                                       |  |      |  | December 31, |        
|                                                                                                                                                                                                                       |  |      |  |              |        
|                                                                                                                                                                                                                       |  | Note |  | 2005         |         | 2004*** |  
|                                                                                                                                                                                                                       |  |      |  |              |         |         |  
|LIABILITIES AND SHAREHOLDERS
  EQUITY                                                                                                                                                                                 |  |      |  |              |         |         |   |         | 
|CURRENT LIABILITIES                                                                                                                                                                                                    |  |      |  |              |         |         |   |         | 
|Short-term loans from banks and
others                                                                                                                                                                                 |  | 11   |  | $            | 3,808   |         | $ | 389     | 
|Current maturities of long-term loans from
  banks and others                                                                                                                                                          |  | 13   |  |              | 2,065   |         |   | 2,974   | 
|Trade payables                                                                                                                                                                                                         |  |      |  |              | 2,146   |         |   | 2,024   | 
|Other payables and accrued expenses                                                                                                                                                                                    |  | 12   |  |              | 11,025  |         |   | 29,681  | 
|Total liabilities attributed to
  discontinued operations                                                                                                                                                              |  | 22   |  |              |        |         |   | 5,602   | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|Total current liabilities                                                                                                                                                                                              |  |      |  |              | 19,044  |         |   | 40,670  | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|LONG-TERM LIABILITIES                                                                                                                                                                                                  |  |      |  |              |         |         |   |         | 
|Long-term loans from banks and
others                                                                                                                                                                                  |  | 13   |  |              | 1,477   |         |   | 4,072   | 
|Accrued severance pay and retirement
  obligations                                                                                                                                                                     |  |      |  |              | 2,635   |         |   | 3,006   | 
|Deferred taxes                                                                                                                                                                                                         |  | 14   |  |              | 9,494   |         |   | 41,233  | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|Total long-term liabilities                                                                                                                                                                                            |  |      |  |              | 13,606  |         |   | 48,311  | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|CONTINGENT LIABILITIES, PLEDGES
  AND COMMITMENTS                                                                                                                                                                      |  | 15   |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|MINORITY INTEREST                                                                                                                                                                                                      |  |      |  |              | 19,007  |         |   | 23,095  | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|SHAREHOLDERS EQUITY:                                                                                                                                                                                                  |  | 16   |  |              |         |         |   |         | 
|Ordinary shares of NIS 0.003 par value;
  Authorized: 35,000,000 shares as of December 31, 2005 and 2004; Issued and
  outstanding: 29,483,455 and 29,414,424 shares as of December 31, 2005 and
  2004, respectively; |  |      |  |              | 9,572   |         |   | 9,572   | 
|Additional paid-in capital                                                                                                                                                                                             |  |      |  |              | 271,132 |         |   | 270,005 | 
|Accumulated other comprehensive
income                                                                                                                                                                                 |  | 24   |  |              | 10,741  |         |   | 57,717  | 
|Retained earnings                                                                                                                                                                                                      |  |      |  |              | 10,671  |         |   | 51,786  | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|Total shareholders equity                                                                                                                                                                                             |  |      |  |              | 302,116 |         |   | 389,080 | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 
|Total liabilities and shareholders equity                                                                                                                                                                             |  |      |  | $            | 353,773 |         | $ | 501,156 | 
|                                                                                                                                                                                                                       |  |      |  |              |         |         |   |         | 

|    |                                          
|--- | -----------------------------------------
|*** | Reclassified  see Note 3(d) and Note 22.

The accompanying notes are an integral part
of the consolidated
financial statements.

|                                               |  |                                                 |  |                           |  |                                                     
|---------------------------------------------- |  | ----------------------------------------------- |  | ------------------------- |  | ----------------------------------------------------
|March 14, 2006                                 |  |                                                 |  |                           |  |                                                     
|                                               |  |                                                 |  |                           |  |                                                     
|Date of approval of the
  financial statements |  | Ami Erel
  Chairman of the Board
  of Directors |  | Avraham Asheri
  Director |  | Doron Birger
  President & Chief
  Executive Officer

4

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|CONSOLIDATED STATEMENTS OF OPERATIONS                     
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|---------------------------------------------------------------------------------------------------------------- |  | ---- |  | ----------------------- | ------- | ------- | - | ------- | - | - | ------- | -
|                                                                                                                 |  |      |  | Years ended December 31 |        
|                                                                                                                 |  |      |  |                         |        
|                                                                                                                 |  | Note |  | 2005                    |         | 2004*** |   | 2003*** |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |  
|INCOME                                                                                                           |  |      |  |                         |         |         |   |         |   |   |         |  
|Net revenues*                                                                                                    |  |      |  | $                       | 12,646  |         | $ | 11,265  |   | $ | 9,157   |  
|Equity in losses of affiliated
companies                                                                         |  | 18   |  |                         | (17,522 | )       |   | (10,492 | ) |   | (8,698  | )
|Gain from disposal of businesses and
  affiliated companies and changes in holdings in affiliated companies, net |  | 19   |  |                         | 23,328  |         |   | 132,396 |   |   | 25,754  |  
|Other income , net                                                                                               |  | 20   |  |                         | 58,648  |         |   | 4,749   |   |   | 14,637  |  
|Financial income , net                                                                                           |  | 21   |  |                         | 5,483   |         |   | 1,433   |   |   | 751     |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         | 82,583  |         |   | 139,351 |   |   | 41,601  |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|COSTS AND EXPENSES                                                                                               |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Cost of revenues                                                                                                 |  |      |  |                         | 7,907   |         |   | 6,791   |   |   | 5,862   |  
|Research and development costs, net                                                                              |  |      |  |                         | 6,163   |         |   | 2,889   |   |   | 3,263   |  
|Marketing and selling expenses, net                                                                              |  |      |  |                         | 2,386   |         |   | 1,311   |   |   | 6,498   |  
|General and administrative expenses                                                                              |  |      |  |                         | 9,249   |         |   | 12,292  |   |   | 12,872  |  
|Amortization of intangible assets                                                                                |  |      |  |                         | 392     |         |   | 142     |   |   | 299     |  
|Impairment of intangible assets                                                                                  |  | 10   |  |                         |        |         |   | 4,192   |   |   |        |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         | 26,097  |         |   | 27,617  |   |   | 28,794  |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Income before taxes on income                                                                                    |  |      |  |                         | 56,486  |         |   | 111,734 |   |   | 12,807  |  
|Taxes on income                                                                                                  |  | 14   |  |                         | (10,461 | )       |   | (15,101 | ) |   | (6,796  | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Income after taxes on income                                                                                     |  |      |  |                         | 46,025  |         |   | 96,633  |   |   | 6,011   |  
|Minority interest in losses (income) of
  subsidiaries                                                           |  |      |  |                         | 5,160   |         |   | (4,135  | ) |   | (10,907 | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Income (loss) from continuing operations                                                                         |  |      |  |                         | 51,185  |         |   | 92,498  |   |   | (4,896  | )
|Loss from discontinued operations**                                                                              |  | 22   |  |                         | (3,850  | )       |   | (8,365  | ) |   | (2,309  | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Net income (loss)                                                                                                |  |      |  | $                       | 47,335  |         | $ | 84,133  |   | $ | (7,205  | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Income (loss) per share                                                                                          |  | 17   |  |                         |         |         |   |         |   |   |         |  
|Basic:                                                                                                           |  |      |  |                         |         |         |   |         |   |   |         |  
|Income (loss) from continuing
operations                                                                         |  |      |  | $                       | 1.74    |         | $ | 3.26    |   | $ | (0.17   | )
|Loss from discontinued operations                                                                                |  |      |  | $                       | (0.13   | )       | $ | (0.39   | ) | $ | (0.08   | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Net income (loss)                                                                                                |  |      |  | $                       | 1.61    |         | $ | 2.87    |   | $ | (0.25   | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Diluted :                                                                                                        |  |      |  |                         |         |         |   |         |   |   |         |  
|Income (loss) from continuing
operations                                                                         |  |      |  | $                       | 1.73    |         | $ | 3.25    |   | $ | (0.17   | )
|Loss from discontinued operations                                                                                |  |      |  | $                       | (0.13   | )       | $ | (0.39   | ) | $ | (0.08   | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Net income (loss)                                                                                                |  |      |  | $                       | 1.60    |         | $ | 2.86    |   | $ | (0.25   | )
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Weighted average number of Ordinary shares
  used in computing basic net income (loss) per share (thousands)     |  |      |  |                         | 29,437  |         |   | 29,266  |   |   | 29,194  |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  
|Weighted average number of Ordinary shares
  used in computing diluted net income (loss) per share (thousands)   |  |      |  |                         | 29,550  |         |   | 29,385  |   |   | 29,194  |  
|                                                                                                                 |  |      |  |                         |         |         |   |         |   |   |         |  

|    |                                                                                                                                                           
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|*   | Includes revenues from related parties in the amount of $8,046,
  $7,182 and $3,535, for the years ended December 31, 2005, 2004 and 2003,
  respectively.
|**  | Includes revenues from related parties in the amount of $174, $1,298
  and $620, for years ended December 31, 2005, 2004 and 2003, respectively.          
|*** | Reclassified  see Note 3(d) and Note 22.                                                                                                                 

The accompanying notes are an integral part
of the consolidated financial statements.

5

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|STATEMENT OF SHAREHOLDERS EQUITY                         
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------- | ---------- | --------------- | - | ---------------------------- |  | -------------------------------------------- | ------- | ---------------------------------------------- | - | ------------------------------ | - | ------------------------------ | ------- | - | - | ------- | - | - | ------- | -
|                                                                                                                                                                                                          |  | Number
  of
  shares |            | Share
  capital |   | Additional
  paid-in capital |  | Accumulated
  other
  comprehensive
  income |         | Retained
  earnings 
  (Accumulated
  deficit) |   | Total
  shareholders
  equity |   | Total
  comprehensive
  income |        
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |        
|Balance as of
  January 1,2003                                                                                                                                                                            |  |                      | 29,180,970 |                 | $ | 9,572                        |  | $                                            | 267,482 |                                                | $ | 7,529                          |   | $                              | (25,142 | ) | $ | 259,441 |   |   |         |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Exercise of
  options                                                                                                                                                                                     |  |                      | 25,875     |                 |   |                             |  |                                              | 177     |                                                |   |                               |   |                                |        |   |   | 177     |   |   |        |  
|Changes in
  additional paid-in capital in affiliated companies                                                                                                                                           |  |                      |           |                 |   |                             |  |                                              | (932    | )                                              |   |                               |   |                                |        |   |   | (932    | ) |   |        |  
|Stock based
  compensation                                                                                                                                                                                |  |                      |           |                 |   |                             |  |                                              | 386     |                                                |   |                               |   |                                |        |   |   | 386     |   |   |        |  
|Other
  comprehensive income (loss), net of tax:                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Unrealized gains
  on available for sale securities                                                                                                                                                       |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | 55,960                         |   |                                |        |   |   | 55,960  |   | $ | 55,960  |  
|Reclassification
  adjustment for gain realized included in net loss                                                                                                                                      |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (11,113                        | ) |                                |        |   |   | (11,113 | ) |   | (11,113 | )
|Foreign currency
  translation adjustment                                                                                                                                                                 |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (304                           | ) |                                |        |   |   | (304    | ) |   | (304    | )
|Minimum pension
  liability in an affiliated company                                                                                                                                                      |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (172                           | ) |                                |        |   |   | (172    | ) |   | (172    | )
|Unrealized loss
  on derivative instrument in affiliated company                                                                                                                                          |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (108                           | ) |                                |        |   |   | (108    | ) |   | (108    | )
|Net loss                                                                                                                                                                                                  |  |                      |           |                 |   |                             |  |                                              |        |                                                |   |                               |   |                                | (7,205  | ) |   | (7,205  | ) |   | (7,205  | )
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Balance as of
  December 31, 2003                                                                                                                                                                         |  |                      | 29,206,845 |                 |   | 9,572                        |  |                                              | 267,113 |                                                |   | 51,792                         |   |                                | (32,347 | ) |   | 296,130 |   |   |         |  
|Total
  comprehensive income                                                                                                                                                                              |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   | $ | 37,058  |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|                                                                                                                                                                                                         
|Exercise of
  options                                                                                                                                                                                     |  |                      | 207,579    |                 |   |                             |  |                                              | 2,097   |                                                |   |                               |   |                                |        |   |   | 2,097   |   |   |         |  
|Stock based
  compensation                                                                                                                                                                                |  |                      |           |                 |   |                             |  |                                              | 545     |                                                |   |                               |   |                                |        |   |   | 545     |   |   |         |  
|Tax benefit in
  respect of options exercised                                                                                                                                                             |  |                      |           |                 |   |                             |  |                                              | 250     |                                                |   |                               |   |                                |        |   |   | 250     |   |   |         |  
|Other comprehensive
  income (loss), net of tax:                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Unrealized gains
  on available for sale securities                                                                                                                                                       |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | 8,489                          |   |                                |        |   |   | 8,489   |   |   | 8,489   |  
|Reclassification
  adjustment for gain realized included in net income                                                                                                                                    |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (3,582                         | ) |                                |        |   |   | (3,582  | ) |   | (3,582  | )
|Foreign currency
  translation adjustments                                                                                                                                                                |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | 202                            |   |                                |        |   |   | 202     |   |   | 202     |  
|Unrealized gain
  on derivative instruments in affiliated company                                                                                                                                         |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | 84                             |   |                                |        |   |   | 84      |   |   | 84      |  
|Reclassification
  adjustments for loss on derivative instruments, minimum pension liability and
  foreign currency translation adjustments, included in net income due to sale
  of affiliated companies |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | 732                            |   |                                |        |   |   | 732     |   |   | 732     |  
|Net income                                                                                                                                                                                                |  |                      |           |                 |   |                             |  |                                              |        |                                                |   |                               |   |                                | 84,133  |   |   | 84,133  |   |   | 84,133  |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Balance as of
  December 31, 2004                                                                                                                                                                         |  |                      | 29,414,424 |                 |   | 9,572                        |  |                                              | 270,005 |                                                |   | 57,717                         |   |                                | 51,786  |   |   | 389,080 |   |   |         |  
|Total
  comprehensive income                                                                                                                                                                              |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   | $ | 90,058  |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Exercise of
  options                                                                                                                                                                                     |  |                      | 69,031     |                 |   |                             |  |                                              | 697     |                                                |   |                               |   |                                |        |   |   | 697     |   |   |         |  
|Stock based
  compensation                                                                                                                                                                                |  |                      |           |                 |   |                             |  |                                              | 405     |                                                |   |                               |   |                                |        |   |   | 405     |   |   |         |  
|Tax benefit in
  respect of options exercised                                                                                                                                                             |  |                      |           |                 |   |                             |  |                                              | 25      |                                                |   |                               |   |                                |        |   |   | 25      |   |   |         |  
|Dividend paid                                                                                                                                                                                             |  |                      |           |                 |   |                             |  |                                              |         |                                                |   |                               |   |                                | (88,450 | ) |   | (88,450 | ) |   |         |  
|Other
  comprehensive income (loss), net of tax:                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Unrealized loss
  on available for sale securities                                                                                                                                                        |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (10,450                        | ) |                                |        |   |   | (10,450 | ) |   | (10,450 | )
|Reclassification
  adjustment for gain realized and other than temporary impairment included in
  net income                                                                                              |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (36,335                        | ) |                                |        |   |   | (36,335 | ) |   | (36,335 | )
|Foreign currency
  translation adjustments                                                                                                                                                                |  |                      |           |                 |   |                             |  |                                              |        |                                                |   | (191                           | ) |                                |        |   |   | (191    | ) |   | (191    | )
|Net income                                                                                                                                                                                                |  |                      |           |                 |   |                             |  |                                              |        |                                                |   |                               |   |                                | 47,335  |   |   | 47,335  |   |   | 47,335  |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|                                                                                                                                                                                                         
|Balance as of
  December 31, 2005                                                                                                                                                                         |  |                      | 29,483,455 |                 | $ | 9,572                        |  | $                                            | 271,132 |                                                | $ | 10,741                         |   | $                              | 10,671  |   | $ | 302,116 |   |   |         |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  
|Total
  comprehensive income                                                                                                                                                                              |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   | $ | 359     |  
|                                                                                                                                                                                                          |  |                      |            |                 |   |                              |  |                                              |         |                                                |   |                                |   |                                |         |   |   |         |   |   |         |  

The accompanying notes are an integral part of the consolidated
financial statements.

6

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|CONSOLIDATED STATEMENTS OF CASH FLOWS                     
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|---------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | ---- | - | -------- | - | - | ------- | -
|                                                                                                                 |  | Year ended December 31, |        
|                                                                                                                 |  |                         |        
|                                                                                                                 |  | 2005                    |         | 2004 |   | 2003     |  
|                                                                                                                 |  |                         |         |      |   |          |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                                             |  |                         |         |      |   |          |   |   |         |  
|Net income (loss)                                                                                                |  | $                       | 47,335  |      | $ | 84,133   |   | $ | (7,205  | )
|Adjustments to reconcile net income (loss) to
net cash used in
  operating activities:                           |  |                         |         |      |   |          |   |   |         |  
|Equity in losses of affiliated
companies                                                                         |  |                         | 17,522  |      |   | 10,492   |   |   | 8,698   |  
|Dividend from affiliated companies                                                                               |  |                         |        |      |   | 1,719    |   |   | 2,971   |  
|Minority interest in income (losses) of
subsidiaries                                                             |  |                         | (5,160  | )    |   | 4,135    |   |   | 10,907  |  
|Gain from disposal of businesses and
affiliated companies and changes
  in holdings in affiliated companies, net |  |                         | (23,328 | )    |   | (132,396 | ) |   | (25,754 | )
|Gain from sale of investments in available for
sale securities                                                   |  |                         | (56,515 | )    |   | (5,360   | ) |   | (17,924 | )
|Gain from disposal of businesses included in
discontinued operations                                             |  |                         | (213    | )    |   |         |   |   | (4,137  | )
|Depreciation and amortization                                                                                    |  |                         | 1,513   |      |   | 1,868    |   |   | 3,573   |  
|Impairment of intangible assets and property
and equipment                                                       |  |                         | 1,329   |      |   | 7,097    |   |   |        |  
|Impairment of goodwill                                                                                           |  |                         |        |      |   | 1,980    |   |   |        |  
|Decline in value of other
investments                                                                            |  |                         | 636     |      |   | 803      |   |   | 3,716   |  
|Equity in losses (gains) of
partnerships                                                                         |  |                         | (174    | )    |   | 7        |   |   | 547     |  
|Stock based compensation and changes in
liability in respect of call
  options                                   |  |                         | (811    | )    |   | 3,033    |   |   | 2,564   |  
|Deferred taxes, net                                                                                              |  |                         | (7,288  | )    |   | (2,409   | ) |   | 6,229   |  
|Changes in operating assets and
liabilities                                                                      |  |                         |         |      |   |          |   |   |         |  
|Decrease (increase) in trade
receivables                                                                         |  |                         | (947    | )    |   | (139     | ) |   | 3,491   |  
|Decrease (increase) in other receivables and
prepaid expenses                                                    |  |                         | (38     | )    |   | 88       |   |   | 1,888   |  
|Decrease (increase) in trading securities,
net                                                                   |  |                         | 4       |      |   | 5        |   |   | (4      | )
|Decrease (increase) in inventories and
contracts-in-progress                                                     |  |                         | (519    | )    |   | 333      |   |   | 589     |  
|Decrease in trade payables                                                                                       |  |                         | (834    | )    |   | (1,184   | ) |   | (2,009  | )
|Increase (decrease) in other payables and
accrued expenses (mainly
  provision for income taxes)                 |  |                         | (12,139 | )    |   | 16,935   |   |   | (5,275  | )
|Other                                                                                                            |  |                         | (753    | )    |   | (552     | ) |   | 652     |  
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|Net cash used in operating activities                                                                            |  |                         | (40,380 | )    |   | (9,412   | ) |   | (16,483 | )
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                                                             |  |                         |         |      |   |          |   |   |         |  
|Investment in affiliated companies                                                                               |  |                         | (3,823  | )    |   | (57,916  | ) |   | (14,884 | )
|Proceeds from sale of affiliated companies
shares                                                                |  |                         | 10,522  |      |   | 211,360  |   |   | 13,878  |  
|Cash and cash equivalents resulting from newly
consolidated
  subsidiaries(Schedule A)                           |  |                         |        |      |   | 247      |   |   |        |  
|Change in cash and cash equivalents resulting
from disposal of
  businesses (Schedule B)                         |  |                         | 1,800   |      |   |         |   |   | (4,648  | )
|Investment in other companies                                                                                    |  |                         | (27,651 | )    |   | (15,264  | ) |   | (299    | )
|Proceeds from sale of investments in other
companies                                                             |  |                         | 237     |      |   |         |   |   |        |  
|Proceeds from repayment of loan from an
affiliate                                                                |  |                         | 2,253   |      |   |         |   |   |        |  
|Collection of long term receivables                                                                              |  |                         |        |      |   |         |   |   | 772     |  
|Proceeds from sale of available for sale
securities                                                              |  |                         | 119,888 |      |   | 8,062    |   |   | 46,143  |  
|Investments in debentures and
deposits                                                                           |  |                         | (59,185 | )    |   | (105,378 | ) |   | (8,925  | )
|Investment in available for sale
securities                                                                      |  |                         | (35,405 | )    |   | (43,000  | ) |   | (1,952  | )
|Proceeds from maturities of held to maturity
debentures and deposits                                             |  |                         | 105,802 |      |   | 33,345   |   |   | 8,975   |  
|Purchase of property and equipment                                                                               |  |                         | (995    | )    |   | (728     | ) |   | (547    | )
|Proceeds from sale of property and
equipment                                                                     |  |                         | 197     |      |   |         |   |   | 329     |  
|Purchase of treasury stock from the minority
by a subsidiary                                                     |  |                         | (823    | )    |   |         |   |   |        |  
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|Net cash provided by investing activities                                                                        |  |                         | 112,817 |      |   | 30,728   |   |   | 38,842  |  
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                                                             |  |                         |         |      |   |          |   |   |         |  
|Proceeds from options exercised                                                                                  |  |                         | 697     |      |   | 2,097    |   |   | 177     |  
|Proceeds from exercise of options in a
subsidiary                                                                |  |                         | 8       |      |   |         |   |   |        |  
|Receipt of long-term loans from
banks                                                                            |  |                         |        |      |   | 519      |   |   | 4,032   |  
|Repayment of long-term loans                                                                                     |  |                         | (777    | )    |   | (50,677  | ) |   | (6,200  | )
|Decrease in short-term bank loan,
net                                                                            |  |                         | (1,079  | )    |   | (15,842  | ) |   | (4,076  | )
|Repayment of loans from minority shareholders
of a subsidiary                                                    |  |                         |        |      |   |         |   |   | (4,246  | )
|Receipt of short-term loans, convertible loans
and long-term loans
  from minority shareholders of a subsidiary  |  |                         | 1,003   |      |   | 1,539    |   |   | 3,959   |  
|Issuance expenses in a subsidiary                                                                                |  |                         | (75     | )    |   | (180     | ) |   |        |  
|Issuance of shares to the minority of a
subsidiary                                                               |  |                         | 145     |      |   |         |   |   |        |  
|Dividend paid                                                                                                    |  |                         | (88,450 | )    |   |          |   |   |         |  
|Dividend to minority shareholders of a
subsidiary                                                                |  |                         |        |      |   | (67      | ) |   |        |  
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|Net cash used in financing activities                                                                            |  |                         | (88,528 | )    |   | (62,611  | ) |   | (6,354  | )
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                                 |  |                         | (16,091 | )    |   | (41,295  | ) |   | 16,005  |  
|CASH AND CASH EQUIVALENTS AT THE BEGINNING OF THE YEAR                                                           |  |                         | 42,611  |      |   | 83,906   |   |   | 67,901  |  
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|                                                                                                                 |  |                         | 26,520  |      |   | 42,611   |   |   | 83,906  |  
|LESS CASH AND CASH EQUIVALEMENTS ATTRIBUTED TO DISCONTINUED
OPERATIONS                                           |  |                         |        |      |   | (514     | ) |   | (2,567  | )
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  
|CASH AND CASH EQUIVALENTS AT THE END OF THE YEAR                                                                 |  |                         | 26,520  |      | $ | 42,097   |   | $ | 81,339  |  
|                                                                                                                 |  |                         |         |      |   |          |   |   |         |  

The accompanying notes are an integral part of the consolidated
financial statements.

7

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|CONSOLIDATED STATEMENTS OF CASH FLOWS (Cont.)             
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                              |  |                         |        |      |   |       |  |   |       | 
|------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ----- |  | - | ----- | 
|                                                              |  | Year ended December 31, |       
|                                                              |  |                         |       
|                                                              |  | 2005                    |        | 2004 |   | 2003  | 
|                                                              |  |                         |        |      |   |       | 
|Supplemental
  cash flow information:                         |  |                         |        |      |   |       |  |   |       | 
|Cash paid during the year for:                                |  |                         |        |      |   |       |  |   |       | 
|Income taxes                                                  |  | $                       | 30,591 |      | $ | 172   |  | $ | 96    | 
|                                                              |  |                         |        |      |   |       |  |   |       | 
|                                                              |  |                         |        |      |   |       |  |   |       | 
|Interest                                                      |  | $                       | 203    |      | $ | 1,044 |  | $ | 1,466 | 
|                                                              |  |                         |        |      |   |       |  |   |       | 
|                                                              |  |                         |        |      |   |       |  |   |       | 
|Proceeds
  from sale of an affiliate not yet received         |  | $                       | 1,958  |      | $ |      |  | $ |      | 
|                                                              |  |                         |        |      |   |       |  |   |       | 
|                                                              |  |                         |        |      |   |       |  |   |       | 
|Proceeds
  from sale of an affiliate received in Zoran shares |  | $                       | 7,700  |      | $ |      |  | $ |      | 
|                                                              |  |                         |        |      |   |       |  |   |       | 

SCHEDULE A:

|                                                                                     |  |                         |      |      |   |        |   |   |   | 
|------------------------------------------------------------------------------------ |  | ----------------------- | ---- | ---- | - | ------ | - | - | - | 
|                                                                                     |  | Year ended December 31, |     
|                                                                                     |  |                         |     
|                                                                                     |  | 2005                    |      | 2004 |   | 2003   |  
|                                                                                     |  |                         |      |      |   |        |  
|Change in cash and cash equivalents resulting from
  newly consolidated subsidiaries |  |                         |      |      |   |        |   |   |   | 
|Assets and liabilities at date of
sale:                                              |  |                         |      |      |   |        |   |   |   | 
|Working capital deficiency, net (except cash
  and cash equivalents)                 |  | $                       | 75   |      | $ | 1,071  |   | $ |  | 
|Deposits                                                                             |  |                         |     |      |   | (31    | ) |   |  | 
|Property and equipment                                                               |  |                         | (14  | )    |   | (618   | ) |   |  | 
|Intangible assets                                                                    |  |                         | (237 | )    |   | (1,350 | ) |   |  | 
|Accrued severance pay, net                                                           |  |                         | 27   |      |   |       |   |   |  | 
|Long-term liabilities                                                                |  |                         |     |      |   | 431    |   |   |  | 
|Investment at equity prior to
acquisition                                            |  |                         |     |      |   | 678    |   |   |  | 
|Minority interests                                                                   |  |                         |     |      |   | 66     |   |   |  | 
|Liability incurred                                                                   |  |                         | 149  |      |   |       |   |   |  | 
|                                                                                     |  |                         |      |      |   |        |   |   |   | 
|                                                                                     |  |                         |      |      |   |        |   |   |   | 
|Cash and cash equivalents acquired                                                   |  | $                       |     |      | $ | 247    |   | $ |  | 
|                                                                                     |  |                         |      |      |   |        |   |   |   | 

SCHEDULE
B:

|                                                                            |  |      |       |      |   |      |  |   |         |  
|--------------------------------------------------------------------------- |  | ---- | ----- | ---- | - | ---- |  | - | ------- | -
|                                                                            |  | 2005 |       | 2004 |   | 2003 | 
|                                                                            |  |      |       |      |   |      | 
|Change in cash and cash equivalents resulting from
  disposal of businesses |  |      |       |      |   |      |  |   |         |  
|Assets and liabilities at date of
sale:                                     |  |      |       |      |   |      |  |   |         |  
|Working capital deficiency, net (except cash
  and cash equivalents)        |  | $    | (671  | )    | $ |     |  | $ | (708    | )
|Property and equipment                                                      |  |      | 40    |      |   |     |  |   | 1,274   |  
|Intangible assets                                                           |  |      | 2,389 |      |   |     |  |   | 6,532   |  
|Deferred tax liability                                                      |  |      |      |      |   |     |  |   | (907    | )
|Accrued severance pay, net                                                  |  |      | (171  | )    |   |     |  |   |        |  
|Gain resulting from sale of
businesses                                      |  |      | 213   |      |   |     |  |   | 22,833  |  
|Securities received:                                                        |  |      |       |      |   |      |  |   |         |  
|Marketable securities                                                       |  |      |      |      |   |     |  |   | (5,400  | )
|Other investments                                                           |  |      |      |      |   |     |  |   | (1,000  | )
|Investment in affiliated Company                                            |  |      |      |      |   |     |  |   | (30,272 | )
|Liability incurred                                                          |  |      |      |      |   |     |  |   | 3,000   |  
|                                                                            |  |      |       |      |   |      |  |   |         |  
|                                                                            |  |      |       |      |   |      |  |   |         |  
|Net increase (decrease) in cash and cash
equivalents                        |  | $    | 1,800 |      | $ |     |  | $ | (4,648  | )
|                                                                            |  |      |       |      |   |      |  |   |         |  

The accompanying notes are an integral part
of the consolidated
financial statements.

8

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|-------- | --------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 1:- | GENERAL                                                                                                                                      
|         |                                                                                                                                              
|         | a.                                                                                                                                            | Elron
  Electronic Industries Ltd. (Elron or the Company), an Israeli
  corporation, is high technology operational holding company. Elrons global
  business is conducted through subsidiaries and affiliates, primarily in the
  fields of medical devices, information and communication technology,
  semiconductors and advanced materials.                                                                                                                                  
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | b.                                                                                                                                            | On August 22, 2004
  Discount Investment Corporation Ltd. (DIC) completed a tender offer to
  purchase 7.5% of the Companys shares. In addition, in May 2005, DIC
  purchased additional 1.8% of the Companys shares. Following the consummation
  of the tender offer and the additional purchase of shares, DICs interest in
  the Company increased from approximately 38.5% to approximately 46% in 2004
  and to 47.5% in 2005 of the Companys outstanding shares.          
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES                                                                                                              
|         |                                                                                                                                              
|         | The
  financial statements have been prepared in accordance with accounting
  principles generally accepted in the United States (US GAAP).
|         |                                                                                                                                              
|         | The
  significant accounting policies followed in the preparation of the financial
  statements, applied on a consistent basis, are:         
|         |                                                                                                                                              
|         | a.                                                                                                                                            | Use of
  estimates                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               | The
  preparation of financial statements in conformity with generally accepted
  accounting principles requires management to make estimates and assumptions
  that affect the reported amounts of assets and liabilities and disclosure of
  contingent assets and liabilities at the date of the financial statements,
  and the reported amounts of income and expenses during the reported period.
  Actual results could differ from those estimates.                            
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | b.                                                                                                                                            | Financial
  statements in U.S. dollars                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               | The
  financial statements have been prepared in U.S. dollars, since the currency
  of the primary economic environment in which the operations of the Company,
  its principal subsidiaries and affiliates are conducted is the U.S. dollar.
  Most of the Companys assets and liabilities are in U.S. dollars and sales of
  its subsidiaries are mainly in U.S. dollars. Therefore, the functional and
  reporting currency of the Company and its subsidiaries is the U.S. dollar.
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               | Transactions
  and balances originally denominated in U.S. dollars are presented at their
  original amounts. Transactions and balances in other currencies have been
  remeasured into U.S. dollars in accordance with the principles set forth in
  Statement of Financial Accounting Standards (SFAS) No. 52, Foreign
  Currency Translation (SFAS 52).                                                                                                                       
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               | Accordingly,
  amounts in currencies other than U.S dollars have been translated as follows:                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               | Monetary
  balances - at the exchange rate in effect on the balance sheet date.                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               | Revenues and
  costs  at the exchange rates in effect as of the date of recognition of the
  transactions.                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                               | All exchange
  gains and losses from the remeasurement mentioned above are reflected in the
  statement of operations in financial income, net.                                                                                                                                                                                                                                                                                                                                        

9

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-------- | --------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | b.                                      | Financial
  statements in U.S. dollars (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         | The
  financial statements of an affiliate accounted for under the equity method,
  whose functional currency is not the U.S. dollar, have been translated into
  dollars in accordance with SFAS 52. All balance sheet accounts have been
  translated using the exchange rate in effect at the balance sheet date.
  Statement of income amounts have been translated using average exchange rates
  prevailing during the year. The resulting aggregate translation adjustments
  are reported as a component of accumulated other comprehensive income in
  shareholders equity.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | c.                                      | Principles
  of consolidation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         | The
  consolidated financial statements include the accounts of the Company and its
  subsidiaries, in which the Company has a controlling voting interest and of
  VIEs for which the Company is the primary beneficiary according to the
  provisions of FIN 46, as described below. Inter-company balances and
  transactions have been eliminated upon consolidation.                                                                                                                                                                                                            
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         | In December 2003, the
  Financial Accounting Standards Board (FASB) issued Interpretation No.
  46(R), Consolidation of Variable Interest Entities, an Interpretation of ARB
  No. 51 (FIN 46). FIN 46 provides a new framework for identifying variable
  interest entities (VIE) and determining when a company should include the
  assets, liabilities, noncontrolling interests and results of activities of a
  VIE in its consolidated financial statements.                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         | In general, a VIE is a
  corporation, partnership, limited-liability corporation, trust, or any other
  legal structure used to conduct activities or hold assets that either (1) has
  an insufficient amount of equity to carry out its principal activities
  without additional subordinated financial support, (2) has a group of equity
  owners that is unable to make significant decisions about its activities, or
  (3) has a group of equity owners that does not have the obligation to absorb
  losses or the right to receive returns generated by its operations.    
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         | FIN 46 requires a VIE to
  be consolidated by the party with an ownership, contractual or other
  financial interest in the VIE (a variable interest holder) that will absorb a
  majority of the risk of loss from the VIEs activities, is entitled to
  receive a majority of the VIEs residual returns (if no other variable
  interests absorb a majority of the VIEs losses), or both.                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         | A variable interest holder
  that consolidates the VIE is called the primary beneficiary. Upon
  consolidation, the primary beneficiary generally must initially record all of
  the VIEs assets, liabilities and noncontrolling interests at fair value and
  subsequently account for the VIE as if it were consolidated based on a
  majority voting interest. FIN 46 also requires disclosures about VIEs that
  the variable interest holder is not required to consolidate but in which it
  has a significant variable interest.                                             
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         | FIN 46 was effective
  immediately for VIEs created after January 31, 2003. For VIEs created before
  January 31, 2003, the provisions of FIN 46, as revised, were adopted as of
  March 31, 2004. The adoption of FIN 46 did not have a material effect on the
  companys financial statements.                                                                                                                                                                                                                                                                                    

10

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                               
|-------- | --------------------------------------- | --------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | c.                                      | Principles
  of consolidation (Cont.)                                                                         
|         |                                         |                                                                                                               
|         |                                         | As of the
  balance sheet date the significant subsidiaries whose balances and results
  are consolidated are:

| |                                                                                    |  |                                           |       |      |  |  |       |  | 
| | ---------------------------------------------------------------------------------- |  | ----------------------------------------- | ----- | ---- |  |  | ----- |  | 
| |                                                                                    |  | December
  31,                            |      
| |                                                                                    |  |                                           |      
| |                                                                                    |  | 2005                                      |       | 2004 | 
| |                                                                                    |  |                                           |       |      | 
| |                                                                                    |  | Consolidated%of outstanding share capital |      
| |                                                                                    |  |                                           |      
| |                                                                                    |  |                                           |       |      |  |  |       |  | 
| |                                                                                    |  |                                           |       |      |  |  |       |  | 
| | Elbit Ltd. (Elbit)                                                               |  |                                           | 100.0 |      |  |  | 100.0 |  | 
| | DEP Technology Holdings Ltd. (DEP)                                               |  |                                           | 100.0 |      |  |  | 100.0 |  | 
| | RDC Rafael Development Corporation Ltd.
  (RDC)                                  |  |                                           | 50.1  |      |  |  | 49.6  |  | 
| | Elron Telesoft Ltd. and Elron Telesoft
  Export Ltd. (together the ET group)     |  |                                           |      |      |  |  | 100.0 |  | 
| | Galil Medical Ltd. (Galil)                                                       |  |                                           | 59.1  |      |  |  | 59.1  |  | 
| | Mediagate Ltd.
  (Mediagate)                                                     |  |                                           | 100.0 |      |  |  | 100.0 |  | 
| | SELA Semiconductors
  Engineering Laboratories Ltd. (SELA)                       |  |                                           | 66.2  |      |  |  | 54.4  |  | 
| | Starling Advanced Communications Ltd.
  (Starling)                               |  |                                           | 66.5  |      |  |  | 66.5  |  | 
| | 3DV Systems Ltd. (3DV)                                                           |  |                                           | 88.7  |      |  |  | 94.8  |  | 
| | Enure Networks Ltd. (Enure) (formerly
  Gaia broadband services management Ltd.) |  |                                           | 57.2  |      |  |  |      |  | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | d. | Business
  combinations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |    | Business
  combinations have been accounted for using the purchase method of accounting.
  Under the purchase method of accounting the results of operations of the
  acquired business are included from the effective date of acquisition. The
  costs to acquire companies, including transactions costs, have been allocated
  to the underlying net assets of each acquired company in proportion to their
  respective fair values. Any excess of the purchase price over estimated fair
  values of the identifiable net assets acquired has been recorded as goodwill.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | e. | Cash and
  cash equivalents                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |    | Cash and
  cash equivalents are short-term highly liquid investments that are readily
  convertible to cash with original maturities of three months or less at the
  date acquired.                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | f. | Bank
  deposits                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |    | Bank
  deposits with original maturities of more than three months but less than one
  year are presented as part of short-term investments. Deposits are presented
  at their cost including accrued interest. Interest on deposits is recorded as
  financial income.                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | g. | Marketable
  securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |    | Management
  determines the classification of marketable investments in debt securities
  with fixed maturities and marketable equity securities at the time of
  purchase and reevaluates such designations at each balance sheet date.                                                                                                                                                                                                                                                                                                                                      

11

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-------- | --------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | g.                                      | Marketable
  securities (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         | Certain
  marketable securities covered by SFAS No. 115 Accounting for Certain
  Investments in Debt and Equity Securities, (SFAS 115) are classified as
  available-for-sale. Accordingly, these securities are measured at fair value,
  with unrealized gains and losses reported net-of-tax in accumulated other
  comprehensive income, a separate component of shareholders equity. Realized
  gains and losses on sales of investments, and a decline in value which is
  considered as other than temporary, are included in the consolidated
  statement of operations. The Company considers a decline in value to be other
  than temporary with regard to available-for-sale marketable debentures when
  the fair value is lower than cost for a continuing period which exceeds six
  months and when the Company does not intend to hold the debentures until
  maturity. When computing realized gain or loss, cost is
  determined on an average basis. Interest and amortization of premium and
  discount on debt securities are recorded as financial income.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         | Debt
  securities, which the Company has the positive intent and ability to hold to
  maturity, are classified as held-to-maturity investments. Held-to-maturity
  investments are measured at amortized cost plus accrued interest. Interest
  and amortization of premium and discount on such debt securities are recorded
  as financial income.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         | h.                                      | Inventories
  and contracts in progress                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         | Inventories
  are stated at the lower of cost or market value. Inventory write-offs are
  provided for slow-moving items and technological obsolescence.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         | Cost is
  determined as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|        
|         |                                         | Raw
  materials - using the first in, first out method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|        
|         |                                         | Contracts-in-progress
  (included in assets attributed to discontinued operations) - represent
  amounts related to contracts as determined by the percentage of completion
  method of accounting.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|        
|         |                                         | Finished
  Products  on the basis of direct manufacturing costs with the additional of
  allocable indirect manufacturing costs, with cost measured on an average
  basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         | i.                                      | Investments
  in companies                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         | Investments
  in common stock or in-substance-common stock of entities in which the Company
  has significant influence but less than a controlling voting interest are
  accounted for using the equity method (affiliated companies) (see below for
  provisions of EITF 02-14). Significant influence is presumed to exist when
  the Company holds between 20%-50% of the investees voting stock. However,
  whether or not the Company has significant influence depends on evaluation of
  certain factors including among others, the Companys representation on the
  investees board of directors, agreements with other shareholders, additional
  voting rights, participation in policy making processes, existence of
  material intercompany transactions and technological dependency and the
  extent of ownership by the Company in relation to the concentration of other
  shareholders.                                                                                                                                                                      
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         | The Company
  discontinues applying the equity method when its investment (including
  advances and loans) is reduced to zero and it has not guaranteed obligations
  of the affiliate or is not otherwise committed to provide further financial
  support to the affiliate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

12

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-------- | --------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | i.                                      | Investments
  in companies (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | In July
  2004, the EITF reached a consensus on Issue No. 02-14, Whether an Investor
  Should Apply the Equity Method of Accounting to Investments Other Than Common
  Stock (EITF 02-14).EITF 02-14 states that the Company must apply the equity method of
  accounting to investments in common stock and in in-substance-common stock if it has the ability to exercise
  significant influence over the operating and financial policies of the
  investee.                                                                                                                                                                                                                                                                                                                                                       
|        
|         |                                         | EITF 02-14
  defines in-substance-common stock as an investment with similar riskand reward characteristics to common
  stock. The provisions of EITF 02-14 are effective since the beginning of the
  fourth quarter of 2004. For investments that are not common stock or
  in-substance-common stock, but were accounted for under the equity method
  prior to the effective date of EITF 02-14, the equity method of accounting
  should be discontinued at the effective date. Previously recognized equity
  method earnings and losses were not reversed. Upon adoption of EITF 02-14,
  the Company evaluated all of its investments at the adoption date and
  concluded that no change should be made to its then implemented accounting
  treatment as a result of the adoption of EITF 02-14.                 
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | The Company applies EITF
  02-18 Accounting for Subsequent Investments in an Investee after suspension
  of Equity Method Loss Recognition (EITF 02-18) in cases where the Company
  suspended equity method loss recognition in a certain investee, and it
  subsequently invests in the aforementioned investee (not resulting in the
  ownership interest increasing from one of significant influence to one of
  control), if the additional investment, in whole or in part, represents, in
  substance, the funding of prior losses, the Company recognizes previously
  suspended losses up to the amount of the additional investment determined to
  represent the funding of prior losses. Whether the investment represents the
  funding of prior losses, however, depends on the facts and circumstances.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | In circumstances where the
  Companys ownership in an affiliate is in the form of a preferred security or
  other senior security, the Company recognizes losses based on the ownership
  level of the particular affiliates security or loan held by the Company to
  which the equity method losses are being applied.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | The excess
  of the purchase price over the proportional fair value of net tangible assets
  acquired is attributed to goodwill, technology and other identifiable
  intangible assets. Technology and other identifiable intangible assets are
  amortized over a weighted averaged period of approximately 14 years,
  commencing from the acquisition date.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | Gains
  arising from issuance of shares by affiliated companies to third parties are
  recorded as income in the consolidated statements of operations, unless the
  issuing company is a development stage company for which the gain (loss) from
  issuance is accounted for as an equity transaction pursuant to Staff
  Accounting Bulletin (SAB) No. 51 Accounting for Sales of Stock by a
  Subsidiary.                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | When an investment
  in common stock or in-substance common stock, that was previously accounted
  for on other than the equity method, becomes qualified for use of the equity
  method by an increase in level of ownership, the equity method of accounting
  is adopted retroactively and financial statements of prior periods are
  adjusted accordingly.                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | Investments
  in partnerships in which the Company has a greater than five percent
  interest, are accounted for under the equity method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

13

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|           |                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|---------- | ----------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE
  2:- | SIGNIFICANT
  ACCOUNTING POLICIES (Cont.)
|           |                                          
|           | i.                                        | Investments
  in companies (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|           |                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|           |                                           | Investments
  in non-marketable securities of companies, in which the Company does not have
  the ability to exercise significant influence over their operating and
  financial policies, and investments in non-marketable companies that are not
  common stock or in-substance-common stock, are presented at cost.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|           |                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|           |                                           | Management
  evaluates investments in affiliates and other companies for evidence of other
  than temporary declines in value. When relevant factors indicate a decline in
  value that is other than temporary, the Company records a provision for the
  decline in value. A judgmental aspect of accounting for investments involves
  determining whether an other-than-temporary decline in value of the
  investment has been sustained. Such evaluation is dependent on the specific
  facts and circumstances. Accordingly, management evaluates financial
  information (e.g. budgets, business plans, financial statements, etc.) in
  determining whether an other-than-temporary decline in value exists. Factors
  indicative of an other-than-temporary decline include recurring operating
  losses, failure of research and development efforts, extremely negative
  deviation from the business plan, credit defaults, specific conditions
  affecting the investment such as in the industry or in geographic area and
  subsequent rounds of financings at an amount below the cost basis of the
  investment. This list is not all inclusive and management weighs all
  quantitative and qualitative factors in determining if an
  other-than-temporary decline in value of an investment has occurred.
|           |                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|           | j.                                        | Property and
  equipment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|           |                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|           |                                           | Property and
  equipment are stated at cost, net of accumulated depreciation and investment
  grants. Depreciation is calculated by the straight-line method over the
  estimated useful lives of the assets at the following annual rates:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

| |                                    |  |                            | 
| | ---------------------------------- |  | -------------------------- | 
| |                                    |  | %                          | 
| |                                    |  |                            | 
| | Land and Buildings                 |  | 0 - 4                      | 
| | Computers, Machinery and Furniture |  | 6 - 33                     | 
| | Motor vehicles                     |  | 15                         | 
| | Leasehold improvements             |  | over the term of the lease | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | k. | Impairment
  and disposal of long-lived assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    | The Company
  and its subsidiaries long-lived assets (including identifiable intangible
  assets subject to amortization) are reviewed for impairment in accordance
  with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
  Assets (SFAS 144), whenever events or changes in circumstances indicate
  that the carrying amount of an asset may not be recoverable. Recoverability
  of assets to be held and used is measured by a comparison of the carrying
  amount of an asset to the future undiscounted cash flows expected to be
  generated by the asset. If an asset is considered to be impaired, the
  impairment is measured by the difference between the carrying amount of the
  asset and its fair value. Assets to be disposed of are reported at the lower
  of their carrying amount or fair value less costs to sell.
|
| |    | See Note 3c
  regarding impairment of intangible assets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

14

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-------- | --------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | l.                                      | Intangible
  assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | Intangible
  assets include mainly technology, goodwill and other identifiable intangible
  assets acquired in connection with the purchase of subsidiaries and
  businesses. Technology and other identifiable intangible definite lived
  assets are amortized over their estimated useful lives.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | The Company
  evaluates the amortization periods of all identifiable intangible assets to
  determine whether events or circumstances warrant revised estimates of useful
  lives.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | Under SFAS
  No. 142 Goodwill and other Intangible Assets (SFAS 142) goodwill and
  intangible assets with indefinite lives are no longer amortized but instead
  are tested for impairment at least annually (or more frequently if impairment
  indicators arise).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | SFAS 142
  prescribes a two phase process for impairment testing of goodwill. The first
  phase screens for impairment; while the second phase (if necessary) measures
  impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         | In the first
  phase of impairment testing, goodwill attributable to each of the reporting
  units is tested for impairment by comparing the fair value of each reporting
  unit with its carrying value. If the carrying value of the reporting unit
  exceeds its fair value the second phase is then performed. The second phase
  of the goodwill impairment test compares the implied fair value of the
  reporting units goodwill with the carrying amount of that goodwill. If the
  carrying amount of the reporting units goodwill exceeds the implied fair
  value of that goodwill, an impairment loss is recognized in an amount equal
  to that excess. The implied fair value of goodwill is determined in the same
  manner as the amount of goodwill recognized in a business combination. That
  is, the fair value of the reporting unit is allocated to all of the assets
  and liabilities of that unit (including any unrecognized intangible assets)
  as if the reporting unit had been acquired in a business combination and the
  fair value of the reporting unit was the purchase price paid to acquire the
  reporting unit.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | Fair value
  of the companys reporting unit is determined using market capitalization.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | In 2004 and
  in the second quarter of 2005 when performing the first phase of the goodwill
  impairment test, the fair value of the systems and projects segment
  (reporting unit) of the ET group, which is included in discontinued
  operations, was found to be lower than its carrying value. Therefore the
  second phase of the goodwill impairment test was then performed and as a
  result goodwill was written down by $1,980 in 2004 and $1,300 in 2005. The
  fair value of the reporting unit was determined using the discounted cash
  flow method. Significant estimates used in the discounted cash flow
  methodology include estimates of future cash flows, future short-term and
  long-term growth rates and discount rates. The Company performs its annual
  impairment tests during the fourth fiscal quarter of each year.                                                                                                                                                                                                                                                                                                    
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | The
  impairment test for other intangible assets not subject to amortization
  consists of a comparison of the fair value of the intangible asset with its
  carrying value. If the carrying value of the intangible asset exceeds its
  fair value, an impairment loss is recognized in an amount equal to that excess.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | m.                                      | Revenue
  recognition                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         | The
  Companys subsidiaries sell software license, support systems products and
  disposable medical products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

15

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-------- | --------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | m.                                      | Revenue
  recognition (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | The ET group
  generated revenues from sale of software, license and support systems, which
  are included in discontinued operations. Software sales are accounted for in
  accordance with Statement of Position (SOP) 97-2, Software Revenue
  Recognition, as amended. Other product sales and revenues are accounted for
  in accordance with SAB No. 104, Revenue Recognition in Financial Statements
  (SAB 104).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Revenues
  from license fees or product sales are recognized when delivery of the
  product has occurred, the fee is fixed or determinable, collectibility is
  probable and persuasive evidence of an arrangement exists.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | When the
  products are warranted, a provision is recorded for probable costs, in
  connection with the warranties, based on the Companys subsidiaries
  experience and estimates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Revenues
  from software licenses that require significant customization, integration
  and installation (included in discontinued operations) are recognized based
  on SOP 81-1, Accounting for Performance of Construction Type and Certain
  Production - Type Contracts, according to which revenues are recognized on a
  percentage of completion basis. Percentage of completion is measured by the
  efforts expended method based on the ratio of hours performed to date to
  estimated total hours at completion. Anticipated losses on contracts are
  charged to earnings when identified. Estimated gross profit or loss from
  contracts may change due to changes in estimates resulting from differences
  between actual performance and original forecasts. Such changes in estimated
  gross profit are recorded in results of operations when they are reasonably
  determinable by management, on a cumulative catch-up basis. Revenues derived
  from software licensing arrangements based on new technology, in which the
  Companys subsidiary does not have sufficient prior experience and estimates
  are not reasonably determinable, are recognized using the completed-contract
  method.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Deferred
  revenues include unearned amounts received under maintenance and support
  contracts and amounts received from customers but not recognized as revenues.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Revenues
  from service agreement on a cost plus basis are recognized as the services
  are performed, based on the costs incurred.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | n.                                      | Research and
  development costs                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Research and
  development costs, net of grants received, are charged to the statement of
  operations as incurred. SFAS No. 86, Accounting for the Costs of Computer
  Software to be Sold, Leased or Otherwise Marketed requires capitalization of
  certain software development costs subsequent to the establishment of
  technological feasibility. Based on the subsidiaries product development
  process, technological feasibility is established upon completion of a
  working model. Costs, incurred by the Companys subsidiaries between
  completion of the working models and the point at which the products are
  ready for general release, have been insignificant. Therefore, research and
  development costs are charged to the statement of operations, as incurred.                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | o.                                      | Advertising
  costs                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Advertising
  costs are charged to the consolidated statement of operations as incurred.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

16

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|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|-------- | --------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | p.                                      | Royalty-bearing
  grants                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | Royalty-bearing
  grants from the Government of Israel and other governmental institutions for
  funding approved research and development projects are recognized at the time
  the Company is entitled to such grants, on the basis of the costs incurred.
  Such grants are included as a deduction of research and development costs,
  since at the time received it is not probable that they will be repaid.                                                                                                                                                                                                                                                                                                                              
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | Research and
  development grants received by certain of the Companys subsidiaries in 2005
  amounted to $1,528 (2004 - $1,535, 2003 - $382).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | Research and
  development grants received by the ET group, which are presented in the
  discontinued operations in 2005 amounted to $0 (2004 - $181, 2003 - $105).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         | q.                                      | Income taxes                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | The Company
  and its subsidiaries account for income taxes in accordance with SFAS No.
  109, Accounting for Income Taxes. This Statement prescribes the use of the
  liability method whereby deferred tax assets and liability account balances
  are determined based on differences between financial reporting and tax bases
  of assets and liabilities, using the enacted tax rates and laws that will be
  in effect when the differences are expected to reverse. The Company and its
  subsidiaries provide a valuation allowance, if necessary, to reduce deferred
  tax assets to the amount that is more likely than not to be realized.                                                                                         
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         | r.                                      | Income
  (loss) per share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | Basic net
  income (loss) per share is computed based on the weighted average number of
  ordinary shares outstanding during each year. Diluted net income (loss) per
  share is computed based on the weighted average number of ordinary shares and
  ordinary share equivalents outstanding during the year; ordinary share
  equivalents are excluded from the computation if their effect is
  anti-dilutive.                                                                                                                                                                                                                                                                                                                               
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | In 2003, all
  shares relating to the outstanding stock options were excluded from the
  calculation of the diluted net loss per ordinary share because all such stock
  options were anti-dilutive. The total ordinary share equivalents relating to
  the outstanding options, excluded from the calculations of diluted net loss
  per share, were 1,799 for the year ended December 31, 2003.                                                                                                                                                                                                                                                                                                                                                
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         | s.                                      | Stock based
  compensation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | For stock
  options granted prior to 2003, the Company has elected to follow Accounting
  Principles Board Opinion No. 25, Accounting for Stock Issued to Employees
  (APB 25) and the FASB Interpretation No. 44, Accounting for Certain
  Transactions Involving Stock Compensation in accounting for its employee
  stock option plans. According to APB 25, compensation expense is measured
  under the intrinsic value method, whereby compensation expense is equal to
  the excess, if any, of the quoted market price of the stock over the exercise
  price at the grant date of the award or if applicable at a subsequent
  measurement date. Compensation cost is recorded over the vesting period on a
  straight line basis.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                         | Effective
  January 1, 2003 the Company adopted the fair value recognition provisions of
  FASB Statement No.123, Accounting for Stock-Based Compensation (SFAS
  123). Under the prospective method of adoption selected by the company under
  the provisions of FASB Statement No.148, Accounting for Stock-Based
  Compensation - Transition and Disclosure (SFAS 148), the fair value
  recognition provisions were applied to all employee awards granted, modified,
  or settled after January 1, 2003. Compensation cost is recorded over the
  vesting period on a straight line basis.                                                                                                                                         

17

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------- | --------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | s.                                      | Stock based
  compensation (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                         | The expense
  related to stock-based employee compensation included in the determination of
  net income (loss) for 2005, 2004 and 2003 is less than that which would have
  been recognized if the fair value method had been applied to all awards
  granted after the original effective date of SFAS 123. If the Company, its
  subsidiaries and its affiliated companies had elected to adopt the fair value
  recognition provisions of SFAS 123 as of its original effective date, pro
  forma net income (loss) and pro forma basic and diluted net income (loss) per
  share would be as follows:

| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| | ----------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ |  | - | ------ | -
| |                                                                                                                         |  | Year ended
  December 31, |       
| |                                                                                                                         |  |                           |       
| |                                                                                                                         |  | 2005                      |        | 2004 |   | 2003   | 
| |                                                                                                                         |  |                           |        |      |   |        | 
| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| | Net income (loss), as reported                                                                                          |  | $                         | 47,335 |      | $ | 84,133 |  | $ | (7,205 | )
| | Add: Stock-based employee compensation
  expense included in reported net income (loss)                                 |  |                           | 347    |      |   | 202    |  |   | 1,030  |  
| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| | Deduct: Total stock-based employee
  compensation expense determined under the fair value based method for all
  awards |  |                           | 2,739  |      |   | 2,981  |  |   | 3,094  |  
| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| | Pro forma net
  income (loss)                                                                                           |  | $                         | 44,943 |      | $ | 81,354 |  | $ | (9,269 | )
| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| | Income (loss) per share:                                                                                                |  |                           |        |      |   |        |  |   |        |  
| | Basic - as reported                                                                                                     |  | $                         | 1.61   |      | $ | 2.87   |  | $ | (0.25  | )
| | Basic - pro forma                                                                                                       |  |                           | 1.53   |      |   | 2.78   |  |   | (0.32  | )
| |                                                                                                                         |  |                           |        |      |   |        |  |   |        |  
| | Diluted - as reported                                                                                                   |  |                           | 1.60   |      |   | 2.86   |  |   | (0.25  | )
| | Diluted - pro forma                                                                                                     |  |                           | 1.52   |      |   | 2.77   |  |   | (0.32  | )

| |  |                                                                                                                                                                                                             
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The fair
  value of stock options for the company was estimated at the date of grant
  using a Black-Scholes option-pricing model with the following
  weighted-average assumptions for 2005, 2004 and 2003:

| |                              |  |      |      |      |  |      |     |   |  |  |     |   | 
| | ---------------------------- |  | ---- | ---- | ---- |  | ---- | --- | - |  |  | --- | - | 
| |                              |  | 2005 |      | 2004 |  | 2003 |    
| |                              |  |      |      |      |  |      |    
| |                              |  |      |      |      |  |      |     |   |  | 
| | Risk-free
  Interest Rate    |  |      | 4.75 | %    |  |      | 2.5 | % |  |  | 1   | % | 
| |                              |  |      |      |      |  |      |     |   |  |  |     |   | 
| | Expected
  Dividend Yield *) |  |      | 0    | %    |  |      | 0   | % |  |  | 0   | % | 
| |                              |  |      |      |      |  |      |     |   |  |  |     |   | 
| | Expected
  Volatility        |  |      | 38   | %    |  |      | 42  | % |  |  | 53  | % | 
| |                              |  |      |      |      |  |      |     |   |  |  |     |   | 
| | Expected
  Lives             |  |      | 2.8  |      |  |      | 2.8 |   |  |  | 2.7 |   | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | *) | According to
  the Companys option plan, the exercise price is to be reduced in the event
  of a distribution of a dividend in the amount of the dividend distributed per
  share. Accordingly, the Company, when calculating fair value of the options
  based on the Black-Scholes option-pricing model, assumes a 0% dividend yield.
  Consequently, when such a reduction in exercise occurs, there is no
  accounting consequence.

18

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-------- | --------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | s.                                      | Stock based
  compensation (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | The
  Companys additional disclosures required by SFAS 123 and SFAS 148 are
  provided in Note 16.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Call options
  granted to employees to purchase shares in subsidiaries, affiliates and other
  companies are recorded at fair value using the Black-Scholes option-pricing
  model. The fair value of the option is recorded as a liability and changes in
  the liability are recorded as compensation expenses in general and
  administrative expenses.                                                                                                                                                                                                                                                                                                                                   
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | t.                                      | Comprehensive
  income                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Comprehensive
  income consists of net income (loss) and other gains and losses affecting
  shareholders equity that under generally accepted accounting principles are
  excluded from the net income (loss). For the Company, such items consist of
  unrealized gains and losses on available for sale securities and foreign
  currency translation adjustments (See Note 24).                                                                                                                                                                                                                                                                                                           
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | u.                                      | Severance
  pay                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | The
  Companys and its subsidiaries liability for severance pay, with respect to
  their Israeli employees, is calculated pursuant to Israeli severance pay law
  and employee agreements based on the most recent salary of the employees. The
  Companys liability for all of its Israeli employees is fully provided for by
  monthly deposits with insurance policies and by an accrual. The value of
  these policies is recorded as an asset in the Companys balance sheet.                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | The
  deposited funds include profits accumulated up to the balance sheet date. The
  deposited funds may be withdrawn only upon the fulfillment of the obligations
  pursuant to Israeli severance pay law or labor agreements. The value of the
  deposited funds is based on the cash surrender value of these policies, and
  includes immaterial profits.                                                                                                                                                                                                                                                                                                                               
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Severance
  pay expenses for the years ended December 31, 2005, 2004 and 2003 amounted to
  $354, $816 and $611, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Severance
  pay expenses for the years ended December 31, 2005, 2004 and 2003 presented
  in the discontinued operations amounted to $28, $62 and $120, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | v.                                      | Discontinued
  operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | Under SFAS
  144, when a component of an entity, as defined in SFAS 144, has been disposed
  of or is classified as held for sale, the results of its operations,
  including the gain or loss on its disposal should be classified as
  discontinued operations and the assets and liabilities of such component
  should be classified as assets and liabilities attributed to discontinued
  operations, that is provided that the operations, assets and liabilities and
  cash flows of the component have been eliminated from the Companys
  consolidated operations and the Company will no longer have any significant
  continuing involvement in the operations of the component.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | w.                                      | Fair value
  of financial instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         | SFAS No.
  107, Disclosure about Fair Value of Financial Instruments, requires disclosure
  of an estimate of the fair value of certain financial instruments. The
  Companys financial instruments consist of cash and cash equivalents,
  marketable securities, short-term deposits and debentures, trade receivables,
  other receivables, trade payables, other payables and short-term and
  long-term bank loans. The estimated fair value of these financial instruments
  approximates their carrying value as of December 31, 2005 and 2004, unless
  otherwise                                                                                                                 

19

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-------- | --------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | w.                                      | Fair value
  of financial instruments (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         | stated. The
  estimated fair values have been determined through information obtained from
  market sources and management estimates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         | It was not
  practical to estimate the fair value of the Companys investments in shares
  and loans of non-public affiliates and other companies because of the lack of
  a quoted market price or without incurring excessive costs. The carrying
  amounts of these companies were $75,143 and $64,146 at December 31, 2005 and
  2004, respectively, and they represent the original cost, net of any
  impairment charges, and in the case of affiliates also the Companys equity
  in the losses of the affiliates and its share in the changes of the
  affiliates equity, since the dates of acquisition.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | x.                                      | Concentrations
  of credit risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         | Financial
  instruments that potentially subject the Company and its subsidiaries to
  concentrations of credit risk consist principally of cash and cash
  equivalents, short-term bank deposits, marketable debentures and trade
  receivables.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         | Cash and
  cash equivalents and bank deposits are invested mainly in U.S. dollars with
  major banks in the United States and Israel. Marketable debentures are mainly
  debentures of U.S. government agencies with high credit quality and with
  limited amount of credit exposure to any corporation. Accordingly, the
  Companys management believes that minimal credit risk exists with respect to
  these investments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         | Trade
  receivables are derived from sales to major customers located primarily in
  the U.S and in Asia. The Companys subsidiaries perform ongoing credit
  evaluations of their customers and obtain letters of credit and bank
  guarantees for certain receivables. An allowance for doubtful accounts is
  determined with respect to those amounts that were determined to be doubtful
  of collection and a general allowance is provided to cover additional
  potential exposures.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         | As of the
  balance sheet date there is no significant off-balance-sheet concentration of
  credit risk such as foreign exchange contracts, option contracts or other
  foreign hedging arrangements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | y.                                      | Recently
  issued accounting pronouncements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                         | i.     In May 2005,
  the FASB issued SFAS No. 154 Accounting Changes and Errors Corrections
  (FAS 154). FAS 154 replaces APB No. 20 accounting changes (APB 20) and
  SFAS No. 3 Reporting Accounting changes in Interim Financial Statements.
  FAS 154 applies to all voluntary changes in accounting principle, and changes
  the accounting for and reporting of a change in accounting principle. FAS 154
  requires, unless impracticable, retrospective application as the required
  method for reporting a change in accounting principle in the absence of
  explicit transition requirements specific to the newly adopted accounting
  principle. This statement also provides guidance for determining whether
  retrospective application of a change in accounting principle is
  impracticable and for reporting a change when retrospective application is
  impracticable. APB 20 previously required that most voluntary changes in
  accounting principle be recognized by including in net income of the period
  of the change the cumulative effect of changing to the new accounting
  principle. FAS 154 is effective for accounting changes and corrections of
  errors made in fiscal years beginning after December 15, 2005. There is no
  effect on the Companys financial position and results of operations.

20

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------- | --------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | y.                                      | Recently
  issued accounting pronouncements (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                         | ii.          In
  November 2005, the FASB issued FSP (FASB staff positions) FAS 115-1. The
  FSP addresses the determination as to when an investment is considered impaired,
  whether that impairment is other than temporary, and the measurement of an
  impairment loss. The FSP also includes accounting considerations subsequent
  to the recognition of other than-temporary impairment and requires certain
  disclosures about unrealized losses that have not been recognized as
  other-than-temporary impairments. The guidance in this FSP amends FASB
  Statements No. 115, Accounting for Certain Investments in Debt and Equity.
  The FSP replaces the impairment evaluation guidance of EITF Issue No. 03-1,
  The Meaning of other-than-Temporary Impairment and its Application to
  Certain Investments, with references to the existing other-than-temporary
  impairment guidance. The FSP clarifies that an investor should recognize an
  impairment loss no later than when the impairment is deemed
  other-than-temporary, even if a decision to sell an impaired security has not
  been made. The guidance in this FSP is to be applied to reporting periods
  beginning after December 15, 2005. The Company does not expect that the
  adoption of FSP FAS 115-1 will have a material effect on its financial
  position or results of operations.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                         | iii.          On
  December 16, 2004 the FASB issued FASB Statement No. 123 (revised 2004),
  Share-Based Payment (SFAS 123(R)), which is a revision of SFAS 123. SFAS
  123(R), supersedes APB 25, and amends FASB Statement No. 95, Statements of
  Cash Flows. Generally, the approach in SFAS 123(R) is similar to the
  approach described in SFAS 123. However, SFAS 123(R) requires all share-based
  payments to employees, including grants of employee stock options, to be
  recognized in the income statement based on their fair values. Pro forma
  disclosure is no longer an alternative. SFAS 123(R) was to have been
  effective as of the beginning of the first interim or annual reporting period
  that commences after June 15, 2005 (July 1, 2005 for the Company); however,
  on April 14, 2005, the United States Securities and Exchange Commission
  (SEC) delayed effectiveness of FAS 123(R) for companies with fiscal years
  ending December 31, 2005 (such as the Company) to January 1, 2006.                                                                                                                                                                                                                                                                                                                                                  
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                         | SFAS
  123(R) permits public companies to adopt its requirements using one of two
  methods:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                         
| |  | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 1. | A
  modified prospective method in which compensation cost is recognized beginning
  with the effective date (a) based on the requirements of SFAS 123(R) for all
  share-based payments granted after the effective date and (b) based on the
  requirements of SFAS 123 for all awards granted to employees prior to the
  effective date of SFAS 123(R) that remain unvested on the effective date.
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                         
| |  | 2. | A
  modified retrospective method which includes the requirements of the
  modified prospective method described above, but also permits entities to
  restate based on the amounts previously recognized under SFAS 123 for purpose
  of pro forma disclosures all prior periods presented.                                                                                                          

| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The
  company plans to adopt SFAS 123(R) using the modified-prospective method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | The
  Company adopted the fair-value-based method of accounting for share-based
  payments effective January 1, 2003 using the prospective method described in
  SFAS 148.                                                                                                                                                                                                                                                                                                                                                                              
| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Because
  SFAS 123(R) must be applied not only to new awards but also to previously
  granted awards that are not fully vested on the effective date, and because the
  Company adopted SFAS 123 using the prospective transition method (which
  applied only to award granted, modified or settled after the adoption date),
  compensation cost for some previously granted awards that were not recognized
  under SFAS 123 will be recognized under SFAS 123(R). However, had the Company
  adopted SFAS 123(R) in prior periods, the impact of that

21

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|-------- | --------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)
|         |                                        
|         | y.                                      | Recently
  issued accounting pronouncements (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                         | standard
  would have approximated the impact of SFAS 123 as described in the disclosure
  of pro forma net income and earnings per share in Note 2(s) to the
  consolidated financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                         | In March
  2005, the SEC released SEC Staff Accounting Bulletin No. 107, Share-Based
  Payment (SAB 107). SAB 107 provides the SEC staffs position regarding the
  application of FAS 123(R) and contains interpretive guidance related to the
  interaction between SFAS 123(R) and certain SEC rules and regulations, and
  also provides the SEC staffs views regarding the valuation of share-based
  payment arrangements for public companies. SAB 107 highlights the importance
  of disclosures made relating to the accounting for share-based payment
  transactions. The Company is currently reviewing the effect of SAB 107,
  however it does not believe that SAB 107 will have a material effect on its
  financial position, results of operations or cash flows.
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         | z.                                      | Reclassifications                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                         | Certain
  prior year amounts were reclassified to conform with current year financial
  statement presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

|         |                                              |                                                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-------- | -------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 3:- | BUSINESS COMBINATIONS AND SALE OF BUSINESSES
|         |                                             
|         | a.                                           | Galil                                                                                                                                                                              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                              |                                                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                              | Galil Medical Ltd. (Galil) develops, manufactures and
  markets systems and disposable kits for the performance of minimal invasive
  cryo-therapy by means of freezing tissues.
|         |                                              |                                                                                                                                                                                   
|         |                                              | 1.                                                                                                                                                                                 | On July 1, 2003, Galil announced the completion of the merger of
  Galils urology business and the Brachytherapy business of Amersham plc
  (Amersham) (Amersham was subsequently acquired by General Electric Company
  (NYSE:GE) (GE)). According to an agreement signed on April 22, 2003, a new company,
  Oncura Inc. (Oncura), was incorporated. Oncura provides minimally invasive
  treatment options for prostate cancer using brachytherapy and cryotherapy
  technologies. At the closing, Amersham and Galil each contributed the assets
  necessary for Oncura to conduct the Cryotherapy business and the
  Brachytherapy business, respectively, in the urology field and in exchange,
  Amersham received 78% and Galil received 22% of the outstanding shares of
  Oncura. In addition, at the closing, Galil purchased 3% of Oncura from
  Amersham in consideration for $4,500 resulting in Galils owning an aggregate
  interest of 25% in Oncura.
|         |                                              |                                                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                              |                                                                                                                                                                                    | Galil and Amersham each entered, separately, into supply and R&D
  service agreements pursuant to which Galil and Amersham provide Oncura with
  certain exclusive supply, manufacturing and R&D services, on a cost plus
  basis, according to terms and conditions stipulated in the relevant
  agreements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                              |                                                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                              |                                                                                                                                                                                    | Galil accounted for the transfer of its business in exchange for an
  interest in Oncura as a non-monetary exchange which was recorded at fair
  value. The fair value of the transaction was approximately $150,000. As Galil
  retains an indirect interest in the tangible and intangible assets
  transferred to Oncura, the portion of the gain relating to the interest
  retained has been deferred. This deferred gain is realized according to the
  rate of amortization of the assets transferred by Galil to Oncura.                                                                                                                                                                                                                                                                                                                                                                                                                                              

22

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-------- | ---------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 3:- | BUSINESS COMBINATIONS AND SALE OF BUSINESSES (Cont.)
|         |                                                     
|         | a.                                                   | Galil
  (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Accordingly, the investment in Oncura, which is accounted for under the equity method, was recorded in the amount of
approximately $30,000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | As a result,
  a gain on the transaction of approximately $21,200 was recorded in 2003 in
  the statement of operations under Gain from disposal of businesses and
  affiliated companies and changes in holdings in affiliated companies, net.
  The gain is net of realization of goodwill, related to the Other Holdings
  and Corporate Operations segment, in the amount of approximately $500.
  Elrons share in the gain (net of minority interest and income taxes)
  amounted to approximately $4,400.                                                                                                                                                                                                  
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | The
  investment in Oncura as of the date of the transaction included amounts
  allocated to goodwill of approximately $14,200, to other intangibles of
  $23,800 and to deferred tax liabilities of $9,100.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | In 2005, due
  to an impairment of a certain intangible relating to a contract, the Company
  wrote down an amount of $1,700 ($800 net of minority interest), which is the
  unamortized portion of the investment amount allocated to the aforementioned
  intangible asset at the date of the investment in Oncura. In addition, in
  light of Oncuras results, the Company recorded in 2005 an impairment loss on
  the investment in Oncura in the amount of $3,400 ($1,400 net of minority
  interest), due to an other than temporary decline in value of such
  investment. The impairment losses were presented in the statement of
  operations in the line item equity in losses of affiliated companies.
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | In 2003,
  Galil signed a loan agreement with Oncura, according to which Galil has
  committed to extend loans to Oncura up to an aggregate principal amount of
  $2,000. As of December 31, 2005, Galil advanced $875 to Oncura in respect of
  this agreement. The loan bears an interest rate of Libor+0.75% per annum and
  is to be repaid in March 2007.                                                                                                                                                                                                                                                                                                                                                        
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Each of
  Galil and GE provided to Oncura a letter in which they confirmed their
  intention to continue providing financial support to Oncura through March 1,
  2007 or such later date, as may be agreed by Oncuras shareholders.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         | b.                                                   | ESW                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      | On September
  2, 2003, Elrons majority owned subsidiary, Elron Software Inc. (ESI), sold
  substantially all of its assets and business to Zix Corporation (Zix), a
  publicly traded company on NASDAQ (NASDAQ: ZIXI). In consideration for the
  assets and business sold, Zix issued to ESI 1,709,402 unregistered shares of
  its Common stock, with a market value of approximately $6,000 and a convertible
  note bearing an interest rate of 5.75% (the Note) in the amount of $1,000.
  The Note was converted into 262,454 shares of Zix Common stock, in the fourth
  quarter of 2003. As part of the transaction, Zix assumed certain liabilities
  of ESI in the net amount of approximately $1,000. Following the transaction,
  ESI changed its name to ELRON SW, INC. (ESW).
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                      | In
  determining the gain on the sale of ESIs business, Elron valued the Zix
  Common stock at $5,400 (a discount from market value of approximately 10% due
  to certain restrictions on their sale). Accordingly, Elron recorded a gain on
  the sale of approximately $4,100, of which $2,500 represents an elimination
  of a liability to minority shareholders previously recorded by Elron with
  respect to options granted to ESWs employees due to the expiration of the
  unexercised options.                                                                                                                                                                                                                                                                                           

23

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------- | ---------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 3:- | BUSINESS COMBINATIONS AND SALE OF BUSINESSES (Cont.)
|         |                                                     
|         | b.                                                   | ESW (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      | The business
  sold by ESW represents a component of an entity as defined in SFAS 144 and
  since the criteria for reporting discontinued operations under SFAS 144 is
  met, the results of operations of the business and the gain on the sale have
  been classified as discontinued operations in the statement of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      | The Zix
  Common stock had been accounted for as available for sale securities in
  accordance with SFAS 115. Of the 1,971,856 shares received, 1,117,155 shares
  (including 262,454 shares which resulted from the conversion of the
  convertible note) were sold in 2003 in consideration for approximately
  $9,000, resulting in a realized gain of approximately $4,800 ($3,200 net of
  tax) and 854,701 shares were sold in 2004 in consideration for approximately
  $8,100 resulting in a realized gain of approximately $5,400 ($3,600 net of
  tax).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      | ESW was
  voluntarily dissolved in December 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | c.                                                   | Mediagate                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      | In December
  2003, Mediagate signed an agreement, for the sale of its technology and
  related intellectual property assets. The closing of the transaction occurred
  on January 28, 2004 with no effect on the consolidated results of operations.
  According to the agreement, the consideration for the technology is in the
  form of royalties, up to a maximum of $5,000 to be paid on future sales
  through December 31, 2009, of products that are based on Mediagates
  technology.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      | As a result
  of the Companys revised estimate about the realizability of future royalties
  to be received, the Company recorded in 2004 an impairment loss of
  approximately $4,200 ($2,700 net of tax) in respect of the intangible asset
  relating to Mediagates technology. This impairment loss is included as a
  separate line item in the statement of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | d.                                                   | Elron
  Telesoft                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      | On December
  29, 2005, Elron sold all of its shares of Elron Telesoft to ECtel Ltd.
  (NASDAQ: ECRX) for $2,500, of which $2,100 paid in cash immediately and up to
  an additional $400 shall be paid if certain milestones will be achieved
  during 2006. The above transaction resulted in an immaterial gain (due to
  previous impairment charges which were recorded on Elron Telesoft assets).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                      | According to
  SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets,
  when a component of an entity, as defined in SFAS 144, has been disposed of
  or is classified as held for sale, the results of its operations, including
  the gain or loss on its disposal should be classified as discontinued
  operations when the operations and cash flows of the component have been
  eliminated from the Companys consolidated operations and the Company will no
  longer have any significant continuing involvement in the operations of the
  component. The business sold by Elron Telesoft met the criteria for reporting
  discontinued operations and therefore the 2005 results of operations of the
  business and the gain on the sale have been classified as discontinued
  operations in the statement of operations and prior periods results have been
  reclassified accordingly. In addition, the comparative data of the assets and
  liabilities have been reclassified as assets and liabilities attributed to
  discontinued operations in the balance sheets.

24

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--------- | -------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 3:-  | BUSINESS COMBINATIONS AND SALE OF BUSINESSES (Cont.)                                                                                              
|          |                                                                                                                                                   
|          | e.                                                                                                                                                 | Enure                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|          |                                                                                                                                                    | On October
  2, 2005, Elron completed an investment of approximately $4,000 in Enure, in
  consideration for 213,690 Series A preferred shares. Enure is an Israeli
  software company engaged in developing unique solutions in the field of
  broadband services management and home networks. Following Elrons
  investment, Elron holds approximately 44% of Enure, on a fully diluted and on
  an as converted basis (approximately 57% on an outstanding basis).Since the
  Company has control over Enure, Enures financial statements have been
  consolidated in the Companys consolidated financial statements. The majority
  of the purchase price was allocated to cash and other monetary current assets
  and liabilities.
|          |                                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|NOTE 4:-  | CASH AND CASH EQUIVALENTS                                                                                                                         
|          |                                                                                                                                                   
|          | Includes
  mainly bank deposits in U.S. dollars, bearing an annual weighted average
  interest rate of 4.1% per annum (December 31, 2004  2.22%).
|          |                                                                                                                                                   
|NOTE 5: - | SHORT-TERM INVESTMENTS                                                                                                                            

| |                           |  |                                                                       |       |              |   |        |  |   |         | 
| | ------------------------- |  | --------------------------------------------------------------------- | ----- | ------------ | - | ------ |  | - | ------- | 
| |                           |  | Annual Weighted 
  Average
  Interest rate as of 
  December 31, 2005 |       | December 31, |  
| |                           |  |                                                                       |       |              |  
| |                           |  | %                                                                     |       | 2005         |   | 2004   | 
| |                           |  |                                                                       |       |              |   |        | 
| |                           |  |                                                                       |       |              |   |        |  |   |         | 
| | Certificate
  of deposits |  |                                                                       |       |              |   |       |  |   | 223     | 
| | Bank
  deposits           |  |                                                                       | 3.77% |              |   | 54,661 |  |   | 100,801 | 
| |                           |  |                                                                       |       |              |   |        |  |   |         | 
| |                           |  |                                                                       |       |              |   |        |  |   |         | 
| |                           |  |                                                                       |       |              | $ | 54,661 |  | $ | 101,024 | 
| |                           |  |                                                                       |       |              |   |        |  |   |         | 

|          |                                        
|--------- | ---------------------------------------
|NOTE 6: - | AVAILBLE FOR SALE MARKETABLE SECURITIES

|                                                                                      |     |                                                                                                                                                |       |  |   |        |   |        |        |   |        | 
|------------------------------------------------------------------------------------- | --- | ---------------------------------------------------------------------------------------------------------------------------------------------- | ----- |  | - | ------ | - | ------ | ------ | - | ------ | 
|Available-for-sale securities: (1)U.S.
  government agencies and corporate debentures |     |                                                                                                                                                | 3.68% |  | $ | 62,617 |   | $      | 44,985 |  
|                                                                                      |     |                                                                                                                                                |       |  |   |        |   |        |        |   |        | 
|                                                                                      |     |                                                                                                                                                |       |  |   |        |   |        |        |  
|                                                                                      |     |                                                                                                                                                |       |  |   |        |   | 62,617 |        |   | 44,985 | 
|                                                                                      |     |                                                                                                                                                |       |  |   |        |   |        |        |   |        | 
|                                                                                      | (1) | Includes
  unrealized losses                                                                                                                   |       |  |   |        | $ |       | *)     | $ | 253    | 
|                                                                                      |     |                                                                                                                                                |       |  |   |        |   |        |        |   |        | 
|                                                                                      |     |                                                                                                                                                |       |  |   |        |   |        |        |   |        | 
|                                                                                      | * ) | In 2005 the
  unrealized losses in the amount of $909 were reclassified as finance income,
  net due to other than temporary decline in value |       |  |   |        |   |        |        |   |        | 

|                                    |  |  |  |  | Maturities |        |  |  | 
|----------------------------------- |  |  |  |  | ---------- | ------ |  |  | 
|                                    |  |  |  |  |            |        |  |  | 
|As of December 31, 2005:            |  |  |  |  |            |        |  |  | 
|                                    |  |  |  |  |            |        |  |  | 
|Available-for-sale securities:      |  |  |  |  |            |        |  |  | 
|Due in one year or less             |  |  |  |  | $          | 19,882 |  |  | 
|Due after one year to three
years   |  |  |  |  |            | 35,755 |  |  | 
|Due after three years to five
years |  |  |  |  |            | 6,980  |  |  | 
|                                    |  |  |  |  |            | 62,617 |  |  | 
|                                    |  |  |  |  |            |        |  |  | 

25

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                     |                                       
|-------- | ----------------------------------- | --------------------------------------
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES
|         |                                    
|         | a.                                  | Affiliated
  companies are as follows:

| |                         |  |      |  |                                                |   |      |  |      |  |  |      | 
| | ----------------------- |  | ---- |  | ---------------------------------------------- | - | ---- |  | ---- |  |  | ---- | 
| |                         |  |      |  | December 31,                                   |  
| |                         |  |      |  |                                                |  
| |                         |  |      |  | 2005                                           |   | 2004 | 
| |                         |  |      |  |                                                |   |      | 
| |                         |  | Note |  | Consolidated % of 
  outstanding share capital |  
| |                         |  |      |  |                                                |  
| |                         |  |      |  |                                                |   |      |  |      |  |  |      | 
| | Elbit
  Systems (ESL) |  |      |  | 7d(1                                           | ) |      |  |     |  |  |     | 
| | Given
  Imaging         |  |      |  | 7d(2                                           | ) |      |  | 24.2 |  |  | 24.7 | 
| | ChipX                   |  |      |  | 7d(3                                           | ) |      |  | 26.5 |  |  | 26.5 | 
| | K.I.T
  eLearning       |  |      |  | 7d(4                                           | ) |      |  |     |  |  |     | 
| | Wavion                  |  |      |  | 7d(5                                           | ) |      |  | 37.8 |  |  | 37.5 | 
| | Oren
  Semiconductors   |  |      |  | 7d(6                                           | ) |      |  |     |  |  | 40.9 | 
| | NetVision               |  |      |  | 7d(7                                           | ) |      |  | 39.1 |  |  | 45.7 | 
| | AMT                     |  |      |  | 7d(8                                           | ) |      |  | 41.8 |  |  | 40.3 | 
| | Oncura                  |  |      |  | 3a                                             |   |      |  | 25.0 |  |  | 25.0 | 
| | Pulsicom                |  |      |  |                                               |   |      |  | 18.2 |  |  | 18.2 | 
| | Notal Vision            |  |      |  |                                               |   |      |  | 25.6 |  |  | 25.5 | 
| | CellAct                 |  |      |  |                                               |   |      |  | 45.0 |  |  | 45.0 | 

| |    |                                     
| | -- | ------------------------------------
| | b. | Composition
  of investments: (1)(2)

| |                                                                                                                                                                                   |  |   |             |  |      |         | 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | - | ----------- |  | ---- | ------- | 
| |                                                                                                                                                                                   |  |   | December 31 | 
| |                                                                                                                                                                                   |  |   |             | 
| |                                                                                                                                                                                   |  |   | 2005        |  | 2004 |        
| |                                                                                                                                                                                   |  |   |             |  |      |        
| |                                                                                                                                                                                   |  |   |             |  |      |         | 
| | Given Imaging                                                                                                                                                                     |  |   | 68,956      |  |      | 71,748  | 
| | Oncura                                                                                                                                                                            |  |   | 22,072      |  |      | 29,259  | 
| | Netvision                                                                                                                                                                         |  |   | 5,549       |  |      | 3,542   | 
| | Others                                                                                                                                                                            |  |   | 6,203       |  |      | 12,575  | 
| |                                                                                                                                                                                   |  |   |             |  |      |         | 
| |                                                                                                                                                                                   |  |   |             |  |      |         | 
| |                                                                                                                                                                                   |  | $ | 102,780     |  | $    | 117,124 | 
| |                                                                                                                                                                                   |  |   |             |  |      |         | 
| |                                                                                                                                                                                   |  |   |             |  |      |         | 
| | (1)Includes loans and convertible loans
(bearing a weighted average interest rate of 6.42% per annum (December 31,
2004  5.03%))                                                 |  | $ | 1,417       |  | $    | 7,122   | 
| |                                                                                                                                                                                   |  |   |             |  |      |         | 
| | (2)Difference between the carrying amounts
of investments and the Companys share in the net equity of affiliates,
attributed to technology, goodwill and other intangible assets |  | $ | 69,913      |  | $    | 81,726  | 
| |                                                                                                                                                                                   |  |   |             |  |      |         | 

| |    |                                                
| | -- | -----------------------------------------------
| | c. | Fair market
  value of public traded companies:

| |                 |                       |  |  |  |                          |      |      |   |     | 
| | --------------- | --------------------- |  |  |  | ------------------------ | ---- | ---- | - | --- | 
| |                 |                       |  |  |  | December 31              |     
| |                 |                       |  |  |  |                          |     
| |                 |                       |  |  |  | 2005                     |      | 2004 |  
| |                 |                       |  |  |  |                          |      |      |  
| |                 | Stock Exchange        |  |  |  | U.S. dollars in millions |     
| |                 |                       |  |  |  |                          |      |      |  
| | Given
  Imaging | Tel-Aviv and
  NASDAQ |  |  |  | $                        | 176  |      | $ | 245 | 
| | Netvision       | Tel-Aviv              |  |  |  | $                        | 27.7 |      |   |    | 

26

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 
|-------- | ------------------------------------------- | ------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES (Cont.)
|         |                                            
|         | d.                                          | Additional
  information
|         |                                             |                         
|         |                                             | 1.                       | ESL                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | 
|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 
|         |                                             |                          | On July 8,
  2004, Elron announced the signing of a definitive agreement for the sale of
  all of its holdings in Elbit Systems Ltd. (ESL) (NASDAQ: ESLT) constituting
  approximately 19.6% of the outstanding share capital of ESL to Tadiran
  Communications Ltd., in consideration for approximately $197,000. The closing
  of the transaction was subject to the right of first refusal of Federmann
  Enterprises Ltd. (Federmann Enterprises), the other major shareholder of
  ESL. On July 28, 2004, Federmann Enterprises exercised its right of first
  refusal, following which the shares were sold to Federmann Enterprises for
  approximately $197,000. As a result, Elron recorded, in 2004, a gain of
  approximately $104,600 which net of tax amounted to approximately $91,500.
  The gain net of tax includes a reduction of approximately $21,600 in the tax
  expense as a result of the reversal of a valuation allowance previously
  recorded in respect of deferred tax assets relating to loss carryforwards.
|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                             | 2.                       | Given                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | 
|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 
|         |                                             | a.                       | Given
  Imaging Ltd. (Given), a medical device company that develops, manufactures
  and markets innovative diagnostic systems for visualizing the
  gastrointestinal tract, using a disposable miniature swallowable video
  capsules.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                             |                          | In 2003,
  RDC, then a 48% held subsidiary sold 753,600 shares of Given for a total
  consideration of approximately $7,800, resulting in a gain of approximately
  $4,400 ($70 net of tax and minority interest) as a result, Elrons directly
  and indirectly ownership interest in Given decreased to approximately 17%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 
|         |                                             | b.                       | In May 2003,
  a Share Purchase Agreement was signed between RDC, Elron and Rafael Armament
  Development Authority (Rafael) (the other shareholder of RDC), according to
  which, RDC sold 2,000,000 unregistered shares of Given to Elron and Rafael
  (one million each) for a total consideration of $12,184. RDC used $5,000 of
  the proceeds to repay shareholders loans to Rafael and Elron. This
  transaction did not have any effect on the Companys consolidated results of
  operations and the Companys direct and indirect interest in Given.                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 
|         |                                             | c.                       | In April
  2004, RDC purchased from one of its shareholders (a former senior executive
  of RDC) treasury shares amounting to approximately 3% of its outstanding share
  capital. In consideration for the treasury shares, RDC distributed to the
  shareholder 200,000 shares of Given. The number of the distributed Given
  shares was calculated based on the relative fair values of the shares of RDC
  and of Given on the date the agreement to purchase the treasury shares was
  signed (May 2003). The transaction was completed in April 2004, after receipt
  of various approvals required under the agreement.                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                             |                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 
|         |                                             |                          | RDC recorded
  the purchase of the treasury shares based on the fair value of Givens shares
  on the date of distribution. Accordingly, RDC recorded a gain on the
  distribution of Given shares of approximately $5,800. RDCs purchase of the
  treasury shares resulted in Elron increasing its interest in RDC by
  approximately 1.5% to approximately 49.6%. This acquisition of the additional
  interest in RDC was accounted for by the purchase method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

27

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES     
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-------- | ------------------------------------------- | -------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES (Cont.)
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | d.                                          | Additional
  information (Cont.)
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             | 2.                               | Given
  (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             |                                  | Accordingly,
  Elron recorded the additional interest in RDC at fair value of approximately
  $1,900 and recorded its share of the gain in the distribution of Given shares
  in the amount of $1,400, net of tax and minority interest.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             |                                  | The excess
  of the purchase price over the Companys share in the equity acquired
  amounted to approximately $1,900 and was allocated mostly to RDCs remaining
  investment in Given.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             | d.                               | In June
  2004, Given completed its secondary public offering of 2,880,750 ordinary
  shares at $32.00 per share, comprising 1,500,000 shares issued by Given and
  1,380,750 shares (including 375,750 shares as a result of the exercise of the
  underwriters over allotment option) sold by existing shareholders. In the
  aforementioned offering, RDC sold 300,000 ordinary shares in consideration
  for approximately $9,000. Given received net proceeds of approximately
  $44,300. As a result of the sale of Givens shares by RDC and the issuance of
  shares by Given, Elrons directly and indirectly ownership interest in Given
  decreased from approximately 16% to approximately 15%, and Elron recorded a
  gain of $15,200 ($6,700 net of tax and minority interest).                                                                                                 
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             | e.                               | During the
  second half of 2004, Elron purchased 1,373,513 ordinary shares of Given in
  consideration for approximately $43,900. As a result, Elrons direct and
  indirect ownership interest in Given increased from approximately 15% to
  approximately 20%. The excess of the purchase price over the Companys share
  in the equity acquired amounted to approximately $39,500 and was allocated as
  follows: approximately $30,400, net of deferred tax liability in the amount
  of $1,900, to intangible assets other than goodwill, such as customer
  relationships and technology, approximately $1,700 to in-process research and
  development activities (IPR&D), and approximately $7,400 to goodwill.                                                                                                                                                                   
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             |                                  | Products
  which did not receive marketing clearance by regulatory authorities as of the
  acquisition date are considered to be incomplete and accordingly the amount
  allocated to such products is considered to be IPR&D. The amount
  allocated to IPR&D was charged immediately to the Companys results of
  operations in accordance with FASB Interpretation No. 4, Applicability of
  FASB Statement No. 2 to Business Combinations Accounted for by the Purchase
  Method (FIN 4). The amounts allocated to intangible assets other than
  goodwill are amortized on a straight-line basis over their weighted average
  expected useful life of 12 years. The amortization of the identifiable
  intangible assets as well as the write-off of the IPR&D are included as
  part of the line item Equity in losses of affiliated companies in the
  statements of operations.
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             | f.                               | During 2004,
  the Companys Chairman of the Board exercised options previously granted to
  him and purchased 21,751 shares of Given from the company, in consideration
  for approximately $49 and the elimination of the related liability previously
  recorded in Elrons books. As a result, Elron recorded a gain of
  approximately $600.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

28

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES     
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-------- | ------------------------------------------- | -------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES (Cont.)
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         | d.                                          | Additional
  information (Cont.)
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  | During 2005
  a former senior employee of RDC exercised options previously granted to him,
  and purchased from RDC 70,200 shares of Given in consideration for
  approximately $12 and the elimination of the related liability previously
  recorded in RDCS books. As a result, RDC recorded a gain of approximately
  $1,200 ($500 net of tax and minority interest).                                                                                                                                                                                                                                                                                                                            
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             | 3.                               | ChipX                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  | ChipX is a
  manufacturer of late stage programmable structured ASICs (application-specific
  integrated circuits). In March 2004, ChipX Incorporated (ChipX) completed a
  private placement in which it issued 7,594,928 redeemable preferred shares in
  consideration for $12,000. Elron purchased 1,632,564 redeemable preferred shares
  in consideration for approximately $2,600. As a result, Elrons voting
  interest in ChipX decreased from approximately 33% to approximately 26%. The
  aforementioned transaction had no effect on Elrons results of operations.                                                                                                                   
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             | 4.                               | KIT                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  | In July 2003 Elron
  invested $2,000 in K.I.T.eLearning B.V (KIT), in
  consideration for 1,243,396 Series B-2 preferred shares, as part of an
  aggregate investment of $4,000, the balance of which was invested by DIC. KIT
  was previously held by Elron at a rate of approximately 29%.                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  | In addition to this
  investment, Elrons loan to KIT in the amount of $1,500 (which was granted
  during 2001 and 2002) was converted into 324,388 series B-1 preferred shares
  of KIT. Following the investment and the loan conversion, Elron held
  approximately 45% of KITs outstanding shares.                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  | In March
  2004, Elron together with the other shareholders of KIT, DIC and Kidum IT
  Ltd. (together the sellers) completed the sale of KIT, to Online
  Higher Education B.V, a subsidiary of Laureate Education, Inc. (NASDAQ: LAUR),
  a global leader in higher education, in consideration for $9,400, of which
  Elron received approximately $5,700. The gain resulting from the sale
  amounted to approximately $5,300. In addition, the sellers are entitled to a
  future payment of up to $10,000 based on future earnings of KIT in the years
  2006 and 2007, from which Elrons share will be up to approximately $5,700.                                                           
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             | 5.                               | Wavion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                             |                                  | In 2003,
  Elron invested $3,000 in Wavion Inc. (Wavion) in consideration for
  3,575,686 Series B preferred shares, out of an aggregate amount of $12,500
  raised by Wavion in a private placement from Elron and new investors. In
  addition to this investment, Elron converted previously granted loans into
  1,787,843 Series A1 preferred shares. In 2005, Elron invested $1,424 in
  consideration for 1,696,728 Series B preferred shares, out of an aggregate
  amount of $3,600. Wavion is a developer of broadband wireless access systems
  for Wi-Fi networks. As of December 31, 2005, Elrons holds approximately 38%
  of Wavion on a fully diluted and on an as converted basis.

29

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES     
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-------- | ------------------------------------------- | -------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES (Cont.)
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | d.                                          | Additional
  information (Cont.)
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             | 5.                               | Wavion
  (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             |                                  | Wavion is
  considered to be a variable interest entity, however, the Company is not the
  primary beneficiary of Wavion, and accordingly has not consolidated Wavion.
  As of December 31, 2005, the Companys maximum exposure to loss as a result
  of its involvement in Wavion does not exceed the carrying value of its
  investment in Wavion in the amount of approximately $761.                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             | 6.                               | Oren                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             | a.                               | In July
  2003, Elron purchased 6,581,671 preferred E2 shares of Oren Semiconductors
  Inc. (Oren) in consideration for $3,000, as part of an aggregate investment
  of $8,000 of existing shareholders and of Zoran Corporation (NASDAQ: ZRAN)
  (Zoran).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             |                                  | In addition
  to this investment, Elron and other existing shareholders converted all the
  loans previously granted to Oren, in the amount of approximately $8,400, of
  which Elrons part was approximately $4,400. Elrons loans were converted to
  3,824,563 preferred E1 shares of Oren. Following the investment and the loan
  conversion, Elrons interest in Oren increased from approximately 17% to
  approximately 41% and accordingly Elron began applying retroactively the
  equity method of accounting to its investment in Oren.                                                                                                                                                                                                                                                                         
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             | b.                               | On June 10,
  2005, Zoran completed the acquisition of Oren. Prior to the transaction,
  Zoran held approximately 17% of Oren.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             |                                  | The
  consideration paid by Zoran to the other shareholders in Oren was determined
  based on a value of Oren of $53,500. Zoran paid approximately $44,600 in the
  form of cash and Zoran common stock for the remaining 83% of Oren. Upon
  completion of the transaction, Elron received cash of approximately $12,500
  and Zoran common stock with a value of approximately $7,700 (based on the
  market price of Zoran shares on the date of completion). An amount of
  approximately $1,900 out of the cash received is deposited in an escrow
  account, half until June 2006 and half until June 2007, for the assurance of
  Orens representations in accordance with the agreement. As a result of the
  sale, Elron recorded a gain, in 2005, of approximately $19,700 (approximately
  $17,200 net of taxes).
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             |                                  | In July
  2005, Elron sold all shares of Zoran received by it in the aforementioned
  sale for approximately $8,800 and recorded a gain of approximately $1,100
  (approximately $700 net of tax).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             | 7.                               | NetVision                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                             |                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                             | a.                               | NetVision
  provides Internet services and solutions in Israel and international
  telephony services through Voice over IP technology. During
  2004, Elron and DIC each granted NetVision Ltd. (NetVision) a loan of
  $2,000 in order to enable NetVision to repay a portion of its line of credit
  to a lending bank. DIC is the other major shareholder of Netvision. In
  accordance with EITF 02-18, Elron recognized all previously suspended equity
  method losses in NetVision in the amount of the loan granted.                                                                                                                                                                                                                                                                                              

30

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES     
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-------- | ------------------------------------------- | ------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES (Cont.)
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | d.                                          | Additional information (Cont.)
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             | 7.                             | NetVision (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             |                                | During the
  second half of 2004, Elron and DIC each granted NetVision additional loans of
  approximately $3,300. The loans from Elron bore an interest rate of Libor +2% per annum.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             | b.                             | On May 19,
  2005, Netvision completed its initial public offering on the Tel Aviv Stock
  Exchange in Israel of shares and convertible securities in consideration for
  the immediate net proceeds of approximately NIS 135 million (approximately
  $31,000). Out of the proceeds received, an amount of approximately NIS 38
  million (approximately $8,600) was allocated to the shares and an amount of
  approximately NIS 97 million (approximately $22,400) was allocated to the
  convertible securities based on the relative fair value of such securities.
  In addition, future proceeds from the exercise of options sold in the
  offering may amount to a maximum of approximately NIS 28.8 million
  (approximately $6,600). Elron and DIC each converted approximately $3,100 of
  loans into equity of Netvision immediately prior to the offering and $2,200
  in loans was repaid to each Elron and DIC from the proceeds of the offering.
  As a result of the initial public offering, Elrons interest in Netvision
  decreased from 45.7% to approximately 39% resulting in a gain of
  approximately $3,000. If all convertible securities in Netvision are
  converted to shares, Elrons interest in Netvision will decrease to 27.4%.                                                                                                                                                 
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             | 8.                             | AMT                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             |                                | The AMT
  group develops technologies and products based on amorphous metals. In June
  2004, Elron completed an investment of $3,000 in convertible notes of AMT
  then held 28% by Elron, together with an international strategic partner
  which also invested $3,000 in AMTs convertible notes. In addition, existing
  AMT shareholders, including Elron, converted shareholder loans into
  convertible notes in the aggregate amount of approximately $2,700, of which
  Elron converted approximately $1,600. In addition, Elron and the other
  investors in AMT were issued warrants to purchase convertible notes of AMT
  for a total amount of up to approximately $33,250, which may be exercised
  over various periods up to a maximum of 48 months from the closing date of
  the transaction. As a result of the transaction, Elron increased its
  ownership interest to approximately 35% on a fully diluted basis (excluding
  warrants) and on an as converted basis. The excess of the purchase price
  over the Companys share in the equity acquired amounted to approximately
  $4,200 and was allocated as follows: approximately $2,900, net of deferred
  tax liability in the amount of approximately $300, to intangible assets other
  than goodwill with a weighted average useful life of 10 years, approximately
  $1,100 to IPR&D and approximately $140 to tangible assets.
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             |                                | In 2005,
  Elron invested additional $900 in convertible notes and $500 in loans bearing
  an interest rate of 8% per annum.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             | 9.                             | Oncura                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                             |                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                             |                                | Regarding
  the investments in Oncura, see Note 3(a)(1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

31

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES     
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                             |                                                          | 
|-------- | ------------------------------------------- | -------------------------------------------------------- | 
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES (Cont.)
|         |                                             |                                                         
|         | e.                                          | Summarized information                                  
|         |                                             |                                                         
|         |                                             | Summarized combined financial information is as follows:

|                                                     |  |       |         |        |   |        |   |   |         |  
|---------------------------------------------------- |  | ----- | ------- | ------ | - | ------ | - | - | ------- | -
|                                                     |  | Given |         | Oncura |   | Others |  
|                                                     |  |       |         |        |   |        |  
|December 31, 2005:                                   |  |       |         |        |   |        |   |   |         |  
|                                                     |  |       |         |        |   |        |   |   |         |  
|Balance sheet information:                           |  |       |         |        |   |        |   |   |         |  
|Current assets                                       |  | $     | 108,976 |        | $ | 23,998 |   | $ | 57,548  |  
|Non-current assets                                   |  |       | 40,134  |        |   | 37,496 |   |   | 53,876  |  
|Total assets                                         |  |       | 149,110 |        |   | 61,494 |   |   | 111,423 |  
|Current liabilities                                  |  |       | 22,759  |        |   | 30,724 |   |   | 53,498  |  
|Non-current liabilities                              |  |       | 24,246  |        |   | 3,574  |   |   | 53,127  |  
|Minority interest                                    |  |       | 61      |        |   |       |   |   | 143     |  
|Redeemable preferred stock                           |  |       |        |        |   |       |   |   | 36,108  |  
|Shareholders equity (deficiency)                    |  |       | 102,044 |        |   | 27,196 |   |   | (31,453 | )
|                                                     |  |       |         |        |   |        |   |   |         |  
|Year Ended December 31, 2005:                        |  |       |         |        |   |        |   |   |         |  
|                                                     |  |       |         |        |   |        |   |   |         |  
|Statement of operations information:                 |  |       |         |        |   |        |   |   |         |  
|Revenues                                             |  | $     | 86,776  |        | $ | 72,063 |   | $ | 95,707  |  
|Gross profit                                         |  |       | 64,706  |        |   | 31,183 |   |   | 25,859  |  
|Net income from continuing operations and net income |  |       | 6,343   |        |   |       |   |   | 5,405   |  
|Net loss from continuing operations and net loss     |  |       |        |        |   | (6,209 | ) |   | (18,680 | )

|                                                     |  |       |         |        |   |         |   |  |  | 
|---------------------------------------------------- |  | ----- | ------- | ------ | - | ------- | - |  |  | 
|                                                     |  | Given |         | Others |  
|                                                     |  |       |         |        |  
|December 31, 2004:                                   |  |       |         |        |   |         |  
|                                                     |  |       |         |        |   |         |  
|Balance sheet information:                           |  |       |         |        |   |         |  
|Current assets                                       |  | $     | 110,433 |        | $ | 66,990  |  
|Non-current assets                                   |  |       | 13,791  |        |   | 96,426  |  
|Total assets                                         |  |       | 124,224 |        |   | 163,419 |  
|Current liabilities                                  |  |       | 17,446  |        |   | 82,060  |  
|Non-current liabilities                              |  |       | 10,984  |        |   | 49,278  |  
|Minority interest                                    |  |       | 1,177   |        |   | 493     |  
|Redeemable preferred stock                           |  |       |        |        |   | 34,272  |  
|Shareholders equity (deficiency)                    |  |       | 94,617  |        |   | (2,684  | )
|                                                     |  |       |         |        |   |         |  
|Year Ended December 31, 2004:                        |  |       |         |        |   |         |  
|                                                     |  |       |         |        |   |         |  
|Statement of operations information:                 |  |       |         |        |   |         |  
|Revenues                                             |  | $     | 65,020  |        | $ | 158,965 |  
|Gross profit                                         |  |       | 47,286  |        |   | 53,494  |  
|Net income from continuing operations and net income |  |       | 2,888   |        |   | 4,446   |  
|Net loss from continuing operations and net loss     |  |       |        |        |   | (23,586 | )

| |  |                                                                                                                                                                                                                                                                                                                                                                      | 
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| |  | Following is the summary of information from ESLs unaudited
  financial report as of June 30, 2004, which the Company used in order to
  record in 2004 its share in the equity and results of ESL until the date of
  sale of the investment in ESL (on July 28, 2004) and in order to determine the
  gain resulting from the aforementioned sale (see Note 7d1).

32

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES     
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                             |                        | 
|-------- | ------------------------------------------- | ---------------------- | 
|NOTE 7:- | INVESTMENTS IN AFFILIATED COMPANIES (Cont.)
|         |                                             |                        | 
|         | e.                                          | Summarized information

| |                                                      |  |     |           | 
| | ---------------------------------------------------- |  | --- | --------- | 
| |                                                      |  | ESL |          
| |                                                      |  |     |          
| | June 30, 2004: (unaudited)                           |  |     |           | 
| |                                                      |  |     |           | 
| | Balance sheet information:                           |  |     |           | 
| | Current assets                                       |  | $   | 559,848   | 
| | Non-current assets                                   |  |     | 452,190   | 
| | Total assets                                         |  |     | 1,012,038 | 
| | Current liabilities                                  |  |     | 358,671   | 
| | Non-current liabilities                              |  |     | 171,419   | 
| | Minority interest                                    |  |     | 3,972     | 
| | Shareholders equity                                 |  |     | 477,976   | 
| |                                                      |  |     |           | 
| | Six months ended June 30, 2004 (unaudited):          |  |     |           | 
| |                                                      |  |     |           | 
| | Statement of operations information:                 |  |     |           | 
| | Revenues                                             |  | $   | 445,317   | 
| | Gross profit                                         |  |     | 115,438   | 
| | Net income from continuing operations and net income |  |     | 24,039    | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | f. | Goodwill and intangible assets allocated to investments                                                                                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| |    | The annual
  estimated amortization expense relating to intangible assets allocated to
  investments accounted for under the equity method, which will be included in
  the line item Equity in losses of affiliated companies in the statement of
  operations, for each of the five years in the period ending December 31, 2010
  is approximately $4,600.                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| |    | The weighted
  average amortization period of the intangible assets is approximately 14
  years.                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| |    | At the
  balance sheet date, the Company has goodwill in the amount of $20,650
  allocated to investments accounted for under the equity method.                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| | g. | Impairment                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| |    | As a result
  of an other-than-temporary decline in value of certain investments, the
  Company recorded impairment losses with respect to affiliated companies of
  $5,300 (including $1,700 relating to a certain intangible asset in an investee),
  $700 and $500, in 2005, 2004 and 2003, respectively. Such impairment losses
  are included as part of the Companys equity in losses of affiliated
  companies.

33

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES     
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                         
|-------- | --------------------------------------------------------
|NOTE 8:- | INVESTMENTS IN OTHER COMPANIES AND LONG-TERM RECEIVABLES

| |                                                                           |  |             |        |      |   |         | 
| | ------------------------------------------------------------------------- |  | ----------- | ------ | ---- | - | ------- | 
| |                                                                           |  | December 31 |       
| |                                                                           |  |             |       
| |                                                                           |  | 2005        |        | 2004 |  
| |                                                                           |  |             |        |      |  
| |                                                                           |  |             |        |      |   |         | 
| | Marketable securities presented as
  available- for- sale securities: (1) |  |             |        |      |   |         | 
| | Partner (2)                                                               |  | $           | 25,998 |      | $ | 136,208 | 
| | Other                                                                     |  |             | 1,065  |      |   | 950     | 
| |                                                                           |  |             |        |      |   |         | 
| |                                                                           |  |             |        |      |   |         | 
| |                                                                           |  |             | 27,063 |      |   | 137,158 | 
| |                                                                           |  |             |        |      |   |         | 
| |                                                                           |  |             |        |      |   |         | 
| | Partnerships                                                              |  |             | 3,698  |      |   | 3,176   | 
| |                                                                           |  |             |        |      |   |         | 
| |                                                                           |  |             |        |      |   |         | 
| | Other investments and long-term receivables
  (3)(4)                      |  |             | 43,170 |      |   | 15,595  | 
| |                                                                           |  |             |        |      |   |         | 
| |                                                                           |  |             |        |      |   |         | 
| |                                                                           |  | $           | 73,931 |      | $ | 155,929 | 
| |                                                                           |  |             |        |      |   |         | 
|
| | (1)     Includes
  unrealized gains                                       |  | $           | 17,540 |      | $ | 90,484  | 
| |                                                                           |  |             |        |      |   |         | 

| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | (2) | Partner
  Communications Company Ltd. (Partner)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  |     | As of
  December 31, 2005 and 2004, Elbit holds 3,091,361 and 15,856,551 shares of
  Partner, respectively. In 2003, Elbit sold 6,278,226 shares of Partner in
  consideration for approximately $29,300. As a result, Elron recorded a
  realized gain of approximately $11,000 ($7,100 net of tax). On April 20, 2005
  Elbit completed the sale of 12,765,190 Partner shares to Partner for
  approximately $94,000, as part of the sale together with the other Israeli
  founding shareholders of Partner, of approximately 33.3 million Partner
  shares to Partner. As a result of the sale, Elron recorded in the statement
  of operations, a gain of approximately $56,400 (approximately $45,400 net of
  tax).
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  |     | The gain net
  of tax includes a reduction of approximately $9,400 in the tax expense as a
  result of the reversal of a valuation allowance previously recorded in
  respect of deferred tax assets relating to loss carryforwards. See Note 14
  (e).                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  |     | Subsequent
  to the aforementioned sale and as of December 31, 2005, Elbit holds approximately
  2% of the outstanding shares of Partner. This interest in Partner is no
  longer pledged to the banks providing financing to Partner.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  |     | On March 8,
  2006, Elron announced the signing of a definitive agreement to acquire
  approximately 823,000 shares of Partner from one of the other Israeli
  founding shareholders of Partner for approximately $5,300, reflecting
  approximately 15% discount from the market price, subject to adjustments in
  accordance with the terms of the agreement. Upon completion of the
  acquisition, we will hold approximately 2.6% of Partner. The completion of
  the acquisition is subject to the satisfaction of certain closing conditions
  including regulatory approval. There is no assurance that the acquisition
  will be completed.                                                                      
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  |     | Almost all
  of these shares are subject to transfer restrictions under Partners license.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | (3) | During 2005,
  2004 and 2003, Elron recorded impairment losses of approximately $600, $800
  and $3,700, respectively, in respect of certain investments and receivables.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

34

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                 
|-------- | ----------------------------------------------------------------
|NOTE 8:- | INVESTMENTS IN OTHER COMPANIES AND LONG-TERM RECEIVABLES (Cont.)

| |  |     |                                                            
| |  | --- | -----------------------------------------------------------
| |  | (4) | Other
  investments include mainly the following companies:

| |  |  |  |                 |  |              |  |                                                            |  |     
| |  |  |  | --------------- |  | ------------ |  | ---------------------------------------------------------- |  | ----
| |  |  |  |                 |  | December 31,
| |  |  |  |                 |  |             
| |  |  |  |                 |  | Note         |  | 2005                                                       |  | 2004
| |  |  |  |                 |  |              |  |                                                            |  |     
| |  |  |  |                 |  |              |  | % of outstanding share capital 
  on an as converted basis
| |  |  |  |                 |  |              |  |                                                           
| |  |  |  | Jordan
  Valley |  | 8(4)(a)      |  | 27.8                                                       |  | 27.8
| |  |  |  | Impliant        |  | 8(4)(b)      |  | 21.5                                                       |  | 20.1
| |  |  |  | Nulens          |  | 8(4)(c)      |  | 21.6                                                       |  |    
| |  |  |  | Teledata        |  | 8(4)(d)      |  | 21.1                                                       |  |    
| |  |  |  | Brainsgate      |  | 8(4)(e)      |  | 22.3                                                       |  |    
| |  |  |  | Safend          |  | 8(4)(f)      |  |                                                           |  |    

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (a) | Jordan
  Valley                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |     | On October
  21, 2004, Elron purchased 32,901 Preferred A shares of Jordan Valley
  Semiconductor Ltd. (Jordan Valley), in consideration for approximately
  $6,700, as part of an aggregate investment of approximately $9,000 raised by
  Jordan Valley. The balance of the aggregate investment in Jordan Valley was
  invested by Clal Industries and Investments Ltd. (Clal) by way of
  conversion of previously granted loans. Jordan Valley is an Israeli private
  company engaged in developing solutions for advanced in-line thin film
  metrology for the semiconductor industry. Following the investment Elron
  holds 25% of Jordan Valley on a fully diluted basis and on an as converted
  basis. According to the agreement, Elrons holding percentage was subject to
  adjustment based on Jordan Valleys future performance and therefore Elron
  invested in October 2005 an additional $1,400. Jordan Valley is also 40%
  owned (indirectly) by Clal, an entity under common control with DIC. Elrons
  investment in Jordan Valley was approved by the shareholders of Elron and
  Clal on October 21, 2004. Since the investment in preferred A shares is not
  considered to be an investment that is in-substance-common stock, the
  investment in Jordan Valley is accounted for under the cost method.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | (b) | Impliant                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |     | On December 28, 2004, Elron invested approximately $7,300 in
  consideration for 19,962,500 Preferred C shares of Impliant Inc. (Impliant)
  as part of a financing round of approximately $18,000 from new and existing
  investors of Impliant. In 2005 Elron invested an additional $1,000 in
  consideration for 2,682,907 Preferred C shares as part of a financing round
  of approximately $5,400. Impliant is a privately held medical device company,
  engaged in the development of a novel posterior motion preservation system
  for spine surgery. Following the aforementioned investments, Elron holds
  approximately 20% of Impliant, on a fully diluted basis and on an as
  converted basis. Since the investment in preferred C shares is not considered
  to be an investment that is in-substance-common stock, the investment in Impliant
  is accounted for under the cost method.                                                                                                                                                                                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | (c) | NuLens                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |     | On April 21,
  2005, Elron completed an investment of approximately $2,900 in NuLens Ltd.
  (NuLens), in consideration for 763,584 Series A preferred shares, as part
  of an aggregate investment of approximately $3,400. NuLens is an Israeli
  medical device company operating in the field of intra-ocular lenses mainly
  for cataract and presbyopia procedures. Elrons investment was in two
  installments, the first of approximately $1,700 was invested immediately for
  approximately 17% of NuLens on a fully diluted and on an                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

35

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                 
|-------- | ----------------------------------------------------------------
|NOTE 8:- | INVESTMENTS IN OTHER COMPANIES AND LONG-TERM RECEIVABLES (Cont.)

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (c) | NuLens
  (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |     | as converted
  basis and an additional amount of approximately $1,200 was invested on March
  9, 2006, simultaneously with an additional investment of $1,500, for 241,158
  Series B preferred shares as part of a new round of investment in the
  aggregate amount of approximately $6,000. The new round was led by Warburg
  Pincus, a leading global private equity fund. Following the above
  investments, Elron holds 25% of NuLens, on a fully diluted and on an as
  converted basis. Since the investments in preferred A and B shares are not
  considered to be an investment that is in-substance-common stock, the
  investment in NuLens is accounted for under the cost method                                                                                                                                                       
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | (d) | Teledata                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |     | On May 8,
  2005, Elron completed an investment of $16,000 in Teledata Networks Ltd.
  (Teledata), in consideration for 4,923,194 series A preferred shares. The
  investment is part of an aggregate round of financing of $19,000, in which
  FBR Infinity II Ventures, an indirectly related venture capital fund
  (Infinity), invested the remaining $3,000. Teledata provides innovative
  access products and solutions for both traditional and next generation
  networks to telecom operators and service providers. Following the
  investment, Elron holds approximately 21% of Teledata, on a fully diluted and
  on an as converted basis. Since the investment in preferred A shares is not
  considered to be an investment that is in-substance-common stock, the
  investment in Teledata is accounted for under the cost method.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | (e) | BrainsGate                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |     | On August 8,
  2005, Elron completed an investment of approximately $6,900 in BrainsGate
  Ltd. (BrainsGate), in consideration for 1,733,141 Series B-1 preferred
  shares, as part of an aggregate investment of approximately $17,000.
  BrainsGate is an Israeli company that is developing implantable medical
  devices to treat various central nervous system diseases (CNS) related
  pathologies. Following Elrons investment, Elron holds approximately 20% of
  BrainsGate, on a fully diluted and on an as converted basis. Since the
  investment is in preferred B-1 shares, which are not considered to be an
  investment that is in-substance- common stock, the investment in BrainsGate
  is accounted for under the cost method.                                                                                                
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | (f) | Safend                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |     | On January
  2, 2006 Elron completed an investment of approximately $3,700 in Safend Ltd.
  (Safend) of which $200 were granted as a bridge loan in December 2005, in
  consideration for 1,942,261 Series B preferred shares, as part of an
  aggregate investment of approximately $7,400. Following Elrons investment,
  Elron holds approximately 22% of Safend on a fully diluted and on an as
  converted basis. Safend is an Israeli company which develops comprehensive
  desktops and laptops endpoint security solutions.                                                                                                                                                                                                                                                                                                                

36

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                            
|-------- | ---------------------------
|NOTE 9:- | PROPERTY AND EQUIPMENT, NET

| |                                      |  |             |        |      |   |        | 
| | ------------------------------------ |  | ----------- | ------ | ---- | - | ------ | 
| |                                      |  | December 31 |       
| |                                      |  |             |       
| |                                      |  | 2005        |        | 2004 |  
| |                                      |  |             |        |      |  
|
| | Land and
  Building                  |  | $           | 9,944  |      | $ | 10,060 | 
| | Leasehold
  improvements             |  |             | 2,508  |      |   | 2,389  | 
| | Computers,
  furniture and machinery |  |             | 4,176  |      |   | 3,691  | 
| | Motor
  vehicles                     |  |             | 561    |      |   | 521    | 
| |                                      |  |             |        |      |   |        | 
| |                                      |  |             | 17,189 |      |   | 16,661 | 
| | Less -
  accumulated depreciation    |  |             | 9,380  |      |   | 8,604  | 
| |                                      |  |             |        |      |   |        | 
| |                                      |  |             |        |      |   |        | 
| | Property and
  equipment, net        |  | $           | 7,809  |      | $ | 8,057  | 
| |                                      |  |             |        |      |   |        | 

| |                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Depreciation
  expenses amounted to approximately $1,016, $1,013 and $1,336 for the years
  ended                                                                                 
| | December 31,
  2005, 2004 and 2003, respectively.                                                                                                                                 
|
| | Depreciation
  expenses included in the discontinued operations, amounted approximately $10,
  $124 and $254 for the years ended December 31,
  2005, 2004 and 2003, respectively.

|          |                                     
|--------- | ------------------------------------
|NOTE 10:- | GOODWILL AND OTHER INTANGIBLE ASSETS

| |                                                 |  |              |       |             |   |       |  |   |       | 
| | ----------------------------------------------- |  | ------------ | ----- | ----------- | - | ----- |  | - | ----- | 
| |                                                 |  |              |       | December 31 |  
| |                                                 |  | Period of    |       |             |  
| |                                                 |  | amortization |       | 2005        |   | 2004  | 
| |                                                 |  |              |       |             |   |       | 
| |                                                 |  |              | years |             |   |       |  |   |       | 
|
| | Cost:                                           |  |              |       |             |   |       |  |   |       | 
| | Technology
  and other intangible assets (1)    |  |              | 14    |             | $ | 425   |  | $ | 383   | 
| |                                                 |  |              |       |             |   |       |  |   |       | 
| | Accumulated
  amortization:                     |  |              |       |             |   |       |  |   |       | 
| | Technology
  and other intangible assets (1)    |  |              |       |             |   | 236   |  |   | 174   | 
| |                                                 |  |              |       |             |   |       |  |   |       | 
|
| |                                                 |  |              |       |             |   | 189   |  |   | 209   | 
| |                                                 |  |              |       |             |   |       |  |   |       | 
|
| | Intangible
  assets with indefinite useful life |  |              |       |             |   | 2,629 |  |   | 2,629 | 
| |                                                 |  |              |       |             |   |       |  |   |       | 
| | Goodwill                                        |  |              |       |             |   | 2,742 |  |   | 6,657 | 
| |                                                 |  |              |       |             |   |       |  |   |       | 
|
| | Amortized
  cost                                |  |              |       |             | $ | 5,560 |  | $ | 9,495 | 
| |                                                 |  |              |       |             |   |       |  |   |       | 

| |    |                                                                                                                                                                                                                            
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | The annual
  estimated amortization expense relating to Elrons amortizable intangible
  assets existing as of December 31, 2005, for each of the five years in the
  period ending December 31, 2010 is approximately $40.

37

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                             
|--------- | --------------------------------------------
|NOTE 10:- | GOODWILL AND OTHER INTANGIBLE ASSETS (Cont.)

| |    |                                                                                                                        
| | -- | -----------------------------------------------------------------------------------------------------------------------
| | 2. | The changes
  in the carrying amount of goodwill for the years ended December 31, 2005, 2004
  and 2003 are as follows:

| |                                                                                                       |  |                                           |             |   |  |  | 
| | ----------------------------------------------------------------------------------------------------- |  | ----------------------------------------- | ----------- | - |  |  | 
| |                                                                                                       |  | Other Holdings and
  Corporate operations |             |   | 
| |                                                                                                       |  |                                           |             |   | 
| | Balance as of January 1, 2003                                                                         |  |                                           | $   14,862  |   |  |  | 
| | Goodwill write-off relating to sale of business                                                       |  |                                           | (781        | ) |  |  | 
| | Adjustment of goodwill due to reversal of valuation allowance in
  respect to deferred tax assets (4) |  |                                           | (7,653      | ) |  |  | 
| |                                                                                                       |  |                                           |             |   |  |  | 
| | Balance as of December 31, 2003                                                                       |  |                                           | $     6,428 |   |  |  | 
| |                                                                                                       |  |                                           |             |   |  |  | 
| | Newly consolidated companies                                                                          |  |                                           | 229         |   |  |  | 
| |                                                                                                       |  |                                           |             |   |  |  | 
| | Balance as of December 31, 2004                                                                       |  |                                           | $     6,657 |   |  |  | 
| | Adjustment of goodwill due to reversal of valuation allowance in
  respect to deferred tax assets (4) |  |                                           | (3,915      | ) |  |  | 
| |                                                                                                       |  |                                           |             |   |  |  | 
|
| | Balance as of December 31, 2005                                                                       |  |                                           | $     2,742 |   |  |  | 
| |                                                                                                       |  |                                           |             |   |  |  | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                      
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3. | Amortization
  expenses amounted to approximately $61, $142 and $299 for the years ended
  December 31, 2005, 2004 and 2003, respectively.                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                      
| | 4. | In 2003, Elbit recorded a
  tax benefit in the amount of approximately $7,700, and reduced its valuation
  allowance in respect of deferred tax assets. Since the tax benefit was in
  respect of losses carryforward of Elbit at the date of Elbits merger with
  Elron (May 2002) (the merger), Elron recorded the tax benefit as a
  reduction from goodwill that had resulted from the merger.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                      
| |    | With respect to 2005  see
  Note 14 (e).                                                                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                      
| | 5. | Regarding the write down
  of an intangible asset relating to Mediagate, see Note 3c.                                                                                                                                                                                                                                                                                                                

|          |                                       
|--------- | --------------------------------------
|NOTE 11:- | SHORT-TERM LOANS FROM BANKS AND OTHERS

| |                                                           |  |                                                             |      |             |   |       |  |   |     | 
| | --------------------------------------------------------- |  | ----------------------------------------------------------- | ---- | ----------- | - | ----- |  | - | --- | 
| |                                                           |  | Weighted 
  Average 
  Interest rate
  December 31, 
  2005 |      | December 31 |  
| |                                                           |  |                                                             |      |             |  
| |                                                           |  | %                                                           |      | 2005        |   | 2004  | 
| |                                                           |  |                                                             |      |             |   |       | 
|
| | Short-term loans from banks denominated in
  NIS          |  |                                                             |     |             | $ |      |  | $ | 9   | 
| | Short-term loans from banks denominated in
  U.S. dollars |  |                                                             | 6.62 | %           |   | 3,808 |  |   | 380 | 
| |                                                           |  |                                                             |      |             |   |       |  |   |     | 
| |                                                           |  |                                                             |      |             |   |       |  |   |     | 
| |                                                           |  |                                                             |      |             | $ | 3,808 |  | $ | 389 | 
| |                                                           |  |                                                             |      |             |   |       |  |   |     | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | As of
  December 31, 2005, the balance also includes a bank loan to Mediagate in the
  amount of approximately $2,600 bearing an annual interest rate of the
  Wholesale Interest Rate plus 1% (the Wholesale Interest Rate as of December
  31, 2005 and 2004 was approximately 5.3% and 3.3%, respectively). In 2004 the
  loan was represented as long term loan. In February 2006, the loan (including
  accrued interest) was extinguished for a consideration of $100. As a result
  Elron will record in the first quarter of 2006 a gain of approximately
  $2,700.

38

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                    
|--------- | -----------------------------------
|NOTE 12:- | OTHER PAYABLES AND ACCRUED EXPENSES

| |                                           |  |             |       
| | ----------------------------------------- |  | ----------- | ------
| |                                           |  | December 31 |       
| |                                           |  |             |       
| |                                           |  | 2005        |       
| |                                           |  |             |       
| |                                           |  |             |       
| | Payroll and
  related expenses (1)        |  | $           | 2,502 
| | Provision
  for income taxes              |  |             | 4,252 
| | Accrued
  expenses                        |  |             | 850   
| | Deferred
  revenues                       |  |             |      
| | Employees
  call options (2)              |  |             | 836   
| | Provision
  for rent                      |  |             |      
| | Provision
  for Professional expenses     |  |             | 455   
| | Chief
  Scientist                         |  |             | 443   
| | Others                                    |  |             | 1,687 
| |                                           |  |             |       
| |                                           |  | $           | 11,025
| |                                           |  |             |       
|
| | (1) Includes
  provision for vacation pay |  | $           | 958   
| |                                           |  |             |       

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (2) | EMPLOYEE
  CALL OPTIONS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | a.  | The
  Companys Chairman of the Board has options to acquire up to 1.5% of any
  shares or other securities acquired by the Company in Wavion and up to 0.75%
  of any shares or other securities acquired directly and indirectly by the
  Company in Galil. These options shall be exercisable at the weighted average
  price of investments made by the Company with respect to any of those two companies
  until the date of exercise of the options. The options shall be exercisable
  for a period of three years commencing on the later of January 1, 2000 or the
  date of the latest investment by the Company in the relevant entity.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | b.  | During 2001,
  the Board of directors approved the grant of options to certain officers of
  the Company to acquire between 1% to 2% of Elrons investments in certain
  private companies. The options are exercisable at the weighted average price
  of the investments made by Elron. The options vest ratably over a three year
  period and are exercisable for an additional three years.                                                                                                                                                                                                                                                   
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | c.  | In 1999, RDC
  granted two former senior employees with call options to purchase up to 5% of
  the investments held by RDC at that date at an exercise price as determined
  in the call option agreement. During 2005, a former senior employee of RDC
  exercised a call option with respect to 70,200 shares of Given at an exercise
  price of $0.17 per share (See Note 7d(2)).                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | d.  | In 2004, RDC
  granted to a key employee call options to purchase up to 0.75% of RDCs
  investment in Starling at an exercise price as determined in the call option
  agreement. Approximately 67% of the options vest ratably over a period of 4
  years and the balance are fully vested.                                                                                                                                                                                                                                                                                                                                                      

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | All
  aforementioned options were recorded at fair value. The fair value of each
  option granted (as described in paragraphs a - d above) is estimated using
  the Black and Scholes option pricing model with the following weighted
  average assumptions for the years ended December 31, 2005, 2004 and 2003,
  respectively: (1) expected life of the option of 1.8, 4 and 3.89,
  respectively; (2) dividend yield of 0% for all periods; (3) expected
  volatility of the options of 50%, 50% and 0% to 65%, respectively; and (4) risk-free
  interest rate of 4.6%, 2.5% and 1%, respectively.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | In respect
  of the aforementioned call options, compensation expense (income) amounted to
  $(1,041), $1,414 and $957 for the years ended December 31, 2005, 2004 and
  2003, respectively. These compensation expenses are included in General and
  administrative expenses.                                                                                                                                                                                                                                                                                                                         

39

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                      
|--------- | -------------------------------------
|NOTE 13:- | LONG-TERM LOANS FROM BANKS AND OTHERS

| |    |            
| | -- | -----------
| | a. | COMPOSITION

| |                                   |  |             |        |      |   |        |  
| | --------------------------------- |  | ----------- | ------ | ---- | - | ------ | -
| |                                   |  | December 31 |       
| |                                   |  |             |       
| |                                   |  | 2005        |        | 2004 |  
| |                                   |  |             |        |      |  
| |                                   |  |             |        |      |   |        |  
| | Long-term
  loans from banks (1)  |  | $           | 23     |      | $ | 3,420  |  
| | Long-term
  loans from others (2) |  |             | 3,519  |      |   | 3,626  |  
| |                                   |  |             |        |      |   |        |  
| |                                   |  |             | 3,542  |      |   | 7,046  |  
| |                                   |  |             |        |      |   |        |  
| | Less-current
  maturities (2)     |  |             | (2,065 | )    |   | (2,974 | )
| |                                   |  |             |        |      |   |        |  
|
| |                                   |  | $           | 1,477  |      | $ | 4,072  |  
| |                                   |  |             |        |      |   |        |  

| |    |                                                                                                      |                                                                                                                                                                                                                                                                                         
| | -- | ---------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | (1)                                                                                                  | In 2004,
  with respect to Mediagates loan see Note 11.                                                                                                                                                                                                                                
| |    |                                                                                                      |                                                                                                                                                                                                                                                                                         
| |    | (2)                                                                                                  | As of
  December 31, 2005 and 2004 an amount of $2,058 and $2,199, respectively,
  represents loans from Rafael to RDC which are denominated in New Israeli
  Shekel (NIS) and do not bear interest or linkage. These amounts are
  included in current maturities of long term loans.
| |    |                                                                                                      |                                                                                                                                                                                                                                                                                         
| |    |                                                                                                      | As of
  December 31, 2005, the amount also includes a loan of approximately $1,379
  from the minority shareholders of Galil. The loan bears interest at a rate of
  Libor plus 3%.                                                                                                     
| |    |                                                                                                      |                                                                                                                                                                                                                                                                                         
| | b. | The
  maturities of long-term loans for years subsequent to the balance sheet date
  are as follows:

| |                                   |  |   |       | 
| | --------------------------------- |  | - | ----- | 
| | First year
  (current maturities) |  | $ | 2,065 | 
| | Second year                       |  |   | 1,469 | 
| | Third year                        |  |   | 8     | 
| |                                   |  |   |       | 
|
| |                                   |  | $ | 3,542 | 
| |                                   |  |   |       | 

|          |             
|--------- | ------------
|NOTE 14:- | INCOME TAXES

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. | Measurement
  of taxable income under the Income Tax (Inflationary Adjustments) Law, 1985:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | In
  accordance with the above law, results for tax purposes are measured and
  reflected in real terms in accordance with the change in the Israeli CPI. As
  explained in Note 2b, the consolidated financial statements are presented in
  U.S. dollars. The differences between the change in the Israeli CPI and in
  the NIS/U.S. dollar exchange rate causes a difference between taxable income
  or loss and the income or loss before taxes reflected in the consolidated
  financial statements. In accordance with paragraph 9(f) of SFAS 109, the
  Company has not provided deferred income taxes on this difference between
  amounts in the reporting currency and the tax bases of assets and
  liabilities.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | b. | Tax benefits
  under Israels Law for the Encouragement of Industry (Taxation), 1969:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | Certain of
  the Companys subsidiaries in Israel are industrial companies, as defined
  by the Law for the Encouragement of Industry (Taxation), 1969, and as such,
  are entitled to certain tax benefits, mainly accelerated depreciation and the
  right to claim public issuance expenses and amortization of costs relating to
  intangible assets and patents as deductible expenses for tax purposes.                                                                                                                                                                                                                                                                                                              

40

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                     
|--------- | --------------------
|NOTE 14:- | INCOME TAXES (Cont.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | c. | Tax benefits
  under the Law for the Encouragement of Capital Investments, 1959:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Some of the
  Companys subsidiaries have been granted an Approved Enterprise status for
  their production facilities in Israel under the Law for the Encouragement of
  Capital Investments, 1959. The main benefit to which these subsidiaries are
  entitled, conditional upon the fulfilling of certain conditions stipulated by
  the above law, is a ten-year exemption from tax on income derived from their
  production facilities in Israel. The ten-year period is limited to the earlier
  of twelve years from the commencement of production, or fourteen years from
  the approval date.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | d. | In 2004, the
  Israeli parliament approved on amendment to the Income Tax Ordinance (No. 140
  and Temporary Provision) which reduces the corporate tax rate from 36% to 35%
  in 2004 and progressively to a rate of 30% in 2007. As a result, Elron
  recorded in 2004 a tax benefit in the amount of approximately $2,900.                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | On July 25,
  2005, the Israeli parliament approved the Law for the Amendment of the Tax
  Ordinance (No. 147), 2005 which progressively reduces the corporate tax rate
  in Israel to the following tax rates: in 2006 - 31%, in 2007  29%, in 2008 -
  27%, in 2009 - 26% and in 2010 and thereafter - 25% (the Amendment). The
  amendment had no material effect on the Companys financial position and
  results of operations in 2005.                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | e. | Taxes on
  income (tax benefit) are comprised as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| | ------------------------------------------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ | - | - | ----- | 
| |                                                                                       |  | Year ended
  December 31, |       
| |                                                                                       |  |                           |       
| |                                                                                       |  | 2005                      |        | 2004 |   | 2003   |  
| |                                                                                       |  |                           |        |      |   |        |  
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| | Current taxes*                                                                        |  | $                         | 19,031 |      | $ | 16,363 |   | $ | 385   | 
| | Adjustments of deferred tax assets and
  liabilities for enacted changes in tax rates |  |                           | 116    |      |   | (2,917 | ) |   |      | 
| | Deferred
  income taxes                                                               |  |                           | (7,404 | )    |   | 508    |   |   | 6,229 | 
| | Taxes in
  respect of prior years                                                     |  |                           | (1,282 | )    |   | 1,147  |   |   | 182   | 
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| |                                                                                       |  | $                         | 10,461 |      | $ | 15,101 |   | $ | 6,796 | 
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| | Domestic                                                                              |  | $                         | 10,461 |      | $ | 15,101 |   | $ | 6,796 | 
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 
| | Foreign                                                                               |  | $                         |       |      | $ |       |   | $ |      | 
| |                                                                                       |  |                           |        |      |   |        |   |   |       | 

| |    |                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | *                                                                                                                                                                                                                                                                                                                   | In 2005,
  Elbit received final tax assessments for the years 2002 to 2004, according to
  which certain prior year losses are to be offset from certain gains.  Consequently, Elbit reversed a valuation
  allowance previously recorded in respect of deferred tax assets relating to
  loss carryforwards. This reversal resulted in a tax benefit of $14,500. Since
  a portion of the valuation allowance reversed was in respect of loss
  carryforwards of Elbit existing at the date of the merger, Elron recorded a
  tax benefit in the amount of $3,900 relating to such portion as a reduction
  of the remaining goodwill.
| |    |                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | f. | Deferred
  income taxes:                                                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | Deferred
  income taxes reflect the net tax effect of temporary differences between the
  carrying amounts of assets and liabilities for financial reporting purposes and
  the amounts used for income tax purposes. Significant components of the
  Companys deferred tax liabilities and assets are as follows:

41

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                     
|--------- | --------------------
|NOTE 14:- | INCOME TAXES (Cont.)

| |    |                         
| | -- | ------------------------
| | f. | Deferred
  income taxes:

| |                                                                  |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| | ---------------------------------------------------------------- |  | -------------------- | ------- | ------------------------ | - | ------- | - | ------------- | - | ----- | - | ------ | - | - | ------- | -
| |                                                                  |  | Deferred
  Tax Asset |         | Deferred
  Tax Liability |   |         |   |              
| |                                                                  |  |                      |         |                          |   |         |   |              
| |                                                                  |  | Non
  current        |         | Current                  |   | Current |   | Non
  current |   | Total |  
| |                                                                  |  |                      |         |                          |   |         |   |               |   |       |  
| | As of December 31, 2005                                          |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| | Deferred tax assets:                                             |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| | Provision for doubtful accounts, vacation and
others             |  | $                    |        |                          | $ | 201     |   | $             |  |       | $ |       |   | $ | 201     |  
| | Accrued severance pay, net                                       |  |                      | 156     |                          |   |        |   |               |  |       |   |       |   |   | 156     |  
| | Trading marketable securities                                    |  |                      |        |                          |   | 22      |   |               |  |       |   |       |   |   | 22      |  
| | Investments in subsidiaries, affiliates and other companies,
net |  |                      | 31,946  |                          |   |        |   |               |  |       |   | (1,848 | ) |   | 30,098  |  
| | Property and equipment and intangible assets                     |  |                      | 28      |                          |   |        |   |               |  |       |   | (744   | ) |   | (716    | )
| | Tax loss carryforwards                                           |  |                      | 36,505  |                          |   |        |   |               |  |       |   | 955    |   |   | 37,460  |  
| | Other                                                            |  |                      |         |                          |   | 356     |   |               |  |       |   |       |   |   | 356     |  
| |                                                                  |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| |                                                                  |  | $                    | 68,635  |                          | $ | 579     |   | $             |  |       | $ | (1,637 | ) | $ | 67,577  |  
| |                                                                  |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| | Deferred tax liabilities:                                        |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| | Available-for-sale marketable securities                         |  |                      |        |                          |   |        |   |               |  |       |   | (7,857 | ) |   | (7,857  | )
| |                                                                  |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| |                                                                  |  |                      |         |                          |   |         |   |               |  |       |   |        |   |   |         |  
| | Valuation allowance (1)                                          |  |                      | (62,114 | )                        |   | (579    | ) |               |  |       |   |       |   |   | (62,693 | )
| |                                                                  |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  
| |                                                                  |  | $                    | 6,521   |                          | $ |        |   | $             |  |       | $ | (9,494 | ) | $ | (2,973  | )
| |                                                                  |  |                      |         |                          |   |         |   |               |   |       |   |        |   |   |         |  

| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| | ---------------------------------------------------------------- |  | ------------- | -------------------- | ------- | ------------------------ | ------- | - | ------------- | - | ----- | - | ------- | - | - | -------- | -
| |                                                                  |  |               | Deferred
  Tax Asset |         | Deferred
  Tax Liability |         |   |               |  
| |                                                                  |  |               |                      |         |                          |         |   |               |  
| |                                                                  |  | Non
  current |                      | Current |                          | Current |   | Non
  current |   | Total |  
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |  
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| | As of December 31, 2004                                          |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| | Deferred tax assets:                                             |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| | Provision for doubtful accounts, vacation and
others             |  | $             |                     |         | $                        | 341     |   | $             |  |       | $ |        |   | $ | 341      |  
| | Accrued severance pay, net                                       |  |               | 363                  |         |                          |        |   |               |  |       |   |        |   |   | 363      |  
| | Trading marketable securities                                    |  |               |                     |         |                          | 20      |   |               |  |       |   |        |   |   | 20       |  
| | Investments in subsidiaries, affiliates and other companies,
net |  |               | 39,801               |         |                          |        |   |               |  |       |   | (1,659  | ) |   | 38,142   |  
| | Property and equipment and intangible assets                     |  |               | 184                  |         |                          |        |   |               |  |       |   | (811    | ) |   | (627     | )
| | Tax loss carryforwards                                           |  |               | 72,545               |         |                          |        |   |               |  |       |   | 6,473   |   |   | 79,018   |  
| | Other                                                            |  |               |                     |         |                          | 1,151   |   |               |  |       |   |        |   |   | 1,151    |  
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| |                                                                  |  | $             | 112,893              |         | $                        | 1,512   |   | $             |  |       | $ | 4,003   |   | $ | 118,408  |  
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| | Deferred tax liabilities:                                        |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| | Available-for-sale marketable securities                         |  |               |                     |         |                          |        |   |               |  |       |   | (45,236 | ) |   | (45,236  | )
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| |                                                                  |  |               | 112,893              |         |                          | 1,512   |   |               |  |       |   | (41,233 | ) |   | 73,172   |  
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| | Valuation allowance                                              |  |               | (107,400             | )       |                          | (1,512  | ) |               |  |       |   |        |   |   | (108,912 | )
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  
| |                                                                  |  | $             | 5,493                |         | $                        |        |   | $             |  |       | $ | (41,233 | ) | $ | (35,740  | )
| |                                                                  |  |               |                      |         |                          |         |   |               |   |       |   |         |   |   |          |  

| |    |                                                                                                                                                                                                                                          |                                                                                                                                                                                                           
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | (1)                                                                                                                                                                                                                                      | As of
  December 31, 2005, the valuation allowance for deferred tax assets, for which
  their reversal will be allocated to reduce other non-current intangible
  assets, aggregated approximately $1,800.
| |    |                                                                                                                                                                                                                                          |                                                                                                                                                                                                           
| | g. | A
  reconciliation between the theoretical tax expense, assuming all income is
  taxed at the statutory tax rate applicable to income of the Company and the
  actual tax expense as reported in the statement of income, is as follows:

42

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                     
|--------- | --------------------
|NOTE 14:- | INCOME TAXES (Cont.)

| |                                                                                       |  |                           |         |      |   |         |   |   |        |  
| | ------------------------------------------------------------------------------------- |  | ------------------------- | ------- | ---- | - | ------- | - | - | ------ | -
| |                                                                                       |  | Year ended
  December 31, |        
| |                                                                                       |  |                           |        
| |                                                                                       |  | 2005                      |         | 2004 |   | 2003    |  
| |                                                                                       |  |                           |         |      |   |         |  
| |                                                                                       |  |                           |         |      |   |         |   |   |        |  
| | Income (loss) before taxes as reported in
  the consolidated statements of operations |  | $                         | 56,486  |      | $ | 111,734 |   | $ | 12,807 |  
| |                                                                                       |  |                           |         |      |   |         |   |   |        |  
| |                                                                                       |  |                           |         |      |   |         |   |   |        |  
| | Statutory tax rate                                                                    |  |                           | 34      | %    |   | 35      | % |   | 36     | %
| |                                                                                       |  |                           |         |      |   |         |   |   |        |  
| | Theoretical tax expense (income)                                                      |  | $                         | 19,205  |      | $ | 39,107  |   | $ | 4,611  |  
| | Equity in losses of affiliated companies                                              |  |                           | 6,076   |      |   | 3,672   |   |   | 3,131  |  
| | Non-deductible expenses, tax exempt and
  reduced tax rate                            |  |                           | (639    | )    |   | 856     |   |   | 1,514  |  
| | Differences arising from the basis of
  measurement for tax purposes                  |  |                           | 1,233   |      |   | (1,024  | ) |   | 2,783  |  
| | Deferred taxes on losses for which
  valuation allowance was provided                 |  |                           | 5,370   |      |   | 2,940   |   |   | 1,977  |  
| | Reversal of valuation allowance                                                       |  |                           | (19,618 | )    |   | (28,680 | ) |   | (7,402 | )
| | Taxes in respect of previous years                                                    |  |                           | (1,282  | )    |   | 1,147   |   |   | 182    |  
| | Effect of change in tax rate                                                          |  |                           | 116     |      |   | (2,917  | ) |   |       |  
| |                                                                                       |  |                           |         |      |   |         |   |   |        |  
| | Actual tax expenses                                                                   |  | $                         | 10,461  |      | $ | 15,101  |   | $ | 6,796  |  
| |                                                                                       |  |                           |         |      |   |         |   |   |        |  
| | Effective tax rate                                                                    |  |                           | 18.5    | %    |   | 13.5    | % |   | 53.1   | %
| |                                                                                       |  |                           |         |      |   |         |   |   |        |  

| |    |                                                                                                                                                                                                                                                                                                
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | h. | As of
  December 31, 2005 the Company had tax loss carryforwards of approximately
  $69,000, its Israeli subsidiaries had tax loss carryforwards of approximately
  $51,000. Carryforward tax losses in Israel may be carryforward indefinitely
  and may be set against future taxable income.
| |    |                                                                                                                                                                                                                                                                                                
| | i. | Income
  before taxes on income is comprised as follows:                                                                                                                                                                                                                                       

| |          |  |                           |        |      |   |         |  |   |        |  
| | -------- |  | ------------------------- | ------ | ---- | - | ------- |  | - | ------ | -
| |          |  | Year ended
  December 31, |       
| |          |  |                           |       
| |          |  | 2005                      |        | 2004 |   | 2003    | 
| |          |  |                           |        |      |   |         | 
| |          |  |                           |        |      |   |         |  |   |        |  
| | Domestic |  | $                         | 56,486 |      | $ | 111,576 |  | $ | 20,671 |  
| | Foreign  |  |                           |       |      |   | 158     |  |   | (7,864 | )
| |          |  |                           |        |      |   |         |  |   |        |  
| |          |  |                           |        |      |   |         |  |   |        |  
| |          |  | $                         | 56,486 |      | $ | 111,734 |  | $ | 12,807 |  
| |          |  |                           |        |      |   |         |  |   |        |  

|          |                                                
|--------- | -----------------------------------------------
|NOTE 15:- | CONTINGENT LIABILITIES, PLEDGES AND COMMITMENTS

| |    |                                                                                                                                                                                                                                                                                                                                                                                                 
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. | The Company
  and its subsidiaries have operating lease agreements in respect of their
  premises for periods ending through 2011. Rent expenses amounted to
  approximately $593, $534 and $456 for the years ended December 31, 2005, 2004
  and 2003, respectively. The future minimum rental payments under these
  agreements in the years following the balance sheet date are as follows:

| |                             |  |   |       | 
| | --------------------------- |  | - | ----- | 
| | First year                  |  | $ | 797   | 
| | Second year                 |  |   | 686   | 
| | Third year                  |  |   | 387   | 
| | Fourth year                 |  |   | 201   | 
| | Fifth year
  and thereafter |  |   | 258   | 
| |                             |  |   |       | 
| |                             |  |   |       | 
| |                             |  | $ | 2,329 | 
| |                             |  |   |       | 

43

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                        
|--------- | -------------------------------------------------------
|NOTE 15:- | CONTINGENT LIABILITIES, PLEDGES AND COMMITMENTS (Cont.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | b. | Certain of
  the Companys subsidiaries are required to pay royalties to the Office of the
  Chief Scientist of the Israeli Ministry of Industry and Trade and other
  institutions at the rate of 3%-5% of revenues derived from research and
  development projects in which the Government of Israel or the other
  institutions participated in financing up to an amount equal to 100% of the
  amount received by each company and in certain cases plus interest of Libor.
  As of December 31, 2005, the aggregate contingent obligation royalty amounted
  to approximately $3,868.                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | c. | Legal
  proceedings:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | 1. | During September 1999, the
  Company received copies of two claims and a request to approve such claims as
  a class action on behalf of public shareholders of Elscint (formerly an
  affiliated company) against the Company and others. The allegation raised by
  the claimants related to the decision regarding the sale of Elscints
  substantial assets.  The claim has
  been stayed pursuant to an arrangement reached by the parties pending the
  outcome of the appeal in the claim described in paragraph 2 below. The
  arrangement provides that if the appeal as described in paragraph 2 below is
  accepted, then the proceedings to recognize the lawsuit as a class action
  will proceed.  Otherwise, the
  application to recognize the claim as a class action suit will be dismissed.                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | 2. | On November
  2, 1999, the Company received a copy of a claim, and a request to approve
  such a claim, as a class action on behalf of some institutional investors and
  others and those who held shares in Elscint on September 6, 1999. The
  allegations raised against the Company and certain of its officers including
  former officers, among others, relate to the period prior to the sale of the
  Companys holdings in Elbit Medical Imaging (EMI) (the parent company of
  Elscint and formerly an affiliated company). The claimants seek a court order
  pursuant to which EMI would be compelled to execute the alleged buy-out of
  Elscints share at $14 per share or other remedies. On August 16, 2000, the
  Haifa District court dismissed the application to recognize the claim as a
  class action. Some of the claimants applied for and have been granted
  permission to appeal to the Supreme Court in Israel, which appeal is
  currently pending.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | In addition,
  in February 2001, the claimants submitted a revised claim similar to the
  previous one but not as a class action. It has not been determined when the
  defendants are required to file their statements of defense to the claim. The
  claimants and the defendants are currently involved in various proceedings,
  mostly regarding the disagreement concerning the court fees.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | The Company
  denies all the allegations set forth in the above claims, and based on legal
  advice received, management is of the opinion that the Company has good
  defense arguments which, if accepted, will cause dismissal of the above
  allegations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

|          |                     
|--------- | --------------------
|NOTE 16:- | SHAREHOLDERS EQUITY

| |    |                                                                                                                                                                     
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. | Share capital                                                                                                                                                       
| |    |                                                                                                                                                                     
| |    | An ordinary
  share confers upon its holder voting rights, the right to receive dividends
  and the right to share in excess assets upon liquidation of the Company.
| |    |                                                                                                                                                                     
| | b. | Dividend                                                                                                                                                            
| |    |                                                                                                                                                                     
| |    | On September
  5, 2005, Elron has declared a cash dividend of $3.00 per share, totaling
  approximately $88,500. The dividend was paid on September 27, 2005.       

44

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                             
|--------- | ----------------------------
|NOTE 16:- | SHAREHOLDERS EQUITY (Cont.)

| |    |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -- | ---------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | c. | Options to
  employees
| |    |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | 1.                     | Options to
  Elrons Employees                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |    |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                        | The Company
  has various stock option plans under which the Company may grant options to
  purchase the Companys shares to officers, directors and employees of the
  Company. Such options have been granted mainly with exercise prices below
  market price at the date of the grant. Generally, the options vest over a
  four-year period from the date of grant in four equal annual portions. The
  options expire after 5 to 7 years from the date of grant. 
| |    |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                        | In May 2003,
  the Board of directors of the Company approved an option plan (the 2003
  Option Plan) providing for the grant of 500,000 options to purchase 500,000
  ordinary shares of the Company to eligible employees, directors and officers
  of the Company or of any subsidiaries of the Company. According to the option
  plan the exercise price is to be reduced in the event of a distribution of a
  dividend in the amount the dividend distributed.
| |    |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                        | As of
  December 31, 2005, 388,000 options were granted under the 2003 Option Plan at
  an average exercise price of $6.37 per share. The exercise price was adjusted
  to reflect the abovementioned dividend. The options vest over a period of
  four years in four equal annual portions and expire after 5 years from date
  of grant.                                                                                                                            

| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   |  |  |         |   |   |       | 
| | ------------------------------------------ |  | ------------------- | ------- | --------------------------------- | - | ------------------- | --- | --------------------------------- | -------- | ------------------- | - | --------------------------------- |  |  | ------- | - | - | ----- | 
| |                                            |  | 2005                |         | 2004                              |   | 2003                |    
| |                                            |  |                     |         |                                   |   |                     |    
| |                                            |  | Number of
  options |         | Weighted
  average exercise price |   | Number of
  options |     | Weighted
  average exercise price |          | Number of
  options |   | Weighted
  average exercise price | 
| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   | 
| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   |  |  |         |   |   |       | 
| | Outstanding-beginning of the year          |  |                     | 574,702 |                                   | $ | 12.44               |     |                                   | 791,777  |                     | $ | 12.01                             |  |  | 557,880 |   | $ | 13.92 | 
| | Granted                                    |  |                     | 120,000 |                                   |   | 9.69                |     |                                   | 20,000   |                     |   | 12.41                             |  |  | 291,333 |   |   | 8.03  | 
| | Exercised                                  |  |                     | (69,031 | )                                 |   | 10.11               |     |                                   | (218,290 | )                   |   | 10.35                             |  |  | (25,875 | ) |   | 6.84  | 
| | Forfeited                                  |  |                     | (85,236 | )                                 |   | 13.95               |     |                                   | (18,785  | )                   |   | 13.39                             |  |  | (31,561 | ) |   | 13.10 | 
| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   |  |  |         |   |   |       | 
| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   |  |  |         |   |   |       | 
| | Outstanding - end of the year              |  |                     | 540,435 |                                   | $ | 9.53                | (*) |                                   | 574,702  |                     | $ | 12.44                             |  |  | 791,777 |   | $ | 12.01 | 
| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   |  |  |         |   |   |       | 
| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   |  |  |         |   |   |       | 
| | Options exercisable at the end of the year |  |                     | 281,435 |                                   | $ | 11.88               | (*) |                                   | 259,369  |                     | $ | 16.56                             |  |  | 313,320 |   | $ | 15.66 | 
| |                                            |  |                     |         |                                   |   |                     |     |                                   |          |                     |   |                                   |  |  |         |   |   |       | 

| |                                                                                                       |  |                                                                                                                                                                      
| | ----------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (*) After an
  adjustment as a result of the dividend distributed of $3 per share (see Note
  16(b)).
| |                                                                                                      
| |                                                                                                       |  | The weighted
  average fair values and weighted average exercise prices of options granted
  during the years ended December 31, 2005, 2004 and 2003 were as follows:

| |                                            |  |                                                              |   |                           |   |      |  |      |      |      |   |      |  |   |       |  |   |      | 
| | ------------------------------------------ |  | ------------------------------------------------------------ | - | ------------------------- | - | ---- |  | ---- | ---- | ---- | - | ---- |  | - | ----- |  | - | ---- | 
| |                                            |  | For
  options with an exercise price on the grant date that: |  
| |                                            |  |                                                              |  
| |                                            |  | Exceeds
  market price                                       |   | Less than
  market price  |  
| |                                            |  |                                                              |   |                           |  
| |                                            |  | Year ended
  December 31,                                    |   | Year ended
  December 31, |  
| |                                            |  |                                                              |   |                           |  
| |                                            |  | 2005                                                         |   | 2004                      |   | 2003 |  | 2005 |      | 2004 |   | 2003 | 
| |                                            |  |                                                              |   |                           |   |      |  |      |      |      |   |      | 
| |                                            |  |                                                              |   |                           |   |      |  |      |      |      |   |      |  |   |       |  |   |      | 
| | Weighted average exercise prices           |  | $                                                            |  |                           | $ |     |  | $    | 8.44 |      | $ | 9.69 |  | $ | 12.41 |  | $ | 8.00 | 
| | Weighted average fair values on grant date |  | $                                                            |  |                           | $ |     |  | $    | 1.3  |      | $ | 4.18 |  | $ | 5.51  |  | $ | 2.95 | 

45

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                              |                                |                                                                                                                      
|--------- | ---------------------------- | ------------------------------ | ---------------------------------------------------------------------------------------------------------------------
|NOTE 16:- | SHAREHOLDERS EQUITY (Cont.)
|          |                              |                                |                                                                                                                      
|          | c.                           | Options to
  employees (Cont.)
|          |                              |                                |                                                                                                                      
|          |                              | 2.                             | The
  following table summarizes information regarding outstanding and exercisable
  options as of December 31, 2005:

| |                     |  |                                                 |         |                                                              |      |                                        |   |                                                 |  |                                        |        
| | ------------------- |  | ----------------------------------------------- | ------- | ------------------------------------------------------------ | ---- | -------------------------------------- | - | ----------------------------------------------- |  | -------------------------------------- | -------
| | Options outstanding |  | Options exercisable                             |        
| |                     |  |                                                 |        
| | Exercise price      |  | Number
  outstanding
  at
  December 31,
  2005 |         | Weighted-
  average
  remaining
  contractual
  life (years) |      | Weighted-
  average
  exercise
  price |   | Number
  outstanding
  at
  December 31,
  2005 |  | Weighted-
  average
  exercise
  price |        
| |                     |  |                                                 |         |                                                              |      |                                        |   |                                                 |  |                                        |        
| | $5-7.838            |  |                                                 | 307,333 |                                                              | 2.67 |                                        | $ | 5.4                                             |  |                                        | 143,333
| | $9.12-10.01         |  |                                                 | 119,384 |                                                              | 4.09 |                                        | $ | 9.31                                            |  |                                        | 24,384 
| | $15.76-18.87        |  |                                                 | 80,718  |                                                              | 1.42 |                                        | $ | 17.45                                           |  |                                        | 80,718 
| | $29.38              |  |                                                 | 33,000  |                                                              | 1.83 |                                        | $ | 29.38                                           |  |                                        | 33,000 
| |                     |  |                                                 |         |                                                              |      |                                        |   |                                                 |  |                                        |        
| |                     |  |                                                 |         |                                                              |      |                                        |   |                                                 |  |                                        |        
| |                     |  |                                                 | 540,435 |                                                              |      |                                        |   |                                                 |  |                                        |        
| |                     |  |                                                 |         |                                                              |      |                                        |   |                                                 |  |                                        |        

| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  | 3. | In December
  1999, the Companys shareholders approved a plan whereby the Chairman of the
  Board and the then Chief Executive Officer of the Company were granted
  options to purchase up to 58,154 ordinary shares of the Company (the 1999
  grant). The options were granted ratably over a period of 3 years commencing
  February 2000 and are exercisable for a period of three years, commencing two
  years after the date of the grant. On February 2005, the first portion
  expired. The exercise prices of the options granted in February 2001 and 2002
  were $15.76 and $10.01, respectively, as adjusted for the abovementioned
  dividend distributed in 2005.
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  |    | In March
  2001, the Companys shareholders approved a plan whereby the Chairman of the
  Board and the then Chief Executive Officer of the Company were granted
  options to purchase up to 58,000 ordinary shares of the Company (the 2001
  grant). The options were granted ratably over a period of 3 years commencing
  June 2001 and are exercisable for a period of three years, from the date of
  the grant. The exercise prices of the options granted in June 2001 and 2003
  were $16.05 and $5.437, respectively as adjusted for the abovementioned
  dividend distributed in 2005.                                                                                 
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  |    | In December
  2004, 19,333 options at an exercise price per share of $8.34 from the 2001
  grant were exercised into 8,623 shares.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  |    | As of grant
  date, the weighted average fair value of the remaining 1999 grant and the
  remaining 2001 grant was $ 7.62 and $ 2.64 per share, respectively.
  The fair value was calculated using the Black & Scholes option-pricing
  model (see Note 2s for the assumptions used in the calculation).                                                                                                                                                                                                                                                                                                                                                                           
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  |    | Upon
  exercise of the options, the option holder will be granted a number of shares
  reflecting the intrinsic value of the options exercised, as calculated at the
  exercise date, in consideration for their par value only. These plans are
  considered to be variable plans as defined in APB 25 (except for the third
  portion of the 2001 grant which is accounted for under SFAS 123, See Note
  2s). For options accounted under APB 25, compensation expense is estimated
  based on the quoted market price of the Companys stock at the end of each
  reporting period and is amortized over the remaining vesting period of the
  options.                         

46

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                   |                                |                                                                                            
|--------- | ------------------------------------------------- | ------------------------------ | -------------------------------------------------------------------------------------------
|NOTE 16:- | SHAREHOLDERS EQUITY (Cont.)                     
|          |                                                   |                                |                                                                                            
|          | c.                                                | Options to
  employees (Cont.)
|          |                                                   |                                |                                                                                            
|          |                                                   | 4.                             | Compensation
  expense recorded during 2005 amounted to $ 405 (2004- $ 545, 2003-
  $ 386).
|          |                                                   |                                |                                                                                            
|          |                                                   | 5.                             | The balance
  of deferred compensation as of December 31, 2005 amounted to $856.           
|          |                                                   |                                |                                                                                            
|NOTE 17:- | INCOME
  (LOSS) PER SHARE                        
|          |                                                  
|          | Income
  (loss) per share is computed as follows:

|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      |  |   |        |   |  |        |  |   |       |  
|-------------------------------- |  | ---------------------- | ------ | ------------------------------------------- |  | -------------------- |  | ------ | ---- | -------------------------------------------- | - | -------------------- | - | ---- | ------ | -------------------------------------------- | - | -------------------- |  | - | ------ | - |  | ------ |  | - | ----- | -
|                                 |  | Year Ended December 31 |       
|                                 |  | income                 |        | 2005
  Number
  of shares
  ( in thousands) |  | Per
  share
  amount |  | Income |      | 2004
  Number
  of shares
  (in
  thousands) |   | Per
  share
  amount |   | Loss |        | 2003
  Number
  of shares
  (in
  thousands) |   | Per
  share
  amount | 
|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      | 
|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      | 
|Basic                            |  | $                      | 47,335 |                                             |  |                      |  | $      | 1.61 |                                              | $ | 84,133               |   |      | 29,266 |                                              | $ | 2.87                 |  | $ | (7,205 | ) |  | 29,194 |  | $ | (0.25 | )
|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      |  |   |        |   |  |        |  |   |       |  
|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      |  |   |        |   |  |        |  |   |       |  
|Effect of options of investees   |  |                        | (20    | )                                           |  |                     |  |        |      |                                              |   | (95                  | ) |      |       |                                              |   |                      |  |   | (200   | ) |  |       |  |   |       |  
|Effect of dilutive stock options |  |                        |        |                                             |  | 113                  |  |        |      |                                              |   |                     |   |      | 119    |                                              |   |                      |  |   |       |   |  |       |  |   |       |  
|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      |  |   |        |   |  |        |  |   |       |  
|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      |  |   |        |   |  |        |  |   |       |  
|Diluted                          |  |                        | 47,315 |                                             |  | 29,550               |  | $      | 1.60 |                                              |   | 84,038               |   |      | 29,385 |                                              | $ | 2.86                 |  |   | (7,405 | ) |  | 29,194 |  | $ | (0.25 | )
|                                 |  |                        |        |                                             |  |                      |  |        |      |                                              |   |                      |   |      |        |                                              |   |                      |  |   |        |   |  |        |  |   |       |  

|          |                                                                                                                                                     
|--------- | ----------------------------------------------------------------------------------------------------------------------------------------------------
|          | In 2003 all
  stock options issued by Elron were not included in the computation of diluted
  loss per share because their effect was anti-dilutive.
|          |                                                                                                                                                     
|NOTE 18:- | EQUITY IN LOSSES OF AFFILIATED COMPANIES                                                                                                            

| |                       |  |                         |         |      |   |         |   |   |         |  
| | --------------------- |  | ----------------------- | ------- | ---- | - | ------- | - | - | ------- | -
| |                       |  | Year ended December 31, |        
| |                       |  |                         |        
| |                       |  | 2005                    |         | 2004 |   | 2003    |  
| |                       |  |                         |         |      |   |         |  
| | Affiliated companies: |  |                         |         |      |   |         |   |   |         |  
| | ESL(1)                |  |                         |        |      |   | 4,706   |   |   | 9,110   |  
| | Given                 |  |                         | (2,036  | )    |   | (2,573  | ) |   | (3,184  | )
| | Others(2)             |  |                         | (15,486 | )    |   | (12,625 | ) |   | (14,624 | )
| |                       |  |                         |         |      |   |         |   |   |         |  
| |                       |  |                         |         |      |   |         |   |   |         |  
| |                       |  | $                       | (17,522 | )    | $ | (10,492 | ) | $ | (8,698  | )
| |                       |  |                         |         |      |   |         |   |   |         |  

| |                                                                                                                           |                                                                                                                
| | ------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------
| | The equity
  in losses includes amortization of intangible assets allocated to the
  investments in affiliated companies.
| |                                                                                                                           |                                                                                                                
| | (1)                                                                                                                       | Through the
  sale date, see Note 7d(1).                                                                       
| | (2)                                                                                                                       | Including equity
  in net losses of consolidated entities through the dates of commencement of
  consolidation.

47

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                                                                                  | 
|--------- | ---------------------------------------------------------------------------------------------------------------- | 
|NOTE 19:- | GAIN FROM DISPOSAL OF BUSINESSES AND AFFILIATED COMPANIES AND CHANGES
  IN HOLDINGS IN AFFILIATED COMPANIES, NET
|          |                                                                                                                  | 

| |                                                  |  |                         |        |      |   |         |  |   |        |  
| | ------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------- |  | - | ------ | -
| |                                                  |  | Year ended December 31, |       
| |                                                  |  |                         |       
| |                                                  |  | 2005                    |        | 2004 |   | 2003    | 
| |                                                  |  |                         |        |      |   |         | 
| | Netvision
  (See Note 7d(7))                     |  |                         | 2,989  |      |   |        |  |   |       |  
| | Oren (See
  Note 7d(6))                          |  |                         | 19,673 |      |   |        |  |   |       |  
| | ESL (See
  Note 7d(1))                           |  | $                       |       |      | $ | 105,171 |  | $ | (35    | )
| | Given (See
  Note 7d(2))                         |  |                         | 666    |      |   | 21,667  |  |   | 4,548  |  
| | KIT (See
  Note 7d(4))                           |  |                         |       |      |   | 5,302   |  |   |       |  
| | Galil
  Medicals urology business (See Note 3a) |  |                         |       |      |   |        |  |   | 21,241 |  
| | Others                                           |  |                         |       |      |   | 256     |  |   |       |  
| |                                                  |  |                         |        |      |   |         |  |   |        |  
| |                                                  |  |                         |        |      |   |         |  |   |        |  
| |                                                  |  | $                       | 23,328 |      | $ | 132,396 |  | $ | 25,754 |  
| |                                                  |  |                         |        |      |   |         |  |   |        |  

|          |                   | 
|--------- | ----------------- | 
|NOTE 20:- | OTHER INCOME, NET

| |                                                                                         |  |                           |        |      |   |       |   |   |        |  
| | --------------------------------------------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ----- | - | - | ------ | -
| |                                                                                         |  | Year ended
  December 31, |       
| |                                                                                         |  |                           |       
| |                                                                                         |  | 2005                      |        | 2004 |   | 2003  |  
| |                                                                                         |  |                           |        |      |   |       |  
| | Gain (loss) from sale and increase
  (decrease) in market value of: (see a and b below) |  |                           |        |      |   |       |   |   |        |  
| | Partner shares (see Note 8(2))                                                          |  | $                         | 56,423 |      | $ |      |   | $ | 11,071 |  
| | 24/7 shares                                                                             |  |                           |       |      |   |      |   |   | 2,019  |  
| | Zix shares (see Note 3(b))                                                              |  |                           |       |      |   | 5,360 |   |   | 4,815  |  
| | Zoran shares (see Note 7(d)(6))                                                         |  |                           | 1,053  |      |   |      |   |   |       |  
| | Kana shares (1)                                                                         |  |                           | (4     | )    |   | (5    | ) |   | 4      |  
| | Other companies, net                                                                    |  |                           | 137    |      |   |      |   |   | 19     |  
| | Other than temporary decline in investments                                             |  |                           | (568   | )    |   | (803  | ) |   | (3,716 | )
| | Equity in losses of partnerships                                                        |  |                           | 174    |      |   | (7    | ) |   | (547   | )
| | Other income, net                                                                       |  |                           | 1,433  |      |   | 204   |   |   | 972    |  
| |                                                                                         |  |                           |        |      |   |       |   |   |        |  
| |                                                                                         |  |                           |        |      |   |       |   |   |        |  
| |                                                                                         |  | $                         | 58,648 |      | $ | 4,749 |   | $ | 14,637 |  
| |                                                                                         |  |                           |        |      |   |       |   |   |        |  

|          |                       |                                                                                                                                                                                                                                                                                                                                                     
|--------- | --------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          | (1)                   | Realized
  gains and losses on trading securities.                                                                                                                                                                                                                                                                                                  
|          |                       |                                                                                                                                                                                                                                                                                                                                                     
|          |                       | Realized
  gains from sale of available-for-sale securities amounted to approximately
  $57,500, $5,400 and $17,900 in the years ended December 31, 2005, 2004 and
  2003, respectively. The proceeds from such sales amounted to approximately
  $103,000, $8,000 and $46,100 for the years ended December 31, 2005, 2004 and
  2003, respectively.
|          |                       |                                                                                                                                                                                                                                                                                                                                                     
|          |                       | Regarding an
  other than temporary decline in value of other investments see Note 8(3).                                                                                                                                                                                                                                                            
|          |                       |                                                                                                                                                                                                                                                                                                                                                     
|NOTE 21:- | FINANCING INCOME, NET

| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| | ----------------------------------------------------------------------- |  | ------------------------- | ----- | ---- | - | ----- |  | - | ----- | 
| |                                                                         |  | Year ended
  December 31, |      
| |                                                                         |  |                           |      
| |                                                                         |  | 2005                      |       | 2004 |   | 2003  | 
| |                                                                         |  |                           |       |      |   |       | 
| | Income:                                                                 |  |                           |       |      |   |       |  |   |       | 
| | Interest on cash equivalents, bank deposits,
  debentures and loans     |  | $                         | 6,473 |      | $ | 2,577 |  | $ | 1,403 | 
| | Foreign currency gains                                                  |  |                           | 1,532 |      |   | 862   |  |   | 615   | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| |                                                                         |  |                           | 8,005 |      |   | 3,439 |  |   | 2,018 | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| | Expenses:                                                               |  |                           |       |      |   |       |  |   |       | 
| | Interest on short-term credit, long-term
  loans and others             |  |                           | 1,333 |      |   | 586   |  |   | 767   | 
| | Foreign currency losses                                                 |  |                           | 88    |      |   | 1,420 |  |   | 500   | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| |                                                                         |  |                           | 1,421 |      |   | 2,006 |  |   | 1,267 | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| | Loss from sale of debentures                                            |  |                           | 192   |      |   |      |  |   |      | 
| | Other than temporary decline in value of
  Availble for sale Debentures |  |                           | 909   |      |   |      |  |   |      | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 
| |                                                                         |  | $                         | 5,483 |      | $ | 1,433 |  | $ | 751   | 
| |                                                                         |  |                           |       |      |   |       |  |   |       | 

48

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                               
|--------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------
|NOTE 22:- | DISCONTINUED OPERATIONS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                               
|          | During 2003
  and 2005, the Company disposed of certain subsidiaries and businesses, which
  met the definition of a component under SFAS 144. Accordingly, the results of
  operations of these subsidiaries and businesses and the gain resulting from
  the disposals have been classified as discontinued operations in the
  statement of operations and prior periods results have been reclassified
  accordingly. In addition comparative data of the assets and liabilities
  attributed to the discontinued operations have been reclassified in the
  balance sheet.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                               
|          | a.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | The
  following is the composition of discontinued operations:

| |                                                              |  |                         |        |      |   |        |   |   |        |  
| | ------------------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | -
| |                                                              |  | Year ended December 31, |       
| |                                                              |  |                         |       
| |                                                              |  | 2005                    |        | 2004 |   | 2003   |  
| |                                                              |  |                         |        |      |   |        |  
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| | Loss from operations of discontinued
  components            |  |                         |        |      |   |        |   |   |        |  
| | ET group (See Note 3d): *                                    |  |                         |        |      |   |        |   |   |        |  
| | Impairment of goodwill                                       |  |                         | (1,329 | )    |   | (1,980 | ) |   |       |  
| | Impairment of intangible assets and
  property and equipment |  |                         |       |      |   | (2,904 | ) |   |       |  
| | Operating losses                                             |  |                         | (2,734 | )    |   | (3,027 | ) |   | (2,074 | )
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| |                                                              |  | $                       | (4,063 | )    | $ | (7,911 | ) | $ | (2,074 | )
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| | ESW (see Note 3b) *                                          |  |                         |       |      |   | (454   | ) | $ | (4,825 | )
| | Vflash *                                                     |  |                         |       |      |   |       |   |   | 453    |  
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| |                                                              |  |                         | (4,063 | )    |   | (8,365 | ) |   | (6,446 | )
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| | Gain on disposal                                             |  |                         |        |      |   |        |   |   |        |  
| | ESW (see Note 3b)                                            |  |                         |       |      |   |       |   |   | 4,137  |  
| | ET group(See Note 3d)                                        |  |                         | 213    |      |   |       |   |   |       |  
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| |                                                              |  |                         | 213    |      |   |       |   |   | 4,137  |  
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| |                                                              |  | $                       | (3,850 | )    | $ | (8,365 | ) | $ | (2,309 | )
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| | * Pre tax loss of ET group                                   |  | $                       | (4,063 | )    | $ | (7911  | ) | $ | (2,074 | )
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| | * Pre-tax loss of ESW                                        |  | $                       |       |      | $ | (454   | ) | $ | (4,829 | )
| |                                                              |  |                         |        |      |   |        |   |   |        |  
| | * Pre-tax income of Vflash                                   |  | $                       |       |      | $ |       |   | $ | 453    |  
| |                                                              |  |                         |        |      |   |        |   |   |        |  

| |                                                                                                                        | 
| | ---------------------------------------------------------------------------------------------------------------------- | 
| | Revenues
  relating to discontinued operations for the years ended December 31, 2005,
  2004 and 2003 were as follows:

| |          |  |                         |       |      |   |       |  |   |        | 
| | -------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | ------ | 
| |          |  | Year ended December 31, |      
| |          |  |                         |      
| |          |  | 2005                    |       | 2004 |   | 2003  | 
| |          |  |                         |       |      |   |       | 
| |          |  |                         |       |      |   |       |  |   |        | 
| | ET group |  | $                       | 2,954 |      | $ | 5,065 |  | $ | 7,390  | 
| |          |  |                         |       |      |   |       |  |   |        | 
| | ESW      |  | $                       |      |      |   |      |  | $ | 4,740  | 
| |          |  |                         |       |      |   |       |  |   |        | 
| |          |  |                         |       |      |   |       |  |   |        | 
| |          |  | $                       | 2,954 |      | $ | 5,065 |  | $ | 12,130 | 
| |          |  |                         |       |      |   |       |  |   |        | 

| |    |                                                                                                                                          
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------
| | b. | The
  breakdown of assets and liabilities attributed to discontinued operations of
  the ET group as of December 31, 2004 was as follows:

49

---



|                                                          
|----------------------------------------------------------
|ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
  SUBSIDIARIES   
|                                                          
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                 | 
|--------- | ------------------------------- | 
|NOTE 22:- | DISCONTINUED OPERATIONS (Cont.)

| |                                        |  |                       |       | 
| | -------------------------------------- |  | --------------------- | ----- | 
| |                                        |  | December
  31,
  2004 |      
| |                                        |  |                       |      
| |                                        |  |                       |       | 
| | Assets:                                |  |                       |       | 
| | Cash and cash equivalents              |  | $                     | 514   | 
| | Trade receivables, net                 |  |                       | 2,414 | 
| | Other receivables and prepaid
expenses |  |                       | 441   | 
| | Contract-in-progress                   |  |                       | 23    | 
| | Severance fund                         |  |                       | 501   | 
| | Property and equipment, net            |  |                       | 9     | 
| | Goodwill                               |  |                       | 3,610 | 
| | Other intangible assets                |  |                       | 140   | 
| |                                        |  |                       |       | 
| |                                        |  |                       |       | 
| |                                        |  | $                     | 7,652 | 
| |                                        |  |                       |       | 
| |                                        |  |                       |       | 
| |                                        |  | December 31,
  2004   |      
| |                                        |  |                       |      
| | Liabilities:                           |  |                       |       | 
| | Short-term loans from banks            |  | $                     | 1,690 | 
| | Trade payables                         |  |                       | 1,435 | 
| | Other payables and accrued expenses    |  |                       | 1,653 | 
| | Accrued severance pay                  |  |                       | 802   | 
| | Other                                  |  |                       | 22    | 
| |                                        |  |                       |       | 
| |                                        |  |                       |       | 
| |                                        |  | $                     | 5,602 | 
| |                                        |  |                       |       | 

|          |                            |                                                                          
|--------- | -------------------------- | -------------------------------------------------------------------------
|          |                            | ESWs assets
  and liabilities were not material as of December 31, 2004.
|          |                            |                                                                          
|NOTE 23:- | RELATED PARTY TRANSACTIONS
|          |                            |                                                                          
|          | a.                         | Balances
  with related parties:                                         

| |                        |  |             |       |      |   |       | 
| | ---------------------- |  | ----------- | ----- | ---- | - | ----- | 
| |                        |  | December 31 |      
| |                        |  |             |      
| |                        |  | 2005        |       | 2004 |  
| |                        |  |             |       |      |  
| | Trade receivables:     |  |             |       |      |   |       | 
| | Affiliated companies   |  | $           | 4,984 |      | $ | 2,271 | 
| |                        |  |             |       |      |   |       | 
| |                        |  |             |       |      |   |       | 
| | Other receivables:     |  |             |       |      |   |       | 
| | Affiliated companies   |  |             | 9     |      |   | 21    | 
| | Other companies        |  |             | 50    |      |   |      | 
| |                        |  |             |       |      |   |       | 
| |                        |  |             | 59    |      |   | 21    | 
| | Long-term receivables: |  |             |       |      |   |       | 
| | Other companies        |  |             | 434   |      |   | 405   | 
| |                        |  |             |       |      |   |       | 
| |                        |  | $           | 5,477 |      | $ | 2,697 | 
| |                        |  |             |       |      |   |       | 

| |    |                                                           
| | -- | ----------------------------------------------------------
| | b. | Income and
  expenses from affiliated and other companies:

| |                                          |  |                         |       |      |   |       |  |   |       | 
| | ---------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | ----- | 
| |                                          |  | Year ended December 31, |      
| |                                          |  |                         |      
| |                                          |  | 2005                    |       | 2004 |   | 2003  | 
| |                                          |  |                         |       |      |   |       | 
| | Income:                                  |  |                         |       |      |   |       |  |   |       | 
| | Revenues                                 |  | $                       | 8,046 |      | $ | 7,182 |  | $ | 3,535 | 
| | Interest and commission for guarantees   |  |                         | 235   |      |   | 142   |  |   | 110   | 
| | Participation in Directors remuneration |  |                         | 68    |      |   | 38    |  |   | 35    | 
| | Participation in expenses                |  |                         | 25    |      |   | 89    |  |   | 76    | 
| | Costs and Expenses:                      |  |                         |       |      |   |       |  |   |       | 
| | Participation in expenses                |  |                         | 19    |      |   | 40    |  |   | 191   | 
| | Directors remuneration                  |  |                         | 91    |      |   | 30    |  |   | 33    | 

50

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                    |                                                                                                                     
|--------- | ---------------------------------- | --------------------------------------------------------------------------------------------------------------------
|NOTE 23:- | RELATED PARTY TRANSACTIONS (Cont.)
|          |                                    |                                                                                                                     
|          | c.                                 | Option to
  the Chairman of the Board - see Note 16c(3).                                                            
|          |                                    |                                                                                                                     
|          | d.                                 | The Company
  holds certain investments together with DIC as of December 31, 2005, the
  significant are as follows:

| |  |           |  |                |      |                 |  |      | 
| |  | --------- |  | -------------- | ---- | --------------- |  | ---- | 
| |  |           |  | % holding
  by |     
| |  |           |  | DIC            |      | Elron and
  RDC | 
| |  |           |  |                |      |                 | 
| |  | Galil     |  |                | 21.9 |                 |  | 59.1 | 
| |  | Netvision |  |                | 39.1 |                 |  | 39.1 | 
| |  | Given     |  |                | 12.4 |                 |  | 24.1 | 

|          |                                       
|--------- | --------------------------------------
|NOTE 24:- | ACCUMULATED OTHER COMPREHENSIVE INCOME

|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |   |      |   |   |         |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------- | ------- | ---------------------------------------------- | - | ------------------------------------------------------------ | - | ---------------------------------------------------------------- | ---- | ----- | - | ---- | - | - | ------- | -
|                                                                                                                                                                                                          |  | Unrealized
  gains on
  securities |         | Foreign
  currency
  translation
  adjustments |   | Minimum
  pension
  liability in
  an
  affiliated
  company |   | Unrealized
  loss on
  derivatives in 
  an affiliated
  company |      | Total |  
|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |  
|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |   |      |   |   |         |  
|Balance as of January 1, 2004 (net of tax
  effect of $29,430)                                                                                                                                            |  | $                                  | 53,306  |                                                | $ | (637                                                         | ) | $                                                                | (769 | )     | $ | (108 | ) | $ | 51,792  |  
|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |   |      |   |   |         |  
|Unrealized gains on available for sale
  securities (net of tax effect of $4,049)                                                                                                                         |  |                                    | 8,489   |                                                |   |                                                             |   |                                                                  |     |       |   |     |   |   | 8,489   |  
|Reclassification adjustment for realized
  gain included in net loss (net of tax effect of $1,179)                                                                                                        |  |                                    | (3,582  | )                                              |   |                                                             |   |                                                                  |     |       |   |     |   |   | (3,582  | )
|Unrealized loss on derivative instruments
  in an affiliated company                                                                                                                                      |  |                                    |        |                                                |   |                                                             |   |                                                                  |     |       |   | 84   |   |   | 84      |  
|Foreign currency translation
adjustment                                                                                                                                                                   |  |                                    |        |                                                |   | 202                                                          |   |                                                                  |     |       |   |     |   |   | 202     |  
|Reclassification adjustments for loss on
  derivative instruments, minimum pension liability and foreign currency
  translation adjustments, included in net income due to sale of affiliated
  companies |  |                                    |        |                                                |   | (61                                                          | ) |                                                                  | 769  |       |   | 24   |   |   | 732     |  
|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |   |      |   |   |         |  
|Balance as of December 31, 2004 (net of
tax
  effect of $32,300)                                                                                                                                          |  |                                    | 58,213  |                                                |   | (496                                                         | ) |                                                                  |     |       |   |     |   |   | 57,717  |  
|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |   |      |   |   |         |  
|Unrealized gains on available for sale
  securities (net of tax effect of $5,359)                                                                                                                         |  |                                    | (10,450 | )                                              |   |                                                             |   |                                                                  |     |       |   |     |   |   | (10,450 | )
|Reclassification adjustment for realized
  gain and other than temporary impairment included in net income (net of tax
  effect of $20,601)                                                               |  |                                    | (36,335 | )                                              |   |                                                             |   |                                                                  |     |       |   |     |   |   | (36,335 | )
|Unrealized loss on derivative instruments
  in an affiliated company                                                                                                                                      |  |                                    |        |                                                |   |                                                             |   |                                                                  |     |       |   |      |   |   |         |  
|Foreign currency translation
adjustments                                                                                                                                                                  |  |                                    |        |                                                |   | (191                                                         | ) |                                                                  |     |       |   |     |   |   | (191    | )
|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |   |      |   |   |         |  
|Balance as of December 31, 2005 (net of
tax
  effect of $6,340)                                                                                                                                           |  | $                                  | 11,428  |                                                | $ | (687                                                         | ) | $                                                                |     |       | $ |     |   | $ | 10,741  |  
|                                                                                                                                                                                                          |  |                                    |         |                                                |   |                                                              |   |                                                                  |      |       |   |      |   |   |         |  

51

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS            
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                  |                                                                                                                                                                                                                                                                                                                                                                                                                        
|--------- | ---------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 25:- | BUSINESS SEGMENT
|          |                  |                                                                                                                                                                                                                                                                                                                                                                                                                        
|          | a.               | Subsequent
  to the sale of ET group (see Note 3d) the Company operates in one segment,
  namely the Other Holdings and Corporate Operations in which the Company is
  directly engaged. This segment includes corporate headquarters and reflects
  the investments in companies that operate in the fields of medical devices,
  information and communication technology, semiconductors and advanced
  materials.
|          |                  |                                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                  | The ET
  group, which comprised the system and projects segment was sold on December
  29, 2005 and therefore has been reclassified as discontinued operations. The
  operations of the System and Projects segment included development and supply
  of software solutions for the management of large and complex communication
  and internet networks.                                                             
|          |                  |                                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                  | Prior to
  September 2, 2003, the Company operated indirectly through ESW in a third
  business segment  Internet Products  which has been sold and therefore
  classified as discontinued operations (see Note 3b).                                                                                                                                                                                                 
|          |                  |                                                                                                                                                                                                                                                                                                                                                                                                                        
|          | b.               | Revenues
  according to location of customers are as follows:                                                                                                                                                                                                                                                                                                                                                          

| |        |  |      |        |      |   |        |  |   |       | 
| | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ----- | 
| |        |  | 2005 |        | 2004 |   | 2003   | 
| |        |  |      |        |      |   |        | 
| |        |  |      |        |      |   |        |  |   |       | 
| | Israel |  | $    | 271    |      | $ | 49     |  | $ | 857   | 
| | USA    |  |      | 9,781  |      |   | 8,688  |  |   | 6,474 | 
| | Europe |  |      | 802    |      |   | 511    |  |   | 565   | 
| | Asia   |  |      | 1,792  |      |   | 2,017  |  |   | 1,261 | 
| |        |  |      |        |      |   |        |  |   |       | 
| |        |  |      |        |      |   |        |  |   |       | 
| |        |  | $    | 12,646 |      | $ | 11,265 |  | $ | 9,157 | 
| |        |  |      |        |      |   |        |  |   |       | 

| |    |                                                 
| | -- | ------------------------------------------------
| | c. | Revenues
  from major customers were as follows:

| |                                                           |  |      |     |      |  |      |  |  |     | 
| | --------------------------------------------------------- |  | ---- | --- | ---- |  | ---- |  |  | --- | 
| |                                                           |  | 2005 |     | 2004 |  | 2003 | 
| |                                                           |  |      |     |      |  |      | 
| | In the Other
  Holdings and Corporate Operations segment: |  |      |     |      |  |      |  |  |     | 
| | Oncura (See
  Note 23)                                    |  |      | 64% |      |  | 64%  |  |  | 39% | 

| |    |                                                               
| | -- | --------------------------------------------------------------
| | d. | The majority
  of the long-lived assets are located in Israel.



---

52

---



ELRON ELECTRONIC INDUSTRIES LTD. AND ITS
SUBSIDIARIES

|                                              
|----------------------------------------------
|ANNEX TO THE CONSOLIDATED FINANCIAL STATEMENTS
|                                              
|U.S. dollars in thousands                     

ANNEX TO THE
FINANCIAL STATEMENTSU.S dollars in thousands

Details relating to
major investments as of December 31, 2005:

|                                      |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|------------------------------------- |  | ------------------------------- | - | -------------------------------------------- |  | ----------------------------------------------------------- | - | ------------------ | ------- |  |  | ------- | 
|                                      |  |                                 |   | Carrying
  value of the
  investment
  as of |  | Market
  value of the
  publicly traded
  investments as of |  
|                                      |  | % of
  ownership
  interest (1) |   | December
  31,
  2005(2)                     |  | December
  31,
  2005                                       |   | March
  13,
  2006 |        
|                                      |  |                                 |   |                                              |  |                                                             |   |                    |        
|                                      |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Consolidated Companies:               |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Galil Medical Ltd. (3)                |  | 40                              | % |                                              |  | 1,999                                                       |   |                    |        |  |  |        | 
|3DV Systems Ltd. (3)                  |  | 62                              | % |                                              |  | (302                                                        | ) |                    |        |  |  |        | 
|Starling (3)                          |  | 50                              | % |                                              |  | 941                                                         |   |                    |        |  |  |        | 
|SELA (3)                              |  | 39                              | % |                                              |  | 1,150                                                       |   |                    |        |  |  |        | 
|Enure (formerly: Gaia)                |  | 57                              | % |                                              |  | 3,492                                                       |   |                    |        |  |  |        | 
|Medingo (3)                           |  | 50                              | % |                                              |  | 47                                                          |   |                    |        |  |  |        | 
|                                      |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Affiliated Companies (equity):        |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Given Imaging Ltd. (NASDAQ: GIVN) (3) |  | 19                              | % |                                              |  | 64,203                                                      |   |                    | 141,376 |  |  | 121,605 | 
|NetVision Ltd. (TASE: NTSN)           |  | 39                              | % |                                              |  | 5,549                                                       |   |                    | 27,692  |  |  | 31,481  | 
|ChipX                                 |  | 26                              | % |                                              |  | 2,287                                                       |   |                    |        |  |  |        | 
|CellAct Ltd.                          |  | 45                              | % |                                              |  | 451                                                         |   |                    |        |  |  |        | 
|Oncura (4)                            |  | 10                              | % |                                              |  | 8,827                                                       |   |                    |        |  |  |        | 
|AMT                                   |  | 42                              | % |                                              |  | 2,780                                                       |   |                    |         |  |  |        | 
|Wavion, Inc.                          |  | 38                              | % |                                              |  | 761                                                         |   |                    |        |  |  |        | 
|Pulsicom Israel Technologies Ltd.     |  | 18                              | % |                                              |  | 17                                                          |   |                    |        |  |  |        | 
|Notal Vision, Inc.                    |  | 26                              | % |                                              |  |                                                            |   |                    |        |  |  |        | 
|                                      |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Available for sale:                   |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Partner (NASDAQ: PTNR)                |  | 2                               | % |                                              |  | 25,998                                                      |   |                    | 25,998  |  |  | 23,494  | 
|EVS (NASDAQ: EVSNF.OB)                |  | 10                              | % |                                              |  | 1,499                                                       |   |                    | 2,030   |  |  | 2,393   | 
|                                      |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Partnership:                          |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Gemini Israel Fund L.P.               |  | 5                               | % |                                              |  | 33                                                          |   |                    |        |  |  |        | 
|InnoMed Ventures L.P.                 |  | 14                              | % |                                              |  | 3,665                                                       |   |                    |        |  |  |        | 
|                                      |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Cost:                                 |  |                                 |   |                                              |  |                                                             |   |                    |         |  |  |         | 
|Avantry (formerly:Witcom Ltd.) (3)    |  | 7                               | % |                                              |  | 2                                                           |   |                    |        |  |  |        | 
|Jordan Valley                         |  | 28                              | % |                                              |  | 8,137                                                       |   |                    |        |  |  |        | 
|Impliant Inc.                         |  | 22                              | % |                                              |  | 8,340                                                       |   |                    |        |  |  |        | 
|Teledata Ltd.                         |  | 21                              | % |                                              |  | 16,000                                                      |   |                    |        |  |  |        | 
|Nulens Ltd.                           |  | 22                              | % |                                              |  | 1,722                                                       |   |                    |        |  |  |        | 
|Brainsgate                            |  | 22                              | % |                                              |  | 6,947                                                       |   |                    |        |  |  |        | 

|    |                                                                                                                                                                                                   
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | On the basis of the
  outstanding share capital.                                                                                                                                                  
|(2) | Includes loans and
  convertible notes.                                                                                                                                                           
|(3) | Represents the carrying
  value and the ownership interest of the investment in Elrons books and
  Elrons share in the carrying value and ownership interest of the investment
  in RDCs books.
|(4) | Represents
  Elrons share in the carrying value and the ownership interest of the
  investment in Galils books.                                                                                 

53

---



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

TO THE SHAREHOLDERS OF

A.M.T. ADVANCED METAL TECHNOLOGIES LTD.



We have audited the accompanying consolidated balance sheets of A.M.T. Advanced MetalTechnologies Ltd.("the Company") as of December 31, 2005 and 2004 and the related consolidated statements of operations, changes in shareholders deficiency and cash flows for the years then ended. These financial statements are the responsibility of the Companys Board of Directors and management. Our responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by the board of directors and management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2005 and 2004 and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.





/s/ Brightman Almagor & Co.

Certified Public Accountants

A member of Deloitte Touche Tohmatsu



Tel-Aviv, March 7, 2006









---



REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM 
TO THE SHAREHOLDERS OF
A.M.T. ADVANCED METAL TECHNOLOGIES LTD.

We have audited the accompanying consolidated balance sheets of A.M.T.
Advanced Metal Technologies Ltd. (the Company) as of December 31, 2004 and
2003 and the related consolidated statements of operations, changes in
shareholders deficiency and cash flows for the years then ended. These
financial statements are the responsibility of the Companys Board of Directors
and management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Companys
internal control over financial reporting. Accordingly, we express no such
opinion. An audit also includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by the board of
directors and management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the consolidated financial statements present fairly,
in all material respects, the consolidated financial position of the Company as
of December 31, 2004 and 2003 and the results of its operations and its cash flows for the
years then ended in conformity with U.S. generally accepted accounting
principles.

/s/ Brightman Almagor & Co. 
Certified Public Accountants
A member of Deloitte Touche Tohmatsu

Tel-Aviv, February 17, 2005

---



Report of Independent Registered
Public Accounting Firm

The Board of Directors and ShareholdersGiven Imaging Ltd.

We have audited the accompanying consolidated balance sheets of Given
Imaging Ltd. and its subsidiaries (the Company) as of December 31, 2005 and
2004, and the related consolidated statements of operations, changes in
shareholders equity and cash flows for each of the years in the three year
period ended December 31, 2005. These consolidated financial statements are the
responsibility of the Companys Board of Directors and of its management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statements presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of the Company
as of December 31, 2005 and 2004, and the consolidated results of its
operations and cash flows for each of the years in the three year period ended
December 31, 2005, in conformity with U.S. generally accepted accounting
principles.

/s/ Somekh Chaikin
Certified Public Accountants (Israel)
Member Firm of KPMG International

Tel - Aviv, Israel
February 7, 2006

---



Report of Independent Registered Public Accounting Firm

To The Board of Directors and Stockholders of

ChipX, Incorporated (formerly Chip Express Corporation)

In our opinion, based on our audits and the report of other auditors, the accompanying consolidated balance sheets and the related consolidated statements of operations, of mandatorily redeemable convertible preferred stock and stockholders deficit and of cash flows present fairly, in all material respects, the financial position of ChipX, Incorporated (formerly Chip Express Corporation) and its subsidiaries at December 31, 2004 and December 31, 2003, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.  These financial statements are the responsibility of the Companys management; our responsibility is to express an opinion on these financial statements based on our audits.  We did not audit the financial statements of ChipX, (Israel) Limited (CXL), a
wholly-owned subsidiary, which statements reflect total assets of $905,000 and $1,225,000 as of December 31, 2004 and December 31, 2003, respectively, and total revenues of $2,603,000 and $2,768,000 for the years then ended.  Those statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for CXL, is based solely on the report of the other auditors.  We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.  We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.





/s/ PricewaterhouseCoopers LLP

February 28, 2005

San Jose, CA









---



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCONTING FIRM

To the Shareholders ofChip X (Israel) Limited.

We have
audited the accompanying balance sheets of ChipX (Israel) Limited. (former
name: Chip Express (Israel) Ltd) (the Company) as of December 31, 2004 and
2003, and the related statements of operations, changes in shareholders equity
and cash flows for the two years in the period ended December 31, 2004. These
financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. We were not engaged to
perform an audit of the Companys internal control over financial reporting.
Our audit included consideration of internal control over financial reporting
as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness
of the Companys internal control over financial reporting. Accordingly, we
express no such opinion. An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits and the reports of other auditors provide a reasonable
basis for our opinion.

In our
opinion the financial statements referred to above present fairly, in all
material respects, the financial position of the Company as of December 31,
2004 and 2003, and the results of its operations and its cash flows for the two
years in the period ended December 31, 2004, in conformity with U.S. generally
accepted accounting principles.

|                   |                                   
|------------------ | ----------------------------------
|Haifa,
  Israel    | /s/ KOST
  FORER GABBAY & KASIERER
|January 30,
  2005 | A Member of
  Ernst & Young Global

---



Report of Independent
Registered Public Accounting Firm

To the board of Directors
Oncura, Inc.:

In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, shareholders equity and cash
flows present fairly, in all material respects, the financial position of
Oncura, Inc. and its subsidiaries at December 31, 2005 and December 31, 2004,
and the results of their operations and their cash flows for the years then
ended in conformity with accounting principles generally accepted in the United
States of America. These financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

As disclosed in Notes 10, 11 and 15, the Company has extensive
transactions with its shareholders.

/s/ PricewaterhouseCoopers LLP
March 6, 2006
Philadelphia, PA

---



Report of Independent Registered Public
Accounting Firm

To the board
of Directors Oncura, Inc.:

In our
opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, shareholders equity and cash flows
present fairly, in all material respects, the financial position of Oncura,
Inc. and its subsidiaries at December 31, 2004 and December 31, 2003, and the
results of their operations and their cash flows for the year ended December
31, 2004 and the period ended December 31, 2003, in conformity with accounting
principles generally accepted in the United States of America. These financial
statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with the
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit of financial statements includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

As disclosed
in Notes 10, 11 and 15, the Company has extensive transactions with its
shareholders.

/s/ PricewaterhouseCoopers LLP February 18, 2005 Philadelphia, PA

---



REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM

To the shareholders ofNOTAL VISION INC.

We have audited the consolidated balance
sheets of Notal Vision Inc. (hereafter - the Company) and its subsidiary, as of
December 31, 2005 and 2004 and the related consolidated statements of
operations, changes in shareholders equity (capital deficiency) and cash flows
for each of the three years in the period ended December 31, 2005. These
financial statements are the responsibility of the Companys board of directors
and management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by the
board of directors and management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the financial statements
referred to above present fairly, in all material respects, the consolidated
financial position of the Company and its subsidiary as of December 31,
2005 and 2004 and the consolidated results of operations, changes in
shareholders equity (capital deficiency) and cash flows for each of the three
years in the period ended December 31, 2005, in conformity with accounting
principles generally accepted in the United States of America.

The accompanying financial
statements have been prepared assuming that the Company will continue as a
going concern. As discussed in Note 1a(1) to the financial statements, the
Company has incurred operating losses and cumulative negative cash flow from
operations since its inception and has capital deficiency of $329,272 through
December 31, 2005. These facts raise substantial doubt about the Companys
ability to continue as a going concern. The financial statements do not include
any adjustments that might result from the outcome of this uncertainty.

|                                                        
|--------------------------------------------------------
|/s/ Kesselman & Kesselman                               
|Certified Public Accountants (Isr.)                     
|A member of PricewaterhouseCoopers International Limited
|                                                        
|Tel-Aviv                                                
|March 7, 2006                                           

---



REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders of:PULSICOM ISRAEL TECHNOLOGIES LTD.

We have audited the balance sheets of Pulsicom Israel Technologies
Ltd., An Israeli corporation in the development stage (the Company) as of
December 31, 2003 and 2002
and the related statements of operations, changes in shareholders equity (capital
deficiency) and cash flows for each of the three years in the period ended
December 31, 2003 and for the period from September 20, 2000 (date of
incorporation and commencement of operations) to December 31, 2003. These
financial statements are the responsibility of the Companys board of directors
and management. Our responsibility is to express anopinion on these financial statements
based on our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. Anaudit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by the companys board of
directors and management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a fair basis for our opinion.

In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of the Company as of
December 31,2003 and
2002and the results
of their operations, the changes in shareholders equity (capital deficiency)
and its cash flows for each of the periods referred to above, in conformity
with accounting principles generally accepted in the United States.

Without qualifying our opinion we draw the attention to the Companys
capital deficiency and ability to continue operating as a going concern. The
abovementioned financial statements have been prepared assuming that the
Company will continue operating as a going concern. Results of the Companys
activity, as described in note 1a in the financial statements, raise
substantial doubt regarding its ability to continue operating as a going
concern. The Companys ability to continue, as a going concern is dependent on
the ability to raise additional funding from its shareholders or from other
investors until the stage in which the Company become profitable from its
operations. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.

|                                                        
|--------------------------------------------------------
|/s/
  Kesselman & Kesselman                             
|Certified
  Public Accountants (Isr.)                   
|A member of PricewaterhouseCoopers International Limited
|                                                        
|Tel-Aviv, Israel                                        
|February 25,
  2004                                     

---



REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM

To
the shareholders of
INGENEO TECHNOLOGIES LTD.

We
have audited the financial statements of Ingeneo Technologies Ltd. (an Israeli
corporation in the development stage; hereafter - the Company) and the
consolidated financial statements of the Company and its subsidiary: balance
sheets as of December 31, 2003 and 2002 and the related statements of
operations, changes in capital deficiency and cash flows for each of the two
years ended on those dates, and cumulatively, for the period from November 4,
1999 (date of inception) to December 31, 2003. These financial statements are
the responsibility of the Companys board of directors and management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States), and auditing standards generally
accepted in Israel, including those prescribed by the Israeli Auditors (Mode of
Performance) Regulations, 1973. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by the board of directors and management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In
our opinion, the financial statements referred to above present fairly, in all
material respects, the financial position - of the Company and consolidated -
as of December 31, 2003 and 2002 and the results of operations, changes in
capital deficiency and cash flows - of the Company and consolidated - for
each of the two years ended on those dates, and cumulatively, for the period
from inception to December 31, 2003, in conformity with accounting principles
generally accepted in Israel.

Accounting
principles generally accepted in Israel vary in certain significant respects
from accounting principles generally accepted in the United States of America.
Information relating to the nature and effect of such differences is presented
in note 12 to the consolidated financial statements.

The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in note 1a to the financial
statements, the Company has suffered recurring losses from operations and has a
net capital deficiency that raise substantial doubt about its ability to
continue as a going concern. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

|                                                          
|----------------------------------------------------------
|/s/
  Kesselman & Kesselman                               
|Certified
  Public Accountants (Isr.)                     
|A
  member of PricewaterhouseCoopers International Limited
|                                                          
|Tel-Aviv, Israel                                          
|February 23, 2004                                         

---



---

ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES


---

CONSOLIDATED FINANCIAL STATEMENTSas of December 31, 2004(In U.S. dollars)

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS
as of December 31, 2004
In U.S. dollars

C O N T E N T S

|                                                         |        
|-------------------------------------------------------- | -------
|                                                         | Page   
|                                                         |        
|                                                         |        
|                                                         |        
|REPORT OF
  INDEPENDENT REGISTRED PUBLIC ACCOUNTING FIRM | 2  3  
|                                                         |        
|CONSOLIDATED FINANCIAL
  STATEMENTS:                     |        
|                                                         |        
|Consolidated Balance
Sheets                              | 4  5  
|                                                         |        
|Consolidated Statements of
Income                        | 6      
|                                                         |        
|Statements of Changes in
Shareholders Equity            | 7  8  
|                                                         |        
|Consolidated Statements of Cash
Flows                    | 9  10 
|                                                         |        
|Notes to the Consolidated Financial
Statements           | 11  56

#  #  #  #  #  #  #

1

---



(ERNST & YOUNG LOGO)

To the Shareholders of
Elbit Systems Ltd.

Haifa, Israel

REPORT OF INDEPENDENT
REGISTRATED PUBLIC ACCOUNTING FIRM

We have audited the accompanying consolidated balance sheets of Elbit
Systems Ltd. (the Company) and its subsidiaries as of December 31, 2004 and
2003 and the related consolidated statements of income, changes in
shareholders equity and cash flows for each of the two years in the period
ended December 31, 2004. Our audits also include the financial statement
schedule listed in the Index at Item 19a. These consolidated financial
statements and schedule are the responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated financial
statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Companys
internal control over financial reporting. Accordingly, we express no such
opinion. An audit also includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above,
present fairly, in all material respects, the consolidated financial position
of the Company and its subsidiaries as of December 31, 2004 and 2003 and the
consolidated results of their operations and their cash flows for each of the
two years in the period ended December 31, 2004 in conformity with U.S.
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.

As discussed in Note 2(X) to the consolidated financial statements, on
January 1, 2004 the Company adopted SFAS No. 123 Accounting for Stock-Based
Compensation.

| |                                  | 
| | -------------------------------- | 
| | Kost Forer
  Gabbay & Kasierer   | 
| | A member of Ernst & Young Global | 

Haifa, Israel
March 14, 2005

2

---



(ERNST & YOUNG LOGO)

REPORT OF INDEPENDENT
AUDITORS

To the Shareholders of Elbit Systems Ltd.

We have audited the accompanying consolidated statements of operations,
changes in shareholders equity and cash flows of Elbit Systems Ltd. And its
subsidiaries for the year ended December 31, 2002. These financial statements
are the responsibility of the Companys management. Our responsibility is to
express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above,
present fairly, in all material respects, the consolidated results of the
Company and its subsidiaries operations and their cash flows for the year ended
December 31, 2002 in conformity with United States generally accepted
accounting principles.

| |                                                      | 
| | ---------------------------------------------------- | 
| | LUBOSHITZ KASIERER                                   | 
| | AN AFFILIATE MEMBER OF ERNST & YOUNG
  INTERNATIONAL | 

Haifa, Israel
March 24, 2003

3

---



|                                       
|---------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES
|                                       
|CONSOLIDATED BALANCE SHEETS            
|                                       
|U. S. dollars (In
  thousands)         

|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|----------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- |  | ------------ | --------- | ---- | - | --------- | 
|                                                                                                                                                |  |      |  | December 31, |          
|                                                                                                                                                |  |      |  |              |          
|                                                                                                                                                |  | Note |  | 2004         |           | 2003 |  
|                                                                                                                                                |  |      |  |              |           |      |  
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|CURRENT ASSETS:                                                                                                                                 |  |      |  |              |           |      |   |           | 
|Cash and cash equivalents                                                                                                                       |  |      |  | $            | 34,109    |      | $ | 76,156    | 
|Short-term bank deposits                                                                                                                        |  |      |  |              | 738       |      |   | 690       | 
|Trade receivables, (net of allowance for doubtful accounts in the
  amount of $3,064 and $3,861 as of December 31, 2004 and 2003, respectively) |  | (3)  |  |              | 214,816   |      |   | 203,281   | 
|Other receivables and prepaid expenses                                                                                                          |  | (4)  |  |              | 52,335    |      |   | 48,363    | 
|Inventories, net of advances                                                                                                                    |  | (5)  |  |              | 249,041   |      |   | 249,225   | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|Total current assets                                                                                                                            |  |      |  |              | 551,039   |      |   | 577,715   | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|INVESTMENTS AND LONG-TERM RECEIVABLES:                                                                                                          |  |      |  |              |           |      |   |           | 
|Investments in affiliated companies and a partnership                                                                                           |  | (6A) |  |              | 33,124    |      |   | 26,478    | 
|Available for sale securities                                                                                                                   |  | (1G) |  |              | 18,017    |      |   |          | 
|Investments in other companies                                                                                                                  |  | (6B) |  |              | 11,745    |      |   | 11,745    | 
|Long-term bank deposits and trade receivables                                                                                                   |  | (7)  |  |              | 2,102     |      |   | 2,347     | 
|Severance pay fund                                                                                                                              |  | (2P) |  |              | 82,998    |      |   | 76,218    | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|                                                                                                                                                |  |      |  |              | 147,986   |      |   | 116,788   | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|PROPERTY, PLANT AND EQUIPMENT, NET                                                                                                              |  | (8)  |  |              | 244,288   |      |   | 229,221   | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|INTANGIBLE ASSETS:                                                                                                                              |  | (9)  |  |              |           |      |   |           | 
|Goodwill                                                                                                                                        |  |      |  |              | 32,847    |      |   | 32,576    | 
|Other intangible assets,
  net                                                                                                                  |  |      |  |              | 63,140    |      |   | 67,436    | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|                                                                                                                                                |  |      |  |              | 95,987    |      |   | 100,012   | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 
|                                                                                                                                                |  |      |  | $            | 1,039,300 |      | $ | 1,023,736 | 
|                                                                                                                                                |  |      |  |              |           |      |   |           | 

The accompanying notes are
an integral part of the consolidated financial statements

4

---



|                                                               
|---------------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES                        
|                                                               
|CONSOLIDATED BALANCE SHEETS                                    
|                                                               
|U. S. dollars (In
  thousands, except share and per share data)

|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------- |  | ------------ | --------- | ---- | - | --------- | -
|                                                                                                                                                                                                                                                                                                                           |  |         |  | December 31, |          
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |          
|                                                                                                                                                                                                                                                                                                                           |  | Note    |  | 2004         |           | 2003 |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |  
|CURRENT LIABILITIES:                                                                                                                                                                                                                                                                                                       |  |         |  |              |           |      |   |           |  
|Short-term bank credit and loans                                                                                                                                                                                                                                                                                           |  | (10)    |  | $            | 8,592     |      | $ | 8,509     |  
|Current maturities of
  long-term loans                                                                                                                                                                                                                                                                                    |  | (13)    |  |              | 1,656     |      |   | 6,532     |  
|Trade payables                                                                                                                                                                                                                                                                                                             |  |         |  |              | 118,391   |      |   | 106,252   |  
|Other payables and accrued expenses                                                                                                                                                                                                                                                                                        |  | (11)    |  |              | 169,702   |      |   | 157,820   |  
|Customers advances and amounts in excess of costs incurred on
  contracts in progress                                                                                                                                                                                                                                      |  | (12)    |  |              | 80,109    |      |   | 99,618    |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|Total current liabilities                                                                                                                                                                                                                                                                                                  |  |         |  |              | 378,450   |      |   | 378,731   |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|LONG-TERM LIABILITIES:                                                                                                                                                                                                                                                                                                     |  |         |  |              |           |      |   |           |  
|Long-term loans                                                                                                                                                                                                                                                                                                            |  | (13)    |  |              | 86,234    |      |   | 62,324    |  
|Advances from customers                                                                                                                                                                                                                                                                                                    |  | (12)    |  |              | 10,320    |      |   | 7,592     |  
|Deferred income taxes                                                                                                                                                                                                                                                                                                      |  | (15)    |  |              | 24,516    |      |   | 24,916    |  
|Accrued termination liability                                                                                                                                                                                                                                                                                              |  | (14,2P) |  |              | 100,740   |      |   | 93,979    |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              | 221,810   |      |   | 188,811   |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|COMMITMENTS AND CONTINGENT LIABILITIES                                                                                                                                                                                                                                                                                     |  | (16)    |  |              |           |      |   |           |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|MINORITY INTERESTS                                                                                                                                                                                                                                                                                                         |  |         |  |              | 4,340     |      |   | 4,115     |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|SHAREHOLDERS EQUITY:                                                                                                                                                                                                                                                                                                      |  | (17)    |  |              |           |      |   |           |  
|Share capital                                                                                                                                                                                                                                                                                                              |  |         |  |              |           |      |   |           |  
|Ordinary shares of New Israeli Shekels (NIS) 1 par value; Authorized
   80,000,000 shares as of December 31, 2004 and 2003; Issued  40,969,947 and
  39,746,125 shares as of December 31, 2004 and 2003, respectively; Outstanding
   40,561,126 and 39,337,304 shares as of December 31, 2004 and 2003,
  respectively |  |         |  |              | 11,548    |      |   | 11,273    |  
|Additional paid-in capital                                                                                                                                                                                                                                                                                                 |  |         |  |              | 274,432   |      |   | 259,033   |  
|Accumulated other comprehensive loss                                                                                                                                                                                                                                                                                       |  |         |  |              | (3,346    | )    |   | (3,992    | )
|Retained earnings                                                                                                                                                                                                                                                                                                          |  |         |  |              | 156,387   |      |   | 190,086   |  
|Treasury shares - 408,821 shares as of December 31, 2004 and
2003                                                                                                                                                                                                                                                          |  |         |  |              | (4,321    | )    |   | (4,321    | )
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              | 434,700   |      |   | 452,079   |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  | $            | 1,039,300 |      | $ | 1,023,736 |  
|                                                                                                                                                                                                                                                                                                                           |  |         |  |              |           |      |   |           |  

The accompanying notes are
an integral part of the consolidated financial statements

5

---



|                                                               
|---------------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES                        
|                                                               
|CONSOLIDATED STATEMENTS OF INCOME                              
|                                                               
|U. S. dollars (In
  thousands, except share and per share data)

|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|--------------------------------------------------------------------- |  | ----- |  | ----------------------- | ------- | ---- | - | ------- | - | - | ------- | -
|                                                                      |  |       |  | Year ended December 31, |        
|                                                                      |  |       |  |                         |        
|                                                                      |  | Note  |  | 2004                    |         | 2003 |   | 2002    |  
|                                                                      |  |       |  |                         |         |      |   |         |  
|Revenues                                                              |  | (18)  |  | $                       | 939,925 |      | $ | 897,980 |   | $ | 827,456 |  
|Cost of revenues                                                      |  |       |  |                         | 689,626 |      |   | 672,711 |   |   | 605,313 |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Gross profit                                                          |  |       |  |                         | 250,299 |      |   | 225,269 |   |   | 222,143 |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Research and development costs, net                                   |  | (19)  |  |                         | 66,846  |      |   | 54,919  |   |   | 57,010  |  
|Marketing and selling expenses                                        |  |       |  |                         | 69,912  |      |   | 69,943  |   |   | 65,691  |  
|General and administrative expenses                                   |  |       |  |                         | 47,832  |      |   | 46,077  |   |   | 41,651  |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         | 184,590 |      |   | 170,939 |   |   | 164,352 |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Operating income                                                      |  |       |  |                         | 65,709  |      |   | 54,330  |   |   | 57,791  |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Financial expenses, net                                               |  | (20)  |  |                         | (5,852  | )    |   | (4,870  | ) |   | (3,035  | )
|Other income (expenses), net                                          |  |       |  |                         | 770     |      |   | 53      |   |   | (462    | )
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Income before
  taxes on income                                       |  |       |  |                         | 60,627  |      |   | 49,513  |   |   | 54,294  |  
|Taxes on income                                                       |  | (15)  |  |                         | 15,219  |      |   | 11,334  |   |   | 9,348   |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         | 45,408  |      |   | 38,179  |   |   | 44,946  |  
|Equity in net earnings of affiliated companies and
partnership        |  |       |  |                         | 7,765   |      |   | 7,209   |   |   | 675     |  
|Minority interests in losses (earnings) of subsidiaries               |  |       |  |                         | (180    | )    |   | 557     |   |   | (508    | )
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Net income                                                            |  |       |  | $                       | 52,993  |      | $ | 45,945  |   | $ | 45,113  |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Earnings per share                                                    |  | (17G) |  |                         |         |      |   |         |   |   |         |  
|Basic net earnings per share                                          |  |       |  | $                       | 1.33    |      | $ | 1.18    |   | $ | 1.17    |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Diluted net earnings per share                                        |  |       |  | $                       | 1.29    |      | $ | 1.14    |   | $ | 1.13    |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Number of share used in computation of basic net
earnings per share   |  |       |  |                         | 39,952  |      |   | 39,061  |   |   | 38,489  |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  
|Number of share used in computation of diluted net
earnings per share |  |       |  |                         | 41,041  |      |   | 40,230  |   |   | 39,863  |  
|                                                                      |  |       |  |                         |         |      |   |         |   |   |         |  

The accompanying notes are
an integral part of the consolidated financial statements

6

---



|                                                               
|---------------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES                        
|                                                               
|STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY                  
|                                                               
|U. S. dollars (In
  thousands, except share and per share data)

|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|------------------------------------------- |  | -------------------------------- | ---------- | --------------- | - | ------------------------------ |  | --------------------------------------------------- | ------- | ------------------- | - | ----------------- | - | ------------------------------ | ------- | ------------------------------------ | - | ------ | - | - | ------- | - | - | ------ | -
|                                            |  | Number of
  outstanding
  shares |            | Share
  capital |   | Additional
  paid-in
  capital |  | Accumulated
  other
  comprehensive
  income (loss) |         | Retained
  earnings |   | Treasury
  shares |   | Total
  shareholders
  equity |         | Total other
  comprehensive
  income |  
|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |  
|Balance as ofJanuary 1,
  2002              |  |                                  | 38,330,272 |                 | $ | 11,054                         |  | $                                                   | 244,625 |                     | $ |                  |   | $                              | 126,627 |                                      | $ | (4,321 | ) | $ | 377,985 |   |   |        |  
|Exercise of options                         |  |                                  | 473,235    |                 |   | 100                            |  |                                                     | 4,040   |                     |   |                  |   |                                |        |                                      |   |       |   |   | 4,140   |   |   |        |  
|Tax benefit in respect of options exercised |  |                                  |           |                 |   |                               |  |                                                     | 648     |                     |   |                  |   |                                |        |                                      |   |       |   |   | 648     |   |   |        |  
|Stock based compensation                    |  |                                  |           |                 |   |                               |  |                                                     | (926    | )                   |   |                  |   |                                |        |                                      |   |       |   |   | (926    | ) |   |        |  
|Dividends paid                              |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   |                  |   |                                | (12,717 | )                                    |   |       |   |   | (12,717 | ) |   |        |  
|Other comprehensive income (loss):          |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Minimum pension liability                   |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   | (2,882            | ) |                                |        |                                      |   |       |   |   | (2,882  | ) | $ | (2,882 | )
|Net income                                  |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   |                  |   |                                | 45,113  |                                      |   |       |   |   | 45,113  |   |   | 45,113 |  
|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Total comprehensive income                  |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   | $ | 42,231 |  
|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Balance as of December 31, 2002             |  |                                  | 38,803,507 |                 | $ | 11,154                         |  | $                                                   | 248,387 |                     | $ | (2,882            | ) | $                              | 159,023 |                                      | $ | (4,321 | ) | $ | 411,361 |   |   |        |  
|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Exercise of options                         |  |                                  | 533,797    |                 |   | 119                            |  |                                                     | 5,147   |                     |   |                  |   |                                |        |                                      |   |       |   |   | 5,266   |   |   |        |  
|Tax benefit in respect of options exercised |  |                                  |           |                 |   |                               |  |                                                     | 758     |                     |   |                  |   |                                |        |                                      |   |       |   |   | 758     |   |   |        |  
|Stock based compensation                    |  |                                  |           |                 |   |                               |  |                                                     | 4,741   |                     |   |                  |   |                                |        |                                      |   |       |   |   | 4,741   |   |   |        |  
|Dividends paid                              |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   |                  |   |                                | (14,882 | )                                    |   |       |   |   | (14,882 | ) |   |        |  
|Other comprehensive income (loss):          |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Unrealized loss on derivative instruments   |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   | (578              | ) |                                |        |                                      |   |       |   |   | (578    | ) | $ | (578   | )
|Foreign currency translation differences    |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   | 340               |   |                                |        |                                      |   |       |   |   | 340     |   |   | 340    |  
|Minimum pension liability                   |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   | (872              | ) |                                |        |                                      |   |       |   |   | (872    | ) |   | (872   | )
|Net income                                  |  |                                  |           |                 |   |                               |  |                                                     |        |                     |   |                  |   |                                | 45,945  |                                      |   |       |   |   | 45,945  |   |   | 45,945 |  
|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Total comprehensive income                  |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   | $ | 44,835 |  
|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Balance as of December 31, 2003             |  |                                  | 39,337,304 |                 | $ | 11,273                         |  | $                                                   | 259,033 |                     | $ | (3,992            | ) | $                              | 190,086 |                                      | $ | (4,321 | ) | $ | 452,079 |   |   |        |  
|                                            |  |                                  |            |                 |   |                                |  |                                                     |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  

The accompanying notes are
an integral part of the consolidated financial statements

7

---



|                                                               
|---------------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES                        
|                                                               
|STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY (CONT.)          
|                                                               
|U. S. dollars (In
  thousands, except share and per share data)

|                                                                                                               |  |                                  |            |                 |   |                                |  |                                            |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|-------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ---------- | --------------- | - | ------------------------------ |  | ------------------------------------------ | ------- | ------------------- | - | ----------------- | - | ------------------------------ | ------- | ------------------------------------ | - | ------ | - | - | ------- | - | - | ------ | -
|                                                                                                               |  | Number of
  outstanding
  shares |            | Share
  capital |   | Additional
  paid-in
  capital |  | Accumulated
  other
  comprehensive
  loss |         | Retained
  earnings |   | Treasury
  shares |   | Total
  shareholders
  equity |         | Total other
  comprehensive
  income |  
|                                                                                                               |  |                                  |            |                 |   |                                |  |                                            |         |                     |   |                   |   |                                |         |                                      |  
|Balance as of
  January 1, 2004                                                                                |  |                                  | 39,337,304 |                 | $ | 11,273                         |  | $                                          | 259,033 |                     | $ | (3,992            | ) | $                              | 190,086 |                                      | $ | (4,321 | ) | $ | 452,079 |   |   |        |  
|Cumulative effect of first time
  adoption of the fair value based method for stock based compensation expense |  |                                  |           |                 |   |                               |  |                                            | (152    | )                   |   |                  |   |                                |        |                                      |   |       |   |   | (152    | ) |   |        |  
|Exercise of options                                                                                            |  |                                  | 1,223,822  |                 |   | 275                            |  |                                            | 10,985  |                     |   |                  |   |                                |        |                                      |   |       |   |   | 11,260  |   |   |        |  
|Tax benefit in respect of options exercised                                                                    |  |                                  |           |                 |   |                               |  |                                            | 1,179   |                     |   |                  |   |                                |        |                                      |   |       |   |   | 1,179   |   |   |        |  
|Stock based compensation                                                                                       |  |                                  |           |                 |   |                               |  |                                            | 3,387   |                     |   |                  |   |                                |        |                                      |   |       |   |   | 3,387   |   |   |        |  
|Dividends paid                                                                                                 |  |                                  |           |                 |   |                               |  |                                            |        |                     |   |                  |   |                                | (86,692 | )                                    |   |       |   |   | (86,692 | ) |   |        |  
|Other comprehensive income (loss):                                                                             |  |                                  |            |                 |   |                                |  |                                            |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Unrealized loss on derivative instruments                                                                      |  |                                  |           |                 |   |                               |  |                                            |        |                     |   | (299              | ) |                                |        |                                      |   |       |   |   | (299    | ) |   | (299   | )
|Foreign currency translation differences                                                                       |  |                                  |           |                 |   |                               |  |                                            |        |                     |   | 450               |   |                                |        |                                      |   |       |   |   | 450     |   |   | 450    |  
|Unrealized gains on available for sale securities,
net                                                         |  |                                  |            |                 |   |                                |  |                                            |         |                     |   | 1,396             |   |                                |         |                                      |   |        |   |   | 1,396   |   |   | 1,396  |  
|Minimum pension liability                                                                                      |  |                                  |           |                 |   |                               |  |                                            |        |                     |   | (901              | ) |                                |        |                                      |   |       |   |   | (901    | ) |   | (901   | )
|Net income                                                                                                     |  |                                  |           |                 |   |                               |  |                                            |        |                     |   |                  |   |                                | 52,993  |                                      |   |       |   |   | 52,993  |   |   | 52,993 |  
|                                                                                                               |  |                                  |            |                 |   |                                |  |                                            |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Total comprehensive income                                                                                     |  |                                  |            |                 |   |                                |  |                                            |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   | $ | 53,639 |  
|                                                                                                               |  |                                  |            |                 |   |                                |  |                                            |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  
|Balance as of December 31, 2004                                                                                |  |                                  | 40,561,126 |                 | $ | 11,548                         |  | $                                          | 274,432 |                     | $ | (3,346            | ) | $                              | 156,387 |                                      | $ | (4,321 | ) | $ | 434,700 |   |   |        |  
|                                                                                                               |  |                                  |            |                 |   |                                |  |                                            |         |                     |   |                   |   |                                |         |                                      |   |        |   |   |         |   |   |        |  

Accumulated other comprehensive loss (net of taxes)

|                                                       |  |              |        |      |   |        |  
|------------------------------------------------------ |  | ------------ | ------ | ---- | - | ------ | -
|                                                       |  | December 31, |       
|                                                       |  |              |       
|                                                       |  | 2004         |        | 2003 |  
|                                                       |  |              |        |      |  
|Accumulated gains on
  derivative instruments          |  | $            | (877   | )    | $ | (578   | )
|Accumulated foreign
  currency translation differences |  |              | 790    |      |   | 340    |  
|Accumulated
  gains on available for sale securities   |  |              | 1,396  |      |   |       |  
|Accumulated
  minimum pension
  liability              |  |              | (4,655 | )    |   | (3,754 | )
|                                                       |  |              |        |      |   |        |  
|Accumulated other
  comprehensive loss                 |  | $            | (3,346 | )    | $ | (3,992 | )
|                                                       |  |              |        |      |   |        |  

The accompanying notes are an integral part of the consolidated
financial statements.

8

---



|                                       
|---------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES
|                                       
|CONSOLIDATED STATEMENTS OF CASH FLOWS  
|                                       
|U. S. dollars (In
  thousands)         

|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------- | ---- | - | ------- | - | - | ------- | -
|                                                                                                        |  | Year ended
  December 31, |        
|                                                                                                        |  |                           |        
|                                                                                                        |  | 2004                      |         | 2003 |   | 2002    |  
|                                                                                                        |  |                           |         |      |   |         |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                                    |  |                           |         |      |   |         |   |   |         |  
|Net income                                                                                              |  | $                         | 52,993  |      | $ | 45,945  |   | $ | 45,113  |  
|Adjustments required to reconcile net income to net cash provided by
  operating activities:            |  |                           |         |      |   |         |   |   |         |  
|Depreciation and amortization                                                                           |  |                           | 42,261  |      |   | 37,890  |   |   | 32,937  |  
|Stock based compensation                                                                                |  |                           | 3,387   |      |   | 4,741   |   |   | (926    | )
|Deferred income taxes, net                                                                              |  |                           | 153     |      |   | 35      |   |   | (5,620  | )
|Accrued severance pay, net                                                                              |  |                           | (2,304  | )    |   | (1,240  | ) |   | 6,260   |  
|Gain (loss) on sale of property, plant and equipment                                                    |  |                           | 143     |      |   | (915    | ) |   | 743     |  
|Tax benefit in respect of options exercised                                                             |  |                           | 1,179   |      |   | 758     |   |   | 648     |  
|Minority interests in earnings (losses) of subsidiaries                                                 |  |                           | 180     |      |   | (557    | ) |   | 508     |  
|Equity in net losses (earnings) of affiliated companies and
  partnership, net of dividend received (*) |  |                           | 385     |      |   | (4,995  | ) |   | (675    | )
|Changes in operating assets and liabilities:                                                            |  |                           |         |      |   |         |   |   |         |  
|Decrease (increase) in short and long-term trade receivables, other
  receivables and prepaid expenses  |  |                           | (16,871 | )    |   | 45,297  |   |   | 58,554  |  
|Decrease (increase) in inventories                                                                      |  |                           | 2,932   |      |   | (38,651 | ) |   | (55,106 | )
|Increase (decrease) in trade payables, other payables and accrued
  expenses                            |  |                           | 20,522  |      |   | 32,147  |   |   | (19,321 | )
|Increase (decrease) in advances received from customers                                                 |  |                           | (18,535 | )    |   | (27,855 | ) |   | 42,999  |  
|Settlement of royalties with the Office of the Chief
Scientist                                          |  |                           | (3,714  | )    |   | (1,581  | ) |   | 9,197   |  
|Other adjustments                                                                                       |  |                           | (1,228  | )    |   | 337     |   |   | 683     |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|Net cash provided by operating activities                                                               |  |                           | 81,483  |      |   | 91,356  |   |   | 115,994 |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                                                    |  |                           |         |      |   |         |   |   |         |  
|Purchase of property, plant and equipment                                                               |  |                           | (53,008 | )    |   | (61,287 | ) |   | (46,003 | )
|Investment grants received for property, plant and
equipment                                            |  |                           |        |      |   |        |   |   | 119     |  
|Acquisition of subsidiaries and businesses (Schedule A)                                                 |  |                           | (2,315  | )    |   | (2,458  | ) |   | (5,280  | )
|Investments in affiliated companies and subsidiaries                                                    |  |                           | (2,522  | )    |   | (1,049  | ) |   | (1,681  | )
|Proceeds from sale of property, plant and equipment                                                     |  |                           | 2,560   |      |   | 5,815   |   |   | 956     |  
|Grant of long-term loan                                                                                 |  |                           |        |      |   |        |   |   | (714    | )
|Collection of long-term loan                                                                            |  |                           |        |      |   | 2,400   |   |   |        |  
|Collection of short-term loan                                                                           |  |                           |        |      |   |        |   |   | 1,371   |  
|Investment in long-term bank deposits                                                                   |  |                           | (1,203  | )    |   | (1,750  | ) |   | (1,228  | )
|Proceeds from sale of long-term bank deposits                                                           |  |                           | 1,507   |      |   | 3,568   |   |   | 1,689   |  
|Short-term bank deposits, net                                                                           |  |                           | (48     | )    |   | 960     |   |   | (204    | )
|Investment in available for sale securities                                                             |  |                           | (15,869 | )    |   |        |   |   |        |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|Net cash used in investing activities                                                                   |  |                           | (70,898 | )    |   | (53,801 | ) |   | (50,975 | )
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                                                    |  |                           |         |      |   |         |   |   |         |  
|Proceeds from exercise of options                                                                       |  |                           | 11,260  |      |   | 5,266   |   |   | 4,140   |  
|Repayment of long-term bank loans                                                                       |  |                           | (35,826 | )    |   | (27,066 | ) |   | (3,249  | )
|Receipt of long-term bank loans                                                                         |  |                           | 58,410  |      |   | 10,000  |   |   | 2,233   |  
|Dividends paid                                                                                          |  |                           | (86,692 | )    |   | (14,882 | ) |   | (12,717 | )
|Change in short-term bank credit and loans, net                                                         |  |                           | 216     |      |   | (10,997 | ) |   | (19,729 | )
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|Net cash used in financing activities                                                                   |  |                           | (52,632 | )    |   | (37,679 | ) |   | (29,322 | )
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                    |  |                           | (42,047 | )    |   | (124    | ) |   | 35,697  |  
|CASH AND CASH EQUIVALENTS AT THE BEGINNING OF THE YEAR                                                  |  |                           | 76,156  |      |   | 76,280  |   |   | 40,583  |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|CASH AND CASH EQUIVALENTS AT THE END OF THE YEAR                                                        |  | $                         | 34,109  |      | $ | 76,156  |   | $ | 76,280  |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  
|(*)
  Dividend received                                                                                 |  | $                         | 8,150   |      | $ | 2,214   |   | $ |        |  
|                                                                                                        |  |                           |         |      |   |         |   |   |         |  

The accompanying notes are an integral part of the consolidated
financial statements.

9

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                             
|---------------------------------------------
|CONSOLIDATED STATEMENTS OF CASH FLOWS (CONT.)
|                                             
|U. S. dollars
  (In thousands)               

|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|------------------------------------------------------------------------------------------------------------------ |  | ------------------------- | ------ | ---- | - | ------ | - | - | ------ | -
|                                                                                                                   |  | Year ended
  December 31, |       
|                                                                                                                   |  |                           |       
|                                                                                                                   |  | 2004                      |        | 2003 |   | 2002   |  
|                                                                                                                   |  |                           |        |      |   |        |  
|                                                                                                                  
|SUPPLEMENTAL CASH FLOW
  INFORMATION:                                                                              |  |                           |        |      |   |        |   |   |        |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|Cash paid during the year
  for:                                                                                   |  |                           |        |      |   |        |   |   |        |  
|Income taxes                                                                                                       |  | $                         | 13,305 |      | $ | 14,666 |   | $ | 21,730 |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|Interest                                                                                                           |  | $                         | 3,122  |      | $ | 4,034  |   | $ | 2,947  |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|SCHEDULE A:                                                                                                        |  |                           |        |      |   |        |   |   |        |  
|Subsidiaries and
  businesses acquired (*)                                                                         |  |                           |        |      |   |        |   |   |        |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|Estimated net fair value
  of assets acquired and liabilities assumed at the date of acquisition was as
  follows: |  |                           |        |      |   |        |   |   |        |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|Working capital (surplus)
  deficiency (excluding cash and cash equivalents)                                       |  | $                         | (707   | )    | $ | 657    |   | $ |       |  
|Property, plant and
  equipment                                                                                    |  |                           | (10    | )    |   | (249   | ) |   | (275   | )
|Goodwill and other
  intangible assets                                                                             |  |                           | (1,598 | )    |   | (1,334 | ) |   | (5,078 | )
|Deferred income taxes                                                                                              |  |                           |       |      |   | (1,765 | ) |   |       |  
|Long-term liabilities                                                                                              |  |                           |       |      |   | 198    |   |   |       |  
|Minority interest                                                                                                  |  |                           |       |      |   | 35     |   |   |       |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|                                                                                                                   |  |                           | (2,315 | )    |   | (2,458 | ) |   | (5,353 | )
|Less short-term debt
  incurred on acquisition                                                                     |  |                           |       |      |   |       |   |   | 73     |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  
|                                                                                                                   |  | $                         | (2,315 | )    | $ | (2,458 | ) | $ | (5,280 | )
|                                                                                                                   |  |                           |        |      |   |        |   |   |        |  

|    |                                                                              
|--- | -----------------------------------------------------------------------------
|(*) | Defense Systems Division
  of Elron Telesoft in 2002 (see Note 1(C)).        
|    | In 2003 a European
  subsidiary (see Note 1(D)) and AD&D (see Note 1(E)).    
|    | In 2004 the assets of
  Computer Instruments Corporation Inc. (see Note 1(F))

The accompanying notes are an integral part of the consolidated
financial statements.

10

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                
|------------------------------------------------
|NOTES TO THE CONSOLIDATED
  FINANCIAL STATEMENTS
|                                                
|U. S. dollars
  (In thousands)                  

|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|------------ | ------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1     - | GENERAL
|             |        
|             | A.      | Elbit Systems Ltd. (the
  Company) is an Israeli corporation, 49% owned by the Federmann Group. On
  July 28, 2004, Elron Electronic Industries Ltd. completed the sale of all of
  its holdings in the Company, constituting approximately 19% of the Companys
  outstanding share capital, to Federmann Enterprises Ltd. The Companys shares
  are traded on the Tel Aviv Stock Exchange and on the Nasdaq National Market
  in the United States. The Company and its subsidiaries (the Group) are
  engaged mainly in the field of defense electronics. The Companys principal
  wholly-owned subsidiaries are EFW Inc. (EFW) and Elop Electro-Optics Industries,
  Ltd. (El-Op).
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             | B.      | A majority of the Groups
  revenues are derived from direct or indirect sales to governments or to
  government agencies. As a result, a substantial portion of the Groups sales
  is subject to the special risks associated with sales to governments or to
  government agencies. These risks include, among others, the dependency on the
  resources allocated by governments to defense programs, changes
  in governmental priorities and changes in governmental approvals regarding
  export licenses required for the Group products and for its suppliers. As for
  major customers refer to Note 18(C).                                                                           
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             | C.      | In January 2002, the
  Company acquired from Elron Telesoft Inc. and its subsidiaries (Elron
  Telesoft) the assets and the business of the Defense Systems Division of
  Elron Telesoft (the Government Division) in consideration for $5,700 in
  cash. The excess of the purchase price over the fair value of net tangible
  assets acquired in the amount of approximately $5,100 was allocated to
  technology and other intangible assets to be amortized over a weighted
  average period of 3 years.                                                                                                                                                                               
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |         | The Government Division is
  engaged mainly in the development of communication systems, information
  technology and image intelligence processing for defense and military
  applications.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |         | The results of the
  Government Division have been included in the consolidated financial
  statements from the first quarter of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |         | Pro forma information in
  accordance with SFAS No. 141 has not been provided, since the revenues and
  net income of the Government Division were not material in relation to total
  consolidated revenues and net income for the year 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             | D.      | In June 2003, the Company
  (through El-Op) acquired all of the outstanding ordinary shares of a European
  subsidiary, a company registered in Belgium, in consideration for $1,846 in
  cash. The acquisition was accounted for by the purchase method of accounting.                                                                                                                                                                                                                                                                                                                                                                                                                         
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |         | This subsidiary develops,
  manufactures and supports electro-optical products, mainly for the defense
  and space markets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|             |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |         | The results of this
  subsidiarys operations have been included in the consolidated financial
  statements from the date of acquisition.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

11

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars
  (In thousands)                        

|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|------------ | --------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1     - | GENERAL (Cont.)
|             |                
|             |                 | Pro forma information in
  accordance with SFAS No. 141 has not been provided, since the revenues and
  net income of this subsidiary. were not material in relation to total consolidated
  revenues and net income for the years 2002 and 2003.                                                                                                      
|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|             | E.              | In July 2003, the Company
  acquired approximately 54% of the outstanding shares of Aero Design
  Development Ltd. (AD&D) an Israeli company in consideration for $1,406
  in cash.  The acquisition was
  accounted for by the purchase method of accounting.                                                                                       
|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|             |                 | AD&D develops,
  manufactures and builds airborne models and other engineered products.                                                                                                                                                                                                                                                                
|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|             |                 | The excess of the purchase
  price over the fair value of net tangible assets acquired in the amount of
  approximately $1,334 was allocated to technology ($1,000) to be amortized by
  the straight-line method over a period of 10 years and to technology goodwill
  ($334).                                                                       
|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|             |                 | The results of AD&D.s
  operations have been included in the consolidated financial statements from
  the date of acquisition.                                                                                                                                                                                                                        
|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|             |                 | Pro forma information in
  accordance with SFAS No. 141 has not been provided, since the revenues and
  net income of AD&D were not material in relation to total consolidated
  revenues and net income for the years 2002 and 2003.                                                                                                                  
|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|             | F.              | In August 2004, the
  Company (through a subsidiary of EFW) acquired a business from Computer
  Instruments Corporation Inc. (CIC) of Westbury, New York in consideration
  for approximately $2,315 in cash.  The
  acquired assets relate to the design and manufacture of aviation pressure
  transducers, air data probes and air data computers.
|             |                 |                                                                                                                                                                                                                                                                                                                                                        
|             |                 | The following table
  summarizes the fair value of the assets acquired and liabilities assumed at
  the date of acquisition as estimated by the Company, with the support of an
  external appraisal:                                                                                                                                                  

| |                               |  |   |       |  
| | ----------------------------- |  | - | ----- | -
| | Current Assets                |  | $ | 994   |  
| | Property and equipment        |  |   | 10    |  
| | Technology                    |  |   | 1,327 |  
| | Goodwill                      |  |   | 271   |  
| |                               |  |   |       |  
| | Total assets acquired         |  |   | 2,602 |  
| | Current liabilities
  assumed |  |   | (287  | )
| |                               |  |   |       |  
| | Net assets acquired           |  | $ | 2,315 |  
| |                               |  |   |       |  

| |  |                                                                                                                                                                                                                                     
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The technology acquired
  will be amortized by the straight-line method over a period of 5-7 years. The
  results of CICs operations have been included in the consolidated financial
  statements from the date of acquisition.   
| |  |                                                                                                                                                                                                                                     
| |  | Pro forma information in
  accordance with SFAS No. 141 has not been provided, since the revenues and
  net income of CIC were not material in relation to total consolidated
  revenues and net income for the years 2003 and 2004.

12

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars
  (In thousands)                        

|             |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|------------ | --------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1     - | GENERAL (Cont.)
|             |                
|             | G.              | On December 27, 2004, the
  Company reached an agreement with Koor Industries (Koor) to purchase all of
  Koors holdings in Tadiran Communications Ltd. (Tadiran), which represents
  approximately a 32% interest in Tadiran. This purchase will be made in
  parallel to Koors purchase of approximately 9.8% of the Companys shares
  from Federmann Enterprises Ltd. (Federmann) based on agreements reached
  between Federmann and Koor. The transaction will be executed in two stages as
  described below.                                                                                                                                                                                                                                                                                                                                                                                                                                    
|             |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                 | In the first stage, the
  Company will purchase from Koor approximately 13.8% of Tadirans shares, and
  Koor will purchase from Federmann approximately 5.3% of the Companys shares.
  As of March 1, 2005, the Company held approximately 6% of Tadirans shares
  acquired through purchases on the market, and therefore, following completion
  of the first stage the Company will own approximately 20% of Tadirans
  shares. On completion of the first stage, Koor will support the Companys
  appointment of the greater of 3 members or 20% of Tadirans board of
  directors, and Federmann will support Koors appointment of a member to the
  Companys board of directors.                                                                                                                                                                                                                                                                   
|             |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                 | In the second stage, the
  Company will purchase the balance of Koors holdings in Tadiran. Koor will
  purchase an additional approximately 4.5% of the Companys shares from
  Federmann, and Federmann will support Koors appointment of an additional
  member to the Companys board of directors, including the boards Vice
  Chairman. The second stage is subject to Koor completing the sale to Tadiran
  of Koors 70% holdings in Elisra Electronic Systems Ltd. (Elisra) on agreed
  upon terms. Subject to those terms the Company agreed to support the purchase
  of the Elisra shares by Tadiran at Tadirans general shareholders meeting. In
  the event that the sale of the Elisra shares to Tadiran is not made by April
  2006, then Koor and the Company will have equal representation on Tadirans
  board of directors, and an agreement regarding joint control of Tadiran will
  enter into effect between the Company and Koor.
|             |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                 | The Company will purchase
  from Koor the 32% of the Tadiran shares at a price of $37 per share,
  resulting in a total purchase price of approximately $146,000. Koor will
  purchase from Federmann the 9.8% of the shares in the Company at a price of
  $24.70 per share, resulting in a total purchase price of approximately
  $99,000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|             |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                 | Under the Koor-Federmann
  shareholders agreement, which will became effective upon the completion of
  the first stage of the Koor-Federmann transaction, Koor will obtain certain
  tag along rights in the event of Federmanns sale of shares in the Company,
  and Koor will be subject to certain restrictions on the transfer of its
  shares in the Company. Also, Koor has agreed to vote at general shareholders
  meetings of the Company in accordance with Federmanns instructions, with
  certain exceptions, and Koor will receive certain additional non-transferable
  rights.                                                                                                                                                                                                                                                                                                                                                                
|             |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                 | On January 5, 2005, the
  Companys Audit Committee and board of directors approved the agreements with
  Koor relating to the Companys purchase of Koors shares in Tadiran.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

13

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars
  (In thousands)                        

|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1     - | GENERAL (Cont.)                                                                                                                                                                                                                                                                                                                                                            
|             |                                                                                                                                                                                                                                                                                                                                                                            
|             |                                                                                                                                                                                                                                                                                                                                                                             | On February 28, 2005, the
  Companys shareholders at an extraordinary general shareholders meeting approved
  the agreements with Koor relating to the Companys purchase of Koors shares
  in Tadiran. As of March 1, 2005, the parties were in the process of obtaining
  the remaining approvals required for the transaction.                                                                                                            
|             |                                                                                                                                                                                                                                                                                                                                                                            
|Note 2     - | SIGNIFICANT ACCOUNTING POLICIES                                                                                                                                                                                                                                                                                                                                            
|             |                                                                                                                                                                                                                                                                                                                                                                            
|             | The consolidated financial
  statements have been prepared in accordance with generally accepted
  accounting principles in the United States (U.S. GAAP).  As applicable to the consolidated
  financial statements of the Group, such principles are substantially
  identical to accounting principles generally accepted in Israel, except as
  described in Note 22.
|             |                                                                                                                                                                                                                                                                                                                                                                            
|             | A.                                                                                                                                                                                                                                                                                                                                                                          | USE OF ESTIMATES                                                                                                                                                                                                                                                                                                                                                                                                                               
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                                                                                                                                                                                                                                                                                                                                                             | The preparation of
  financial statements in conformity with generally accepted accounting
  principles requires management to make estimates and assumptions that affect
  the amounts reported and disclosure of contingent assets and liabilities in
  the financial statements and accompanying notes. Actual results could differ
  from those estimates.                                                                                 
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             | B.                                                                                                                                                                                                                                                                                                                                                                          | FINANCIAL STATEMENTS IN
  U.S. DOLLARS                                                                                                                                                                                                                                                                                                                                                                                                         
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                                                                                                                                                                                                                                                                                                                                                             | The Companys revenues are
  generated mainly in U.S. dollars. In addition, most of the Companys costs
  are incurred in U.S. dollars. The Companys management believes that the U.S.
  dollar is the primary currency of the economic environment in which the
  Company operates. Thus, the functional and reporting currency of the Company
  is the U.S. dollar.                                                                         
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                                                                                                                                                                                                                                                                                                                                                             | Transactions and balances
  originally denominated in U.S. dollars are presented at their original
  amounts. Transaction and balances in other currencies have been remeasured
  into U.S. dollars in accordance with principles set forth in SFAS No. 52
  Foreign Currency Translation. All exchange gains and losses from the
  remeasurement mentioned above are reflected in the statement of income in
  financial income or expenses.
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                                                                                                                                                                                                                                                                                                                                                             | For those foreign
  subsidiaries whose functional currency has been determined to be other than
  the U.S. dollar, assets and liabilities are translated at year-end exchange
  rates and statement of income items are translated at average exchange rates
  prevailing during the year.  Such
  translation adjustments are recorded as a separate component of accumulated
  other comprehensive income in shareholders equity.           
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             | C.                                                                                                                                                                                                                                                                                                                                                                          | PRINCIPLES OF
  CONSOLIDATION                                                                                                                                                                                                                                                                                                                                                                                                                  
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                                                                                                                                                                                                                                                                                                                                                             | The consolidated financial
  statements include the accounts of the Company and its wholly and
  majority-owned subsidiaries.                                                                                                                                                                                                                                                                                                                  
|             |                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                                                                                                                                                                                                                                                                                                                                                             | The consolidated
  subsidiaries include El-Op, EFW and other Israeli and non-Israeli
  subsidiaries.                                                                                                                                                                                                                                                                                                                                           

14

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars
  (In thousands)                        

|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                                                                                                                        
|------------ | --------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 2     - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|             |                                        
|             | C.                                      | PRINCIPLES OF
  CONSOLIDATION (CONT.)                                                                                                                                                                                                                                                                                                                                                                                                                           
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                                         | Intercompany transactions
  and balances including profit from intercompany sales not yet realized
  outside the Group have been eliminated upon consolidation.                                                                                                                                                                                                                                                                                                 
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             | D.                                      | CASH EQUIVALENTS                                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                                         | Cash equivalents, are
  short-term highly liquid investments that are readily convertible to cash
  with maturities of three months or less at the date of acquisition.                                                                                                                                                                                                                                                                                         
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             | E.                                      | SHORT-TERM BANK DEPOSITS                                                                                                                                                                                                                                                                                                                                                                                                                                        
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                                         | Short-term bank deposits
  are deposits with maturities of more than three months but less than one
  year. The shortterm bank deposits are presented at their cost.                                                                                                                                                                                                                                                                                           
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             | F.                                      | MARKETABLE SECURITIES                                                                                                                                                                                                                                                                                                                                                                                                                                           
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                                         | Investments in a
  marketable securities are designed as available for sale according to
  Statement of Financial Accounting Standard No. 115 Accounting for Certain
  Investments in Debt and Equity Securities, (SFAS No. 115).  Accordingly, these securities are stated
  at fair value, with unrealized gains and losses, net of taxes, reported in
  accumulated other comprehensive income (loss), a separate component of the
  shareholders equity.
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             | G.                                      | INVENTORIES                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                                         | Inventories are stated at
  the lower of cost or net realizable value. Inventory write-offs are provided
  for slow-moving items or technological obsolescence for which recoverability
  is not probable.                                                                                                                                                                                                                                                      
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|             |                                         | Cost is determined as
  follows:                                                                                                                                                                                                                                                                                                                                                                                                                                
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | Raw materials using the
  average cost method.                                                                                                                                                                                                                                                                                         
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | Costs incurred on
  long-term contracts in progress include direct labor costs, material costs,
  subcontractors, other direct costs and overheads. These costs represent
  recoverable costs incurred for production, allocable operating overhead cost
  and, where appropriate, research and development costs (refer to Note 2(T)).
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | Labor
  overhead is generally included in our hourly rate and is allocated to each
  project according to the amount of hours invested. Material overhead is
  allocated to each project based on the value of direct material that is
  charged to the project.                                                                       
|             |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                                                                                                                        
|             |                                         | Advances from customers
  are allocated to the applicable contract inventories and are reflected as an
  offset against the related inventory balances.                                                                                                                                                                                                                                                                                                         

15

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                        
|------------- | ---------------------------------------
|Note 2      - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | H. | INVESTMENT IN AFFILIATED
  COMPANIES, PARTNERSHIP AND OTHER COMPANIES                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Investments in
  non-marketable shares of companies in which the Group holds less than 20% and
  the Group does not have the ability to exercise significant influence over
  operating and financial policies of the companies are recorded at cost.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Investments in companies
  and partnership over which the Group can exercise significant influence
  (generally, entities in which the Group holds between 20% and 50% of voting
  rights) are presented using the equity method of accounting. Profits on
  intercompany sales, not realized outside the Group, were eliminated. The
  Group discontinues applying the equity method when its investment (including
  advances and loans) is reduced to zero and it has not guaranteed obligations
  of the affiliate or otherwise committed to provide further financial support
  to the affiliate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | The Group applies Emerging
  Issues Task Force (EITF 99-10) Percentage Used to Determine the Amount of
  Equity Method Losses, according to which the Group recognizes equity method
  losses based on the ownership level of the particular investee security or
  loan held by the Group to which the equity method losses are being applied.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | A change in the Companys
  proportionate share of a subsidiarys or investees equity, resulting from
  issuance of shares by the subsidiary or investee to third parties, is
  recorded as a gain or loss in the consolidated income statements. If the
  realization is not assured, such as when the issuing company is a development
  stage company, the gain from issuance is accounted for as an equity
  transaction pursuant to SAB 51 Accounting Sales of Stock by a Subsidiary.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Management evaluates
  investments in affiliates and other companies for evidence of other than
  temporary declines in value. When relevant factors indicate a decline in
  value that is other than temporary, the Company records a provision for the
  decline in value. A judgmental aspect of accounting for investments involves
  determining whether an other-than-temporary decline in value of the
  investment has been sustained. Such evaluation is dependent on the specific
  facts and circumstances. Accordingly, management evaluates financial
  information (e.g. budgets, business plans, financial statements, etc.) in
  determining whether an other-than-temporary decline in value exists. Factors
  indicative of an other-than-temporary decline include recurring operating
  losses, credit defaults and subsequent rounds of financings at an amount
  below the cost basis of the investment. This list is not all inclusive and
  management weighs all quantitative and qualitative factors in determining if
  an other-than-temporary decline in value of an investment has occurred.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | I. | LONG-TERM TRADE
  RECEIVABLES                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Long-term trade
  receivables from extended payment agreements are recorded at their estimated
  present values (determined based on the original rates of interest).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

16

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                        
|------------- | ---------------------------------------
|Note 2      - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)

| | J. | LONG-TERM BANK DEPOSITS                                                                                                                                                                                                                                            
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                    
| |    | Long-term bank deposits
  are deposits with maturities of more than one year. These deposits are
  presented at cost including accumulated interest.                                                                                                               
| |    |                                                                                                                                                                                                                                                                    
| | K. | PROPERTY, PLANT AND
  EQUIPMENT                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                    
| |    | Property, plant and
  equipment are stated at cost, net of accumulated depreciation and investment
  grants. For equipment produced for the Groups own use, cost includes
  materials, labor and overhead, but not in excess of the fair value of the
  equipment.
| |    |                                                                                                                                                                                                                                                                    
| |    | Depreciation is calculated
  by the straight-line method over the estimated useful life of the assets at
  the following annual rates:                                                                                                                             

| |                                        |  |   |       |  |  |                | 
| | -------------------------------------- |  | - | ----- |  |  | -------------- | 
| |                                        |  | % |       |  | 
| |                                        |  |   |       |  | 
| | Buildings                              |  |   | 2-4   |  |  | (mainly
  4%)  | 
| | Instruments, machinery and
  equipment |  |   | 10-33 |  |  |                | 
| | Office furniture and other             |  |   | 6-33  |  |  |                | 
| | Motor vehicles                         |  |   | 15-20 |  |  | (mainly
  15%) | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | Land rights and leasehold
  improvements - over the term of the lease.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | L. | INVESTMENT
  GRANTS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |    | As a governmental
  incentive for industrial companies in Israel, the Investment Center, which
  is a branch of the Israel Ministry of Industry and Trade, permits industrial
  companies to submit a request to qualify as an Approved Enterprise. An
  Approved Enterprise is entitled to certain benefits in respect of capital
  investments. The benefits may be in the form of reduced tax rates and of
  capital grants received as a percentage of the investments of the Approved
  Enterprise. The amount of a capital grant is determined as a percentage of
  the Approved Enterprise investment in property, plant and equipment. As a
  condition to the granting of these benefits, the Approved Enterprise is
  obligated to perform the applicable industrial plan as detailed in the
  request to the Investment Center (see Note 15(A)(3) and 16(J)). These capital
  grants are non-royalty bearing and are not conditioned on the results of
  operations. As the capital grants are a direct participation in the cost of
  the acquisition, of property, plant and equipment they are offset against
  property, plant and equipment and amortized over the period of the related
  investments.

17

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|             |                                        
|------------ | ---------------------------------------
|Note 2     - | SIGNIFICANT
ACCOUNTING POLICIES (CONT.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | M. | IMPAIRMENT OF LONG-LIVED
  ASSETS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | The Groups long-lived
  assets and identifiable intangible assets are reviewed for impairment in
  accordance with SFAS No. 144 Accounting for the Impairment or Disposal of
  Long-Lived Assets whenever events or changes in circumstances indicate that
  the carrying amount of an asset may not be recoverable. Recoverability of
  assets to be held and used is measured by a comparison of the carrying amount
  of an asset to the future undiscounted cash flows expected to be generated by
  the asset. If an asset is determined to be impaired, the impairment to be
  recognized is measured by the amount by which the carrying amount of the
  asset exceeds its fair value. As of December 31, 2004, no impairment losses
  have been identified.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | N. | INTANGIBLE ASSETS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | Intangible assets are
  stated at cost net of accumulated amortization. Intangible assets are being
  amortized over their useful life using the straight-line method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | O. | GOODWILL                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | Goodwill represents the
  excess of the cost of acquired businesses over the net fair values of the
  assets acquired and liabilities assumed. Goodwill that arose from
  acquisitions prior to July 1, 2001, was amortized until December 31, 2001 on
  a straight-line basis over 10 - 20 years. Under SFAS No. 142, effective as of
  January 1, 2002, goodwill is no longer amortized, but is instead tested for
  impairment at least annually (or more frequently if impairments indicators
  arise).                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | SFAS 142 prescribes a two
  phase process for impairment testing of goodwill. The first phase screens for
  impairment, while the second phase (if necessary) measures impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | In the first phase of
  impairment testing, goodwill attributable to each of the reporting units is
  tested for impairment by comparing the fair value of each reporting unit with
  its carrying value. If the carrying value of the reporting unit exceeds its
  fair value, the second phase is then performed. The second phase of the
  goodwill impairment test compares the implied fair value of the reporting
  units goodwill with the carrying amount of that goodwill. If the carrying
  amount of the reporting units goodwill exceeds the implied fair value of
  that goodwill, an impairment loss is recognized in an amount equal to that
  excess.                                                                                               
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | Fair value of a reporting
  unit is determined using discounted cash flows. Significant estimates used in
  the methodology include estimates of future cash flows, future short-term and
  long-term growth rates and weighted average cost of capital for each of the
  reporting units.                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | As of December 31, 2004,
  no impairment losses have been identified.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

18

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|             |                                        
|------------ | ---------------------------------------
|Note 2     - | SIGNIFICANT
ACCOUNTING POLICIES (CONT.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | P. | SEVERANCE PAY                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Under Israeli law and
  employment agreements, the Groups companies in Israel are required to make
  severance payments and, in certain situations, pay pensions to terminated
  employees. The calculation is based on the employees latest salary and the
  period of his/her employment. The companies obligation for severance pay and
  pension is provided by monthly deposits with insurance companies, pension
  funds and by an accrual.                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | The value of severance pay
  funds is presented in the balance sheet and includes profits accumulated to
  balance sheet date. The amounts deposited may be withdrawn only after
  fulfillment of the obligations pursuant to Israeli severance pay law or labor
  agreements. The values of the deposited funds are based on the cash
  surrendered value of these funds and include immaterial profits.                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Severance pay expenses for
  the years ended December 31, 2004, 2003 and 2002, amounted to approximately
  $15,574, $11,491and $10,138, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | Q. | REVENUE RECOGNITION                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | The Group generates
  revenues from long-term contracts involving the design, development,
  manufacture and integration of defense systems and products and providing
  support and services for such systems and products.                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Revenues from long-term
  contracts are recognized based on Statement of Position 81-1 Accounting for
  Performance of Construction-Type and Certain Production-Type Contracts (SOP
  81-1) according to which revenues are recognized on the percentage of
  completion basis.                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Sales under long-term
  fixed-price contracts which provide for a substantial level of development
  efforts in relation to total contract efforts are recorded using the
  cost-to-cost method of accounting as the basis to measure progress toward
  completing the contract and recognizing revenues. According to this method,
  sales and profits are recorded based on the ratio of costs incurred to
  estimated total costs at completion. In certain circumstances, when measuring
  progress toward completion, the Company considers other factors, such as
  achievement of performance milestones.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Sales and anticipated
  profit under long-term fixed-price production type contracts are recorded on
  a percentage of completion basis, using the units-of-delivery as the basis to
  measure progress toward completing the contract and recognizing revenues.                                                                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Sales and anticipated
  profit under long-term fixed-price contracts that involve both development
  and production are recorded on a percentage of completion basis, using the
  cost-to-cost method and units-of-delivery method as applicable. In certain
  circumstances, when measuring progress toward completion under the
  development portion of the contract, the Company considers other factors,
  such as achievement of performance milestones.                                                                                                                                                  

19

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|             |                                        
|------------ | ---------------------------------------
|Note 2     - | SIGNIFICANT
ACCOUNTING POLICIES (CONT.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Q. | REVENUE RECOGNITION
  (CONT.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | Estimated contract profit is
  included in earnings in proportion to recorded sales.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | The
  percentage-of-completion method of accounting requires management to estimate
  the cost and gross profit margin for each individual contract. Estimated
  gross profit or loss from long-term contracts may change due to changes in
  estimates resulting from differences between actual performance and original
  estimated forecasts. Such changes in estimated gross profit are recorded in
  results of operations when they are reasonably determinable by management, on
  a cumulative catch-up basis. Anticipated losses on contracts are charged to
  earnings when determined to be probable.                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | Sales under
  cost-reimbursement-type contracts are recorded as costs are incurred.
  Applicable estimated profits are included in earnings in the proportion that
  incurred costs bear to total estimated costs.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | Amounts representing
  contract change orders, claims or other items are included in sales only when
  they can be reliably estimated and realization is probable. Penalties and
  awards applicable to performance on contracts are considered in estimating
  sales and profit rates and are recorded when there is sufficient information
  to assess anticipated contract performance.                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | The Group believes that
  the use of the percentage of completion method is appropriate as the Group
  has the ability to make reasonably dependable estimates of the extent of
  progress towards completion, contract revenues and contract costs. In
  addition, contracts executed include provisions that clearly specify the enforceable
  rights regarding services to be provided and received by the parties to the
  contracts, the consideration to be exchanged and the manner and terms of
  settlement. In all cases the Group expects to perform its contractual
  obligations and its customers are expected to satisfy their obligations under
  the contract.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | In cases where the
  contract involves the delivery of products and performance of services, the
  Group follows the guidelines specified in EITF 00-21, Revenue Arrangements
  with Multiple Deliverables in order to allocate the contract fees between
  the products accounted for under SOP 81-1 and the services accounted for
  under SAB 104. The services are recognized throughout the service period.                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | In certain circumstances,
  sales under short-term fixed-price production type contracts are accounted
  for in accordance with SAB No. 104, Revenue Recognition in Financial
  Statements (SAB 104), and recognized when the following criteria are met:
  persuasive evidence of an arrangement exists, delivery has occurred, the
  sellers price to the buyer is fixed or determinable, no further obligation
  exists and collectability is reasonably assured.                                                                                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | As for research and
  development costs accounted for as contract costs refer to Note 2(T).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

20

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|------------- | --------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 2      - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              | R.                                      | PRE-CONTRACT COSTS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                         | Pre-contract costs are
  deferred and included in inventory, only when such costs can be directly
  associated with a specific anticipated contract and if their recoverability
  from the specific contract is probable according to the guidelines of SOP
  81-1.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              | S.                                      | WARRANTY                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                         | The Group estimates the
  costs that may be incurred under its basic warranty and records a liability
  in the amount of such costs at the time revenue is recognized as part of
  contract costs. The specific terms and conditions of those warranties vary
  depending upon the product sold, the country in which the Group does
  business, etc. In addition, the Company estimates the costs to be incurred in
  connection with basic design and system operating difficulties arising
  subsequent to delivery and acceptance by the customers and records a
  liability for such costs as part of contract costs. Factors that affect the
  Groups warranty liability include the number of delivered products, the
  warranty period, engineering estimates and anticipated rates of warranty
  claims. The Group periodically assesses the adequacy of its recorded warranty
  liability and adjusts the amount as necessary.
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                         | Changes in the Groups
  provision for warranty during the year are as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

| |                                                     |  |      |         |      |   |         |  
| | --------------------------------------------------- |  | ---- | ------- | ---- | - | ------- | -
| |                                                     |  | 2004 |         | 2003 |  
| |                                                     |  |      |         |      |  
| | Balance, at January 1                               |  | $    | 36,653  |      | $ | 37,800  |  
| | Warranties issued during
  the year                 |  |      | 17,907  |      |   | 13,301  |  
| | Warranties forfeited or
  exercised during the year |  |      | (20,527 | )    |   | (14,448 | )
| |                                                     |  |      |         |      |   |         |  
| |                                                     |  |      |         |      |   |         |  
| | Balance, at December 31                             |  | $    | 34,033  |      | $ | 36,653  |  
| |                                                     |  |      |         |      |   |         |  

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                          
| | T. | RESEARCH AND DEVELOPMENT
  COSTS                                                                                                                                                                                                                                                                                                                                                                                         
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | Research and development
  costs, net of participations, are charged to operations as incurred. Group
  sponsored research and development costs primarily include independent
  research and development and bid and proposal efforts.                                                                                                                                                                                  
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | Under certain arrangements
  in which a customer participates in product development costs, the Groups
  portion of such unreimbursed costs is expensed as incurred.
  Customer-sponsored research and development costs incurred pursuant to
  contracts are accounted for as part of the contract costs.                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | Certain Group companies in
  Israel receive grants (mainly royalty-bearing) from the Government of Israel
  and from other sources for the purpose of funding approved research and
  development projects. These grants are recognized as a deduction from
  research and development costs at the time the applicable company is entitled
  to such grants on the basis of the research and development costs incurred.

21

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|------------- | --------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 2      - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              | U.                                      | INCOME TAXES                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         | The Group accounts for
  income taxes in accordance with SFAS No. 109, Accounting for Income Taxes.
  This Statement prescribes the use of the liability method whereby deferred
  tax assets and liability account balances are determined based on differences
  between financial reporting and tax bases of assets and liabilities and are
  measured using the enacted tax rates and laws that will be in effect when the
  differences are expected to reverse. The Group provides a valuation
  allowance, if necessary, to reduce deferred tax assets to their estimated
  realizable value.                                                                                                                                                                                                                                         
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              | V.                                      | CONCENTRATION OF CREDIT
  RISKS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         | Financial instruments that
  potentially subject the Group to concentrations of credit risk consist
  principally of cash and cash equivalents, short and long-term deposits and
  trade receivables.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         | The majority of the Groups
  cash and cash equivalents and deposits are invested in dollar instruments
  with major banks in Israel and in the U.S. Management believes that the
  financial institutions that hold the Group investments are financially sound,
  and accordingly, minimal credit risk exists with respect to these
  investments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         | The Groups trade
  receivables are derived primarily from sales to large and stable customers
  and governments located mainly in Israel, the United States and Europe. The Group
  performs ongoing credit evaluations of its customers and to date, has not
  experienced any unexpected material losses except for a one time loss in 2002
  of approximately $4,600 due to the insolvency of one of the Groups
  customers. An allowance for doubtful accounts is determined with respect to
  those amounts that the Group has determined to be doubtful of collection.                                                                                                                                                                                                                                                                 
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              | W.                                      | DERIVATIVE FINANCIAL
  INSTRUMENTS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         | Financial
  Accounting Standards Board Statement No. 133, Accounting for Derivative
  Instruments and Hedging Activities (SFAS No. 133), requires companies to
  recognize all of its derivative instruments as either assets or liabilities
  in the statement of financial position at fair value. The accounting for
  changes in the fair value (i.e. gains or losses) of a derivative instrument
  depends on whether it has been designated and qualifies as part of a hedging
  relationship and further, on the type of hedging relationship. For those
  derivative instruments that are designated and qualify as hedging
  instruments, a company must designate the hedging instrument, based upon the
  exposure being hedged, as a fair value hedge, cash flow hedge or a hedge of a
  net investment in a foreign operation.

22

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|------------- | --------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 2      - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              | W.                                      | DERIVATIVE FINANCIAL
  INSTRUMENTS (CONT.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | For derivative instruments
  that are designated and qualify as a fair value hedge (i.e., hedging the
  exposure to changes in the fair value of an asset or a liability or an
  identified portion thereof that is attributable to a particular risk), the
  gain and loss on the derivative instrument as well as the offsetting loss or
  gain on the hedged item attributable to the hedged risk are recognized in the
  same line item associated with the hedged item in current earnings during the
  period of the change in fair values. For derivative instruments that are
  designated and qualify as a cash flow hedge (i.e. hedging the exposure to
  variability in expected future cash flows that is attributable to a
  particular risk), the effective portion of the gain or loss on the derivative
  instrument is reported as a component of other comprehensive income and
  reclassified into earnings in the same line item associated with the
  forecasted transaction in the same period or periods during which the hedged
  transaction affects earnings.
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | The remaining gain or loss
  on the derivative instrument in excess of the cumulative change in the
  present value of future cash flows of the hedged item, if any, is recognized
  as a financial expense in current earnings during the period of change.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | For derivative instruments
  not designated as hedging instruments, the gain or loss is recognized as a
  financial expense in current earnings during the period of change.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | As part of its hedging
  strategy, the Group enters into forward exchange contracts in order to
  protect the Group from the risk that the eventual dollar cash flows from the
  sale of products to international customers will be adversely affected by
  changes in the exchange rates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | As part of its cash flow
  hedging strategy the Group enters into forward exchange contracts to hedge
  forecasted salary expenses denominated in a currency other than the U.S.
  dollar.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | As of December 31, 2004,
  the Group had forward contracts with a notional amount of approximately
  $30,900 to purchase and sell foreign currencies ($20,800 in Euro, $5,400 in
  Great Britain Pounds (GBP) and $4,800 in other currencies). The Group also
  had options to hedge future cash flow denominated in GBP in the amount of
  $154,000. The forward contracts and the options mature in 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | The fair value of the
  foreign exchange contracts and the options as of December 31, 2004 is minimal.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

23

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|------------- | --------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 2      - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              | X.                                      | STOCK-BASED COMPENSATION                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | Up until January 1, 2004,
  the Company elected to follow Accounting Principles Board Opinion No. 25
  (APB 25) Accounting for Stock Issued to Employees and FASB Interpretation
  No. 44 (FIN 44) Accounting for Certain Transactions Involving Stock
  Compensation in accounting for its employee stock option plans. Under APB
  25, the Company accounted for stock option grants using the intrinsic value
  method whereby compensation expense is equal to the excess, if any, of the
  quoted market price of the stock over the exercise price at the grant date of
  the award or if applicable at a subsequent measurement date. The Company
  recognized the expense over the vesting period of the award on a
  straight-line basis. Phantom options were accounted for as variable awards
  and accordingly, compensation expenses were measured at the end of each
  reporting period and amortized on an accelerated basis over the remaining
  vesting period. (See Note 17).
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | Effective January 1, 2004,
  the Company adopted the fair value recognition provisions of SFAS No. 123.
  Under the modified prospective method of adoption selected by the Company
  under the provisions of SFAS No. 148, the recognition provisions are applied
  to all employee awards granted, modified, or settled after January 1, 2004,
  and to previously granted awards that were not fully vested on the date of
  adoption. Compensation cost is recorded over the vesting period on a
  straight-line basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|              |                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                         | The cumulative effect on
  the deferred taxes relating to stock based compensation resulting from the
  adoption of SFAS No. 123 amounted to a reduction of $152 and was recorded as
  a one time adjustment to additional paid-in capital.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

24

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|                                                             
|-------------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES                      
|                                                             
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)       
|                                                             
|U. S. dollars (In thousands, except share and per share data)

|              |                                         |                                                                                                                                                                                                                                                                               
|------------- | --------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 2      - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|              |                                         |                                                                                                                                                                                                                                                                               
|              | X.                                      | STOCK-BASED COMPENSATION
  (CONT.)                                                                                                                                                                                                                                            
|              |                                         |                                                                                                                                                                                                                                                                               
|              |                                         | If the Company had elected
  to adopt the fair value recognition provisions of SFAS No. 123 as of its
  original effective date, pro forma net income and pro forma basic diluted net
  income per share for the years ended December 31, 2002 and 2003 would be as
  follows:

| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| | ----------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ | - | - | ------ | -
| |                                                                                                                               |  | Year ended
  December 31, |       
| |                                                                                                                               |  | 2004                      |        | 2003 |   | 2002   |  
| |                                                                                                                               |  |                           |        |      |   |        |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| | Net income as reported                                                                                                        |  | $                         | 52,993 |      | $ | 45,945 |   | $ | 45,113 |  
| | Add - Stock based compensation expense (income), net of related
tax
  effects as reported (intrinsic method in 2003 and 2002) |  |                           | 2,710  |      |   | 3,793  |   |   | (741   | )
| | Deduct - Stock based compensation expense under fair value based
  method of SFAS 123 net of related of tax effects           |  |                           | (2,710 | )    |   | (2,956 | ) |   | (2,956 | )
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| | Pro forma net income                                                                                                          |  | $                         | 52,993 |      | $ | 46,782 |   | $ | 41,416 |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| | Net earnings per share:                                                                                                       |  |                           |        |      |   |        |   |   |        |  
| | Basic net earnings per share as reported                                                                                      |  | $                         | 1.33   |      | $ | 1.18   |   | $ | 1.17   |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| | Diluted net earnings per share as reported                                                                                    |  | $                         | 1.29   |      | $ | 1.14   |   | $ | 1.13   |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| | Pro forma basic net earnings per share                                                                                        |  | $                         | 1.33   |      | $ | 1.20   |   | $ | 1.08   |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  
| | Pro forma diluted net earnings per share                                                                                      |  | $                         | 1.29   |      | $ | 1.16   |   | $ | 1.04   |  
| |                                                                                                                               |  |                           |        |      |   |        |   |   |        |  

| |  |                                                                                                                                               
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------
| |  | The fair value for these
  options was estimated using a Black-Scholes option pricing model with the
  following weighted average assumptions:

| |                         |  |  |           |   |      |           |      |  |           |  
| | ----------------------- |  |  | --------- | - | ---- | --------- | ---- |  | --------- | -
| |                         |  |  | 2004      |   | 2003 |           | 2002
| |                         |  |  |           |   |      |           |     
| | Divided yield           |  |  | 2.20      | % |      | 2.19      | %    |  | 1.99      | %
| | Expected volatility     |  |  | 26.7      | % |      | 19.03     | %    |  | 21.9      | %
| | Risk-free interest rate |  |  | 4         | % |      | 1.20      | %    |  | 1.34      | %
| | Expected life           |  |  | 4
  years |   |      | 6
  years |      |  | 6
  years |  

25

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|             |                                         |                                      
|------------ | --------------------------------------- | -------------------------------------
|Note 2     - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|             |                                        
|             | Y.                                      | FAIR VALUE OF FINANCIAL
  INSTRUMENTS

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | The carrying amount
  reported in the balance sheet for cash and cash equivalents, short-term bank
  deposits, trade receivables, short-term bank credit and loans and trade
  payables approximate their fair values due to the short-term maturities of
  such instruments.                                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | The carrying amount of the
  available for sale marketable securities is recorded according to its fair
  market value, as determined by quoted market prices on stock exchange.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | Long-term loans are
  estimated by discounting the future cash flows using current interest rates
  for loans of similar terms and maturities. The carrying amount of the
  long-term loans approximates their fair value.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | The fair value of foreign
  currency contracts (used for hedging purposes) is estimated by obtaining
  current quotes from investment bankers.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | It was not practicable to
  estimate the fair value of the Groups investments in shares of non-public
  companies that are accounted for under the cost and equity method because of
  the lack of a quoted market price and the inability to obtain valuation of
  each company without incurring excessive costs. The carrying amounts of these
  companies as of December 31, 2003 and 2004 were $38,223 and $44,869,
  respectively, and represent the original cost of acquisition, and in the case
  of affiliates also the Companys equity in the earnings/losses of the
  affiliates and its share in the changes of the affiliates equity since the
  dates of acquisition.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | Z. | BASIC AND DILUTED NET
  EARNINGS PER SHARE                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | Basic net earnings per
  share are computed based on the weighted average number of ordinary shares
  outstanding during each year. Diluted net earnings per share is computed
  based on the weighted average number of ordinary shares outstanding during
  each year, plus dilutive potential ordinary shares considered outstanding
  during the year. Outstanding stock options are excluded from the calculation
  of the diluted net earnings per ordinary share when such securities are anti-dilutive. In all the years
  presented no stock options were excluded.                                                                                                           

26

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|             |                                         |                                                 
|------------ | --------------------------------------- | ------------------------------------------------
|Note 2     - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|             |                                        
|             | AA.                                     | IMPACT OF RECENTLY ISSUED
  ACCOUNTING STANDARDS

| |  |      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | (1). | In February 2004, the
  FASB issued EITF Issue No. 03-1, The Meaning of
  Other-Than-Temporary Impairment and Its Application to Certain Investments
  (EITF 03-1). This EITF was issued to determine the meaning of
  other-than-temporary impairment and its application to investments in debt
  and equity securities within the scope of SFAS 115. EITF 03-1 also applies to
  investments in equity securities that are both outside SFAS 115s scope and
  are not accounted for by the equity method, which are defined as cost method
  investments. The impairment measurement and recognition guidance prescribed
  in EITF 03-1 is delayed until the final issuance of FSP EITF 03-01-a. The
  disclosure requirements for investments accounted for under SFAS 115 are
  effective for annual reporting periods ending after June 15, 2003 and
  for costs method investments for annual reporting periods ending after June
  15, 2004. The Company does not expect that the adoption of the provisions of
  EITF 03-1 will have a material effect on its financial position or results of
  operations.                                                                                                                                                                                                   
| |  |      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | (2). | In November 2004, the FASB
  issued Statement of Financial Accounting Standard No. 151, Inventory Costs,
  an amendment of ARB No. 43, Chapter 4. (SFAS 151). SFAS 151 amends
  Accounting Research Bulletin (ARB) No. 43, Chapter 4, to clarify that
  abnormal amounts of idle facility expense, freight handling costs and wasted
  materials (spoilage) should be recognized as current-period charges. In
  addition, SFAS 151 requires that allocation of fixed production overheads to
  the costs of conversion be based on normal capacity of the production
  facilities. SFAS 151 is effective for inventory costs incurred during fiscal
  years beginning after June 15, 2005. The Company does not expect that the
  adoption of SFAS 151 will have a material effect on its financial position or
  results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  |      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | (3). | On December 16, 2004, the
  Financial Accounting Standards Board (FASB) issued FASB Statement No. 123
  (revised 2004) (123(R)), Share-Based Payment, which is a revision of FASB
  Statement No. 123, Accounting for Stock-Based Compensation. Statement
  123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to
  Employees, and amends FASB Statement No. 95, Statement of Cash Flows.
  Generally, the approach in Statement 123(R) is similar to the approach
  described in Statement 123. However, Statement 123(R) requires all
  share-based payments to employees, including grants of employee stock
  options, to be recognized in the income statement based on their fair values.
  Pro forma disclosure is no longer an alternative. Statement 123(R) must be
  adopted no later than July 1, 2005. Early adoption will be permitted in
  periods in which financial statements have not yet been issued. The Company
  expects to adopt Statement 123(R) on July 1, 2005. Since, as noted in Note
  2(AA) below, the Company adopted, effective January 1, 2004, the
  fair-value-based method of accounting for share-based payments, the adoption
  of Statement 123(R) is not expected to have a material impact on the
  Companys results of operation or its financial position.

27

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|             |                                         |                                                         
|------------ | --------------------------------------- | --------------------------------------------------------
|Note 2     - | SIGNIFICANT ACCOUNTING POLICIES (CONT.)
|             |                                         |                                                         
|             | AA.                                     | IMPACT OF RECENTLY ISSUED
  ACCOUNTING STANDARDS (CONT.)

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                            
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Statement 123(R) permits
  public companies to adopt its requirements using one of two methods:
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                                                
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                                                | A modified prospective
  method in which compensation cost is recognized beginning with the effective
  date (a) based on the requirements of Statement 123(R) for all share-based
  payments granted after the effective date and (b) based on the requirements
  of Statement 123(R) for all awards granted to employees prior to the effective
  date of Statement 123(R) that remains unvested on the effective date.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                            
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                                                | A modified retrospective
  method which includes the requirements of the modified prospective method
  described above, but also permits entities to restate based on the amounts
  previously recognized under Statement 123 for purposes of pro forma
  disclosures either (a) all prior periods presented or (b) prior interim
  periods of the year of adoption.                                                     
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                            
| |     | The Company plans to adopt
  Statement No. 123(R) using the modified prospective method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |     | The Company adopted the
  fair-value-based method of accounting for share-based payments effective
  January 1, 2004 using the modified prospective method described in FASB
  Statement No. 148, Accounting for Stock-Based Compensation  Transition and
  Disclosure. Currently, the Company uses the Black-Scholes-Merton formula to
  estimate the value of stock options granted to employees and expects to
  continue to use this acceptable option valuation model upon the required
  adoption of Statement 123(R) on July 1, 2005. The Company does not anticipate
  that adoption of Statement 123(R) will have a material impact on its results
  of operations or its financial position. However, Statement 123(R) also
  requires that the benefits of tax deductions in excess of recognized
  compensation cost be reported as a financing cash flow, rather than as an
  operating cash flow as required under current literature. This requirement
  will reduce net operating cash flows and increase net financing cash flows in
  periods after the effective date. While the Company cannot estimate what
  those amounts will be in the future (because they depend on, among other
  things, when employees exercise stock options), the amount of operating cash
  flows recognized in prior periods for such excess tax deductions was $1,179,
  $758, and $648 in 2004, 2003 and 2002, respectively.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | AB. | RECLASSIFICATIONS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |     | Certain financial statement data for prior years has
  been reclassified to conform to current year financial statement presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

28

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|             |                       
|------------ | ----------------------
|Note 3     - | TRADE RECEIVABLES, NET
|             |                       
|             | Trade receivables     

| |                                        |  |              |         |      |   |         |  
| | -------------------------------------- |  | ------------ | ------- | ---- | - | ------- | -
| |                                        |  | December 31, |        
| |                                        |  |              |        
| |                                        |  | 2004         |         | 2003 |  
| |                                        |  |              |         |      |  
| | Open accounts (*)                      |  | $            | 181,995 |      | $ | 170,287 |  
| | Unbilled receivables                   |  |              | 35,885  |      |   | 36,855  |  
| | Less - allowance for doubtful
accounts |  |              | (3,064  | )    |   | (3,861  | )
| |                                        |  |              |         |      |   |         |  
| |                                        |  | $            | 214,816 |      | $ | 203,281 |  
| |                                        |  |              |         |      |   |         |  
| | (*)     Includes affiliated
companies) |  | $            | 10,823  |      | $ | 6,668   |  
| |                                        |  |              |         |      |   |         |  

|             |                                       
|------------ | --------------------------------------
|Note 4     - | OTHER RECEIVABLES AND PREPAID EXPENSES

| |                         |  |              |        |      |   |        | 
| | ----------------------- |  | ------------ | ------ | ---- | - | ------ | 
| |                         |  | December 31, |       
| |                         |  |              |       
| |                         |  | 2004         |        | 2003 |  
| |                         |  |              |        |      |  
| | Deferred income taxes   |  | $            | 20,603 |      | $ | 21,908 | 
| | Prepaid expenses        |  |              | 17,914 |      |   | 14,310 | 
| | Government institutions |  |              | 5,719  |      |   | 5,826  | 
| | Employees               |  |              | 1,204  |      |   | 513    | 
| | Others                  |  |              | 6,895  |      |   | 5,806  | 
| |                         |  |              |        |      |   |        | 
| |                         |  | $            | 52,335 |      | $ | 48,363 | 
| |                         |  |              |        |      |   |        | 

|             |                             
|------------ | ----------------------------
|Note 5     - | INVENTORIES, NET OF ADVANCES

| |                                                                        |  |              |         |      |   |         | 
| | ---------------------------------------------------------------------- |  | ------------ | ------- | ---- | - | ------- | 
| |                                                                        |  | December 31, |        
| |                                                                        |  |              |        
| |                                                                        |  | 2004         |         | 2003 |  
| |                                                                        |  |              |         |      |  
| | Cost incurred on long-term
contracts in progress                       |  | $            | 254,009 |      | $ | 254,910 | 
| | Raw materials                                                          |  |              | 71,813  |      |   | 78,504  | 
| | Advances to suppliers and
subcontractors                               |  |              | 21,164  |      |   | 20,137  | 
| |                                                                        |  |              |         |      |   |         | 
| |                                                                        |  |              | 346,986 |      |   | 353,551 | 
| | Less -                                                                 |  |              |         |      |   |         | 
| | Cost incurred on contracts in
progress deducted from customer advances |  |              | 14,533  |      |   | 14,581  | 
| |                                                                        |  |              |         |      |   |         | 
| |                                                                        |  |              | 332,453 |      |   | 338,970 | 
| | Less -                                                                 |  |              |         |      |   |         | 
| | Advances received from customers
(*)                                   |  |              | 75,776  |      |   | 77,482  | 
| | Provision for losses                                                   |  |              | 7,636   |      |   | 12,263  | 
| |                                                                        |  |              |         |      |   |         | 
| |                                                                        |  | $            | 249,041 |      | $ | 249,225 | 
| |                                                                        |  |              |         |      |   |         | 

| |                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company has
  transferred legal title of inventories to certain customers as collateral for
  advances received.                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                        
| | (*) Advances are
  allocated to the relevant inventories on a per-project basis. In cases
  (projects) where the advances are in excess of the inventories, the net
  amount is presented as a liability. In cases where the inventories are in
  excess of advances received, the net amount is presented as an asset.

29

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|               |                                                                        |                                                                  
|-------------- | ---------------------------------------------------------------------- | -----------------------------------------------------------------
|Note
  6     - | INVESTMENTS
  IN AFFILIATED COMPANIES, PARTNERSHIP AND OTHER COMPANIES
|               |                                                                       
|               | A.                                                                     | Investments
  in companies accounted for under the equity method:

| |            |  |              |        |      |   |        | 
| | ---------- |  | ------------ | ------ | ---- | - | ------ | 
| |            |  | December 31, |       
| |            |  |              |       
| |            |  | 2004         |        | 2003 |  
| |            |  |              |        |      |  
| | SCD (1)    |  | $            | 19,186 |      | $ | 17,347 | 
| | VSI (2)    |  |              | 6,966  |      |   | 6,149  | 
| | RedC (5)   |  |              | 3,100  |      |   |       | 
| | Opgal (3)  |  |              | 2,873  |      |   | 2,390  | 
| | Others (4) |  |              | 999    |      |   | 592    | 
| |            |  |              |        |      |   |        | 
| |            |  | $            | 33,124 |      | $ | 26,478 | 
| |            |  |              |        |      |   |        | 

| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |  | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | (1) | Semi Conductor Devices
  (SCD) is an Israeli partnership, held 50% by the Company and 50% by Rafael
  Armaments Development Authority Ltd. (Rafael). SCD is engaged in the
  development and production of various thermal detectors and laser diodes. SCD
  is jointly controlled and therefore is not consolidated in the Companys
  financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |  | (2) | Vision Systems
  International LLC (VSI) based in San Jose, is a California limited
  liability company that is held 50% by EFW and 50% by a subsidiary of Rockwell
  Collins Inc. VSI operates in the area of helmet mounted display systems for
  fixed wing military and paramilitary aircraft. VSI is jointly controlled and
  therefore is not consolidated in the Companys financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |  | (3) | Opgal Optronics Industries
  Ltd. (Opgal) is an Israeli company owned 50.1% by the Company and 49.9% by
  a subsidiary of Rafael. Opgal focuses mainly on commercial applications of
  thermal imaging and electro-optic technologies. The Company jointly controls
  Opgal with Rafael, and therefore Opgal is not consolidated in the Companys
  financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |  | (4) | Mediguide
  Inc. (Mediguide) and its Israeli subsidiary, Mediguide Ltd., were
  established in 2000 as a spin-off from the Company. The share capital of
  Mediguide consists of Common shares and Preferred A, B, C and D shares. The
  Common shares and the Preferred shares, both have voting rights. The Company
  holds all of the Common shares of Mediguide which constitute approximately
  55% (43% on a fully diluted basis) of the voting rights of Mediguide. During
  2001 - 2004, Mediguide issued Preferred shares to other investors in
  consideration for approximately $34,355. The Preferred shares issued entitle
  the other investors to preference rights senior to all other classes of
  shares previously issued by Mediguide in a liquidation or a deemed
  liquidation event. Therefore, the Company did not record any gain as a result
  of the above transaction. In addition, the Preferred shares entitle their
  holders to certain participating rights. Accordingly, based on the guidance
  in EITF 96-16, the Company does not consolidate Mediguide. The carrying value
  of the investment in Mediguide is zero.

30

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                                                               
|------------- | ------------------------------------------------------------------------------
|Note 6      - | INVESTMENTS
  IN AFFILIATED COMPANIES, PARTNERSHIP AND OTHER COMPANIES (CONT.)

| |    |                                                                       
| | -- | ----------------------------------------------------------------------
| | A. | Investments in companies accounted
for under the equity method (cont.)

| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | (5) | RedC Optical Networks Inc.
  (RedC), a company registered in Delaware, is engaged in the multi-focal
  optic communications sector and as of December 31, 2003 was held 36.5% by
  El-Op. RedC designs develops and manufactures optical amplifiers for dense
  wave-length multiplexing optical networks for telecommunications. In the year
  ended December 31, 2002, the Company recorded a provision for loss on its
  investment in RedC of $2,500. This provision has been presented in the
  Consolidated Statements of Income under Equity in net earnings of affiliated
  companies and partnership.
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  |     | In November 2004, El-Op
  acquired all of the outstanding voting Preferred A shares of RedC from MRV
  Communications Inc. for a consideration of $2,000, in accordance with El-Ops
  right of first refusal based on the Preferred A shares investment agreement.
  Prior to the acquisition, El-Op held 57% of the Ordinary shares of RedC which
  reflected 36.5% of its voting rights. Following the acquisition, El-Op held
  57% of the Ordinary shares and 100% of the Preferred A shares, which
  reflected 72.5% of RedCs voting rights.                                                               
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  |     | In December 2004, El-Op
  signed a Transfer Agreement for selling all of its holdings in RedC,
  including the Ordinary shares and Preferred A shares, in consideration for
  $3,100, which was paid in cash on the closing date in January 2005. The
  closing was subject to certain conditions, which were all met by January 21,
  2005.                                                                                                                                                                                                                                                                     
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  |     | El-Op allocated the
  purchase price to the fair value of the assets acquired and liabilities
  assumed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  |     | Such
  allocation resulted in negative goodwill amounting to approximately to
  $1,100. Since RedC had no assets which could be reduced by the negative
  goodwill, according to the provisions of FAS 141, this goodwill was recorded
  as other income in the financial statements.                                                                                                                                                                                                                                                                                                                             

31

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                                                                |                                                                          |                                                                                                                     
|------------- | ------------------------------------------------------------------------------ | ------------------------------------------------------------------------ | --------------------------------------------------------------------------------------------------------------------
|Note 6      - | INVESTMENTS
  IN AFFILIATED COMPANIES, PARTNERSHIP AND OTHER COMPANIES (CONT.)
|              |                                                                               
|              | A.                                                                             | Investments
  in companies accounted for under the equity method (cont.)
|              |                                                                                |                                                                         
|              |                                                                                | (6)                                                                      | The summarized aggregate
  financial information of companies accounted for under the equity method is
  as follows:
|              |                                                                                |                                                                          |                                                                                                                     
|              |                                                                                |                                                                          | Balance Sheet Information:                                                                                          

|                        |  |                |         |      |   |         | 
|----------------------- |  | -------------- | ------- | ---- | - | ------- | 
|                        |  | December
  31, |        
|                        |  |                |        
|                        |  | 2004           |         | 2003 |  
|                        |  |                |         |      |  
|                        |  |                |         |      |   |         | 
|Current assets          |  | $              | 124,352 |      | $ | 105,457 | 
|Non-current assets      |  |                | 21,646  |      |   | 15,799  | 
|                        |  |                |         |      |   |         | 
|Total assets            |  |                | 145,998 |      |   | 121,256 | 
|                        |  |                |         |      |   |         | 
|                        |  |                |         |      |   |         | 
|Current liabilities     |  |                | 68,655  |      |   | 59,076  | 
|Non-current liabilities |  |                | 3,868   |      |   | 4,584   | 
|Shareholders equity    |  |                | 73,475  |      |   | 57,596  | 
|                        |  |                |         |      |   |         | 
|                        |  | $              | 145,998 |      | $ | 121,256 | 
|                        |  |                |         |      |   |         | 

| |  |  |                                
| |  |  | -------------------------------
| |  |  | Income Statement
  Information:

|             |  |                           |         |      |   |         |  |   |         | 
|------------ |  | ------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
|             |  | Year ended
  December 31, |        
|             |  |                           |        
|             |  | 2004                      |         | 2003 |   | 2002    | 
|             |  |                           |         |      |   |         | 
|             |  |                           |         |      |   |         |  |   |         | 
|Revenues     |  | $                         | 213,680 |      | $ | 183,426 |  | $ | 138,493 | 
|Gross profit |  |                           | 55, 285 |      |   | 45,616  |  |   | 36,278  | 
|Net income   |  |                           | 15,195  |      |   | 13,976  |  |   | 6,904   | 
|             |  |                           |         |      |   |         |  |   |         | 

| |  |     |                                 
| |  | --- | --------------------------------
| |  | (7) | See Note 16(F) for
  guarantees.

32

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                                                                |                                                               
|------------- | ------------------------------------------------------------------------------ | --------------------------------------------------------------
|Note 6      - | INVESTMENTS
  IN AFFILIATED COMPANIES, PARTNERSHIP AND OTHER COMPANIES (CONT.)
|              |                                                                               
|              | B.                                                                             | Investments
  in companies accounted for under the cost method

|             |  |                |        |      |   |        | 
|------------ |  | -------------- | ------ | ---- | - | ------ | 
|             |  | December
  31, |       
|             |  |                |       
|             |  | 2004           |        | 2003 |  
|             |  |                |        |      |  
|Sultam
  (1) |  | $              | 3,500  |      | $ | 3,500  | 
|ISI
  (2)    |  |                | 7,230  |      |   | 7,230  | 
|AAI (3)      |  |                | 1,000  |      |   | 1,000  | 
|Others       |  |                | 15     |      |   | 15     | 
|             |  |                |        |      |   |        | 
|             |  | $              | 11,745 |      | $ | 11,745 | 
|             |  |                |        |      |   |        | 

|              |                                                 |     |                                                                                                                                                                                                                                                                                                                                                                                                             
|------------- | ----------------------------------------------- | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|              |                                                 | (1) | Sultam Systems Ltd.
  (Sultam), held 10%, is an Israeli company engaged in the development and
  manufacturing of military systems in the artillery sector.                                                                                                                                                                                                                                               
|              |                                                 |     |                                                                                                                                                                                                                                                                                                                                                                                                             
|              |                                                 | (2) | ImageSat International
  N.V. (ISI), held 14% (10% on a fully diluted basis), is engaged in the operation
  of satellite photography formations and commercial delivery of satellite
  photography for civil purposes.                                                                                                                                                                                    
|              |                                                 |     |                                                                                                                                                                                                                                                                                                                                                                                                             
|              |                                                 | (3) | AeroAstro Inc. (AAI) -
  In January 2003, the Company purchased 8.33% (on a fully diluted basis) of
  the common stock of AAI, a Delaware corporation in consideration for $1,000.
  AAI is engaged in innovative micro and nanospacecraft applications. AAI
  manufactures low-cost satellite systems and components, used in its own
  spacecraft and for spacecraft development in and outside the U.S.
|              |                                                 |     |                                                                                                                                                                                                                                                                                                                                                                                                             
|Note 7      - | LONGTERM
  BANK DEPOSITS AND TRADE RECEIVABLES

|                                                         |  |                |       |      |   |       | 
|-------------------------------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|                                                         |  | December
  31, |      
|                                                         |  |                |      
|                                                         |  | 2004           |       | 2003 |  
|                                                         |  |                |       |      |  
|                                                         |  |                |       |      |   |       | 
|Deposits with banks for
  loans granted to employees (*) |  | $              | 1,603 |      | $ | 1,901 | 
|Long-term trade
  receivables                            |  |                | 452   |      |   | 393   | 
|Other deposits with banks                                |  |                | 47    |      |   | 53    | 
|                                                         |  |                |       |      |   |       | 
|                                                         |  | $              | 2,102 |      | $ | 2,347 | 
|                                                         |  |                |       |      |   |       | 

| |     |                                                                                                                                              
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------
| | (*) | The deposits are linked to
  the Israeli CPI, bear annual interest of 4% and are presented net of current
  maturities of $534 (2003 - $633).

33

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE
CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                     
|------------- | ------------------------------------
|Note 8      - | PROPERTY,
  PLANT AND EQUIPMENT, NET

|                                                 |  |                |          |      |   |          |  
|------------------------------------------------ |  | -------------- | -------- | ---- | - | -------- | -
|                                                 |  | December
  31, |         
|                                                 |  |                |         
|                                                 |  | 2004           |          | 2003 |  
|                                                 |  |                |          |      |  
|Cost (1):                                        |  |                |          |      |   |          |  
|Land, buildings and leasehold
  improvements (2) |  | $              | 151,285  |      | $ | 140,812  |  
|Instruments, machinery and
  equipment (3)       |  |                | 222,153  |      |   | 196,229  |  
|Office furniture and other                       |  |                | 26,828   |      |   | 25,254   |  
|Motor vehicles                                   |  |                | 37,308   |      |   | 29,776   |  
|                                                 |  |                |          |      |   |          |  
|                                                 |  |                | 437,574  |      |   | 392,071  |  
|Accumulated depreciation                         |  |                | (193,286 | )    |   | (162,850 | )
|                                                 |  |                |          |      |   |          |  
|Depreciated cost                                 |  | $              | 244,288  |      | $ | 229,221  |  
|                                                 |  |                |          |      |   |          |  

| |                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Depreciation expenses for
  the years ended December 31, 2004, 2003 and 2002 amounted to $35,001, $30,775
  and $26,525, respectively.
| |                                                                                                                                       
| | (1)                                                                                                                                    | Net of investment grants
  received (mainly for instruments, machinery and equipment) in the amounts of
  approximately $29,800 as of both December 31, 2004 and 2003.                                                                                                                                                         
| |                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                
| | (2)                                                                                                                                    | Includes, rights in
  approximately 9,225 square meters of land in Tirat Hacarmel, Israel. The land
  is leased from the Israel Land Administration until the years 2014 to 2024
  with a renewal option for additional periods of up to 49 years. The Companys
  rights in the land have not yet been registered in its name.
| |                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                        | Includes, rights in
  approximately 10,633 square meters of land in Rehovot, Israel. The land is
  leased from the Israel Land Administration until the year of 2043 with a
  renewal option for additional periods of up to 49 years. The Companys rights
  in the land have not yet been registered in its name.            
| |                                                                                                                                       
| | (3)                                                                                                                                    | Includes equipment
  produced by the Group for its own use in the aggregate amount of $69,146 and
  $59,318 as of December 31, 2004 and 2003, respectively.                                                                                                                                                                    
| |                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                
| | (4)                                                                                                                                    | As for pledges of assets 
  see Note 16(I).                                                                                                                                                                                                                                                                                   

34

---



|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|------------------------------------------------------
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|Note 9      - | INTANGIBLE
  ASSETS, NET
|------------- | ------------------------
|              |                         
|              | A.                      

|                          |  |                                                          |    |                |      |         |      |   |         | 
|------------------------- |  | -------------------------------------------------------- | -- | -------------- | ---- | ------- | ---- | - | ------- | 
|                          |  | Weighted
  average 
  number of years 
  of amortization |    | December
  31, |     
|                          |  |                                                          |    |                |     
|                          |  |                                                          |    |                | 2004 |         | 2003 |  
|                          |  |                                                          |    |                |      |         |      |  
|Original cost:            |  |                                                          |    |                |      |         |      |   |         | 
|Technology (1)            |  |                                                          | 15 |                | $    | 85,413  |      | $ | 82,449  | 
|Trade marks (2)           |  |                                                          | 17 |                |      | 8,000   |      |   | 8,000   | 
|Goodwill (3)              |  |                                                          |    |                |      | 37,884  |      |   | 37,613  | 
|                          |  |                                                          |    |                |      |         |      |   |         | 
|                          |  |                                                          |    |                |      | 131,297 |      |   | 128,062 | 
|                          |  |                                                          |    |                |      |         |      |   |         | 
|Accumulated amortization: |  |                                                          |    |                |      |         |      |   |         | 
|Technology                |  |                                                          |    |                |      | 28,365  |      |   | 21,555  | 
|Trade marks               |  |                                                          |    |                |      | 1,908   |      |   | 1,458   | 
|Goodwill                  |  |                                                          |    |                |      | 5,037   |      |   | 5,037   | 
|                          |  |                                                          |    |                |      |         |      |   |         | 
|                          |  |                                                          |    |                |      | 35,310  |      |   | 28,050  | 
|                          |  |                                                          |    |                |      |         |      |   |         | 
|                          |  |                                                          |    |                |      |         |      |   |         | 
|Amortized cost            |  |                                                          |    |                | $    | 95,987  |      | $ | 100,012 | 
|                          |  |                                                          |    |                |      |         |      |   |         | 

| |     |                                                                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                  
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | The technology acquired
  consists of four major items as follows:                                                                                                                                                                                                   
| |     |                                                                                                                                                                                                                                                                      
| |     | In 2000,
  the Company completed a merger with El-Op. A portion of the purchase price
  was allocated to technology ($45,000), based on an independent appraisal. The
  technology acquired in the merger with El-Op comprises various technologies
  relating to:   
| |     |                                                                                                                                                                                                                                                                      
| |     | a.                                                                                                                                                                                                                                                                    | Diode
  pumped and other advanced solid-state lasers incorporating add-on eye-safety
  options.                                                                                                                                                                  
| |     |                                                                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                  
| |     | b.                                                                                                                                                                                                                                                                    | Detectors
  for thermal imaging devices, including 2-D arrays for second and third
  generation forward looking infrared sensors.                                                                                                                                
| |     |                                                                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                  
| |     | c.                                                                                                                                                                                                                                                                    | Line of
  sight command, control and stabilization systems employing computerized
  digital controllers.                                                                                                                                                         
| |     |                                                                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                  
| |     | d.                                                                                                                                                                                                                                                                    | Sophisticated
  image and signal processing, utilizing the modern equipment and software.                                                                                                                                                                        
| |     |                                                                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                  
| |     | e.                                                                                                                                                                                                                                                                    | High
  precision mechanical and optical component design and manufacturing for the
  visible, ultraviolet and infrared spectra, including special and exotic materials, diffractive and planar
  optics, space borne lightweight optics and multi-layer coatings.
| |     |                                                                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                  
| |     | f.                                                                                                                                                                                                                                                                    | Aviation
  instruments such as precision altimeters and air speedometer.                                                                                                                                                                                         
| |     |                                                                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                  
| |     | In 2000, EFW acquired from
  Honeywell Inc., Honeywells business relating to head-up displays and
  tracking systems for pilot helmets. An amount of $9,300 was allocated to the acquired technology based on its
estimated fair
  value as prepared by the Company.

35

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                               
|------------- | ------------------------------
|Note 9      - | INTANGIBLE ASSETS, NET (CONT.)

| |    |                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                  
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                 | In 2001
  and 2002, the Company acquired a Brazilian company which serves as a center
  for the production and logistic support of defense electronics programs in
  Brazil. An amount of $5,500 was allocated to technology related to the
  maintenance and support of avionic equipment.                                      
| |    |                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                  
| |    |                                                                                                                                                 | In 2002,
  the Company acquired the business of the Defense Systems Division of Elron
  Telesoft as detailed in Note 1(C) above in consideration for $5,700. An
  amount of $5,100 was allocated to the technology related to the government
  information technology control systems software developed by Elron Telesoft.      
| |    |                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                  
| |    | (2)                                                                                                                                             | Includes trade marks
  acquired in the merger with El-Op in 2000.                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                  
| |    | (3)                                                                                                                                             | Includes mainly goodwill
  resulting from the merger with El-Op ($34,200) in 2000 and goodwill acquired
  from Honeywell Inc. ($1,800) in 2000. Until January 1, 2002, goodwill was
  amortized at an annual rate of 5% - 10%. The change in goodwill results from
  an acquisition of the business of CIC (See Note 1(F) above).
| |    |                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                  
| | B. | Amortization expenses
  amounted to $7,260, $7,222 and $6,412 for the years ended December 31, 2004,
  2003 and 2002, respectively.            
| |    |                                                                                                                                                
| | C. | The annual amortization
  expense relating to intangible assets existing as of December 31, 2004 is
  estimated to be approximately as follows:

|2005       |  | $ | 6,900  | 
|---------- |  | - | ------ | 
|2006       |  |   | 5,600  | 
|2007       |  |   | 5,400  | 
|2008       |  |   | 5,200  | 
|2009       |  |   | 4,900  | 
|Thereafter |  |   | 35,140 | 
|           |  |   |        | 
|Total      |  | $ | 63,140 | 
|           |  |   |        | 

|              |                                   
|------------- | ----------------------------------
|Note 10     - | SHORT-TERM
  BANK CREDIT AND LOANS

|                                 |  |                |         |      |  |          |   |      |       |  |   |       | 
|-------------------------------- |  | -------------- | ------- | ---- |  | -------- | - | ---- | ----- |  | - | ----- | 
|                                 |  | December
  31, |        
|                                 |  |                |        
|                                 |  | 2004           |         | 2003 |  | 2004     |   | 2003 |      
|                                 |  | Interest
Rate  |         |      |  |          |  
|                                 |  |                |         |      |  |          |  
|                                 |  |                |         |      |  |          |  
|Short-term bank loans:           |  |                |         |      |  |          |   |      |       |  |   |       | 
|In U.S. dollars                  |  |                | 4.2-4.6 | %    |  | 3.3-4.75 | % | $    | 3,967 |  | $ | 533   | 
|In Euro                          |  |                |        |      |  | 3.5      | % |      |      |  |   | 1,927 | 
|                                 |  |                |         |      |  |          |   |      |       |  |   |       | 
|                                 |  |                |         |      |  |          |   |      | 3,967 |  |   | 2,460 | 
|                                 |  |                |         |      |  |          |   |      |       |  |   |       | 
|Short-term bank credit:          |  |                |         |      |  |          |   |      |       |  |   |       | 
|In NIS unlinked                  |  |                | 5.7-8.1 | %    |  | 7.2      | % |      | 2,120 |  |   | 4,684 | 
|In U.S. dollars                  |  |                | 4.4     | %    |  | 2.6      | % |      | 2,505 |  |   | 1,365 | 
|                                 |  |                |         |      |  |          |   |      |       |  |   |       | 
|                                 |  |                |         |      |  |          |   |      | 4,625 |  |   | 6,049 | 
|                                 |  |                |         |      |  |          |   |      |       |  |   |       | 
|                                 |  |                |         |      |  |          |   | $    | 8,592 |  | $ | 8,509 | 
|                                 |  |                |         |      |  |          |   |      |       |  |   |       | 
|Weighted
  Average Interest Rate |  |                | 4.7     | %    |  | 5.4      | % |      |       |  |   |       | 

36

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                      
|--------------- | -------------------------------------
|Note
  11     - | OTHER
  PAYABLES AND ACCRUED EXPENSES

| |                                                                              |  |                |         |      |   |         | 
| | ---------------------------------------------------------------------------- |  | -------------- | ------- | ---- | - | ------- | 
| |                                                                              |  | December
  31, |        
| |                                                                              |  |                |        
| |                                                                              |  | 2004           |         | 2003 |  
| |                                                                              |  |                |         |      |  
| | Payroll and related expenses                                                 |  | $              | 42,491  |      | $ | 33,382  | 
| | Provision for vacation pay                                                   |  |                | 26,936  |      |   | 25,280  | 
| | Provision for income taxes, net of advances paid, and VAT                    |  |                | 13,774  |      |   | 9,094   | 
| | Provisions for royalties                                                     |  |                | 17,845  |      |   | 16,149  | 
| | Provision for warranty                                                       |  |                | 34,033  |      |   | 36,653  | 
| | Cost provision for unbilled services rendered to the Company and
  others(*) |  |                | 34,623  |      |   | 37,262  | 
| |                                                                              |  |                |         |      |   |         | 
| |                                                                              |  | $              | 169,702 |      | $ | 157,820 | 
| |                                                                              |  |                |         |      |   |         | 

| |                                                                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (*) The other cost
  provision, primarily includes provisions for (1) estimated future costs in
  respect of potential contractual penalties and the probable loss from claims
  (legal or unasserted) in the ordinary course of business (e.g. damages caused
  by the items sold and claims as to the specific products ordered).
| |                                                                                                                                                                                                                                                                                                                                    
| | Note
  12     -    CUSTOMERS ADVANCES AND AMOUNTS
  IN EXCESS OF COSTS INCURRED ON CONTRACTS IN PROGRESS                                                                                                                                                                                                                           

| |                                                |  |                |         |      |   |         | 
| | ---------------------------------------------- |  | -------------- | ------- | ---- | - | ------- | 
| |                                                |  | December
  31, |        
| |                                                |  |                |        
| |                                                |  | 2004           |         | 2003 |  
| |                                                |  |                |         |      |  
| | Advances received                              |  | $              | 180,738 |      | $ | 199,273 | 
| | Less -                                         |  |                |         |      |   |         | 
| | Advances presented under long-term
liabilities |  |                | 10,320  |      |   | 7,592   | 
| | Advances deducted from inventories             |  |                | 75,776  |      |   | 77,482  | 
| |                                                |  |                |         |      |   |         | 
| |                                                |  |                | 94,642  |      |   | 114,199 | 
| | Less -                                         |  |                |         |      |   |         | 
| | Costs incurred on contracts in progress        |  |                | 14,533  |      |   | 14,581  | 
| |                                                |  |                |         |      |   |         | 
| |                                                |  | $              | 80,109  |      | $ | 99,618  | 
| |                                                |  |                |         |      |   |         | 

|             |                                              
|------------ | ---------------------------------------------
|             | As for guarantees and
  liens see Note 16(F).
|             |                                              
|Note13     - | LONG-TERM
  LOANS                            

| |                           |  |                               |  |                       |  |                     |            |      |                |        |  |   |        | 
| | ------------------------- |  | ----------------------------- |  | --------------------- |  | ------------------- | ---------- | ---- | -------------- | ------ |  | - | ------ | 
| |                           |  |                               |  |                       |  |                     |            |      | December
  31, |       
| |                           |  |                               |  | Interest
  %          |  | Years of
  maturity |            |      |               
| |                           |  | Currency                      |  |                       |  | 2004                |            | 2003 |               
| |                           |  |                               |  |                       |  |                     |            |      |                |        | 
| | Banks                     |  | U.S. dollars                  |  | Libor
  + 0.75%-1.25% |  |                     | mainly 2-3 |      | $              | 83,469 |  | $ | 57,574 | 
| | Banks                     |  | NIS-unlinked                  |  | Israeli
  Prime       |  |                     |           |      |                |       |  |   | 3,599  | 
| | Office of Chief Scientist |  | NIS-linked to the Israeli-CPI |  | 4.4%                  |  |                     | 3          |      |                | 4,131  |  |   | 7,683  | 
| | Other                     |  |                               |  |                       |  |                     |            |      |                | 290    |  |   |       | 
| |                           |  |                               |  |                       |  |                     |            |      |                |        |  |   |        | 
| |                           |  |                               |  |                       |  |                     |            |      |                | 87,890 |  |   | 68,856 | 
| | Less-current maturities   |  |                               |  |                       |  |                     |            |      |                | 1,656  |  |   | 6,532  | 
| |                           |  |                               |  |                       |  |                     |            |      |                |        |  |   |        | 
| |                           |  |                               |  |                       |  |                     |            |      | $              | 86,234 |  | $ | 62,324 | 
| |                           |  |                               |  |                       |  |                     |            |      |                |        |  |   |        | 

37

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                                                        
|--------------- | -----------------------------------------------------------------------
|Note
  13     - | LONG-TERM
  LOANS (CONT.)                                              
|                |                                                                        
|                | The Libor rate as of
  December 31, 2004 was 2.56%.                    
|                | The maturities of these
  loans after December 31, 2004 are as follows:

| |                           |  |   |        | 
| | ------------------------- |  | - | ------ | 
| | 2005  current maturities |  | $ | 1,656  | 
| | 2006                      |  |   | 40,527 | 
| | 2007                      |  |   | 42,550 | 
| | 2008                      |  |   | 165    | 
| | 2009                      |  |   | 170    | 
| | 2010 and thereafter       |  |   | 2,822  | 
| |                           |  |   |        | 
| |                           |  | $ | 87,890 | 
| |                           |  |   |        | 

|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                | See Note 16(G) for
  covenants.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Note
  14     - | BENEFIT
  PLANS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                | EFW, the Companys
  subsidiary in the U.S., has adopted for its employees in the U.S. benefits
  plans as follows:                                                                                                                                                                                                                                                                                                                                                                                                       
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                | Defined
  Benefit Retirement Plan                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                | EFW has two defined
  benefit pension plans (the Plans) substantially covering its employees in
  the U.S.  Monthly benefits are based
  on years of benefit service and annual compensation. Annual contributions to
  the Plans are determined using the unit credit actuarial cost method and are
  equal to or exceed the minimum required by law.  Pension fund assets of the Plans are invested primarily in
  stock, bonds and cash by a financial institution, as the investment manager
  of the Plans assets.

38

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                                                                                                                            
|--------------- | -------------------------------------------------------------------------------------------------------------------------------------------
|Note
  14     - | BENEFIT
  PLANS (Cont.)                                                                                                                    
|                |                                                                                                                                            
|                | The following table
  reconciles the benefit obligations, Plans assets, funded status and net asset
  (liability) information of the Plans:

| |                                                      |  |                |         |      |   |         |  
| | ---------------------------------------------------- |  | -------------- | ------- | ---- | - | ------- | -
| |                                                      |  | December
  31, |        
| |                                                      |  |                |        
| |                                                      |  | 2004           |         | 2003 |  
| |                                                      |  |                |         |      |  
| | Benefit obligation at beginning of year              |  | $              | 34,965  |      | $ | 28,439  |  
| | Service cost                                         |  |                | 3,000   |      |   | 2,480   |  
| | Interest cost                                        |  |                | 2,191   |      |   | 1,921   |  
| | Actuarial losses                                     |  |                | 2,307   |      |   | 2,825   |  
| | Unrecognized transition obligation                   |  |                | 1,056   |      |   |        |  
| | Benefits repaid                                      |  |                | (822    | )    |   | (700    | )
| |                                                      |  |                |         |      |   |         |  
| | Benefit obligation at end of year                    |  |                | 42,697  |      |   | 34,965  |  
| |                                                      |  |                |         |      |   |         |  
| |                                                      |  |                |         |      |   |         |  
| | Plans assets at beginning of year                    |  |                | 21,196  |      |   | 15,558  |  
| | Actual return on Plan assets                         |  |                | 1,756   |      |   | 2,689   |  
| | Contributions by employer                            |  |                | 2,971   |      |   | 3,649   |  
| | Benefits repaid                                      |  |                | (822    | )    |   | (700    | )
| |                                                      |  |                |         |      |   |         |  
| | Plans assets at end of year                          |  |                | 25,101  |      |   | 21,196  |  
| |                                                      |  |                |         |      |   |         |  
| | Funded status of Plans (underfunded)                 |  |                | (17,595 | )    |   | (13,769 | )
| | Unrecognized prior service cost                      |  |                | (180    | )    |   | (195    | )
| | Unrecognized transition obligation                   |  |                | 1,056   |      |   |        |  
| | Unrecognized net actuarial loss                      |  |                | 11,447  |      |   | 9,395   |  
| |                                                      |  |                |         |      |   |         |  
| | Net amount recognized                                |  | $              | (5,272  | )    | $ | (4,569  | )
| |                                                      |  |                |         |      |   |         |  
| | Net asset (liability) consists of:                   |  |                |         |      |   |         |  
| | Accrued benefit liability                            |  | $              | (13,899 | )    | $ | (11,011 | )
| | Intangible asset                                     |  |                | 895     |      |   | 51      |  
| | Accumulated other comprehensive income               |  |                | 7,732   |      |   | 6,391   |  
| |                                                      |  |                |         |      |   |         |  
| | Net amount recognized                                |  | $              | (5,272  | )    | $ | (4,569  | )
| |                                                      |  |                |         |      |   |         |  
| | Weighted average assumptions:                        |  |                |         |      |   |         |  
| | Discount rate as of December
  31,                   |  |                | 6.00    | %    |   | 6.25    | %
| | Expected long-term rate of
  return on Plans assets |  |                | 8.50    | %    |   | 9.00    | %
| | Rate of compensation increase                        |  |                | 3.00    | %    |   | 3.00    | %

| |                                          |  |                           |        |      |   |        |   |   |        |  
| | ---------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ | - | - | ------ | -
| |                                          |  | Year ended
  December 31, |       
| |                                          |  |                           |       
| |                                          |  | 2004                      |        | 2003 |   | 2002   |  
| |                                          |  |                           |        |      |   |        |  
| | Components of net periodic pension cost: |  |                           |        |      |   |        |   |   |        |  
| | Service cost                             |  | $                         | 3,000  |      | $ | 2,480  |   | $ | 2,067  |  
| | Interest cost                            |  |                           | 2,191  |      |   | 1,921  |   |   | 1,678  |  
| | Expected return on  Plans
  assets      |  |                           | (1,951 | )    |   | (1,573 | ) |   | (1,597 | )
| | Amortization of prior service cost       |  |                           | (15    | )    |   | (15    | ) |   | 28     |  
| | Recognized net actuarial loss            |  |                           | 451    |      |   | 339    |   |   |       |  
| |                                          |  |                           |        |      |   |        |   |   |        |  
| | Net periodic pension cost                |  | $                         | 3,676  |      | $ | 3,152  |   | $ | 2,176  |  
| |                                          |  |                           |        |      |   |        |   |   |        |  

39

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note
  14     - | BENEFIT
  PLANS (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                | Defined
  Contribution Plan                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                | The 401(k) savings plan
  (401(k) plan) is a defined contribution retirement plan that covers all
  eligible employees, as defined in section 401(k) of the U.S. Internal Revenue
  Code. EFWs employees may elect to contribute a percentage of their annual
  gross compensation to the 401(k) plan. EFW may make discretionary matching
  contributions as determined by the subsidiary. Total expense under the 401(k)
  plan amounted to $1,744 for the year ended December 31, 2004 (2003 - $1,629,
  2002 - $1,369).
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Note
  15    -  | TAXES ON
  INCOME                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                | A.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | APPLICABLE TAX LAWS
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | (1)                 | Measurement
  of taxable income under Israels Income Tax (Inflationary Adjustments) Law,
  1985:                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     | Results for tax purposes
  for the Company and certain of its Israeli subsidiaries are measured and
  reflected in accordance with the change in the Israeli Consumer Price Index
  (CPI). As explained above in Note 2(B), the consolidated financial
  statements are presented in U.S. dollars. The differences between the change
  in the Israeli CPI and in the NIS/U.S. dollar exchange rate cause a
  difference between taxable income and the income before taxes reflected in
  the consolidated financial statements.
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     | In accordance with
  paragraph 9(f) of SFAS No. 109, the Company has not provided deferred income
  taxes on the above differences resulting from changes in exchange rates and
  indexing for tax purposes.                                                                                                                                                                                                                                                                                                                       
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | (2)                 | Tax
  benefits under Israels Law for the Encouragement of Industry (Taxes), 1969:                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                     | The Company
  and certain subsidiaries in Israel (mainly El-Op and Cyclone Aviation
  Products Ltd.) are Industrial Companies, as defined by the Law for the
  Encouragement of Industry (Taxes), 1969, and as such, these companies are
  entitled to certain tax benefits, mainly amortization of costs relating to
  know-how and patents over eight years, accelerated depreciation and the right
  to deduct public issuance expenses for tax purposes.                                                                     

40

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                           |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|------------- | ------------------------- | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 15     - | TAXES ON
  INCOME (CONT.)
|              |                           |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                           | (3) | Tax
  benefits under Israels Law for the Encouragement of Capital Investments,
  1969:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|              |                           |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                           |     | Several expansion programs
  of the Company and certain of its Israeli subsidiaries (the companies) have
  been granted Approved Enterprise status under Israels Law for the
  Encouragement of Capital Investments, 1959. For some expansion programs, the
  companies have elected the grants track and for others they have elected the
  alternative tax benefits track, waiving grants in return for tax exemptions.                                                                                                                                                                                           
|              |                           |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                           |     | Accordingly, certain
  income of the companies, derived from the Approved Enterprise expansion
  programs is tax exempt for two-year to ten-year period and subject to reduced
  tax rates of 25% for a five-year to eight-year period commencing in the year
  in which the companies had taxable income (limited to twelve years from
  commencement of production or fourteen years from the date of approval,
  whichever is earlier). As of December 31, 2004, the tax benefits for these
  exiting expansion programs will expire within the period of 2005 to 2012.                                             
|              |                           |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                           |     | The entitlement to the
  above benefits is subject to the companies fulfilling the conditions
  specified in the above referred law, regulations published hereunder and the
  letters of approval for the specific investments in Approved Enterprises.
  In the event of failure to comply with these conditions, the benefits may be
  canceled and the companies may be required to refund the amount of the
  benefits, in whole or in part, including interest. (For liens  see Note
  16(J)).  As of December 31, 2004,
  Management believes that the companies are meeting all conditions of the
  approvals.
|              |                           |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                           |     | As of December 31, 2004,
  retained earnings included approximately $116,500 in tax-exempt profits
  earned by the companies Approved Enterprises. If
  the retained tax-exempt income is distributed, it would be taxed at the
  corporate tax rate applicable to such profits as if the Company had not
  elected the alternative tax benefits track (currently - 25%) and an income
  tax liability would be incurred of approximately $29,100 as of December 31,
  2004.                                                                                                                                          
|              |                           |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                           |     | The companies boards of
  directors have decided that their policy is not to declare dividends out of
  such tax-exempt income. Accordingly, no deferred income taxes have been
  provided on income attributable to the companies Approved Enterprises.                                                                                                                                                                                                                                                                                                                                                             

41

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                   |                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|------------- | ----------------- | -------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 15     - | TAXES ON
  INCOME
|              |                   |                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|              |                   | (3)                                                                                                            | Tax
  benefits under Israels Law for the Encouragement of Capital Investments,
  1969 (Cont.):                                                                                                                                                                                                                                                                                                                                                                                       
|              |                   |                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|              |                   |                                                                                                                | In
  Israel, income from sources other than the Approved Enterprise during the
  benefit period will be subject to tax at the regular corporate tax rate of
  35%.                                                                                                                                                                                                                                                                                                                  
|              |                   |                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|              |                   |                                                                                                                | Since
  the companies are operating under more than one approval, and since part of
  their taxable income is not entitled to tax benefits under the above
  mentioned law and is taxed at the regular tax rate of 35%, the effective tax
  rate is the result of a weighted combination of the various applicable rates
  and tax exemptions, and the computation is made for income derived from each
  approval on the basis of formulas specified in the law and in the approvals.
|              |                   |                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|              | B.                | NON  ISRAELI SUBSIDIARIES                                                                                    
|              |                   |                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|              |                   | Non-Israeli subsidiaries
  are taxed based on tax laws in their countries of residence (mainly in the
  U.S.).
|              |                   |                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|              | C.                | INCOME BEFORE TAXES ON
  INCOME                                                                               

| |                                  |  |                         |        |      |   |        |  |   |        | 
| | -------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |                                  |  | Year ended December 31, |       
| |                                  |  |                         |       
| |                                  |  | 2004                    |        | 2003 |   | 2002   | 
| |                                  |  |                         |        |      |   |        | 
| | Income before taxes on
  income: |  |                         |        |      |   |        |  |   |        | 
| | Domestic                         |  | $                       | 43,642 |      | $ | 38,423 |  | $ | 42,317 | 
| | Foreign                          |  |                         | 16,985 |      |   | 11,090 |  |   | 11,977 | 
| |                                  |  |                         |        |      |   |        |  |   |        | 
| |                                  |  | $                       | 60,627 |      | $ | 49,513 |  | $ | 54,294 | 
| |                                  |  |                         |        |      |   |        |  |   |        | 

42

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                        |                
|------------- | ---------------------- | ---------------
|Note 15     - | INCOME
  TAXES (CONT.)
|              |                        |                
|              | D.                     | TAXES ON INCOME

| |                                   |  |                         |        |      |   |        |   |   |        |     
| | --------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | ----
| |                                   |  | Year ended December 31, |       
| |                                   |  |                         |       
| |                                   |  | 2004                    |        | 2003 |   | 2002   |  
| |                                   |  |                         |        |      |   |        |  
| | Taxes on income:                  |  |                         |        |      |   |        |   |   |        |     
| | Current taxes:                    |  |                         |        |      |   |        |   |   |        |     
| | Domestic                          |  | $                       | 7,415  |      | $ | 12,346 |   | $ | 11,654 |     
| | Foreign                           |  |                         | 7,651  |      |   | 718    |   |   | 6,114  |     
| |                                   |  |                         |        |      |   |        |   |   |        |     
| |                                   |  |                         | 15,066 |      | $ | 13,064 |   | $ | 17,768 |     
| |                                   |  |                         |        |      |   |        |   |   |        |     
| |                                   |  |                         |        |      |   |        |   |   |        |     
| | Deferred income taxes:            |  |                         |        |      |   |        |   |   |        |     
| | Domestic                          |  |                         | 709    |      |   | (4,672 | ) |   | (3,561 | )   
| | Foreign                           |  |                         | (556   | )    |   | 2,942  |   |   | (2,059 | )   
| |                                   |  |                         |        |      |   |        |   |   |        |     
| |                                   |  |                         | 153    |      |   | (1,730 | ) |   | (5,620 | )   
| |                                   |  |                         |        |      |   |        |   |   |        |     
| |                                   |  |                         |        |      |   |        |   |   |        |     
| | Taxes in respect of prior
  years |  |                         |       |      |   |       |   |   | (2,800 | )(*)
| |                                   |  |                         |        |      |   |        |   |   |        |     
| |                                   |  | $                       | 15,219 |      | $ | 11,334 |   | $ | 9,348  |     
| |                                   |  |                         |        |      |   |        |   |   |        |     

| |     |                                                                                                                                                                                                           
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (*) | A reduction of tax
  expenses due to adjustments of estimated tax provision pursuant to the
  completion of prior years tax assessments in respect of various Group
  companies with the tax authorities.

43

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                        |                                                                                                                                                                                                                                                                                                         
|------------- | ---------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 15     - | INCOME
  TAXES (CONT.)
|              |                        |                                                                                                                                                                                                                                                                                                         
|              | E.                     | DEFERRED INCOME TAXES                                                                                                                                                                                                                                                                                   
|              |                        |                                                                                                                                                                                                                                                                                                         
|              |                        | Deferred income taxes
  reflect the net tax effect of temporary differences between the carrying
  amount of assets and liabilities for financial reporting purposes and the
  amounts used for income tax purposes. Significant components of net deferred
  tax assets and liabilities are as follows:

| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | --------------------------------------- |  | ----- | ------- | ---------------------------------- | - | ----------- | - | - | ------- | -
| |                                         |  |       |         | Deferred
  Tax asset(liability)(1) |  
| |                                         |  |       |         |                                    |  
| |                                         |  | Total |         | Current                            |   | Non-current |  
| |                                         |  |       |         |                                    |   |             |  
| | As of December 31, 2004                 |  |       |         |                                    |   |             |   |   |         |  
| | Deferred tax assets:                    |  |       |         |                                    |   |             |   |   |         |  
| | Reserves and allowances                 |  | $     | 12,797  |                                    | $ | 13,191      |   | $ | (394    | )
| | Inventory                               |  |       | 5,376   |                                    |   | 5,376       |   |   |        |  
| | Net operating loss
  carryforwards      |  |       | 5,395   |                                    |   | 149         |   |   | 5,246   |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       | 23,568  |                                    |   | 18,716      |   |   | 4,852   |  
| | Valuation allowance                     |  |       | (3,445  | )                                  |   |            |   |   | (3,445  | )
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | Net deferred tax assets                 |  |       | 20,123  |                                    |   | 18,716      |   |   | 1,407   |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | Deferred tax liabilities:               |  |       |         |                                    |   |             |   |   |         |  
| | Property, plant and
  equipment         |  |       | (12,999 | )                                  |   |            |   |   | (12,999 | )
| | Intangible assets                       |  |       | (10,285 | )                                  |   | 2,639       |   |   | (12,924 | )
| | Available for sale
  securities         |  |       | (752    | )                                  |   | (752        | ) |   |        |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       | (24,036 | )                                  |   | 1,887       |   |   | (25,923 | )
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | Net deferred tax assets
  (liabilities) |  | $     | (3,913  | )                                  | $ | 20,603      |   | $ | (24,516 | )
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | As of December 31, 2003                 |  |       |         |                                    |   |             |   |   |         |  
| | Deferred tax assets:                    |  |       |         |                                    |   |             |   |   |         |  
| | Reserves and allowances                 |  | $     | 11,149  |                                    | $ | 11,187      |   | $ | (38     | )
| | Inventory                               |  |       | 7,952   |                                    |   | 7,952       |   |   |        |  
| | Net operating loss
  carryforwards      |  |       | 6,606   |                                    |   | 439         |   |   | 6,167   |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       | 25,707  |                                    |   | 19,578      |   |   | 6,129   |  
| | Valuation allowance                     |  |       | (3,879  | )                                  |   |            |   |   | (3,879  | )
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | Net deferred tax assets                 |  |       | 21,828  |                                    |   | 19,578      |   |   | 2,250   |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | Deferred tax liabilities:               |  |       |         |                                    |   |             |   |   |         |  
| | Property, plant and
  equipment         |  |       | (12,769 | )                                  |   |            |   |   | (12,769 | )
| | Intangible assets                       |  |       | (12,067 | )                                  |   | 2,330       |   |   | (14,397 | )
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       | (24,836 | )                                  |   | 2,330       |   |   | (27,166 | )
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| |                                         |  |       |         |                                    |   |             |   |   |         |  
| | Net deferred tax assets
  (liabilities) |  | $     | (3,008  | )                                  | $ | 21,908      |   | $ | (24,916 | )
| |                                         |  |       |         |                                    |   |             |   |   |         |  

| |                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------
| | (1) The current tax asset
  is included in other receivables. Noncurrent tax liability is included as a
  long-term liability.

44

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|------------- | ---------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 15     - | INCOME
  TAXES (CONT.)
|              |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|              | F.                     | As of December 31, 2004,
  The Groups Israeli subsidiaries have estimated total available carryforward
  tax losses of approximately $16,700, and the Groups non-Israeli subsidiaries
  have estimated available carryforward tax losses of approximately $7,300.
  These losses can be offset against future taxable profits for an indefinite
  period. Deferred tax assets in respect of the above carryforward losses
  amount to approximately $5,400 in respect of which a valuation allowance has
  been recorded in the amount of approximately $3,400.
|              |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|              | G.                     | Reconciliation of the
  theoretical tax expense, assuming all income is taxed at the statutory rate
  applicable to income of the Group, and the actual tax expense as reported in
  the statements of operations, is as follows:                                                                                                                                                                                                                                                                                                                                

| |                                                                                            |  |                         |        |      |   |        |   |   |        |  
| | ------------------------------------------------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | -
| |                                                                                            |  | Year ended December 31, |       
| |                                                                                            |  |                         |       
| |                                                                                            |  | 2004                    |        | 2003 |   | 2002   |  
| |                                                                                            |  |                         |        |      |   |        |  
| |                                                                                            |  |                         |        |      |   |        |   |   |        |  
| | Income before taxes as reported in the
  consolidated statements of operations             |  | $                       | 60,627 |      | $ | 49,513 |   | $ | 54,294 |  
| | Statutory tax rate                                                                         |  |                         | 35     | %    |   | 36     | % |   | 36     | %
| |                                                                                            |  |                         |        |      |   |        |   |   |        |  
| | Theoretical tax expense                                                                    |  | $                       | 21,219 |      | $ | 17,825 |   | $ | 19,546 |  
| | Tax benefit arising from reduced rate as an
  Approved Enterprise and other tax benefits |  |                         | (7,196 | )    |   | (8,391 | ) |   | (9,054 | )
| | Tax adjustment in respect of different tax rates
  for foreign subsidiaries                |  |                         | 496    |      |   | 279    |   |   | (461   | )
| | Operating carryforward losses for which
  valuation allowance was provided                 |  |                         | (434   | )    |   | 126    |   |   | 2,189  |  
| | Increase (decrease) in taxes resulting from
  nondeductible expenses                       |  |                         | 1,095  |      |   | 993    |   |   | (263   | )
| | Difference in basis of measurement for financial
  reporting and tax return purposes       |  |                         | (210   | )    |   | 846    |   |   | 458    |  
| | Taxes in respect of prior years                                                            |  |                         |       |      |   |       |   |   | (2,800 | )
| | Other differences, net                                                                     |  |                         | 248    |      |   | (344   | ) |   | (267   | )
| |                                                                                            |  |                         |        |      |   |        |   |   |        |  
| | Actual tax expenses                                                                        |  | $                       | 15,219 |      | $ | 11,334 |   | $ | 9,348  |  
| |                                                                                            |  |                         |        |      |   |        |   |   |        |  
| | Effective tax rate                                                                         |  |                         | 25.1   | %    |   | 22.9   | % |   | 17.2   | %
| |                                                                                            |  |                         |        |      |   |        |   |   |        |  

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | H. | AMENDMENT TO THE INCOME
  TAX ORDINANCE                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | On September 29, 2004, the
  Israeli Parliament approved the Amendment to the Income Tax Ordinance (No.
  140 and Temporary Provision) (the Amendment) which reduces the corporate
  tax rate from 36% to 35% in 2004 and to a rate of 30% in 2007
  progressively.  The Amendment was
  signed and published in July 2004 and is therefore considered enacted in July
  2004.  The adoption of the Amendment
  did not have a significant effect on the Companys financial statements.

45

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|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|------------- | --------------------------------------- | ------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 16     - | COMMITMENTS  AND CONTINGENT LIABILITIES
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              | A.                                      | ROYALTY COMMITMENTS
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         | 1.                  | The Company and certain
  Israeli subsidiaries partially finance their research and development
  expenditures under programs sponsored by the OCS for the support of research
  and development activities conducted in Israel. At the time the
  participations were received, successful development of the related projects
  was not assured.                                                                                                                                                                                                                                                             
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         |                     | In exchange for
  participation in the programs by the OCS, the Company and the subsidiaries
  agreed to pay 2% - 5% of total sales of products developed within the
  framework of these programs. The royalties will be paid up to a maximum
  amount equaling 100% to 150% of the grants provided by the OCS, linked to the
  dollar and for grants received after January 1, 1999, also bearing annual
  interest at a rate based on LIBOR. The obligation to pay these royalties is
  contingent on actual sales of the products, and in the absence of such sales
  payment of royalties is not required.
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         |                     | In some cases, the
  Government of Israel participation (through the OCS) is subject to export
  sales or other conditions. The maximum amount of royalties is increased in
  the event of production outside of Israel.                                                                                                                                                                                                                                                                                                                                                                                       
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         |                     | The Company and certain of
  its subsidiaries may also be obligated to pay certain amounts to the Israeli
  Ministry of Defense and others on certain sales including sales resulting
  from the development of certain technologies.                                                                                                                                                                                                                                                                                                                                                                          
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         |                     | Royalties expensed
  amounted to $5,802, $7,812 and $14,471 in 2004, 2003 and 2002, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         | 2.                  | In September 2001, the OCS
  issued Regulations for the Encouragement of Research and Development in
  Industry (rules for determining the level and payment of royalties) (the
  regulations). The regulations allow large R&D intensive companies to
  reach certain agreements with the OCS regarding determination of the amount
  and payment schedule of royalties, subject to certain conditions.                                                                                                                                                                                                   
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         |                     | If the Company elects to
  adopt the regulations, it will have to record a significant one-time expense
  resulting from accruing a liability for an absolute amount of royalties.                                                                                                                                                                                                                                                                                                                                                                                                                             
|              |                                         |                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              |                                         |                     | In May 2002,
  El-Ops Board of Directors approved an arrangement, proposed by the OCS,
  according to which El-Op pays commencing in 2002, an agreed amount of $10,632
  in exchange for a release from all obligations to pay royalties in the
  future.As a result,
  El-Op recorded an expense for the agreed amount net of the accrual for
  royalties previously recorded by El-Op in the amount of $9,801. This expense
  is included cost of revenues.                                                                                                                                                 

46

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|              |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|------------- | ------------------------------------------------ | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 16     - | COMMITMENTS
  AND CONTINGENT LIABILITIES (CONT.)
|              |                                                 
|              | B.                                               | COMMITMENTS IN RESPECT OF
  LONG-TERM PROJECTS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|              |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                                  | In connection with
  long-term projects in certain countries, the Company and certain subsidiaries
  undertook to use their respective best efforts to make or facilitate
  purchases or investments in those countries at certain percentages of the
  amount of the projects. The companies obligation to make or facilitate third
  parties making such investments and purchases is subject to commercial
  conditions in the local market, typically without a specific financial
  penalty. The maximum aggregate undertaking as of December 31, 2004 amounted
  to $673,000 to be performed over a period of up to 11 years. This amount is
  typically tied to a percentage (up to 100%) of the amount of a specific
  contract.
|              |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                                  | In the opinion of the
  Companys Management, the actual amount of the investments and purchases is
  anticipated to be less than that mentioned above, since certain investments
  and purchases can result in reducing the overall undertaking on more than a
  one-to-one basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|              |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              | C.                                               | LEGAL CLAIMS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|              |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                                  | The Company and its subsidiaries
  are involved in legal claims arising in the ordinary course of business,
  including claims by employees, consultants and others. Companys Management,
  based on the opinion of its legal counsel, believes that the financial impact
  for the settlement of such claims in excess of the accruals recorded in the
  financial statements will not have a material adverse effect on the financial
  position or results of operations of the Group.                                                                                                                                                                                                                                               
|              |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              | D.                                               | LEASE COMMITMENTS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              |                                                  | The future minimum lease
  commitments of the Group under various non-cancelable operating lease
  agreements in respect of premises, motor vehicles and office equipment are as
  of December 31, 2004 as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

| |  |                     |  |   |        | 
| |  | ------------------- |  | - | ------ | 
| |  | 2005                |  | $ | 6,655  | 
| |  | 2006                |  |   | 5,939  | 
| |  | 2007                |  |   | 4,547  | 
| |  | 2008                |  |   | 3,022  | 
| |  | 2009 and thereafter |  |   | 13,060 | 
| |  |                     |  |   |        | 
| |  |                     |  | $ | 33,223 | 
| |  |                     |  |   |        | 

| |  |                                                                                                                             
| |  | ----------------------------------------------------------------------------------------------------------------------------
| |  | Rent expenses for the
  years ended December 31, 2004, 2003 and 2002 amounted to $6,842, $9,177, and
  $9,215, respectively.

47

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--------------- | ------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note
  16     - | COMMITMENTS
  AND CONTINGENT LIABILITIES (CONT.)
|                |                                                 
|                | E.                                               | PUT OPTION                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | Three founding employees (the Founders), who
  collectively hold approximately 32.3% of the outstanding shares of Kinetics
  Ltd. (Kinetics), a 51%-owned Israeli subsidiary, have a put option to
  jointly sell all of their shares in Kinetics to the Company. Two private
  investors holding in the aggregate approximately 16.7% of Kinetics
  outstanding shares have tag along rights in the event the Founders exercise
  the put option.                                                                                                   
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | The put option is exercisable from January 1, 2005 until
  December 31, 2005 at a price equal to the higher of the Founders pro-rata
  share (corresponding to the Founders shareholding percentage) of:                                                                                                                                                                                                                                                                                                                                                  
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | (1) The value of Kinetics as of the option exercise date
  as determined by a third party appraiser mutually acceptable to the Founders
  and to the Company. The appraiser will value Kinetics as if Kinetics had
  distributed as dividends net profits accumulated up to the option exercise
  date; or                                                                                                                                                                                                                                                  
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | (2) $12,077, reduced by 3% per annum, or pro-rata part
  thereof, for the period beginning on July 1, 2003 and ending on the option
  exercise date.                                                                                                                                                                                                                                                                                                                                                                                                        
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | As of December 31, 2004,
  the fair value of the aforementioned option was immaterial.                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                | F.                                               | GUARANTEES                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | 1.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | Guarantees in the amount
  of approximately $380,000 were issued by banks on behalf of Group companies
  in order to secure certain advances from customers and performance bonds.                                                                                                                                                                                                                                                                                                                                    
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                |                                                  | 2.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | The Company has provided,
  on a proportional basis to its ownership interest, guarantees for two of its
  investees in respect of credit lines granted to them from banks amounting to
  $12,000 (2003- $13,900), of which $11,500 (2003 - $13,400) relates to a
  50%-owned foreign investee. The guarantees will exist as long as the credit
  lines are in effect. The Company would be liable under the guarantee for any
  debt for which the investee would be in default under the terms of the credit
  line.
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                | G.                                               | COVENANTS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | In connection with bank
  credits and loans, including performance guarantees issued by banks and bank
  guarantees in order to secure certain advances from customers, the Company
  and certain subsidiaries are obligated to meet certain financial covenants.
  Such covenants include requirements for shareholders equity, current ratio,
  operating profit margin, tangible net worth, EBITDA, interest coverage ratio
  and total leverage. As of December 31, 2004 the Company and its subsidiaries
  were in full compliance with all covenants.

48

---



|                                                      
|------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES               
|                                                      
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--------------- | ------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note
  16     - | COMMITMENTS
  AND CONTINGENT LIABILITIES (CONT.)
|                |                                                 
|                | H.                                               | CONTRACTUAL OBLIGATIONS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                |                                                  | Substantially all of the
  purchase commitments relate to obligations under purchase orders and
  subcontracts entered into by the Company. These purchase orders and
  subcontracts are typically in a standard format proposed by the Company, with
  the subcontracts and purchase orders also reflecting provisions from the
  Companys applicable prime contract that are appropriate to flow down to
  subcontractors and vendors. The terms typically included in these purchase
  orders and subcontracts are consistent with Uniform Commercial Code
  provisions in the United States for sales of goods, as well as with specific
  terms called for by its customers in international contracts. These terms
  include the Companys right to terminate the purchase order or subcontract in
  the event of the vendors or subcontractors default, as well as the Companys
  right to terminate the order or subcontract for the Companys convenience (or
  if the Companys prime contractor has so terminated the prime contract). Such
  purchase orders and subcontracts typically are not subject to variable price
  provisions. As of December 31, 2004 and 2003 the purchase commitments were
  $345,000 and $348,400 respectively.
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                | I.                                               | In order to secure bank
  loans and bank guarantees in the amount of $10,019 as of December 31, 2004,
  certain Group companies recorded fixed charges on most of their machinery and
  equipment, mortgages on most of their real estate and floating charges on
  most of their assets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                |                                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                | J.                                               | A lien on the Groups
  Approved Enterprises has been registered in favor of the State of Israel.
  Grants received in respect of projects which have not yet been approved
  amount to approximately $220 (see Note 15 (A) (3) above).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

49

---



|                                                             
|-------------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES                      
|                                                             
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)       
|                                                             
|U. S. dollars (In thousands, except share and per share data)

|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|--------------- | ---------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note
  17     - | SHAREHOLDERS
  EQUITY
|                |                       
|                | A.                     | SHARE CAPITAL                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                |                        | Ordinary shares confer
  upon their holders voting rights, the right to receive dividends and the
  right to share in equity upon liquidation of the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                | B.                     | 2000 EMPLOYEE STOCK OPTION
  PLAN                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                |                        | In 2000, the Company
  adopted an employee stock option plan for employees comprising options to
  purchase up to 2,500,000 ordinary shares. The exercise price approximates the
  market price of the shares at the grant date. The plan includes an additional
  2,500,000 options to be issued as phantom share options that grant the
  option holders a number of shares reflecting the benefit component of the
  options exercised, as calculated at the exercise date, in consideration for
  their par value only. Options vest over a period of one to four years from
  the date of grant and expire no later than six years from the date of grant.
|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                |                        | Any options which are
  canceled or forfeited before expiration become available for future grants.
  As of December 31, 2004, 453,794 options of the Company were still available
  for future grants.                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                | C.                     | PHANTOM SHARE OPTIONS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                |                        | Until January 1, 2004, the
  Company applied the provision of APB No. 25, under which the phantom share
  options were considered to be part a variable awards as defined in APB No.
  25, and accordingly the compensation cost of the options was measured at the
  end of each reporting period and amortized by the accelerated method over the
  remaining vesting period. Starting January 1, 2004, the Company accounts for
  its stock based compensation awards under the fair value based method.                                                                                                                                                      
|                |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                | D.                     | A summary of the Companys
  share option activity under the plans is as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                



|                                           |  |                     |            |                                    |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
|------------------------------------------ |  | ------------------- | ---------- | ---------------------------------- | - | ------------------- |  | ------------------------------------- | --------- | ------------------- | - | ------------------------------------- |  |  | --------- | - | - | ----- | 
|                                           |  | 2004                |            | 2003                               |   | 2002                | 
|                                           |  |                     |            |                                    |   |                     | 
|                                           |  | Number of
  options |            | Weightedaverage
  exercise
  price |   | Number of
  options |  | Weighted
  average
  exercise
  price |           | Number of
  options |   | Weighted
  average
  exercise
  price | 
|                                           |  |                     |            |                                    |   |                     |  |                                       |           |                     |   |                                       | 
|Outstanding - beginning of the year        |  |                     | 3,735,602  |                                    | $ | 12.30               |  |                                       | 4,511,724 |                     | $ | 12.26                                 |  |  | 5,107,634 |   | $ | 11.93 | 
|Granted                                    |  |                     | 130,500    |                                    |   | 15.67               |  |                                       | 13,000    |                     |   | 14.91                                 |  |  | 27,000    |   |   | 14.92 | 
|Exercised                                  |  |                     | (1,666,774 | )                                  |   | 12.12               |  |                                       | (757,947  | )                   |   | 12.13                                 |  |  | (558,901  | ) |   | 9.45  | 
|Forfeited                                  |  |                     | (69,071    | )                                  |   | 12.10               |  |                                       | (31,175   | )                   |   | 12.29                                 |  |  | (64,009   | ) |   | 11.33 | 
|                                           |  |                     |            |                                    |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
|Outstanding - end of the year              |  |                     | 2,130,257  |                                    | $ | 12.60               |  |                                       | 3,735,602 |                     | $ | 12.30                                 |  |  | 4,511,724 |   | $ | 12.26 | 
|                                           |  |                     |            |                                    |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
|Options exercisable at the end of the year |  |                     | 1,950,903  |                                    | $ | 12.36               |  |                                       | 2,547,196 |                     | $ | 12.23                                 |  |  | 2,287,790 |   | $ | 12.18 | 
|                                           |  |                     |            |                                    |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 

50

---



|                                                               
|---------------------------------------------------------------
|ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES                        
|                                                               
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)         
|                                                               
|U. S. dollars (In
  thousands, except share and per share data)

|Note 17        - | SHAREHOLDERS EQUITY (CONT.)
|---------------- | ----------------------------
|                 |                             
|                 | E.                          

|                 |  |                                                    |           |                                                             |  |                                                   |  |                                                     |       |                                                   |  |           |  |   |       | 
|---------------- |  | -------------------------------------------------- | --------- | ----------------------------------------------------------- |  | ------------------------------------------------- |  | --------------------------------------------------- | ----- | ------------------------------------------------- |  | --------- |  | - | ----- | 
|                 |  | Options outstanding                                |           | Options exercisable                                         | 
|                 |  |                                                    |           |                                                             | 
|Exercise price   |  | Number
  outstanding
  as of
  December 31,
  2004 |           | Weighted
  average
  remaining
  contractual
  life (years) |  | Weighted
  average
  exercise
  price per
  share |  | Number
  outstanding
  as of 
  December
  31, 2004 |       | Weighted
  average
  exercise
  price per
  share | 
|                 |  |                                                    |           |                                                             |  |                                                   |  |                                                     |       |                                                   | 
|                 |  |                                                    |           |                                                             |  |                                                   |  |                                                     |       |                                                   |  |           |  |   |       | 
|$10.61-$12.16    |  |                                                    | 1,500     |                                                             |  | 0.82                                              |  | $                                                   | 12.16 |                                                   |  | 1,500     |  | $ | 12.16 | 
|$12.18-$18.99    |  |                                                    | 1,050,427 |                                                             |  | 2.17                                              |  |                                                     | 12.60 |                                                   |  | 960,750   |  |   | 12.36 | 
|$12.18-$18.99(*) |  |                                                    | 1,078,330 |                                                             |  | 2.23                                              |  |                                                     | 12.59 |                                                   |  | 988,563   |  |   | 12.35 | 
|                 |  |                                                    |           |                                                             |  |                                                   |  |                                                     |       |                                                   |  |           |  |   |       | 
|                 |  |                                                    | 2,130,257 |                                                             |  | 2.20                                              |  | $                                                   | 12.60 |                                                   |  | 1,950,903 |  | $ | 12.36 | 
|                 |  |                                                    |           |                                                             |  |                                                   |  |                                                     |       |                                                   |  |           |  |   |       | 

| |                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | --------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (*)  Phantom share options.
| |                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                             | Compensation expense
  (income) amounted to $3,387, $4,741 and $(926) were recognized during the
  years ended December 31, 2004, 2003 and 2002, respectively. All the
  compensation expenses (income) in the years 2002 and 2003 were related to the
  Phantom share options under the stock option plan. The expenses in 2004 were
  recorded based on SFAS No. 123 and SFAS No. 148 according to the modified
  prospective method. The expenses (income) were recorded as follows:

| |                                     |  |                           |       |      |   |       |  |   |      |  
| | ----------------------------------- |  | ------------------------- | ----- | ---- | - | ----- |  | - | ---- | -
| |                                     |  | Year ended
  December 31, |      
| |                                     |  |                           |      
| |                                     |  | 2004                      |       | 2003 |   | 2002  | 
| |                                     |  |                           |       |      |   |       | 
| | Cost of revenues                    |  | $                         | 1,863 |      | $ | 2,608 |  | $ | (509 | )
| | R&D and marketing expenses          |  |                           | 677   |      |   | 948   |  |   | (185 | )
| | General and administration expenses |  |                           | 847   |      |   | 1,185 |  |   | (232 | )
| |                                     |  |                           |       |      |   |       |  |   |      |  
| |                                     |  | $                         | 3,387 |      | $ | 4,741 |  | $ | (926 | )
| |                                     |  |                           |       |      |   |       |  |   |      |  

| |    |                                                                                                                                        
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------
| | F. | The weighted average
  exercise price and fair value of options granted during the years ended
  December 31, 2004, 2003 and 2002 were:

| |                                            |  |                           |       |      |   |       |  |   |       | 
| | ------------------------------------------ |  | ------------------------- | ----- | ---- | - | ----- |  | - | ----- | 
| |                                            |  | Less than
  market price  |      
| |                                            |  |                           |      
| |                                            |  | Year ended
  December 31, |      
| |                                            |  |                           |      
| |                                            |  | 2004                      |       | 2003 |   | 2002  | 
| |                                            |  |                           |       |      |   |       | 
| | Weighted average exercise price            |  | $                         | 15.67 |      | $ | 14.91 |  | $ | 14.92 | 
| | Weighted average fair values on grant date |  | $                         | 6.62  |      | $ | 4.63  |  | $ | 4.31  | 

51

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                               
|---------------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)         
|                                                               
|U. S. dollars (In
  thousands, except share and per share data)

|               |                                |                                                           
|-------------- | ------------------------------ | ----------------------------------------------------------
|Note
  17    - | SHAREHOLDERS
  EQUITY (CONT.)
|               |                               
|               | G.                             | Computation of basic and
  diluted net earnings per share:

|                               |  |                                                       |        |                                              |  |                                |  |                                                       |      |                                                |   |                      |  |                                                       |        |                                              |   |                      |  |   |        |  |  |        |  |   |      | 
|------------------------------ |  | ----------------------------------------------------- | ------ | -------------------------------------------- |  | ------------------------------ |  | ----------------------------------------------------- | ---- | ---------------------------------------------- | - | -------------------- |  | ----------------------------------------------------- | ------ | -------------------------------------------- | - | -------------------- |  | - | ------ |  |  | ------ |  | - | ---- | 
|                               |  | Year ended
  December 31, 2004                        |        | Year ended
  December 31, 2003               |  | Year ended
  December 31, 2002 | 
|                               |  |                                                       |        |                                              |  |                                | 
|                               |  |                                                       |        |                                              |  |                                |  |                                                       |      |                                                |   |                      |  |                                                       |        |                                              |   |                      | 
|                               |  | Net income
  to
  shareholders
  of Ordinary
  shares |        | Weighted
  averaged
  number of
  shares (*) |  | Per
  share
  amount           |  | Net income
  to
  shareholders
  of ordinary
  shares |      | Weighted
  averaged
  number
  of
  shares (*) |   | Per
  share
  amount |  | Net income
  to
  shareholders
  of ordinary
  shares |        | Weighted
  averaged
  number of
  shares (*) |   | Per
  share
  amount | 
|                               |  |                                                       |        |                                              |  |                                |  |                                                       |      |                                                |   |                      |  |                                                       |        |                                              |   |                      | 
|                              
|Basic net earnings             |  | $                                                     | 52,993 |                                              |  | 39,952                         |  | $                                                     | 1.33 |                                                | $ | 45,945               |  |                                                       | 39,061 |                                              | $ | 1.18                 |  | $ | 45,113 |  |  | 38,489 |  | $ | 1.17 | 
|                               |  |                                                       |        |                                              |  |                                |  |                                                       |      |                                                |   |                      |  |                                                       |        |                                              |   |                      |  |   |        |  |  |        |  |   |      | 
|Effect of dilutive securities: |  |                                                       |        |                                              |  |                                |  |                                                       |      |                                                |   |                      |  |                                                       |        |                                              |   |                      |  |   |        |  |  |        |  |   |      | 
|Employee stock options         |  |                                                       |       |                                              |  | 1,089                          |  |                                                       |      |                                                |   |                     |  |                                                       | 1,169  |                                              |   |                      |  |   |       |  |  | 1,374  |  |   |      | 
|                               |  |                                                       |        |                                              |  |                                |  |                                                       |      |                                                |   |                      |  |                                                       |        |                                              |   |                      |  |   |        |  |  |        |  |   |      | 
|Diluted net earnings           |  | $                                                     | 52,993 |                                              |  | 41,041                         |  | $                                                     | 1.29 |                                                | $ | 45,945               |  |                                                       | 40,230 |                                              | $ | 1.14                 |  | $ | 45,113 |  |  | 39,863 |  | $ | 1.13 | 
|                               |  |                                                       |        |                                              |  |                                |  |                                                       |      |                                                |   |                      |  |                                                       |        |                                              |   |                      |  |   |        |  |  |        |  |   |      | 

*
In thousands

| |    |                                                                                                                                                                                      
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | H. | TREASURY SHARES                                                                                                                                                                      
| |    |                                                                                                                                                                                      
| |    | The Companys shares held
  by the Company and its subsidiaries are presented at cost and deducted from
  shareholders equity.                                                      
| |    |                                                                                                                                                                                      
| | I. | DIVIDEND POLICY                                                                                                                                                                      
| |    |                                                                                                                                                                                      
| |    | Dividends declared by the
  Company are paid subject to statutory limitations. The Companys board of
  directors has determined not to declare dividends out of tax exempt earnings.

52

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                                                                                                                                                                                                                                                                   |                                                                                                 
|--------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------
|Note
  18     - | MAJOR
  CUSTOMER AND GEOGRAPHIC INFORMATION                                                                                                                                                                                                                                      
|                |                                                                                                                                                                                                                                                                                   |                                                                                                 
|                | The Group applies
  Statement of Financial Accounting Standards No. 131, Disclosures About
  Segments of an Enterprise and Related Information, (SFAS No. 131).  The Group operates in one reportable
  segment (see Note 1 for a brief description of the Groups business).
|                |                                                                                                                                                                                                                                                                                   |                                                                                                 
|                | A.                                                                                                                                                                                                                                                                                | Revenues are attributed to
  geographic areas based on location of the end customers as follows:

| |        |  |                           |         |      |   |         |  |   |         | 
| | ------ |  | ------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
| |        |  | Year ended
  December 31, |        
| |        |  |                           |        
| |        |  | 2004                      |         | 2003 |   | 2002    | 
| |        |  |                           |         |      |   |         | 
| | Europe |  | $                         | 124,130 |      | $ | 109,409 |  | $ | 144,862 | 
| | U.S.   |  |                           | 348,509 |      |   | 332,323 |  |   | 267,686 | 
| | Israel |  |                           | 241,601 |      |   | 255,742 |  |   | 225,674 | 
| | Others |  |                           | 225,685 |      |   | 200,506 |  |   | 189,234 | 
| |        |  |                           |         |      |   |         |  |   |         | 
| |        |  | $                         | 939,925 |      | $ | 897,980 |  | $ | 827,456 | 
| |        |  |                           |         |      |   |         |  |   |         | 

| |    |                                                         
| | -- | --------------------------------------------------------
| | B. | Revenues are generated by
  the following product lines:

| |                                                                                                              |  |                           |         |      |   |         |  |   |         | 
| | ------------------------------------------------------------------------------------------------------------ |  | ------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
| |                                                                                                              |  | Year ended
  December 31, |        
| |                                                                                                              |  |                           |        
| |                                                                                                              |  | 2004                      |         | 2003 |   | 2002    | 
| |                                                                                                              |  |                           |         |      |   |         | 
| | Airborne systems                                                                                             |  | $                         | 367,927 |      | $ | 373,580 |  | $ | 372,756 | 
| | Land vehicles systems                                                                                        |  |                           | 199,224 |      |   | 199,800 |  |   | 135,700 | 
| | Command, control, communications,
  computers, intelligence, surveillance and reconnaissance systems (C4ISR) |  |                           | 108,925 |      |   | 133,900 |  |   | 122,700 | 
| | Electro-optical systems                                                                                      |  |                           | 200,322 |      |   | 140,500 |  |   | 148,200 | 
| | Others                                                                                                       |  |                           | 63,527  |      |   | 50,200  |  |   | 48,100  | 
| |                                                                                                              |  |                           |         |      |   |         |  |   |         | 
| |                                                                                                              |  | $                         | 939,925 |      | $ | 897,980 |  | $ | 827,456 | 
| |                                                                                                              |  |                           |         |      |   |         |  |   |         | 

| |    |                                                                                            
| | -- | -------------------------------------------------------------------------------------------
| | C. | Revenues from single
  customers, which exceed 10% of total revenues in the reported years:

| |                 |  |                           |    |      |  |      |   |  |    |  
| | --------------- |  | ------------------------- | -- | ---- |  | ---- | - |  | -- | -
| |                 |  | Year ended
  December 31, |   
| |                 |  |                           |   
| |                 |  | 2004                      |    | 2003 |  | 2002 |  
| |                 |  |                           |    |      |  |      |  
| |                 |  |                           |    |      |  |      |   |  |    |  
| | IMOD            |  |                           | 17 | %    |  | 21   | % |  | 20 | %
| | U.S. Government |  |                           | 10 | %    |  | *    |   |  | *  |  
| |                 |  |                           |    |      |  |      |   |  |    |  
| | *Less than 10%  |  |                           |    |      |  |      |   |  |    |  

53

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|               |                                                     |                                         
|-------------- | --------------------------------------------------- | ----------------------------------------
|Note
  18    - | MAJOR
  CUSTOMER AND GEOGRAPHIC INFORMATION (CONT.)
|               |                                                    
|               | D.                                                  | Long-lived assets by
  geographic areas:

| |        |  |                           |         |      |   |         |  |   |         | 
| | ------ |  | ------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
| |        |  | Year ended
  December 31, |        
| |        |  |                           |        
| |        |  | 2004                      |         | 2003 |   | 2002    | 
| |        |  |                           |         |      |   |         | 
| | Israel |  | $                         | 237,887 |      | $ | 229,396 |  | $ | 211,256 | 
| | U.S.   |  |                           | 84,701  |      |   | 81,261  |  |   | 83,814  | 
| | Others |  |                           | 17,687  |      |   | 18,576  |  |   | 13,660  | 
| |        |  |                           |         |      |   |         |  |   |         | 
| |        |  | $                         | 340,275 |      | $ | 329,233 |  | $ | 308,730 | 
| |        |  |                           |         |      |   |         |  |   |         | 

|               |                                      
|-------------- | -------------------------------------
|Note
  19    - | RESEARCH
  AND DEVELOPMENT COSTS, NET

| |                       |  |                           |         |      |   |         |   |   |        |  
| | --------------------- |  | ------------------------- | ------- | ---- | - | ------- | - | - | ------ | -
| |                       |  | Year ended
  December 31, |        
| |                       |  |                           |        
| |                       |  | 2004                      |         | 2003 |   | 2002    |  
| |                       |  |                           |         |      |   |         |  
| | Total expenses        |  | $                         | 86,368  |      | $ | 65,487  |   | $ | 62,560 |  
| | Less  participations |  |                           | (19,522 | )    |   | (10,568 | ) |   | (5,550 | )
| |                       |  |                           |         |      |   |         |   |   |        |  
| |                       |  | $                         | 66,846  |      | $ | 54,919  |   | $ | 57,010 |  
| |                       |  |                           |         |      |   |         |   |   |        |  

|               |                          
|-------------- | -------------------------
|Note
  20    - | FINANCIAL
  EXPENSES, NET

| |                                                      |  |                           |        |      |   |        |   |   |        |  
| | ---------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ | - | - | ------ | -
| |                                                      |  | Year ended
  December 31, |       
| |                                                      |  |                           |       
| |                                                      |  | 2004                      |        | 2003 |   | 2002   |  
| |                                                      |  |                           |        |      |   |        |  
| | Expenses:                                            |  |                           |        |      |   |        |   |   |        |  
| | On long-term bank debt                               |  | $                         | (1,544 | )    | $ | (2,215 | ) | $ | (2,765 | )
| | On short-term bank credit and loans                  |  |                           | (2,309 | )    |   | (2,182 | ) |   | (2,435 | )
| | Others                                               |  |                           | (3,181 | )    |   | (3,905 | ) |   | (1,899 | )
| |                                                      |  |                           |        |      |   |        |   |   |        |  
| |                                                      |  | $                         | (7,034 | )    |   | (8,302 | ) |   | (7,099 | )
| |                                                      |  |                           |        |      |   |        |   |   |        |  
| | Income:                                              |  |                           |        |      |   |        |   |   |        |  
| | Interest on cash, cash equivalents and bank deposits |  |                           | 628    |      |   | 309    |   |   | 1,547  |  
| | Others                                               |  |                           | 1,115  |      |   | 4,397  |   |   | 1,063  |  
| |                                                      |  |                           |        |      |   |        |   |   |        |  
| |                                                      |  |                           | 1,743  |      |   | 4,706  |   |   | 2,610  |  
| |                                                      |  |                           |        |      |   |        |   |   |        |  
| | Gain (loss) from exchange rate differences           |  |                           | (561   | )    |   | (1,274 | ) |   | 1,454  |  
| |                                                      |  |                           |        |      |   |        |   |   |        |  
| |                                                      |  | $                         | (5,852 | )    | $ | (4,870 | ) | $ | (3,035 | )
| |                                                      |  |                           |        |      |   |        |   |   |        |  

54

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ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|               |                                            
|-------------- | -------------------------------------------
|Note
  21    - | RELATED
  PARTIES TRANSACTIONS AND BALANCES

| |                                                      |  |                           |        |      |   |        |  |   |        | 
| | ---------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |                                                      |  | Year ended
  December 31, |       
| |                                                      |  |                           |       
| |                                                      |  | 2004                      |        | 2003 |   | 2002   | 
| |                                                      |  |                           |        |      |   |        | 
| | Income -                                             |  |                           |        |      |   |        |  |   |        | 
| | Sales to affiliated companies (*)                    |  | $                         | 56,346 |      | $ | 34,674 |  | $ | 37,924 | 
| | Participation in expenses                            |  | $                         | 2,594  |      | $ | 1,773  |  | $ | 902    | 
| |                                                      |  |                           |        |      |   |        |  |   |        | 
| | Cost and expenses -                                  |  |                           |        |      |   |        |  |   |        | 
| | Supplies and services from affiliated companies
(**) |  | $                         | 16,338 |      | $ | 21,606 |  | $ | 10,457 | 
| | Participation in expenses                            |  | $                         | 627    |      | $ | 1,751  |  | $ | 1,498  | 
| | Financial expenses                                   |  | $                         | 3      |      | $ | 23     |  | $ | 110    | 

| |                                               |  |                |        |      |   |       | 
| | --------------------------------------------- |  | -------------- | ------ | ---- | - | ----- | 
| |                                               |  | December
  31, |       
| |                                               |  |                |       
| |                                               |  | 2004           |        | 2003 |  
| |                                               |  |                |        |      |  
| | Trade receivables and
  other receivables (*) |  | $              | 13,214 |      | $ | 6,668 | 
| | Trade payables (**)                           |  | $              | 5,445  |      | $ | 4,975 | 

|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                       | 
|-------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------- | 
|               | The purchases from our
  related parties are made at prices and on terms equivalent to those used in
  transacting business with unrelated parties under similar conditions. The
  sales to our related parties in respect with government defense contracts are
  made on the basis of costs incurred.
|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                       | 
|               | (*)                                                                                                                                                                                                                                                                                                     | The significant sales
  include sales of helmet mounted cueing systems purchased from the Company by
  VSI.                                          
|               | (**)                                                                                                                                                                                                                                                                                                    | Includes
  electro-optics components and sensors purchased by the Company from SCD and
  electro-optics products purchased by the Company from Opgal.
|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                      
|Note
  22    - | RECONCILIATION
  TO ISRAELI GAAP                                                                                                                                                                                                                                                                       
|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                      
|               | As described in Note 1,
  the Company prepares its financial statements in accordance with U.S. GAAP.
  The effects of the differences between U.S. GAAP and generally accepted
  accounting principles in Israel (Israeli GAAP) on the Companys financial
  statements are detailed below.         
|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                      
|               | A building purchased from
  Elbit Ltd.                                                                                                                                                                                                                                                                 
|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                      
|               | According to Israeli GAAP,
  the Company charged to additional paid-in capital reserves the excess of the
  amount paid over net book value of a building acquired from Elbit Ltd in
  1999. According to U.S. GAAP, the entire amount paid is considered as the
  cost of the building acquired.      
|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                      
|               | Proportional consolidation
  method                                                                                                                                                                                                                                                                    
|               |                                                                                                                                                                                                                                                                                                         |                                                                                                                                                      
|               | According to Israeli GAAP,
  a jointly controlled company should be included according to the proportional
  consolidation method.  According to
  U.S. GAAP, the investment in such a company is recorded according to the equity
  method.                                                           

55

---



ELBIT SYSTEMS LTD. AND ITS SUBSIDIARIES

|                                                      
|------------------------------------------------------
|NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
|                                                      
|U. S. dollars (In
  thousands)                        

|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|--------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|Note
  22     - | RECONCILIATION
  TO ISRAELI GAAP (cont.)                                                                                                                                                                                                                                                                                                                                                                
|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|                | Tax benefit in respect of
  options exercised                                                                                                                                                                                                                                                                                                                                                           
|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|                | According to Israeli GAAP,
  tax benefits from employee options exercised are recorded as a reduction of
  tax expense. According to U.S. GAAP, the difference between the above
  mentioned tax benefits and the benefits recorded in respect of compensation
  expense in the financial statements are credited to additional paid-in
  capital.                                                      
|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|                | Goodwill                                                                                                                                                                                                                                                                                                                                                                                                
|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|                | Effective January 1, 2002,
  the Company adopted SFAS 142, Goodwill and Other Intangible Assets
  according to which goodwill and intangible assets with indefinite lives are
  no longer amortized periodically but are reviewed annually for impairment (or
  more frequently if impairment indicators arise). According to Israeli GAAP,
  all intangibles, including goodwill should be amortized.
|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|                | Investment in marketable
  securities  Tadiran                                                                                                                                                                                                                                                                                                                                                         
|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|                | Pursuant to SFAS 115,
  marketable securities which are available-for-sale are presented on the basis
  of their market value and changes in such value are charged (or credited) to
  other comprehensive income. According to Israeli GAAP non-current investments
  in marketable securities are presented at cost                                                                                   
|                |                                                                                                                                                                                                                                                                                                                                                                                                          | 
|1.              | Effect on
  net income and earnings per share                                                                                                                                                                                                                                                                                                                                                           

| |                                                 |  |                           |        |      |   |        |  |   |        |  
| | ----------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ |  | - | ------ | -
| |                                                 |  | Year ended
  December 31, |       
| |                                                 |  |                           |       
| |                                                 |  | 2004                      |        | 2003 |   | 2002   | 
| |                                                 |  |                           |        |      |   |        | 
| | Net income as reported
  according to U.S. GAAP |  | $                         | 52,993 |      | $ | 45,945 |  | $ | 45,113 |  
| | Adjustments to Israeli
  GAAP                   |  |                           | (458   | )    |   | 595    |  |   | (4,227 | )
| |                                                 |  |                           |        |      |   |        |  |   |        |  
| | Net income according to
  Israeli GAAP          |  | $                         | 52,535 |      | $ | 46,540 |  | $ | 40,886 |  
| |                                                 |  |                           |        |      |   |        |  |   |        |  

|   |                                 
|-- | --------------------------------
|2. | Effect on
  shareholders equity

| |                           |  |               |         |             |   |                         |   |   |         | 
| | ------------------------- |  | ------------- | ------- | ----------- | - | ----------------------- | - | - | ------- | 
| |                           |  | As
  reported |         | Adjustments |   | As per
  Israeli
  GAAP |  
| |                           |  |               |         |             |   |                         |  
| | As of
  December 31, 2004 |  |               |         |             |   |                         |   |   |         | 
| | Shareholders equity      |  | $             | 434,700 |             | $ | (13,124                 | ) | $ | 421,576 | 
| |                           |  |               |         |             |   |                         |   |   |         | 
| |                           |  |               |         |             |   |                         |   |   |         | 
| | As of
  December 31, 2003 |  |               |         |             |   |                         |   |   |         | 
| | Shareholders equity      |  | $             | 432,079 |             | $ | (10,367                 | ) | $ | 421,712 | 
| |                           |  |               |         |             |   |                         |   |   |         | 

#  #  #  #  #  #  #  #

56

---