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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

(Mark One)
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934
                For the fiscal year ended: DECEMBER 31, 1999, OR

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
     For the transition period from              to
                                    ------------     ------------

                         Commission file number: 0-20679

                            MECHANICAL DYNAMICS, INC.
             (Exact name of registrant as specified in its charter)

        MICHIGAN                                         38-2163045
(State of incorporation)                    (I.R.S. Employer Identification No.)

                             2301 COMMONWEALTH BLVD.
                            ANN ARBOR, MICHIGAN 48105
                                 (734) 994-3800
             (Address of principal executive offices, including zip
                code, and telephone number, including area code)

           Securities registered pursuant to Section 12(b) of the Act:
Title of each class: NONE        Name of each exchange on which registered: NONE

           Securities registered pursuant to Section 12(g) of the Act:
                           COMMON SHARES, NO PAR VALUE
                                (Title of class)

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 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.
              [X] Yes                             [ ] No

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

     The aggregate market value of the voting stock of the Registrant held by
non-affiliates of the Registrant as of March 15, 2000, computed by reference to
The Nasdaq Stock Market closing price on such date, was approximately
$29,392,000.

     The number of outstanding shares of the Registrant's common stock, as of
March 15, 2000, was 6,288,818.

                       DOCUMENTS INCORPORATED BY REFERENCE
     Portions of the Proxy Statement for the 2000 Annual Meeting of
Shareholders, scheduled to be held on May 11, 2000, are incorporated by
reference into Part III.

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                            MECHANICAL DYNAMICS, INC.

                                    FORM 10-K
                                TABLE OF CONTENTS

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                                                PART I
Item 1.    Business.................................................................................            3
Item 2.    Properties...............................................................................           13
Item 3.    Legal Proceedings........................................................................           13
Item 4.    Submission of Matters to a Vote of Security Holders......................................           13

                                                PART II
Item 5.    Market for Registrant's Common Equity and Related Stockholder Matters....................           14
Item 6.    Selected Consolidated Financial Data.....................................................           15
Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations....           16
Item 7a.   Quantitative and Qualitative Disclosures about Market Risk...............................           24
Item 8.    Financial Statements and Supplementary Data..............................................           25
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.....           42

                                               PART III
Item 10.   Directors and Executive Officers of the Registrant.......................................           42
Item 11.   Executive Compensation...................................................................           43
Item 12.   Security Ownership of Certain Beneficial Owners and Management...........................           43
Item 13.   Certain Relationships and Related Transactions...........................................           43

                                                PART IV
Item 14.   Exhibits, Financial Statement Schedules and Reports on Form 8-K..........................           44

SIGNATURES..........................................................................................           46

INDEX TO EXHIBITS...................................................................................           47
</TABLE>


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                                     PART I
ITEM 1. BUSINESS

GENERAL

     Since Mechanical Dynamics, Inc. ("MDI" or the "Company") was incorporated
in Michigan in 1977, the Company has developed, marketed and supported virtual
prototyping solutions. The Company's ADAMS mechanical system simulation software
allows engineering teams to create virtual prototypes of their complex
mechanical system designs on the computer. By realistically simulating the
full-motion behavior of their designs, they can explore multiple design
variations, testing and refining until optimizing system performance. In doing
so, they reduce the need for costly, time-consuming physical prototype testing,
while significantly improving product quality.

     ADAMS makes the idea of concurrent engineering real. It enables those
involved at each step of the product development process - from initial concept
through design and testing - to interact with the virtual prototype, to see the
whole system in motion and provide input even from the earliest stages. This not
only shortens the development cycle and increases product quality, but also
improves the product development process itself. Leading manufacturers from
nearly every industry today use the Company's software and consulting services.

     In recent years, the Company has made strategic business acquisitions to
expand its ability to develop and market new products to customers. In 1994, the
Company acquired five European entities that previously had distributed the
Company's products in Europe and are now wholly-owned subsidiaries: Mechanical
Dynamics GmbH, a German corporation; Mechanical Dynamics Sarl, a French
corporation; Mechanical Dynamics International Ltd., a United Kingdom
corporation; Mechanical Dynamics Sweden AB, a Swedish corporation; and
Mechanical Dynamics Italy srl, an Italian corporation.

     In 1997, the Company established a Japanese subsidiary, Mechanical Dynamics
Japan K.K., through a joint venture agreement with Information Services
International-Dentsu, Ltd. ("ISI-Dentsu") of Tokyo, Japan, the distributor of
the Company's software in Japan. In 1997, the Company also acquired StatDesign,
Inc., an engineering software and services firm based in Dearborn, Michigan. The
aggregate purchase price of approximately $2.2 million consisted of $1.4 million
in cash and 170,227 shares of the Company's common stock valued at approximately
$868,000. Subsequent to the closing of the acquisition, the operations of
StatDesign were integrated within the Company. See Note 2 of Notes to
Consolidated Financial Statements.

     In January 1998, the Company acquired 100% of the outstanding capital stock
of DTI Asia Pte. Ltd. ("DTI"), a provider of mechanical design simulation
software embedded in the AutoCAD and Mechanical Desktop product lines from
Autodesk, Inc. The aggregate purchase price of approximately $1.7 million
consisted of $563,000 in cash and 142,540 shares of the Company's common stock
valued at approximately $1.1 million. Subsequent to the closing of the
acquisition, the operations of DTI were integrated within the Company. See Note
2 of Notes to Consolidated Financial Statements.

     In August 1998, the Company established a Canadian subsidiary, Mechanical
Dynamics Ltd. ("MDI-Canada"). Immediately following its formation, MDI-Canada
acquired the Design Analysis Group and certain other assets of H.G.E. Inc.
("HGE"), an engineering software and services firm focusing on the aerospace
industry based in Toronto, Ontario, Canada. The aggregate purchase price of
approximately $2.2 million consisted principally of cash. Subsequent to the
closing of the acquisition, the operations of HGE were integrated within the
Company. See Note 2 of Notes to Consolidated Financial Statements.

     In November 1998, the Company formed a strategic partnership with the
University of Iowa in which component-level durability sensitivity analysis
technology developed by the University will be integrated with the Company's
ADAMS virtual prototyping software to provide system-level durability design
sensitivity analysis capabilities. The Company paid $400,000 to the University
for the ability to jointly develop and market this technology. See Note 2 of
Notes to Consolidated Financial Statements.



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     ADAMS(R) and the Company's logo are registered trademarks of the Company.
ADAMS/Animation, ADAMS/Car, ADAMS/Controls, ADAMS/Driver, ADAMS/Engine,
ADAMS/Exchange, ADAMS/Flex, ADAMS/Hydraulics, ADAMS/Insight, ADAMS/Linear,
ADAMS/PostProcessor, ADAMS/Pre, ADAMS/Rail, ADAMS/Solver, ADAMS/Tire,
ADAMS/View, CAT/ADAMS, Dynamic Designer and MECHANISM/Pro are trademarks of the
Company. All rights reserved. All other trade names and trademarks appearing in
this Form 10-K are the property of their respective holders.

PRODUCTS

     MDI develops, markets and supports virtual prototyping software packages
capable of simulating the many varied and complex component interactions and
operating environments that companies face when designing their products. The
Company's primary software line is the ADAMS Professional Series. The principal
product in this line, the ADAMS Full Simulation Package, is comprised of
ADAMS/Solver and ADAMS/View, and can be used as a self-contained software
package or with additional modules developed by the Company as well as with
third-party software. In addition, certain original equipment manufacturers
("OEM") license the Company's motion simulation software in order to embed the
Company's software in the OEM's design software packages. The U.S. list price
for the ADAMS Full Simulation Package is approximately $24,000 per license
depending upon configuration. The U.S. list prices for the Company's additional
software products typically range from $3,000 to $27,000. The Company also
packages several of its additional software products into industry or
application-specific packages. These packages have U.S. list prices ranging from
$13,000 to $60,000. In the future, the Company intends to offer additional
products and packages as part of its ADAMS software product line. Since the
Company's sales are concentrated in the ADAMS Professional Series product line,
a decline in the demand for ADAMS software and services would have a material
adverse effect on the Company's business, financial condition and results of
operations.

     ADAMS and the modular packages of ADAMS software are available on a number
of platforms, including Intel Pentium-based PCs running the Microsoft Windows NT
operating system and UNIX-based workstations and servers from Silicon Graphics,
Hewlett-Packard, Sun Microsystems, IBM and Digital Equipment.

ADAMS PROFESSIONAL SERIES

     Full Simulation Package

     - ADAMS/Solver is the underlying solution "engine." ADAMS/Solver
automatically formulates and solves the equations of motion to provide complete
kinematic, static and dynamics analysis of mechanical systems.

     - ADAMS/View is an interactive graphical environment for the full ADAMS
product line. ADAMS/View combines simple iconic, point-and-click operation with
advanced model-building, simulation, animation and xy plotting capabilities.

   Industry-specific packages

     - ADAMS/Car was developed by the Company in collaboration with a consortium
of major automotive manufacturers. ADAMS/Car is a special version of ADAMS
designed specifically for advanced vehicle simulation. Embedded within the
software are the specialized design and analytical expertise of automotive
industry leaders. A custom menu-driven user interface highlights capabilities
familiar to vehicle designers so customers can use ADAMS/Car with little formal
training.

     - ADAMS/Driver allows the user to add the element of human driver response
to vehicle simulations. ADAMS/Driver can simulate the actions and reactions of a
vehicle's operator under a variety of driving conditions.

     - ADAMS/Engine is a specialized software environment which enables an
engineering team to predict, refine, and optimize the high-frequency performance
of powertrain components and subsystems as part of an overall vehicle design.
Users can also combine their designs of individual powertrain components and
subsystems into a complete


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engine simulation, allowing them to solve problems of structural load, life,
durability, vibration, and performance within defined cost, weight, and
packaging constraints.

     - ADAMS/Pre is a pre-processing environment for ADAMS designed specifically
for the automotive environment.

     - ADAMS/Rail was developed by the Company in collaboration with Dutch Rail
and provides virtual prototyping capabilities tailored to the needs of the
worldwide railcar manufacturing industry. The software combines specialized
railcar design and analytical know-how with custom menus and functions developed
specifically for railcar engineers.

     - ADAMS/Tire is a comprehensive set of tools for simulating the complex
force interactions between rubber tires and driving surfaces. This can be
important input for understanding vehicle behavior under a variety of
conditions.

     Visualization and Other Options

     - ADAMS/Animation allows a user to see the complete system in motion -- in
real time, fully shaded and rendered. ADAMS/Animation checks and reports
potential collision of parts and components and shows important measurements on
screen. ADAMS/Animation also allows for multiple light sources, texture mapping,
detailed color specifications and multiple perspectives. These enhance the
understanding of the design and can result in more successful design reviews.

     - ADAMS/Insight provides experimental design methods for improved
understanding and refinement of complex mechanical system designs. It enables
Web-based collaboration through allowing experiment results to be posted and
shared among engineering groups.

     - ADAMS/PostProcessor is a high-performance tool for visualizing ADAMS
simulation results. Used as a standalone or integrated with ADAMS/View,
ADAMS/PostProcessor simplifies and speeds the steps required to view, study, and
understand ADAMS simulation results.

ADAMS INTERFACE PRODUCTS

Interface Products are products specifically designed for the CAD/CAM/CAE
environments. Assemblies created within the Company's partners' software
environments are converted into realistic, fully three-dimensional mechanical
system models. These software environments then verify and evaluate motion
paths, locate lock-up positions, detect interferences, establish work-space
envelopes and calculate joint reaction forces.

     ADAMS CAE Interface Products

     - ADAMS/Controls simplifies the integration of non-linear ADAMS mechanical
models with control and hydraulic systems developed in leading control system
design packages including MATLAB, MATRIXx and EASY5. The product allows the user
to test how control systems will affect their mechanical system, and visualize
the effects of both controls and mechanics in a virtual system test environment.

     - ADAMS/Flex automates the exchange of data between ADAMS and finite
element analysis ("FEA") software, including ANSYS and MSC/NASTRAN. This two-way
interface provides for accurate loading conditions for FEA and a more complete
understanding of flexible effects on mechanical systems.

     - ADAMS/Hydraulics is an add-on module for the simulation of complex
mechanical systems powered by hydraulic elements. Static, linear, transient, and
dynamic analyses are all supported for combined mechanical and hydraulic models.

     - ADAMS/Linear simplifies the non-linear equations of motion calculated by
ADAMS. Having such data in linear form can significantly enhance the ability to
study the stability and vibratory behavior of mechanical system models.
ADAMS/Linear can also provide an easy link to popular control system design
packages such as MATRIXx and MATLAB.

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     ADAMS CAD/CAM Interface Products

     - ADAMS/Exchange provides an industry-standard, two-way interface for
exchanging model geometry between ADAMS and many other CAD/CAM packages. This
saves time in data transfer, while enhancing the accuracy and realism of
mechanical system simulations.

     - CAT/ADAMS was developed by the Company in collaboration with a consortium
of major automotive manufacturers and was designed to facilitate the exchange of
data between ADAMS and the widely used CATIA computer-aided design,
manufacturing, and engineering (CAD/CAM/CAE) package from Dassault Systemes.

     - Dynamic Designer was purchased by the Company in conjunction with its
acquisition of DTI in January 1998. Dynamic Designer is a mechanical design
simulation software product embedded in leading mid-range CAD environments,
which today includes the AutoCAD and Mechanical Desktop product lines from
Autodesk, Inc., the SolidWorks product line from SolidWorks Corp., and the Solid
Edge product line from Unigraphics Solutions, Inc.

     - MECHANISM/Pro is a program specifically designed for Parametric
Technology Corp.'s ("PTC") Pro/ENGINEER environment. MECHANISM/Pro converts
assemblies created within PTC's Pro/ASSEMBLY software into realistic, fully
three-dimensional mechanical system models. MECHANISM/Pro can verify and
evaluate motion paths, locate lock-up positions, detect interferences, establish
work-space envelopes and calculate joint reaction forces.

ADAMS OEM PRODUCTS

     OEM Products are kinematic and dynamics motion simulation products that are
embedded in OEMs' design software packages. The Company has entered into license
agreements or arrangements with several OEMs, including Structural Dynamics
Research Corporation ("SDRC"), Unigraphics Solutions, Inc., Bentley Systems,
Engineering Animation, Inc., and Tecnomatix Technologies Ltd. under which the
OEMs are licensed to embed the Company's products in the OEMs' software
packages. These products provide limited virtual prototyping capabilities, and
can be upgraded by licensing ADAMS/Solver directly from the Company.

SERVICES

     Software Maintenance Services

     A critical component of MDI's strategy is to provide a wide range of
customer support services. These services include hotline support and on-site
support and training. Product support is provided pursuant to renewable annual
maintenance contracts. Customers who purchase maintenance agreements receive
product enhancement releases and hotline support at no additional charge.
On-site support and training are priced separately. Approximately 19.7%, 16.3%,
and 15.9% of the Company's total revenue was realized from maintenance contracts
in 1999, 1998, and 1997, respectively.

     Professional Services

     The Company provides consulting, training and funded research and
development services to customers in connection with a wide range of product
design and engineering projects. MDI's primary objectives with regard to its
services include: (1) providing total solutions to its customers' problems; (2)
leveraging software sales; (3) enhancing customer loyalty and repeat and renewal
business; (4) growing the services business of the Company profitably; (5)
aggressively exploring and penetrating new markets; and (6) obtaining customer
feedback on its products.

     The Company strives to identify key companies within various industries
with whom it seeks to develop close working relationships. The Company seeks to
foster technological partnerships with these companies by providing a
comprehensive service package, which addresses the particular virtual
prototyping needs of the companies. By doing this, MDI provides a total solution
for the customer, which can lead to increased acceptance of virtual prototyping
in the applicable industry.


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     The Company's services staff provides these services on either a time and
materials or a fixed fee basis depending on the project and the requirements of
the customer. Contract fees range from a few thousand dollars to several hundred
thousand dollars depending upon the scope of the project, and contract durations
range from a few weeks to several years. From time to time the Company has
incurred losses in connection with fixed price contracts. If the Company
underestimates the expenses required to perform under fixed fee contracts, it
could incur losses on these contracts. The Company has not incurred a material
loss from underestimating the expenses on any fixed fee contract during 1999,
1998 or 1997.

CUSTOMERS

     The Company's customers include companies in a wide variety of industries.
Historically, the Company's largest customers have been automobile manufacturers
and automotive suppliers operating in an industry which can be highly cyclical.
During 1999, 1998, and 1997, automotive-related customers accounted for
approximately 54.0%, 54.7%, and 50.5% of the Company's total revenue,
respectively. No customer accounted for greater than 10% of the Company's total
revenue in 1999 or 1998. Ford Motor Company accounted for approximately 10.6% of
the Company's total revenue in 1997. No other customer accounted for greater
than 10% of the Company's total revenue in 1997.

     Segments within the auto industry, in each of the United States, Europe and
Japan, have, from time to time, experienced significant economic downturns
characterized by decreased product demand, reductions in capital expenditures,
production over-capacity, price erosion, work slowdowns, strikes and layoffs.
The Company's operations may in the future reflect substantial fluctuations from
period to period as a consequence of such industry patterns, general economic
conditions affecting the timing of orders from major customers and other factors
affecting capital spending. There can be no assurance that such factors will not
have a material adverse effect upon the Company's business, financial condition
and results of operations.

SALES AND MARKETING

     The Company markets its products through direct sales in North America,
Europe and to a lesser extent in Asia, a group of international distributors in
over 25 countries and through reselling alliances with certain integrated
mechanical CAD/CAM/CAE software vendors. The Company conducts sales activities
from its headquarters in Ann Arbor, Michigan, domestic sales offices in Atlanta,
GA; Austin, TX; Chicago, IL; Cleveland, OH; Los Angeles, CA; Phoenix, AZ;
Seattle, WA; and Washington D.C., as well as its subsidiaries' offices in
England, France, Germany (three offices), Italy (two offices), Sweden (2
offices), Canada (2 offices), Japan and Singapore, and its foreign branch
offices in China and India. The Company employs engineers and technically
proficient salespersons capable of serving the technology needs of current and
prospective customers' engineering, design and manufacturing staffs.

     The Company has formed strategic alliances with several leading hardware
vendors, including Hewlett-Packard, Silicon Graphics and Sun Microsystems.
Through these strategic alliances, the Company and the vendor participate in
various projects which enhance both the visibility and acceptance of the
Company's products, such as joint presentations to customers and the trade
press, joint advertising and promotion, conference presentations and displays.

     The Company also has alliances with vendors of complementary computer-aided
engineering and testing solutions, such as ANSYS, Inc., MSC.Software Corp., MTS
Systems Corp., The Mathworks, Inc., nCode International Ltd., Structural
Research & Analysis Corp., and Wind River Systems, Inc. These relationships
entail collaborative development to support interfaces between the products of
the Company and each partner, as well as cooperative marketing and selling
activity. By working with these vendors, the Company seeks to satisfy the needs
of its customers across a wide range of computer-aided engineering and testing
applications. The Company and its partners jointly participate in promotional
activities, trade shows, user conferences, customer presentations and customer
proposals.

     The Company markets and sells third party software products through
distributor agreements with certain other CAE vendors whose technologies help it
provide a total solution to its customers. As of December 31, 1999 the Company
distributes software products of ANSYS, Inc. in both the United Kingdom and
Canada in addition to

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providing consulting services related to those products. Throughout Sweden, the
Company distributes MATRIXx, a product of Wind River Systems, Inc. Revenue from
third party software products accounted for approximately 9.7%, 7.1%, and 2.2%
of the Company's total revenue in 1999, 1998 and 1997, respectively.

     The Company has formed relationships with several CAD/CAM companies,
including Autodesk, Inc., Bentley Systems, Inc., Dassault Systemes, Engineering
Animation, Inc., Parametric Technology Corp., SolidWorks Corp., Structural
Dynamics Research Corporation, Tecnomatix Technologies Ltd., and Unigraphics
Solutions Inc. Through these alliances, the Company collaborates with its
partners to develop and support embedded, add-on software modules for each
CAD/CAM environment. These embedded modules enable CAD/CAM users to model and
simulate mechanical systems and interface with the Company's full ADAMS product
line. The Company believes that strategic alliances are important to its
long-term success and intends to continue to pursue such alliances in the
future.

     International revenue (i.e., revenue from sales outside of North America)
accounted for approximately 61.7%, 62.4%, and 65.2% of the Company's total
revenue in 1999, 1998, and 1997, respectively. A summary of the Company's
revenue by geographic area is presented in Note 8 of Notes to Consolidated
Financial Statements.

     In Asia, and, to a lesser extent, in North America and Europe, the Company
markets its products and services through contractual relationships with
distributors. A significant portion of the Company's revenue in Asia is derived
from its distributors in Japan, Korea, India, China, Taiwan and Singapore. The
Company's largest distributor, ISI-Dentsu, is located in Japan and accounted for
approximately 12.6%, 13.2%, and 15.3% of the Company's total revenue in 1999,
1998, and 1997, respectively. There can be no assurance that in the future the
Company's current distributors will choose or be able to market or service and
support the Company's products effectively, that economic conditions or industry
demand will not adversely affect the distributors or that such distributors will
not devote greater resources to marketing and supporting products of other
companies. Additionally, because the Company's products are typically used by
skilled professionals, in order to be effective, a distributor must possess
sufficient technical, marketing and sales resources and must devote these
resources to a lengthy sales cycle, customer training and product service and
support. Only a limited number of distributors possess such resources. The loss
of or a significant reduction in revenue from a distributor could have a
material adverse effect on the Company's business, financial condition and
results of operations.

     The Company generally prices its software products and services in local
currencies in Europe, Canada and Japan. In 1999, the net impact of exchange rate
fluctuations positively affected the Company's international revenue by
approximately $432,000. The strengthening of the dollar in 1998, relative to the
European and Japanese currencies, negatively affected 1998 international revenue
by approximately $883,000. Since most of the Company's international operating
expenses were incurred in foreign currencies, the net impact of exchange rate
fluctuations on income from operations in 1999 and 1998 was considerably less
than the impact on revenue. If the U.S. dollar strengthens in 2000 relative to
the European, Canadian or Japanese currencies, the Company's international
revenue will be negatively impacted, which could have a material adverse effect
on the Company's consolidated results of operations.

     The Company expects that international sales will continue to account for a
significant portion of its total revenue in future periods. The Company intends
to continue to expand its operations outside of the United States, which will
require significant management attention and financial resources. International
operations are subject to inherent risks, including unexpected changes in
regulatory requirements, tariffs and taxes, difficulties in staffing and
managing foreign operations, longer payment cycles, greater difficulty in
accounts receivable collection, compliance with applicable export licensing
requirements and other trade barriers and political and economic instability.
Moreover, gains and losses on the conversion to U.S. dollars of receivables and
payables arising from international operations may contribute to fluctuations in
the Company's results of operations. As more fully described in Note 1 of Notes
to Consolidated Financial Statements, the Company's risk management strategy
uses derivative financial instruments in the form of forward foreign exchange
contracts for the purpose of hedging foreign currency market exposures of its
ongoing business operations. The Company does not enter into derivative
contracts for the purpose of trading or speculative transactions. If for any
reason exchange or price controls or other restrictions on foreign currencies
were imposed, the Company's business, financial condition and results of
operations could be materially adversely affected. Currency exchange
fluctuations in countries in which the Company licenses its products in U.S.

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dollars could have a material adverse effect on the Company's business,
financial condition and results of operations by resulting in pricing that is
not competitive with products priced in local currencies. In addition, the laws
of certain countries do not protect the Company's products and intellectual
property rights to the same extent as do the laws of the United States. There
can be no assurance that any of these factors will not have a material adverse
effect on the Company's future international operations and sales and,
consequently, on the Company's business, financial condition and results of
operations.

RESEARCH AND DEVELOPMENT

     The Company's success depends in large part upon its ability to enhance
current products and to develop and introduce new products on a timely and
cost-effective basis. The Company's current software development efforts are
focused on developing additional products and services to complement its core
competencies of developing, marketing and supporting mechanical system modeling
and simulation software packages.

     The Company has historically released at least one new version of its
software to its customers per year and intends to continue such releases. The
Company also provides periodic releases to its OEM software partners. As part of
this release process, the Company continually communicates with its customers
and partners and solicits comments for improved ease of use and general customer
satisfaction. The Company's software developers work as a team with the
Company's sales, marketing and consulting personnel to achieve a robust,
high-quality product line.

     The Company also sponsors and maintains a network of academic and
commercial research affiliates to promote recognition and commercialization of
applicable emerging technology. Some of the technology areas which have recently
been explored include: kinematics, elastodynamics, numerical methods, design
sensitivity, optimization, symbolic computing, advance graphics and
visualization, user interfaces, tire dynamics, biomechanics, ergonomics,
controls design and hydraulics.

     The virtual prototyping industry is characterized by rapid technological
changes, frequent new product introductions and evolving industry standards that
may render existing products and services obsolete. Consequently, to maintain
its competitive position, the Company must enhance its existing software
products and develop and introduce new products on a timely basis. In addition,
in order to maintain and broaden the market for its software products, the
Company must support a variety of computer systems and graphics devices. There
can be no assurance that the Company will not experience difficulties that could
delay or prevent the successful development, introduction and marketing of these
products, or that such new products and product enhancements will adequately
meet the requirements of the marketplace and achieve market acceptance. If the
Company is unable to develop and introduce products in a timely manner in
response to changing market conditions or customer requirements, the Company's
business, financial condition and results of operations would be materially
adversely affected.

     Software products as complex as those offered by the Company may contain
defects or failures that may be detected at any point in the product's life
cycle. The Company has, in the past, discovered software defects in certain of
its products. The Company's standard warranty provides that if the software does
not function to published specifications, the Company will, within a limited
time period following delivery, use its best efforts to repair or replace the
defective software without charge. To date, the Company has not experienced
significant technical errors or other product performance issues, and warranty
costs have been insignificant. There can be no assurance that, despite testing
by the Company, errors will not be found in current or new products after
commencement of commercial shipments, resulting in injury to the Company's
reputation, increased warranty and service costs, loss of market share or
failure to achieve market acceptance. Any such occurrence could have a material
adverse effect upon the Company's business, financial condition and results of
operations.

     As of December 31, 1999, the Company's research and development group
consisted of 55 full-time employees. During 1999, 1998, and 1997, the Company's
research and development expenses were approximately $5.6 million, $5.3 million,
and $4.7 million, respectively. The Company anticipates that it will commit
substantial resources to research and development in the future.


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BACKLOG

     The Company typically ships its products within 30 days after acceptance of
a customer purchase order and execution of a software license agreement.
Accordingly, the Company does not believe that its backlog at any particular
point in time is indicative of future revenue levels.

COMPETITION

     The markets for the Company's products and services are highly competitive
and subject to rapid change. The Company believes the principal competitive
factors in this market are product quality, ease of use, quality of support,
performance and price, functionality and features, ease of integration with
customers' design processes, strategic alliances and vendor and product
reputation. In general, the Company's current competition comes from three
sources: the traditional method of testing hardware prototypes, whether
performed internally or externally, by the Company's current or potential
customers, other virtual prototyping software vendors, including Parametric
Technology Corp. and MSC.Software Corp., and the internal software development
groups of its current or potential customers. A number of the Company's
competitors have longer operating histories, greater financial, technical,
sales, marketing and other resources, greater name recognition, more extensive
distribution and sales networks and a larger, more established customer base.

     Among the Company's current and potential competitors are also a number of
large hardware and software companies that may develop or acquire products that
compete with the Company's products. Current and potential competitors have
established or may establish cooperative relationships among themselves or with
third parties to increase the ability of their products to address the needs of
the Company's prospective customers. Accordingly, it is possible that new
competitors or alliances among competitors may emerge and rapidly acquire
significant market share. Increased competition is likely to result in price
reductions, reduced operating margins and loss of market share, any of which
could materially adversely affect the Company's business, results of operations
and financial condition. There can be no assurance that the Company will be able
to compete successfully in the future or that competitive pressures will not
have a material adverse effect the Company's business, financial condition and
results of operations.

     The Company's products address the market for virtual prototyping software.
Because this market is still evolving, it is difficult to assess or predict with
any assurance the growth rate, if any, and size of this market. Also, as is
typical in the case of a new and evolving industry, demand and market acceptance
for virtual prototyping software products and services are subject to a high
level of uncertainty. The Company's future financial performance will depend in
large part on growth in the virtual prototyping market and upon the Company's
ability to successfully market its ADAMS products and services. There can be no
assurance the virtual prototyping market will grow in the future or that the
Company's products and services will achieve wider market acceptance. There are
certain prototyping applications to which the Company's products may not provide
an effective solution due to limitations in the capabilities of the Company's
products and, as such, the Company's products may not be accepted by certain
customers. If the virtual prototyping market fails to grow or grows more slowly
than anticipated, or if the Company's products do not achieve significant market
acceptance, the Company's business, financial condition and results of
operations will be materially adversely affected.

PROPRIETARY RIGHTS

     The Company's success depends in large part upon its proprietary software
technology. The Company currently relies on trade secret, copyright and
trademark laws, and license agreements with all of its customers to protect its
proprietary rights in its software products. The Company also ships its ADAMS
software with either an encoded password scheme or a security device. The
Company's software copies are locked to a specific central processing unit and
contain codes that will prohibit the user from running the software after a
certain date. The Company generally enters into proprietary information and
confidentiality agreements with its employees and distributors, and limits
access to and distribution of its software, documentation and other proprietary
information. The Company generally does not license or release the source code
for its proprietary software to third parties. Despite these precautions, there
can be no assurance that a third party will not copy or otherwise obtain and use
the Company's products or technology without authorization, or develop similar
or superior technology independently. The

                                       10
<PAGE>   11

Company distributes its Dynamic Designer software products and demonstration
copies of its other products in North America, Europe and Asia pursuant to
"shrink-wrap" licenses. There can be no assurance that such licenses are
enforceable. In addition, effective copyright and trade secret protection may be
unavailable or limited in certain foreign countries. Litigation may be necessary
in the future to enforce the Company's intellectual property rights, to protect
the Company's trade secrets, to determine the validity and scope of the
proprietary rights of others or to defend against claims of infringement or
invalidity. Such litigation could result in substantial costs and diversion of
resources and could have a material adverse effect on the Company's business,
financial condition and results of operations. Although the Company believes
that its products do not infringe on the proprietary rights of third parties,
and although the Company has received no communications from third parties
alleging the infringement of the proprietary rights of such parties, there can
be no assurance that infringement claims will not be asserted against the
Company in the future or that any such claims will not require the Company to
enter into costly litigation. Irrespective of the validity or the successful
assertion of such claims, any such litigation could result in substantial costs
and a significant diversion of management's attention and resources, and these
results as well as any adverse judgment that might be rendered could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, if any claims or actions are asserted
against the Company, the Company may choose or be required to obtain a license
under a third party's intellectual property rights. There can be no assurance
that under such circumstances a license would be available upon reasonable terms
or at all.

     Certain technology used by the Company's products is licensed from third
parties, generally on a nonexclusive basis. The Company believes there are
alternative sources for each of the material components of technology licensed
by the Company from third parties. However, the termination of any such
licenses, the failure of the third parties to adequately maintain or update
their products, including making their products year 2000 compliant, or a
substantial increase in the license fee associated with such licenses could
result in a delay in the Company's ability to deliver certain of its products
while it seeks to implement technology offered by alternative sources and may
adversely affect the Company's business, financial condition and results of
operations. Any required replacement licenses could prove costly. Also, any such
delay, to the extent it occurs at or near the end of a quarter, could result in
a material adverse effect on the Company's quarterly results of operations.
While it may be necessary or desirable in the future to obtain other licenses
relating to one or more of the Company's products or relating to current or
future technologies, there can be no assurance that the Company will be able to
do so on reasonable terms or at all. Further, increased merger and acquisition
activity in the technology industry could affect the Company's relationships
with other third-party developers, and thus adversely affect the Company's
results of operations.

EMPLOYEES

     As of December 31, 1999, the Company had 284 employees, consisting of 107
in engineering services, 94 in sales and marketing, 55 in research and
development and 28 in general and administrative capacities. Of these, 140 are
located at the Company's headquarters in Ann Arbor, Michigan, 20 are located at
the Company's domestic offices in Arizona, California, Georgia, Illinois,
Maryland, Ohio, Texas, Washington, and Wisconsin, 18 are located at the
Company's Canadian subsidiary, 96 are located at the Company's European and
Asian subsidiaries and 10 are located at the Company's foreign branch offices in
China and India. None of the Company's employees is represented by a labor union
or is subject to a collective bargaining agreement. The Company believes that
its relations with its employees are good.

     The Company's success depends in large part upon the continued service of
its key technical and senior management personnel. The Company's success also
depends on its continuing ability to attract and retain highly qualified
technical, sales and marketing, and managerial personnel. Competition for such
personnel is intense, and there can be no assurance that the Company can retain
its key managerial and technical employees or that it can attract, assimilate or
retain other highly qualified personnel in the future. If the Company is unable
to hire the necessary technical personnel, the development of new products could
be impaired. The Company's inability to attract, assimilate or retain personnel
in the future on a timely basis could have a material adverse effect on the
Company's business, financial condition and results of operations.


                                       11
<PAGE>   12


ACQUISITIONS

     The Company periodically acquires or invests in businesses, software
products and technologies which are complementary to the Company's business. The
risks associated with such acquisitions or investments include, among others,
the difficulty of assimilating the operations and personnel of the companies,
the failure to realize anticipated synergies and the diversion of management's
time and attention. In addition, such investments and acquisitions may
contribute to fluctuations in quarterly results of operations due to
merger-related costs and charges associated with eliminating redundant expenses
or write-offs of impaired assets or in-process research and development recorded
in connection with the acquisitions, any of which could negatively impact
results of operations for a given period. There can be no assurance that the
Company will be successful in overcoming such risks or that such investments and
acquisitions will not have a material adverse effect upon on the Company's
business, financial condition or results of operations.

POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS

     The Company's quarterly operating results have in the past varied and may
vary in the future depending on factors such as mix of direct and indirect
sales, product mix, service mix, increased competition, size and timing of
significant orders, seasonal factors and budgeting cycles of customers, product
releases and pricing changes by the Company or its competitors, timing of new
product announcements, market acceptance or delays in the introduction of new or
enhanced versions of the Company's products and general economic conditions. A
significant portion of the Company's revenue in previous quarter has been
derived from sales to a limited number of customers, and the Company currently
anticipates that future quarters will continue to reflect this trend. In
addition, like many software companies, the Company has generally recognized a
substantial portion of its revenue in the last month of each quarter, with this
revenue concentrated in the last weeks of the quarter. Accordingly, the
cancellation or deferral of even a small number of purchases of the Company's
products could have a material adverse effect on the Company's business, results
of operations and financial condition in any particular quarter. To the extent
that significant sales occur earlier than expected, operating results for
subsequent quarters may fail to keep pace or even decline. The Company's
quarterly operating results have also fluctuated as a result of seasonality of
customer buying patterns. Revenue is typically lower or constant in the first
quarter of the year in relation to the previous year's last quarter due
primarily to budgeting cycles of customers. The Company's third quarter revenue
is also typically lower or constant in relation to the second quarter of the
year due to the decreased level of sales from its European operations in the
third quarter. Revenue from quarter to quarter is difficult to forecast, as
minimal order backlog exists at the end of any quarter because the Company's
products typically are shipped and revenue recognized promptly after receipt of
the customers' orders.

     The Company's expense levels are based, in part, on its expectations as to
future revenue. If revenue levels are below expectations, operating results are
likely to be adversely affected. In particular, net income may be
disproportionately affected by a reduction in revenue because only a small
portion of the Company's expenses varies with its revenue. There can be no
assurance that the Company will be able to grow in future periods, that it will
be able to sustain its historical rate of revenue growth or that its operations
will remain profitable. As a result of the foregoing and other factors, the
Company believes that period-to-period comparisons of its results of operations
are not necessarily meaningful and should not be relied upon as indications of
future performance. Fluctuations in operating results may also result in
volatility in the price of the shares of the Company's common stock.

STOCK PRICE VOLATILITY

     The trading price of the Company's common stock could be subject to wide
fluctuations in response to quarterly variations in operating results,
announcements of technological innovations, the introduction of new products or
pricing changes by the Company or its competitors, proprietary rights or
litigation, changes in earnings estimates by analysts and other events or
factors. In addition, the stock market has from time to time experienced extreme
price and volume fluctuations that have been unrelated to the operating
performance of particular companies. These broad market fluctuations may
adversely affect the market price of the Company's common stock. In the past,
following periods of volatility in the market price of a company's securities,
securities class action litigation has sometimes occurred against companies.
There can be no assurance that such litigation will not occur in the future with
respect to the Company. Such litigation could result in substantial costs and a
significant diversion of management's attention

                                       12
<PAGE>   13

and resources, and could have a material adverse effect on the Company's
business, financial condition and results of operations. Any adverse
determination in such litigation could also subject the Company to significant
liabilities.


ITEM 2. PROPERTIES

     The Company currently occupies approximately 39,000 square feet of space at
its headquarters in Ann Arbor, Michigan. Approximately 3,200 square feet will
expire on December 31, 2000 with the remaining 35,800 square feet expiring upon
completion of construction of the Company's new headquarters (see below). The
Company also leases sales offices in Michigan, Texas, California, Maryland,
Canada, France, Sweden, England, Germany, Italy, Czech Republic, Japan, China,
Singapore and India.

     The Company has signed an agreement with its current landlord to lease
office space in a new headquarters facility in Ann Arbor, Michigan. The new
facility is currently under construction with an expected completion date in the
fourth quarter of 2000. This facility will consist of approximately 70,500
square feet of space, and the initial lease term will be ten years expiring in
December 2010. The new lease agreement allows for the Company to continue to
occupy its current headquarters until construction is complete on the new
building. At that time, the current lease will terminate and the new lease will
become effective.


ITEM 3.  LEGAL PROCEEDINGS

     The Company is involved in various ordinary or routine litigation
incidental to its business, none of which, in the opinion of management, is
deemed to be material.


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of shareholders during the last quarter
of the year ended December 31, 1999.



                                       13
<PAGE>   14


                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     The Company's common stock trades on The Nasdaq Stock Market under the
symbol "MDII." The range of high and low sale prices for the Company's common
stock on that market for each of the quarters in the last two years are as
follows:

<TABLE>
<CAPTION>
                                                                                          MARKET PRICES
                                                                               -------------------------------------
                                                                                     HIGH                LOW
--------------------------------------------------------------------------------------------------------------------
<S>                                                                                 <C>                <C>
Year ended December 31, 1999:
  Fourth quarter..........................................................          $  5.38            $  4.25
  Third quarter...........................................................             6.00               4.38
  Second quarter..........................................................             7.38               4.75
  First quarter...........................................................             8.13               6.00
Year ended December 31, 1998:
  Fourth quarter..........................................................          $  8.25            $  3.75
  Third quarter...........................................................            11.00               6.31
  Second quarter..........................................................            14.00               9.63
  First quarter...........................................................            10.50               6.63
</TABLE>

     As of December 31, 1999, there were 188 shareholders of record of the
Company's common stock. This may not be an accurate indication of the total
shareholders of the Company as of December 31, 1999, since many nominees hold
the Company's shares in street name for the beneficial owners.

     The Company has never declared or paid cash dividends on its capital stock
and anticipates that, for the foreseeable future, it will continue to retain any
earnings for use in the operation of its business.


                                       14
<PAGE>   15


ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

     The consolidated statement of income data for the years ended December 31,
1999, 1998, 1997, 1996 and 1995 and the consolidated balance sheet data as of
December 31, 1999, 1998, 1997, 1996 and 1995 presented below are derived from
the Company's consolidated financial statements audited by Arthur Andersen LLP.

<TABLE>
<CAPTION>
                                                                      FOR THE YEARS ENDED DECEMBER 31,
                                                   -----------------------------------------------------------------------
In thousands, except per share data                    1999            1998           1997          1996          1995
--------------------------------------------------------------------------------------------------------------------------
<S>                                                 <C>            <C>              <C>           <C>           <C>
CONSOLIDATED STATEMENT OF INCOME DATA:
  Revenue........................................   $  40,255      $  36,575        $ 30,191      $ 25,383      $ 21,256
  Operating income (loss) .......................         340           (556)(1)         965(2)      2,503         1,666

  Net income (loss) .............................       1,095           (217)            744         2,071         1,381
  Accretion of value of warrants.................          --             --              --            --           234
  Net income (loss) available to common
     shareholders................................       1,095           (217)            744         2,071         1,147
  Pro forma diluted net income (loss) per common
     share.......................................        0.18          (0.04)           0.13          0.41          0.30
</TABLE>

<TABLE>
<CAPTION>
                                                   -----------------------------------------------------------------------
                                                                             AS OF DECEMBER 31,
                                                   -----------------------------------------------------------------------
In thousands                                            1999            1998           1997          1996         1995
--------------------------------------------------------------------------------------------------------------------------
<S>                                                 <C>            <C>              <C>           <C>           <C>
CONSOLIDATED BALANCE SHEET DATA (3):
  Cash and cash equivalents......................   $  17,741      $  16,843        $ 20,261      $ 20,570 (4)  $  1,141
  Total assets...................................      38,189         36,247          34,147        29,812         9,338
  Long-term debt, less current portion...........          --             --              --            --            --
  Redeemable common stock........................          --             --              --           167           859
  Shareholders' equity...........................      27,171         25,600          23,970        22,185 (4)     1,334
</TABLE>

NOTES:

(1)  For the year ended December 31, 1998, the Company recorded approximately
     $1.7 million in charges to operations for acquisition and related costs
     resulting primarily from the acquisitions of DTI Asia Pte. Ltd., certain
     assets of HGE, Inc. and technology from the University of Iowa.

(2)  For the year ended December 31, 1997, the Company recorded a $1.7 million
     charge to operations for acquisition and related costs resulting from the
     acquisition of StatDesign, Inc.

(3)  The Company has never declared or paid cash dividends on its capital stock
     and anticipates that, for the foreseeable future, it will continue to
     retain any earnings for use in the operation of its business.

(4)  For the year ended December 31, 1996, the Company completed an initial
     public offering of its stock, which resulted in the issuance of 1,500,000
     shares at $11.00 per share. An additional 354,750 shares were sold by the
     Company at $11.00 per share to cover over-allotments. The offering,
     including the over-allotments, raised $17.8 million in net proceeds.


                                       15
<PAGE>   16


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

     The following discussion provides an analysis of the Company's financial
condition and results of operations, and should be read in conjunction with the
Company's consolidated financial statements and the notes included in Item 8 of
this Form 10-K.

OVERVIEW

     The Company develops, markets, and supports virtual prototyping solutions.
The Company's virtual prototyping software allows an engineer or designer to
design a complete product by simulating, both visually and mathematically, a
product in motion. The Company's principal software product, ADAMS Full
Simulation Package, is used by customers to simulate mechanical systems. The
Company's revenue has in the past been, and is expected to be in the future,
derived primarily from its ADAMS Full Simulation Package and related software
products and services.

FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY

     Except for the historical information contained in this report, the matters
herein contain "forward-looking" statements (as defined in the Private
Securities Litigation Reform Act of 1995) that involve risk and uncertainty.
These forward-looking statements include, but are not limited to, revenue
levels, including the level of international revenue, certain costs and
operating expense levels, the level of other income, the Company's liquidity and
capital needs and various business environment and trend information. Actual
future results and trends may differ materially depending on a variety of
factors, including the volume and timing of orders received during the quarter;
the mix of and changes in distribution channels through which the Company's
products are sold; the timing and acceptance of new products and product
enhancements by the Company or its competitors; changes in pricing; the level of
the Company's sales of third-party products; purchasing patterns of distributors
and customers; competitive conditions in the industry; business cycles affecting
the markets in which the Company's products are sold; extraordinary events, such
as litigation; risks inherent in seeking and consummating acquisitions,
including the diversion of management attention to the assimilation of the
operations and personnel of the acquired business; fluctuations in foreign
exchange rates; the impact of undetected errors or defects, including those
associated with Year 2000 date functions, on the Company's current products,
vendors and internal systems; and economic conditions generally or in various
geographic areas. All of the foregoing factors are difficult to forecast. The
future operating results of the Company may fluctuate as a result of these and
other risk factors detailed from time to time in the Company's Securities and
Exchange Commission reports and included in Item 1 of this Form 10-K entitled
"Business."

     Due to all of the foregoing factors, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as an indication of future performance.
It is likely that, in some future quarters, the Company's operating results will
be below the expectations of stock market analysts and investors. In such an
event, the price of the Company's common stock would likely be materially
adversely affected.


                                       16
<PAGE>   17



RESULTS OF OPERATIONS

   REVENUE

<TABLE>
<CAPTION>

In thousands                                 1999        % CHANGE         1998         % CHANGE         1997
-----------------------------------------------------------------------------------------------------------------
<S>                                      <C>             <C>            <C>            <C>            <C>
Software licenses...................     $  19,159          (2.5%)      $  19,659         13.9%       $  17,258
  % of total revenue................          47.6%                          53.7%                         57.2%

Software maintenance services.......     $   7,941          33.5%       $   5,949         23.8%       $   4,806
  % of total revenue................          19.7%                          16.3%                         15.9%

Professional services and other.....     $  13,155          20.0%       $  10,967         34.9%       $   8,127
  % of total revenue................          32.7%                          30.0%                         26.9%

Total revenue.......................     $  40,255          10.1%       $  36,575         21.1%       $  30,191
</TABLE>

     The Company's total revenue increased 10.1% to $40.3 million in 1999 from
$36.6 million in 1998. During 1998, total revenue increased 21.1% from $30.2
million in 1997. The growth in revenue during 1999 and 1998 resulted primarily
from increased software maintenance services on the Company's software products,
increased professional services provided to the Company's customers, and
increased sales of third-party software products. During 1999, the Company
achieved revenue growth in North America and Europe, and experienced a slight
decline in revenue from Asia. During 1998, the Company achieved revenue growth
in each of these three geographic regions. A summary of the Company's revenue by
geographic location is presented in Note 8 of Notes to Consolidated Financial
Statements.

     Revenue from international customers accounted for approximately 61.7%,
62.4%, and 65.2% of the Company's total revenue in 1999, 1998, and 1997,
respectively. The decrease in international revenue as a percent of total
revenue during 1999 and 1998, as compared to 1997, was due primarily to weakness
experienced in certain countries in Asia, as well as an increase in revenue from
North America, due in part to the Company's August 1998 acquisition of the
Design Analysis Group of H.G.E. Inc. ("HGE"), an engineering software and
services firm based in Toronto, Ontario, Canada. The weakness experienced by the
Company in Asia during 1998 and the first half of 1999 resulted primarily from
continuing economic pressures facing Japan and other countries in the region. If
the economies in Asia continue to deteriorate in 2000, the Company's overall
Asian revenue could be adversely impacted, which could have a material adverse
effect on the Company's consolidated results of operations. Consequently, the
Company remains cautious in its overall outlook for Asian revenue in the first
half of 2000. The Company expects that international revenue will continue to
account for a significant portion of its total revenue in future periods.

     Outside of North America and Europe, the Company relies primarily on
distributors and sales representatives for the licensing and support of its
products. Distributors and sales representatives accounted for approximately
20.4%, 21.3%, and 27.8% of the Company's total revenue in 1999, 1998, and 1997,
respectively. The decrease in revenue from distributors and sales
representatives in 1999, as compared to 1998, resulted primarily from increased
revenue from professional services provided directly to the Company's customers
as well as increased revenue generated from sales of third-party software
products. The Company's Japanese distributor, Information Services
International-Dentsu, Ltd. ("ISI-Dentsu"), accounted for approximately 12.6%,
13.2%, and 15.3% of the Company's total revenue in 1999, 1998, and 1997,
respectively.

     The Company generally prices its software products and services in local
currencies in Europe, Canada, and Japan. In 1999, the net impact of exchange
rate fluctuations positively affected the Company's international revenue by
approximately $432,000. The strengthening of the dollar in 1998, relative to the
European and Japanese currencies, negatively affected 1998 international revenue
by approximately $883,000. Since most of the Company's international operating
expenses were incurred in foreign currencies, the net impact of exchange rate
fluctuations on income from operations in 1999 and 1998 was considerably less
than the impact on revenue. If the U.S. dollar strengthens in 2000 relative to
the European, Canadian, or Japanese currencies, the Company's

                                       17
<PAGE>   18

international revenue will be negatively impacted, which could have a material
adverse effect on the Company's consolidated results of operations.

     Revenue from automotive-related customers accounted for approximately
54.0%, 54.7%, and 50.5% of the Company's total revenue in 1999, 1998, and 1997,
respectively. No customer accounted for greater than 10% of the Company's total
revenue in 1999 and 1998. Sales to Ford Motor Company accounted for
approximately 10.6% of the Company's total revenue in 1997. No other customer
accounted for greater than 10% of the Company's total revenue in 1997.

     Software licenses revenue consists primarily of license fees for the
Company's software products and, to a lesser extent, license fees from
third-party software products licensed through the Company's European and
Canadian subsidiaries. Software licenses revenue decreased 2.5% from 1998 to
approximately $19.2 million in 1999. The decrease resulted from a lower volume
of the Company's software licenses sold in North America and Asia, partially
offset by a higher volume of software licenses sold in Europe. In 1998, software
licenses revenue grew 13.9% over 1997 to approximately $19.7 million. The
increase resulted from a higher volume of software licenses sold worldwide,
primarily from third party software products. Revenue from third-party products
accounted for $3.9 million in 1999, or 9.7% of total revenue, $2.6 million in
1998, or 7.1% of total revenue, and $678,000 in 1997, or 2.2% of total revenue.
The increase in revenue from third-party products is a result of the Company's
strategy to provide a growing suite of complementary software products to its
customers.

     Software maintenance services revenue consists of revenue generated from
maintenance and support agreements on the Company's software products. Software
maintenance services revenue increased 33.5% from 1998 to approximately $7.9
million in 1999. In 1998, software maintenance services revenue grew 23.8% over
1997 to approximately $5.9 million. The increases realized in 1999 and 1998
reflect the continuing growth of the Company's customer base, as well as the
strong maintenance renewal rate the Company has historically experienced with
respect to software maintenance agreements.

     Professional services and other revenue consists primarily of revenue from
consulting, training and funded research and development projects. Professional
services revenue grew 20.0% over 1998 to approximately $13.2 million in 1999,
and 34.9% over 1997 to approximately $11.0 million in 1998. The overall
increases in professional services revenue reflect the Company's continued
emphasis on providing total solutions to its customers.

   COST OF REVENUE

<TABLE>
<CAPTION>

In thousands                                 1999        % CHANGE         1998         % CHANGE         1997
-----------------------------------------------------------------------------------------------------------------
<S>                                        <C>           <C>            <C>            <C>           <C>
Cost of software licenses...........       $   3,473        40.1%       $  2,479         213.4%       $     791
  Gross profit margin on software
    licenses revenue................            81.9%                       87.4%                          95.4%

Cost of services....................       $  11,306        18.0%       $  9,581          35.6%       $   7,066
  Gross profit margin on services
    revenue.........................            46.4%                       43.4%                          45.4%
</TABLE>

     Cost of software licenses includes software royalty fees, media costs,
payroll and other costs attributable to software documentation and distribution,
and an allocation of depreciation, utilities and other overhead expenses
incurred by the Company. Cost of software licenses increased 40.1% from 1998 to
approximately $3.5 million in 1999. In 1998, cost of software licenses increased
213.4% from 1997 to approximately $2.5 million. During both years, the increases
were primarily due to additional royalties paid to third parties whose products
are licensed through the Company's European and Canadian subsidiaries, and, to a
lesser extent, additional royalties paid to third parties whose products are
embedded in the Company's ADAMS software.

     Gross profit margin on software licenses revenue was 81.9%, 87.4%, and
95.4% during 1999, 1998, and 1997, respectively. The decline in gross profit
margin during 1999 and 1998 was due to the increased sales of third party
software products as a percentage of total software licenses revenue.
Historically, licenses revenue from the Company's software products has
generated higher profit margins than revenue from third-party software products.

                                       18
<PAGE>   19

     Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development. Cost
of services revenue grew 18.0% over 1998 to approximately $11.3 million in 1999.
In 1998, cost of services revenue grew 35.6% over 1997 to approximately $9.6
million. These increases resulted from the hiring of additional employees to
support the growth in software maintenance services revenue and professional
services revenue during 1999 and 1998.

     Gross profit margin on services revenue was 46.4%, 43.4%, and 45.4% during
1999, 1998, and 1997, respectively. The increase in gross profit margin during
1999, as compared to 1998, was primarily due to the increase in software
maintenance services revenue as a percentage of total services revenue. The
decline in gross profit margin during 1998, as compared to 1997, was primarily
due to the increase in professional services revenue as a percentage of total
services revenue. Historically, software maintenance services revenue has
generated higher profit margins than revenue from professional services.

   OPERATING EXPENSES

<TABLE>
<CAPTION>
In thousands                                 1999        % CHANGE         1998         % CHANGE         1997
----------------------------------------------------------------------------------------------------------------
<S>                                        <C>           <C>            <C>            <C>           <C>
Sales and marketing.................       $  15,394         8.1%       $  14,245         22.3%       $  11,644
  % of total revenue................            38.2%                        38.9%                         38.6%

Research and development............       $   5,603         6.4%       $   5,265         11.3%       $   4,729
  % of total revenue................            13.9%                        14.4%                         15.7%

General and administrative..........       $   3,685         6.1%       $   3,472          8.4%       $   3,202
  % of total revenue................             9.2%                         9.5%                         10.6%

Goodwill amortization...............       $     454        33.1%       $     341        227.9%       $     104
  % of total revenue................             1.1%                         0.9%                          0.3%

Acquisition-related costs and non-
  recurring charges.................       $      --                    $   1,748          3.4%       $   1,690

  % of total revenue................             0.0%                         4.8%                          5.6%
</TABLE>

     Sales and marketing expenses include costs associated with the Company's
sales channels, such as personnel, commissions, sales office costs, travel,
promotional events, sales order processing, including license administration and
order fulfillment, and advertising and public relations programs. Sales and
marketing expenses also include an allocation of overhead expenses incurred by
the Company. The absolute dollar increase in sales and marketing expenses in
1999 and 1998 resulted from the Company's continued expansion of its worldwide
sales and marketing organization, as well as the increase in commissions paid on
the higher level of revenue. During 1999, the number of employees in sales and
marketing increased from 93 to 94. The Company expects to continue to invest
significant resources in sales and marketing, and will expand its sales and
marketing organization as necessary to meet a growing demand for its products
and services.

     Research and development expenses include all payroll costs attributable to
research and development activities, as well as an allocation of overhead
expenses incurred by the Company. The absolute dollar increase in research and
development expenses in 1999 and 1998 resulted from an increase in costs in
support of expanded product development efforts. Funded research and development
expenses, which are not included in research and development expenses but are
included in cost of services revenue, represented 0.9%, 0.7%, and 2.7%, of total
revenue in 1999, 1998, and 1997, respectively. The majority of the revenue
received and expenses incurred for funded research and development was directly
related to projects associated with the ongoing development of the Company's
content-rich software products, including ADAMS/Car, ADAMS/Engine and
ADAMS/Rail. The Company intends to continue to invest significant resources in
research and development in the future.

     General and administrative expenses include the cost of salaries, employee
benefits and other payroll costs associated with the Company's finance,
accounting, human resources, information systems and executive

                                       19
<PAGE>   20

management functions. General and administrative expenses also include an
allocation of overhead expenses incurred by the Company. General and
administrative expenses grew 6.1% over 1998 to approximately $3.7 million in
1999, in support of the Company's growing operations worldwide. General and
administrative expenses grew 8.4% over 1997 to approximately $3.5 million in
1998. The Company expects general and administrative expenses to increase in
absolute dollars in the future. However, these expenses may vary as a percentage
of total revenue from period to period.

     Goodwill amortization includes the amortization of purchase price in excess
of net assets on the Company's acquisitions. Goodwill amortization increased
33.1% in 1999, as compared to 1998, due to increased goodwill associated with
the Company's acquisition of HGE in August 1998. Goodwill amortization increased
227.9% in 1998, as compared to 1997, due to increased goodwill associated with
the acquisitions of DTI Asia Pte. Ltd. ("DTI") in January 1998 and StatDesign,
Inc. ("StatDesign") in October 1997. The Company amortizes goodwill over the
periods estimated to be benefited from the acquisitions, after considering such
factors as demand, competition, service lives of employees, and expected actions
of competitors.

     Acquisition-related costs and non-recurring charges were approximately $1.7
million in each of the years ending December 31, 1998 and 1997, and consist
primarily of the write-off of purchased in-process research and development
("R&D") associated with the Company's acquisitions in these years. In each
acquisition, the value assigned to purchased in-process R&D was determined by an
independent appraisal of the acquired company's assets, both tangible and
intangible. The portion of the aggregate purchase price assigned to in-process
R&D was determined by identifying research projects for which technological
feasibility had not yet been established. The appraisals considered such factors
as the estimated percent complete of each project in process at the date of
acquisition, the estimated remaining costs to develop the in-process R&D into
commercially viable products and the estimated discounted net future cash flows
from such products. If the Company were unable to complete the R&D projects in a
timely manner or lost key personnel from the acquired companies, revenue and
operating income in future periods could be adversely impacted. These
acquisitions are discussed below and the related accounting treatment is
summarized in Note 2 of Notes to Consolidated Financial Statements.

     In November 1998, the Company acquired certain technology from the
University of Iowa and recorded a non-recurring charge to operations of $400,000
for the write-off of purchased in-process R&D. The purchase price was allocated
to in-process R&D as the software had not reached technological feasibility and
no other tangible or intangible assets were identified. The technology acquired
consisted of component-level durability sensitivity analysis technology.
Significant projects in process at the date of acquisition included further
development of this technology and integration with the Company's ADAMS software
to provide system-level durability design sensitivity prediction capabilities.
Since the acquisition, the Company, along with scientists from the University of
Iowa, has developed and initiated a plan to jointly enhance and integrate the
University's technology with that of the Company's. Costs associated with the
completion of this project have, thus far, been consistent with the Company's
expectations as of the acquisition date.

     In August 1998, the Company acquired certain assets of HGE and recorded a
non-recurring charge to operations of $203,000 for the write-off of purchased
in-process R&D. The technology consisted of a metal stamping analysis program
that simulates strain in thin metal sheets. Significant projects in process at
the date of acquisition included the incorporation of springback functionality
into the acquired company's technology. Springback is a term used to describe
how a material's elasticity relaxes after it has been bent. The value of the
in-process R&D was appraised using the income approach, and involved the
following assumptions: the net cash inflows from the in-process R&D commencing
in the second half of the year 2000, operating expenses consistent with
historical levels, and a risk-adjusted discount rate of 32.5%. Incorporation of
the springback technology is in the development stages. Costs associated with
the completion of the project have been and are expected to be consistent with
the assumptions used in the valuation.

     In January 1998, the Company acquired DTI and recorded a non-recurring
charge to operations of $980,000 for the write-off of purchased in-process R&D.
DTI was a start-up company, established in 1994, and consisted of four employees
located on three continents whose time was primarily dedicated to developing
motion simulation technology for the mid-range CAD market. Significant projects
in process at the date of acquisition included: (1) integrating the Company's
ADAMS solution engine with the acquired company's existing technology; (2)
developing


                                       20
<PAGE>   21

advanced "wizards" to increase ease of use; and (3) adding finite element
analysis capabilities. The value of the in-process R&D was appraised using the
milestone approach, and involved the following assumptions: the net cash inflows
from the in-process R&D commencing in the fourth quarter of 1998, operating
expenses consistent with historical levels, and a risk-adjusted discount rate of
35.0%. Since the acquisition, the Company has completed integration of the ADAMS
solution engine and released a new version of the acquired company's product
line featuring increased ease of use. The Company is continuing development
activities associated with adding finite element analysis capabilities to the
product line. Costs associated with these projects have been consistent with the
assumptions used in the valuation.

     In October 1997, the Company acquired StatDesign and recorded a
non-recurring charge to operations of $1.7 million for the write-off of
purchased in-process R&D. Established in 1992, StatDesign provided design of
experiments ("DOE") technology, custom graphical user interfaces, and consulting
services for product design and development. DOE methods allow users to run a
battery of simulations on a mechanical system design to determine the effects of
multiple design or manufacturing variations on system performance and behavior.
Significant projects in process at the date of acquisition included improvements
to simulation, enhancement of modeling technology, added suspension capability,
added powertrain capability, enhanced graphics and user interface, and the
modularization of post-processing functions. Completion of these projects has
involved significantly enhancing, or, in some cases, reconstructing the internal
architecture of the existing technology to achieve the desired performance
guidelines and generalizing the technology to appeal to a broader customer base.
The value of the in-process R&D was appraised using the income approach, and
involved the following assumptions: the net cash inflows from the in-process R&D
commencing in the second half of 1998, operating expenses consistent with
historical levels, and a risk-adjusted discount rate of 32.5%. Since the
acquisition, the Company has successfully broadened the former user base of
StatDesign's technology through significant progress on the projects listed
above. Costs associated with the completion of these projects were consistent
with the assumptions used in the valuation.

   OTHER INCOME, NET

<TABLE>
<CAPTION>
In thousands                                 1999        % CHANGE         1998         % CHANGE         1997
----------------------------------------------------------------------------------------------------------------
<S>                                           <C>        <C>              <C>           <C>             <C>
Other income, net.....................        $ 514        (37.9%)        $ 828           4.7%          $ 791
  % of total revenue..................          1.3%                        2.3%                          2.6%
</TABLE>

     Other income, net consists of net interest income (expense), foreign
currency transaction gain (loss), and gain (loss) on the disposal of property
and equipment. Net interest income was $679,000, $828,000, and $953,000 in 1999,
1998, and 1997, respectively. The decline in interest income in 1999, compared
to 1998, resulted from a higher percentage of the Company's cash and cash
equivalents being invested in tax-exempt securities which return a lower yield
on a pre-tax basis. The decline in interest income in 1998, compared to 1997,
was due to lower cash and cash equivalents balances primarily as a result of
cash paid for the Company's 1998 and 1997 acquisitions. Foreign currency
transaction gain (loss) amounted to ($74,000), $64,000, and ($129,000) in 1999,
1998 and 1997, respectively. The loss on the disposal of property and equipment
was $91,000, $64,000 and $33,000 in 1999, 1998, and 1997, respectively.

   PROVISION FOR INCOME TAXES

     The Company's effective income tax rates were (29.2%), 176.1%, and 57.9%
for 1999, 1998, and 1997, respectively. The differences between the consolidated
tax provision and the income tax provision calculated at the United States
federal statutory rate are summarized in Note 4 of Notes to Consolidated
Financial Statements. In 1999, the difference between the effective and
statutory federal rate resulted primarily from U.S. research and development tax
credits recognized by the Company, and to a lesser extent, benefits realized
from the Company's foreign sales corporation and tax-exempt interest income
earned during the year. Excluding the tax credits, the company's effective tax
rate for 1999 would have been 29.9%. In 1998 and 1997, the difference between
the effective and statutory federal rate was primarily due to the
non-deductibility of the expense associated with purchased in-process research
and development incurred with certain of the Company's acquisitions. These
unfavorable difference were partially offset by benefits realized from the
Company's foreign sales corporation and tax-exempt interest income. Excluding
acquisition-related charges, the Company's effective tax rates for 1998 and 1997
would have been 29.6% and 29.5%, respectively.

                                       21
<PAGE>   22


   MINORITY INTEREST IN NET INCOME (LOSS) OF SUBSIDIARIES

     In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K. ("MDI-Japan"), through a joint venture agreement with
ISI-Dentsu of Tokyo, Japan, the distributor of the Company's software in Japan.
Minority interest in net income (loss) of subsidiaries of $8,000 in 1999,
$10,000 in 1998, and ($5,000) in 1997 represents ISI-Dentsu's 34% interest in
the net income (loss) of MDI-Japan.

   EMPLOYEES

     The number of the Company's worldwide employees increased by one employee
to 284 at December 31, 1999 compared with 283 at December 31, 1998.

   YEAR 2000 COMPLIANCE

     The Year 2000 issue is the result of computer programs using a two-digit
format, as opposed to four digits, to indicate the year. Such computer systems
will be unable to interpret dates beyond the year 1999, which could cause a
system failure or other computer errors. The Company assessed and identified
risks in four areas of its business: (1) the Company's products, including
third-party software embedded in the Company's products, (2) business management
and accounting systems, (3) computing and communications infrastructure, and (4)
the Company's suppliers.

     The Company has not experienced any significant effects resulting from Year
2000 issues to date. The primary external costs related to the Year 2000 issue
included replacement of the Company's primary business management and accounting
systems in January 1999. The cost of the new systems, including certain hardware
upgrades, was approximately $150,000. These systems are based on third-party
products that were certified for Year 2000 compliance.

     While the Company believes that its efforts to address Year 2000 issues for
which it is responsible were successful, it is possible that there could still
be undetected errors or defects associated with Year 2000 date functions in the
Company's products and internal systems or those of its key suppliers. If a
problem does still arise, it is possible that the Company could be involved in
litigation. Further, although the Company does not believe that it has any
obligation to continue to support prior versions of its products after the
termination of maintenance contracts covering those products, nor any obligation
to make prior versions of its products, including custom applications written by
the Company, Year-2000 compliant, it is possible that its customers may take a
contrary position and initiate litigation. In the event of such litigation or
the occurrence of one or more problems associated with Year 2000 compliance, the
Company's business, financial condition, or results of operations could be
materially adversely affected.

   EURO CONVERSION

     In January 1999, 11 of the 15 member countries of the European Union
established fixed conversion rates between their existing sovereign currencies
and the Euro, making the Euro their common legal currency on that date. There is
a transition period from January 1, 1999 to January 1, 2002, during which the
old currencies will remain legal tender in the participating countries as
denominations of the Euro.

     The Company's subsidiaries in France and Italy are currently reporting in
Euros. The Company's German subsidiary does not expect any interruptions or
adverse effects as a result of its future conversion to Euros. The Company is
also evaluating any other business implications of conversion to the Euro,
including technical adaptation of information technology and other systems to
accommodate Euro-denominated transactions, long-term competitive implications of
the conversion, and the effect on market risk with respect to financial
instruments. At this time, the Company does not expect that the Euro's
introduction will have a material adverse effect on its consolidated results of
operations during or after the transition period.


                                       22
<PAGE>   23

LIQUIDITY AND CAPITAL RESOURCES

     Cash and cash equivalents were $17.7 million at December 31, 1999, compared
to $16.8 million at December 31, 1998. The increase in cash and cash equivalents
during 1999 of $898,000 was primarily due to the $1.8 million in cash generated
from operations and the $254,000 in proceeds from stock issued by the Company,
partially offset by the $1.1 million used for capital expenditures.

     At December 31, 1999, the Company's principal commitments consisted of
obligations under operating leases for facilities and equipment, including
approximately $1.5 million in payments due under noncancellable operating leases
during 2000. The Company had no borrowings under long-term debt arrangements at
December 31, 1999.

     The Company has an agreement with its principal bank for an unsecured $4.0
million line of credit. No borrowings were outstanding under this agreement as
of December 31, 1999. The Company's subsidiaries in Germany, Italy, Sweden, and
France also have line of credit and overdraft facilities that provide for
aggregate borrowing availability of approximately $510,000. Approximately
$14,000 in borrowings were outstanding under these facilities as of December 31,
1999.

     Long-term cash requirements, other than for normal operating expenses, are
anticipated for the development of new software products and enhancements of
existing products, financing growth, repurchases of the Company's common stock,
and the possible acquisition of software products, technologies, and businesses
complementary to the Company's business. The Company believes that cash flows
from operations, together with existing cash balances, and available borrowings
will be adequate to meet the Company's cash requirements for working capital,
capital expenditures and stock repurchases for the next twelve months and the
foreseeable future. The Company has not paid dividends during the period 1997
through 1999 and intends to continue its policy of retaining earnings to finance
future growth.

NEW ACCOUNTING PRONOUNCEMENTS

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts and hedging activities. It requires that
an entity record all derivatives as either assets or liabilities at fair value.
Under certain conditions, a derivative may be designated as a hedge of (1)
potential changes in the fair value of an asset or liability or firm commitment,
(2) the foreign currency exposure of a forecasted transaction, or (3) the
foreign currency exposure of the net investment in a foreign operation. The
accounting for changes in the fair value of a derivative instrument depends on
the intended use of the derivative and the resulting designation. The statement
is effective for all fiscal quarters of fiscal years beginning after June 15,
2000. The Company's derivative activities are currently limited to entering into
forward contracts to hedge potential changes in the fair value of its
receivables denominated in certain foreign currencies.


                                       23
<PAGE>   24


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company is exposed to market risk from changes in foreign exchange and
interest rates. To reduce the risk from changes in foreign exchange rates, the
Company selectively uses financial instruments. The Company does not hold or
issue financial instruments for trading purposes.

   FOREIGN CURRENCY

     The Company, at various times, enters into forward exchange contracts to
hedge certain exposures related to identifiable foreign currency transactions
that are relatively certain as to both timing and amount. The Company does not
use any other types of derivative financial instruments to hedge such exposures,
nor does it use derivatives for speculative purposes. In general, the Company
uses forward exchange contracts to hedge against large, selective transactions
that present the most exposure to exchange rate fluctuations. At December 31,
1999, the Company had forward foreign currency exchange contracts of $108,000
(notional amounts). The contracts outstanding at December 31, 1999 mature
through March 6, 2000 and are intended to hedge various foreign currency
commitments due from foreign subsidiaries and the Company's distributors. Due to
the short-term nature of these financial instruments, the fair value of these
contracts is not materially different than their notional amount at December 31,
1999.

     Gains and losses on the forward contracts are largely offset by gains and
losses on the underlying exposures. The Company conducts business in seven
foreign currencies, predominantly Japanese yen, German marks and British pounds.
A hypothetical 10% appreciation of the U.S. dollar from December 31, 1999 market
rates would increase the unrealized value of the Company's existing forward
contracts at December 31, 1999 by $10,000. Conversely, a hypothetical 10%
depreciation of the U.S. dollar from December 31, 1999 market rates would
decrease the unrealized value of the Company's forward contracts by $12,000. In
either scenario, the gains and losses on the forward contracts are largely
offset by the gains or losses on the underlying transactions.

   INTEREST RATES

     The Company maintains its cash and cash equivalents in highly liquid
investments with maturities of 90 days or less. The Company has the ability to
hold its fixed income investments to maturity, and therefore would not expect
its operating results or cash flows to be affected to any significant degree by
the effect of a hypothetical 10% change in market interest rates on its cash and
cash equivalents.



                                       24
<PAGE>   25


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors and Shareholders of Mechanical Dynamics, Inc.:

     We have audited the accompanying consolidated balance sheets of MECHANICAL
DYNAMICS, INC. (a Michigan corporation) and subsidiaries as of December 31, 1999
and 1998, and the related consolidated statements of income, shareholders'
equity and cash flows for each of the three years in the period ended December
31, 1999. 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 auditing standards generally
accepted in the 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 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 Mechanical Dynamics, Inc.
and its subsidiaries as of December 31, 1999 and 1998, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1999 in conformity with accounting principles generally accepted in
the United States.



                                                    ARTHUR ANDERSEN LLP

Detroit, Michigan,
January 28, 2000


                                       25
<PAGE>   26



                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS
                        AS OF DECEMBER 31, 1999 AND 1998
<TABLE>
<CAPTION>
In thousands, except share data                                                                 1999          1998
---------------------------------------------------------------------------------------------------------------------
<S>                                                                                         <C>            <C>
                                          ASSETS
Current assets:
   Cash and cash equivalents............................................................    $   17,741     $   16,843
   Accounts receivable, net of allowance for doubtful accounts of $342 and $261.........        10,454          9,893
   Prepaid and deferred expenses........................................................         2,755          1,873
                                                                                            ----------     ----------
       Total current assets.............................................................        30,950         28,609
                                                                                            ----------     ----------
Property and equipment, net of accumulated depreciation of $4,387 and $3,551............         3,118          3,674
Goodwill, net of accumulated amortization of $1,154 and $695............................         3,436          3,820
Other assets............................................................................           685            144
                                                                                            ----------     ----------
                                                                                            $   38,189     $   36,247
                                                                                            ==========     ==========
                           LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
   Borrowings under lines of credit.....................................................    $       14     $      105
   Accounts payable.....................................................................         1,447          1,781
   Accrued compensation.................................................................         1,246          1,579
   Other accrued expenses...............................................................         2,000          1,965
   Deferred revenue.....................................................................         5,832          4,745
                                                                                            ----------     ----------
       Total current liabilities........................................................        10,539         10,175
                                                                                            ----------     ----------
Minority interest.......................................................................           479            472
                                                                                            ----------     ----------
Shareholders' equity:
   Common stock, no par value, 15,000,000 shares authorized, 6,275,363 and 6,225,206
     shares issued and outstanding in 1999 and 1998, respectively.......................        22,586         22,332
   Preferred stock, no par value, 1,000,000 shares authorized, no shares issued and
     outstanding........................................................................            --             --
   Retained earnings....................................................................         4,168          3,073
   Accumulated other comprehensive income...............................................           417            195
                                                                                            ----------     ----------
       Total shareholders' equity.......................................................        27,171         25,600
                                                                                            ----------     ----------
                                                                                            $   38,189     $   36,247
                                                                                            ==========     ==========
</TABLE>

 The accompanying notes are an integral part of these consolidated statements.

                                       26
<PAGE>   27



                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

                        CONSOLIDATED STATEMENTS OF INCOME
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

<TABLE>
<CAPTION>
In thousands, except share and per share data                               1999           1998            1997
-----------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>            <C>            <C>
Revenue:
   Software licenses...............................................     $    19,159    $    19,659    $    17,258
   Software maintenance services...................................           7,941          5,949          4,806
   Professional services and other.................................          13,155         10,967          8,127
                                                                        -----------    -----------    -----------
       Total revenue...............................................          40,255         36,575         30,191
                                                                        -----------    -----------    -----------
Cost of revenue:
   Software licenses...............................................           3,473          2,479            791
   Services........................................................          11,306          9,581          7,066
                                                                        -----------    -----------    -----------
       Total cost of revenue.......................................          14,779         12,060          7,857
                                                                        -----------    -----------    -----------
Gross profit.......................................................          25,476         24,515         22,334
                                                                        -----------    -----------    -----------
Operating expenses:
   Sales and marketing.............................................          15,394         14,245         11,644
   Research and development........................................           5,603          5,265          4,729
   General and administrative......................................           3,685          3,472          3,202
   Goodwill amortization...........................................             454            341            104
   Acquisition-related costs and non-recurring charges.............              --          1,748          1,690
                                                                        -----------    -----------    -----------
       Total operating expenses....................................          25,136         25,071         21,369
                                                                        -----------    -----------    -----------
Operating income (loss)............................................             340           (556)           965
Other income, net..................................................             514            828            791
                                                                        -----------    -----------    -----------
Income before income taxes and minority interest...................             854            272          1,756
Provision (credit) for income taxes................................            (249)           479          1,017
                                                                        ------------   -----------    -----------
Income (loss) before minority interest.............................           1,103           (207)           739
Minority interest in net income (loss) of subsidiaries.............               8             10             (5)
                                                                        -----------    -----------    -----------
Net income (loss)..................................................     $     1,095    $      (217)   $       744
                                                                        ===========    ===========    ===========

Basic net income (loss) per common share...........................     $      0.18    $     (0.04)   $      0.13
                                                                        ===========     ==========     ==========
Weighted average common shares.....................................       6,254,308      6,186,469      5,805,936
                                                                        ===========    ===========    ===========

Diluted net income (loss) per common share.........................     $      0.18    $     (0.04)    $     0.13
                                                                        ===========    ===========     ==========
Weighted average common and common equivalent shares...............       6,254,376      6,186,469      5,867,753
                                                                        ===========    ===========    ===========
</TABLE>

 The accompanying notes are an integral part of these consolidated statements.

                                       27
<PAGE>   28



                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

<TABLE>
<CAPTION>
In thousands, except share data                                             1999           1998            1997
------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>            <C>            <C>
                         SHAREHOLDERS' EQUITY
Common Stock
   Balance beginning of year.......................................     $    22,332    $    20,838    $    19,583
     Stock issued under the Employee Stock Purchase Plan...........             254            276            202
     Stock issued upon the exercise of employee stock options......              --             95             18
     Termination of redemption privileges for 20,843 shares of
       redeemable common stock.....................................              --             --            167
     Stock issued in purchase of StatDesign, Inc...................              --             31            868
     Stock issued in purchase of DTI Asia Pte. Ltd.................              --          1,092             --
                                                                        -----------    -----------    -----------
   Balance end of year.............................................          22,586         22,332         20,838
                                                                        -----------    -----------    -----------

Retained Earnings
   Balance beginning of year.......................................           3,073          3,290          2,546
     Net income (loss).............................................           1,095           (217)           744
                                                                        -----------    ------------   -----------
   Balance end of year.............................................           4,168          3,073          3,290
                                                                        -----------    -----------    -----------

Accumulated Other Comprehensive Income (Loss)
   Balance beginning of year.......................................             195           (158)            56
     Foreign currency translation adjustments......................             222            353           (214)
                                                                        -----------    -----------    ------------
   Balance end of year.............................................             417            195           (158)
                                                                        -----------    -----------    ------------

Total shareholders' equity.........................................     $    27,171    $    25,600    $    23,970
                                                                        ===========    ===========    ===========

                         COMPREHENSIVE INCOME
Net income (loss)..................................................     $     1,095    $      (217)   $       744
Foreign currency translation adjustment............................             222            353           (214)
                                                                        -----------    -----------    ------------
Comprehensive income...............................................     $     1,317    $       136    $       530
                                                                        ===========    ===========    ===========
</TABLE>



  The accompanying notes are an integral part of these consolidated statements.

                                       28
<PAGE>   29



                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

<TABLE>
<CAPTION>
In thousands                                                                 1999            1998             1997
---------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>             <C>              <C>
Cash flows from operating activities:
   Net income (loss)...............................................     $     1,095     $      (217)     $       744
   Adjustments to reconcile net income (loss) to net cash provided by
     operating activities:
     Acquisition-related costs and non-recurring charges...........              --           1,748            1,690
     Depreciation and amortization.................................           2,003           1,726              968
     Loss on disposal of assets....................................              91              64               33
     Minority interest in net income (loss) of subsidiaries........               8              10               (5)
     Changes in assets and liabilities, net of effect of acquisitions:
       Accounts receivable.........................................            (945)         (2,245)          (2,304)
       Prepaid and deferred expenses...............................            (934)           (273)             (22)
       Other assets................................................            (567)            117              (45)
       Accounts payable............................................              29             452              499
       Accrued expenses............................................            (153)           (134)             580
       Deferred revenue............................................           1,179            (327)             551
                                                                        -----------     -----------      -----------
         Net cash provided by operating activities.................           1,806             921            2,689
                                                                        -----------     -----------      -----------

Cash flows from investing activities:
   Purchases of property and equipment.............................          (1,093)         (2,250)          (2,177)
   Purchase of technology from the University of Iowa..............              --            (400)              --
   Acquisition of DTI Asia Pte. Ltd., net of cash acquired.........              --            (563)              --
   Acquisition of certain assets of HGE, Inc., net of cash acquired              --          (2,040)              --
   Acquisition of StatDesign Inc., net of cash acquired............              --              --           (1,374)
                                                                        -----------     -----------      -----------
         Net cash used in investing activities.....................          (1,093)         (5,253)          (3,551)
                                                                        -----------     -----------      -----------

Cash flows from financing activities:
   Proceeds from issuance of common stock..........................             254             402              220
   Net borrowings (payments) under line of credit agreements.......             (91)             60               --
   Minority investment in consolidated subsidiary and other........              --              --              467
                                                                        -----------     -----------      -----------
         Net cash provided by financing activities.................             163             462              687
                                                                        -----------     -----------      -----------
Effect of exchange rate changes on cash............................              22             452             (134)
                                                                        -----------     -----------      -----------
Net increase (decrease) in cash....................................             898          (3,418)            (309)
Cash at beginning of year..........................................          16,843          20,261           20,570
                                                                        -----------     -----------      -----------
Cash at end of year................................................     $    17,741     $    16,843      $    20,261
                                                                        ===========     ===========      ===========

Supplemental schedule of non-cash investing and financing activities:
   Details of acquisitions:
<CAPTION>
                                                                                              DTI          STATDESIGN
                                                                                        ------------------------------
<S>                                                                                     <C>              <C>
     Net assets (liabilities), excluding cash acquired.............                     $       (59)     $        22
     Purchase price in excess of net assets acquired...............                             734              530
     Purchased in-process research and development.................                             980            1,690
     Common stock issued...........................................                          (1,092)            (868)
                                                                                        -----------      -----------
         Net cash used.............................................                     $       563      $     1,374
                                                                                        ===========      ===========
<CAPTION>

                                                                                           HGE, INC.
                                                                                        ----------------
<S>                                                                                     <C>
     Net liabilities, excluding cash acquired......................                     $      (118)
     Purchase price in excess of net assets acquired...............                           1,955
     Purchased in-process research and development.................                             203
                                                                                        -----------
         Net cash used.............................................                     $     2,040
                                                                                        ===========
</TABLE>

 The accompanying notes are an integral part of these consolidated statements.

                                       29
<PAGE>   30

                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(1)  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

   Description of Business

     Mechanical Dynamics, Inc. (the "Company") and its subsidiaries develop,
market and support virtual prototyping software and provide consulting,
training, and maintenance services to the automotive, aerospace, defense, rail,
general machinery and other industries on a worldwide basis.

   Principles of Consolidation

     The consolidated financial statements include the accounts of the Company
and its majority-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.

     In August 1998, the Company established a Canadian subsidiary, Mechanical
Dynamics Ltd. ("MDI-Canada"). Immediately following its formation, MDI-Canada
acquired the Design Analysis Group and certain other assets of H.G.E. Inc. (see
Note 2).

     In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K. ("MDI-Japan"), through a joint venture agreement with
Information Services International-Dentsu, Ltd. ("ISI-Dentsu") of Tokyo, Japan,
the distributor of the Company's software in Japan. The Company owns 66% of
MDI-Japan, while ISI-Dentsu owns a 34% minority interest.

   Foreign Currency

     The financial statements of international subsidiaries are translated using
exchange rates in effect at period end for assets and liabilities and at average
rates during the period for results of operations. The resulting foreign
currency translation adjustments are reflected as a separate component of
shareholders' equity. Foreign currency transaction gain (loss) amounted to
($74,000), $64,000, and ($129,000) in 1999, 1998, and 1997, respectively, and is
included in other income, net in the accompanying consolidated statements of
income.

   Revenue

     Software licenses revenue consists primarily of license fees for the
Company's software products and, to a lesser extent, license fees from
third-party software products licensed through the Company's European and
Canadian subsidiaries. Revenue under paid-up software licensing agreements,
including licenses generated through distributors, is recognized when a customer
contract is fully executed and the software is delivered. Revenue under annual
software licensing arrangements is deferred and amortized over the terms of the
agreements. In either instance, revenue is recognized only when no significant
remaining obligations to the customer exist.

     Software maintenance services revenue consists of revenue generated from
maintenance and support agreements on the Company's software products. Revenue
related to advance payments received under software maintenance agreements is
deferred and amortized over the terms of the agreements.

     Professional services and other revenue consists primarily of revenue from
consulting, training and funded research and development projects. Revenue from
professional services is recognized upon performance of the service.

                                       30
<PAGE>   31


   Cost of Revenue

     Cost of software licenses includes software royalty fees, media costs,
payroll and other costs attributable to software documentation and distribution
and an allocation of depreciation, utilities and other overhead expenses
incurred by the Company.

     Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development.

   Research and Development Expenses

     Research and development expenses include all payroll costs attributable to
research and development activities. Research and development expenses also
include an allocation of overhead expenses incurred by the Company.

     Under the criteria set forth in Statement of Financial Accounting Standards
No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed," capitalization of software development costs begins upon
the establishment of technological feasibility of the product. The establishment
of technological feasibility and the ongoing assessment of the recoverability of
these costs require considerable judgment by management with respect to certain
external factors, including, but not limited to, anticipated future gross
product revenue, estimated economic product lives and changes in software and
hardware technology. Amounts that would have been capitalized under this
statement after consideration of the above factors were immaterial, and
therefore no software development costs have been capitalized by the Company.

   Cash and Cash Equivalents

     The Company considers all highly liquid investments with initial maturities
of 90 days or less to be cash equivalents.

   Property and Equipment

     Property and equipment is stated at cost. Office furniture and equipment is
depreciated using accelerated or straight-line methods over estimated useful
lives of three to seven years. Leasehold improvements are amortized using the
straight-line method over the lesser of the respective asset's life or the life
of the related lease, generally ten years. Property and equipment consists
primarily of office furniture and equipment.

   Goodwill

     Goodwill represents the unamortized cost in excess of fair value of net
assets acquired and is amortized on a straight-line basis over five to fifteen
years. On an ongoing basis, management reviews the valuation and amortization of
goodwill. As part of this review, the Company considers the value of projected
future undiscounted cash flows attributable to the acquired operations in
evaluating potential impairment.

   Fair Value of Financial Instruments and Concentration of Credit Risk

     The Company, at various times, enters into forward exchange contracts to
hedge certain exposures related to identifiable foreign currency transactions
that are relatively certain as to both timing and amount. Gains and losses on
the forward contracts are recognized concurrently with the gains and losses from
the underlying transactions. The forward exchange contracts used are classified
as "held for purposes other than trading." The Company does not use any other
types of derivative financial instruments to hedge such exposures, nor does it
use derivatives for speculative purposes. At December 31, 1999 and 1998, the
Company had forward foreign currency exchange contracts of $108,000 and $1.2
million (notional amounts). The contracts outstanding at December 31, 1999
mature through March 6, 2000 and are intended to hedge various foreign currency
commitments due from the Company's foreign subsidiaries and international
distributors. The fair value of the outstanding contracts is not materially
different from their notional amount at December 31, 1999.

                                       31
<PAGE>   32

     Other financial instruments which potentially expose the Company to
concentrations of credit risk, as defined by Statement of Financial Accounting
Standards No. 105, consist primarily of accounts receivable. The Company's
accounts receivable are concentrated in global automotive-related companies,
other manufacturers and the Company's international distributor network. The
Company generally does not require collateral upon delivery of its products.

   Net Income (Loss) Per Common Share

     The following table reconciles the weighted average number of shares in the
basic net income (loss) per common share calculation to the number of shares in
the diluted net income (loss) per common share calculation:

<TABLE>
<CAPTION>
                                                                                YEAR ENDED DECEMBER 31,
                                                                       -----------------------------------------
                                                                           1999           1998         1997
----------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>           <C>           <C>
 Weighted average common shares used in basic net income (loss) per
    common share...................................................        6,254,308     6,186,469    5,805,936
    Effect of stock options........................................               68            --       61,817
                                                                       -------------  ------------  -----------
 Weighted average common and common equivalent shares used in
    diluted net income (loss) per common share.....................        6,254,376     6,186,469    5,867,753
                                                                       =============  ============  ===========
</TABLE>

     For the year ended December 31, 1998, the dilutive effect of stock options
outstanding for the purchase of 95,020 shares was not included in the net income
(loss) per common share calculation because doing so would have been
anti-dilutive.

   Comprehensive Income

     Comprehensive income is the total of net income and all other non-owner
changes in equity. The difference between net income (loss), as reported in the
accompanying consolidated statements of income, and comprehensive income is the
foreign currency translation adjustment for the respective periods. The
accumulated other comprehensive income (loss) consists solely of the cumulative
translation adjustment as presented in the accompanying consolidated balance
sheets.

   Stock-Based Compensation

     The Company has elected to account for stock-based compensation using the
intrinsic value method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the quoted market price of the Company's stock at the date of grant over
the amount the employee must pay to acquire the stock in the accompanying
consolidated statements of income. As supplemental information, the Company has
provided pro forma disclosure of the fair value at the date of grant of stock
options granted during 1999 and 1998 in Note 5, in accordance with the
requirements of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" ("SFAS 123").

   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 as of the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Actual results could differ from those
estimates.

   New Accounting Pronouncements

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts and hedging activities. It requires that
an entity record all derivatives as either assets or liabilities at

                                       32
<PAGE>   33

fair value. Under certain conditions, a derivative may be designated as a hedge
of (1) potential changes in the fair value of an asset or liability or firm
commitment, (2) the foreign currency exposure of a forecasted transaction, or
(3) the foreign currency exposure of the net investment in a foreign operation.
The accounting for changes in the fair value of a derivative instrument depends
on the intended use of the derivative and the resulting designation. The
statement is effective for all fiscal quarters of fiscal years beginning after
June 15, 2000. The Company's derivative activities are currently limited to
entering into forward contracts to hedge potential changes in the fair value of
its receivables denominated in certain foreign currencies. Adoption of this
statement is not expected to have a material impact on the Company's results of
operations or financial position.

   Reclassifications

     Certain amounts in the 1998 and 1997 consolidated financial statements have
been reclassified to conform with the 1999 presentation.

(2) ACQUISITIONS

     In November 1998, the Company formed a strategic partnership with the
University of Iowa in which component-level durability sensitivity analysis
technology developed by the University was acquired and will be integrated with
the Company's ADAMS virtual prototyping software to provide system-level
durability design sensitivity analysis capabilities. In connection with the
transaction, the Company reported a non-recurring charge to operations in 1998
of $400,000, associated with the write-off of in-process research and
development acquired from the University. The purchase price was allocated to
in-process research and development as the software had not reached
technological feasibility and no other tangible or intangible assets were
identified.

     In August 1998, the Company acquired the Design Analysis Group and certain
other assets of H.G.E. Inc. ("HGE"), an engineering software and services firm
based in Toronto, Ontario, Canada. The aggregate purchase price of approximately
$2.2 million consisted principally of cash. In connection with the acquisition,
the Company recorded a non-recurring charge to operations in 1998 of
approximately $203,000, associated with the write-off of in-process research and
development acquired in the transaction which had not reached technological
feasibility.

     In January 1998, the Company acquired 100% of the outstanding capital stock
of DTI Asia Pte. Ltd. ("DTI"), a provider of mechanical design simulation
software embedded in the AutoCAD and Mechanical Desktop product lines from
Autodesk, Inc. The aggregate purchase price of approximately $1.7 million
consisted of $563,000 in cash and 142,540 shares of the Company's common stock
valued at approximately $1.1 million. In connection with the acquisition, the
Company recorded a non-recurring charge to operations in 1998 of approximately
$980,000, associated with the write-off of in-process research and development
acquired in the transaction which had not reached technological feasibility.

     In October 1997, the Company acquired 100% of the outstanding capital stock
of StatDesign, Inc., an engineering software and services firm based in
Dearborn, Michigan. The aggregate purchase price of approximately $2.2 million
consisted of $1.4 million in cash and 170,227 shares of the Company's common
stock valued at approximately $868,000. In connection with the acquisition, the
Company recorded a non-recurring charge to operations in 1997 of approximately
$1.7 million, associated with the write-off of in-process research and
development acquired in the transaction which had not reached technological
feasibility.

     These acquisitions have been accounted for under the purchase method of
accounting. The excess of the aggregate purchase price over the fair value of
the net assets acquired has been recognized as goodwill and is being amortized
over periods ranging from five to fifteen years. The operating results
associated with each acquisition have been included in the Company's
consolidated results of operations from the date of acquisition. The pro forma
effects of these transactions are not deemed to be material to the Company's
results of operations.



                                       33
<PAGE>   34


(3) FINANCING ARRANGEMENTS

     The Company has available an unsecured bank line of credit with a maximum
borrowing capacity of $4.0 million. Borrowings on the line of credit bear
interest at 0.75% below the bank's prime rate of interest. No borrowings were
outstanding at December 31, 1999. The agreement expires on June 30, 2001.

     The Company's subsidiaries in Germany, Italy, Sweden, and France also have
line of credit and overdraft facilities that provide for aggregate borrowing
availability of approximately $510,000, at various fixed and variable interest
rates as of December 31, 1999. Borrowings are primarily due on demand and are
collateralized by certain assets of the subsidiaries. Borrowings outstanding
under these agreements were $14,000 and $105,000 at December 31, 1999 and 1998,
respectively.

     No borrowings were outstanding under long-term debt arrangements at
December 31, 1999 and 1998. Cash paid for interest was $15,000, $16,000, and
$12,000 in 1999, 1998, and 1997, respectively.

 (4) INCOME TAXES

     A summary of income before provision (credit) for income taxes and
components of the provision for income taxes is as follows:

<TABLE>
<CAPTION>
                                                                               YEAR ENDED DECEMBER 31,
                                                                       -----------------------------------------
In thousands                                                               1999           1998         1997
----------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>            <C>           <C>
Income (loss) before provision for income taxes:
  Domestic.........................................................     $    133       $    940      $  1,497
  Foreign..........................................................          721           (668)          259
                                                                        --------       --------      --------
                                                                        $    854       $    272      $  1,756
                                                                        ========       ========      ========
Domestic provision (benefit) for income taxes:
  Current..........................................................     $   (164)      $    241      $    859
  Deferred.........................................................         (421)            30            42
Foreign provision for income taxes:
  Current..........................................................          336            208           116
                                                                        --------       --------      --------
Provision (credit) for income taxes................................     $   (249)      $    479      $  1,017
                                                                        ========       ========      ========
</TABLE>

     The differences between the income tax provision calculated at the United
States federal statutory rate and the consolidated income tax provision are
summarized as follows:

<TABLE>
<CAPTION>
                                                                                YEAR ENDED DECEMBER 31,
                                                                         ---------------------------------------
In thousands                                                                1999          1998          1997
------------------------------------------------------------------------ ------------ -------------- -----------
<S>                                                                        <C>          <C>            <C>
Federal statutory provision.........................................       $   372      $    92        $   597
   Meals and entertainment..........................................            35           33             41
   Acquisition-related costs and non-recurring charges..............            --          402            575
   Goodwill amortization............................................            37           44             35
   Recognition of tax credits.......................................          (637)          --             --
   Foreign losses without tax benefit...............................            --           --              5
   Effect of differences between U.S. and foreign tax rates.........            65           37            (66)
   Tax-exempt interest income.......................................           (72)        (121)          (106)
   Other, net.......................................................           (49)          (8)           (64)
                                                                           -------      -------        -------
Provision (credit) for income taxes.................................       $  (249)     $   479        $ 1,017
                                                                           =======      =======        =======
</TABLE>

                                       34
<PAGE>   35


     Deferred income taxes represent temporary differences in the recognition of
certain items for income tax and financial reporting purposes. The components of
the net deferred income tax asset are summarized as follows:

<TABLE>
<CAPTION>
                                                                                                 AS OF
                                                                                             DECEMBER 31,
                                                                                        ------------------------
In thousands                                                                              1999         1998
----------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>          <C>
Current deferred tax asset (liability):
  Employee benefits.................................................................     $  136       $  131
  Accounts receivable...............................................................        120           89
  Other.............................................................................         33           28
                                                                                         ------       ------
Net current deferred tax asset......................................................        289          248
                                                                                         ------       ------

Long-term deferred tax asset (liability):
  Tax credits.......................................................................        198           --
  Property and equipment............................................................        161           28
  Other.............................................................................         16          (33)
                                                                                         ------       ------
Net long-term deferred tax asset (liability)........................................        375           (5)
                                                                                         ------       ------
  Net deferred tax asset............................................................     $  664       $  243
                                                                                         ======       ======
</TABLE>

     Management believes the Company will obtain the full benefit of the net
deferred tax asset on the basis of its evaluation of the Company's anticipated
profitability over the period of years that the temporary differences are
expected to become tax deductions. It believes that sufficient book and taxable
income will be generated to realize the benefit of these tax assets. This
assessment of profitability takes into account the Company's present and
anticipated split of domestic and international earnings. The tax credits expire
in 2012 through 2019.

     Income taxes have been provided on all undistributed earnings of foreign
subsidiaries. Cash paid for income taxes was $607,000, $1.2 million, and
$764,000 in 1999, 1998, and 1997, respectively.

(5) COMMON STOCK AND SHAREHOLDERS' EQUITY

   Common Stock

     Holders of shares of common stock are entitled to one vote per share on all
matters submitted to a vote of holders of shares of common stock, and do not
have any cumulative voting rights. In the event of a liquidation, dissolution or
winding-up of the Company, the holders of shares of common stock are entitled to
share equally and ratably in the assets of the Company, if any, remaining after
the payment of debts and liabilities of the Company, subject to prior
liquidation rights of any outstanding shares of preferred stock.

   Preferred Stock

     The Board of Directors is authorized to issue up to 1,000,000 shares of
preferred stock in one or more series. Under each issuance of a series of
preferred stock, the Board of Directors is permitted to fix the designations,
preferences, powers, and relative rights and restrictions thereof, including
without limitation, the dividend rate, conversion rights, voting rights,
redemption price, and liquidation preference.

   Employee Stock Purchase Plan

     The Company's Employee Stock Purchase Plan (the "Purchase Plan") was
adopted by the Company's Board of Directors in March 1996. A total of 300,000
shares of common stock have been reserved for issuance under the Purchase Plan.
The Purchase Plan provides that the Company will sell shares to employees who
elect to participate in the Purchase Plan at a price equal to 85% of the lesser
of the fair market value of the common stock on the first trading day of an
offering period or the last trading day of such offering period.

     Under the Purchase Plan, the Company issued 50,157, 43,340 and 33,899
shares of common stock in 1999, 1998 and 1997, respectively, to various
employees. These shares were issued with a weighted average price per share of

                                       35
<PAGE>   36

$5.07, $6.37 and $5.97 in 1999, 1998 and 1997, respectively. As of December 31,
1999, there were 155,391 shares of common stock remaining to be issued under
this plan.

   1996 Stock Incentive Plan For Key Employees

     The Company's 1996 Stock Incentive Plan for Key Employees (the "Stock
Option Plan") was adopted by the Company's Board of Directors in March 1996.
Under the Stock Option Plan, options will be granted or restricted stock will be
awarded for the purpose of attracting and motivating key employees of the
Company. The Stock Option Plan provides for (1) the grant of "incentive stock
options" within the meaning of Section 422 of the Internal Revenue Code, (2) the
grant of "nonqualified stock options" (options which do not meet the
requirements of Section 422), and (3) the award of restricted stock. Subject to
certain provisions outlined in the Stock Option Plan, the Compensation Committee
of the Board of Directors will determine which key employees will be granted
options or awarded restricted stock, the number of options granted or shares
awarded, and other terms and conditions applicable to each award or grant. A
total of 1,050,000 shares of common stock have been reserved for issuance under
the Stock Option Plan.

     Stock option activity for this plan is summarized below:

<TABLE>
<CAPTION>
                                                                                                    WTD. AVG.
                                                                    NUMBER           PRICE          EXERCISE
                                                                   OF SHARES       PER SHARE          PRICE
------------------------------------------------------------------------------------------------------------
<S>                                                                <C>           <C>                <C>
Outstanding at December 31, 1996...............................     182,500      $9.00 - $13.50      $11.47
  Granted......................................................     329,000      $6.50 - $ 9.13      $ 7.75
  Canceled.....................................................    (132,200)     $6.50 - $13.50      $11.81
                                                                   --------      --------------      ------
Outstanding at December 31, 1997...............................     379,300      $6.69 - $ 9.13      $ 8.12
  Granted......................................................     564,150      $6.75 - $11.50      $ 7.76
  Exercised....................................................      (6,125)     $6.75 - $ 9.00      $ 8.84
  Canceled.....................................................    (347,800)     $6.75 - $11.50      $ 9.61
                                                                   --------      --------------      ------
Outstanding at December 31, 1998...............................     589,525      $6.69 - $11.50      $ 7.38
  Granted......................................................      37,000      $4.50 - $ 6.75      $ 6.51
  Canceled.....................................................     (51,405)     $6.63 - $11.50      $ 7.82
                                                                   --------      --------------      ------
Outstanding at December 31, 1999...............................     575,120      $4.50 - $10.88      $ 7.28
                                                                    -------      --------------      ------
</TABLE>

     There were 108,913 and 68,925 options exercisable under the Stock Option
Plan as of December 31, 1999 and 1998, respectively, with a weighted average
exercise price of $8.15 per share in 1999 and $8.21 per share in 1998. The
remaining options vest over a three- or four-year period beginning on the date
of grant at 33% or 25% per year, respectively, and expire five or ten years from
the date they are granted. As of December 31, 1999, there were 468,755 shares of
common stock remaining to be issued under the Stock Option Plan. Options
outstanding under the Stock Option Plan have a weighted average remaining
contractual life of 6.8 years and 7.6 years as of December 31, 1999 and 1998,
respectively.

     In November 1998, the Board of Directors approved a one-for-one stock
option exchange that provided non-director employees with the opportunity to
exchange stock options previously granted for new options with a current market
price and a new vesting period. The new options were priced at $6.75 per share
based on the closing price of the Company's common stock as reported on Nasdaq
on November 10, 1998, vest in equal installments over three years from the
November 10, 1998 grant date and expire on November 10, 2008. The repriced
options can only be exercised when the closing price of the Company's common
stock equals or exceeds $11.00 per share. A total of 335,950 options with prior
exercise prices ranging from $6.75 to $11.50 per share were exchanged. The
weighted average prior exercise price of options exchanged was $8.81 per share.
The exchange of such options is presented in the table above as cancellations
and subsequent grants.

   Non-Employee Director Stock Option Plan

     The Company's Non-Employee Director Stock Option Plan (the "Director Stock
Option Plan") was adopted by the Company's Board of Directors in March 1996. The
Director Stock Option Plan provides for the grant of "nonqualified stock
options" to purchase shares of common stock. Upon appointment to the Board of
Directors, each


                                       36
<PAGE>   37

newly appointed non-employee director will receive an option to purchase 5,000
shares of common stock of the Company. Furthermore, immediately following each
annual meeting of shareholders of the Company, each non-employee director who
has served as a director for at least six months will automatically be granted
an option to purchase 5,000 shares of common stock of the Company. The exercise
price of any option will be equal to the market price of the common stock at the
time of grant. Each option, if not terminated sooner as provided in the Director
Stock Option Plan, will have a five-year term from the date of grant and will
vest and become exercisable in full on the first anniversary of the date of
grant. A total of 200,000 shares of common stock have been reserved for issuance
under the Director Stock Option Plan.

    Stock option activity for this plan is summarized below:

<TABLE>
<CAPTION>
                                                                                                    WTD. AVG.
                                                                    NUMBER           PRICE          EXERCISE
                                                                   OF SHARES       PER SHARE          PRICE
------------------------------------------------------------------------------------------------------------
<S>                                                                <C>            <C>               <C>
Outstanding at December 31, 1996.................................    20,000         $ 11.00          $11.00
  Granted........................................................    20,000         $  9.13          $ 9.13
                                                                     ------         -------          ------
Outstanding at December 31, 1997.................................    40,000      $9.13 - $11.00      $10.07
  Granted........................................................    20,000         $ 13.00          $13.00
                                                                     ------         -------          ------
Outstanding at December 31, 1998.................................    60,000      $9.13 - $13.00      $11.04
  Granted........................................................    20,000         $  6.56          $ 6.56
                                                                     ------         -------          ------
Outstanding at December 31, 1999.................................    80,000      $6.56 - $13.00      $ 9.92
                                                                     ------      --------------      ------
</TABLE>

     There were 60,000 and 40,000 options exercisable under the Director Stock
Option Plan as of December 31, 1999 and 1998, respectively, with a weighted
average exercise price of $11.04 per share in 1999 and $10.07 per share in 1998.
Options outstanding under the Director Stock Option Plan have a weighted average
remaining contractual life of 2.9 years and 3.4 years as of December 31, 1999
and 1998, respectively.

   1993 Stock Option Plan

     In March 1996, the Company's 1993 Stock Option Plan (the "1993 Plan") was
terminated by the Board of Directors. Under the 1993 Plan, the Board was
permitted to grant options to purchase shares of common stock to certain key
employees. The price of such options was determined by the Board when the
options were granted, but could not be less than the book value of the stock.
Management determined that all options granted under the 1993 Plan were at
exercise prices equal to or in excess of fair market value. Stock option
activity for this plan is summarized below:

<TABLE>
<CAPTION>
                                                                                      NUMBER        PRICE
                                                                                     OF SHARES    PER SHARE
-----------------------------------------------------------------------------------------------------------
<S>                                                                                 <C>            <C>
Outstanding at December 31, 1997...............................................        42,171      $ 0.93
  Exercised....................................................................       (42,171)     $ 0.93
                                                                                    ---------      ------
Outstanding at December 31, 1998...............................................            --
                                                                                    =========
</TABLE>

     For various price ranges, information for options outstanding and
exercisable for all option plans at December 31, 1999 was as follows:

<TABLE>
<CAPTION>
                                        OUTSTANDING OPTIONS                        EXERCISABLE OPTIONS
                          ---------------------------------------------------   -----------------------------
         RANGE OF                      WTD. AVG. REMAINING      WTD. AVG.                      WTD. AVG.
     EXERCISE PRICES        SHARES         LIFE (YEARS)      EXERCISE PRICE        SHARES    EXERCISE PRICE
-----------------------------------------------------------------------------   -----------------------------
<S>                         <C>        <C>                   <C>                <C>          <C>
      $4.50 - $ 6.69           57,000             6.98            $  6.53            2,500       $  6.69
          $6.75               335,920             8.65            $  6.75            5,550       $  6.75
      $7.25 - $ 8.00          136,000             2.17            $  7.89           68,750       $  7.88
      $8.50 - $11.00          106,200             4.30            $  9.50           72,113       $  9.62
          $13.00               20,000             3.37            $ 13.00           20,000       $ 13.00
</TABLE>


                                       37

<PAGE>   38


   Stock-Based Compensation

     Using the intrinsic value method of accounting for the value of stock
options granted during 1999 and 1998, no compensation cost was recorded in the
accompanying consolidated statements of income. Had compensation cost been
determined based on the fair value at the date of grant for awards in 1999 and
1998 consistent with the provisions of SFAS 123, net income (loss) and net
income (loss) per share would have been reduced to the pro forma amounts
indicated below:

<TABLE>
<CAPTION>
In thousands, except per share data                            1999             1998            1997
------------------------------------------------------------------------------------------------------
<S>                                                          <C>              <C>             <C>
Net income (loss) - as reported..........................    $  1,095         $   (217)       $    744
Net income (loss) - pro forma............................    $    262         $   (963)       $    406

Diluted net income (loss) per share - as reported........    $   0.18         $  (0.04)       $   0.13
Diluted net income (loss) per share - pro forma..........    $   0.04         $  (0.16)       $   0.07
</TABLE>

     The weighted average estimated fair value of stock options granted during
1999 and 1998 was $3.72 and $4.69, respectively. The fair value of each option
grant was estimated on the date of grant using the Black-Scholes option-pricing
model. The following weighted average assumptions were used in valuing the
option grants:

<TABLE>
<CAPTION>
                                                               1999            1998            1997
-----------------------------------------------------------------------------------------------------
<S>                                                            <C>             <C>              <C>
Expected life (years).....................................      5.0             5.0             5.0
Interest rate.............................................      6.2%            5.2%            6.0%
Volatility................................................      0.6             0.7             0.8
Dividend yield............................................      0.0%            0.0%            0.0%
</TABLE>

(6) COMMITMENTS AND CONTINGENCIES

   Employee Benefit Plans

     The Company maintains a 401(k) plan covering substantially all of its
domestic employees. During 1999, 1998 and 1997, the Company matched 40% of
qualified employee contributions, up to a maximum of 2.4% of eligible
compensation. In 1999, 1998, and 1997, the Company contributed $233,000,
$244,000, and $180,000, respectively, to the plan.

   Lease Commitments

     The Company and its subsidiaries lease office space and certain equipment
under noncancellable operating lease agreements. Future minimum lease payments
at December 31, 1999 are as follows:

<TABLE>
<CAPTION>
In thousands
--------------------------------------------------------------------------------------------------------------
<S>                                                                                                <C>
2000........................................................................................       $  1,516
2001........................................................................................          1,345
2002........................................................................................          1,211
2003........................................................................................          1,050
2004........................................................................................          1,032
Thereafter..................................................................................          6,012
                                                                                                   --------
                                                                                                   $ 12,166
                                                                                                   ========
</TABLE>

     Total lease expense amounted to approximately $2.0 million in each of the
years ending 1999, 1998, and 1997.

     In 1999, the Company signed an agreement with its current landlord to lease
office space in a new headquarters facility in Ann Arbor, Michigan. The new
facility is currently under construction with an expected completion date in the
fourth quarter of 2000. The initial lease term will be ten years expiring in
2010. The future minimum lease payment table above includes the lease payments
required under this lease agreement.


                                       38
<PAGE>   39


   Royalty Agreements

     The Company has entered into various agreements which generally provide for
royalty payments by the Company based on a percentage of revenue derived through
the licensing of certain software products. Royalty expense under these
agreements amounted to approximately $3.2 million, $2.2 million, and $612,000 in
1999, 1998, and 1997, respectively.

(7) LITIGATION

     The Company is party to routine litigation arising in the normal course of
business. In the opinion of management, the liabilities resulting from these
proceedings, if any, will not be material to the Company's consolidated
financial position or results of operations.

 (8) GEOGRAPHIC OPERATIONS AND SEGMENT INFORMATION

     Effective December 31, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and
Related Information" ("SFAS 131"). SFAS 131 introduces a new model for segment
reporting called the "management approach." The management approach is based on
the way that the chief operating decision-maker organizes segments within a
company for making operating decisions and assessing performance.

     The Company operates in one segment - the development, marketing and
support of software products and services for the mechanical segment of the
computer-aided engineering industry. The Company licenses products to customers
on a worldwide basis. Sales and marketing operations outside the United States
are conducted principally through the Company's foreign subsidiaries and
international distributors. Intercompany sales and transfers between geographic
areas are accounted for at prices which are designed to be representative of
third party transactions.


                                       39
<PAGE>   40


     The following table summarizes selected financial information of the
Company's operations by geographic location:

<TABLE>
<CAPTION>
                                                                                 YEAR ENDED DECEMBER 31,
                                                                    --------------------------------------------
In thousands                                                             1999           1998           1997
----------------------------------------------------------------------------------------------------------------
<S>                                                                   <C>             <C>            <C>
Revenue:
  North America
     United States..............................................      $  11,613       $  12,223      $  10,340
     Canada and Mexico..........................................          3,820           1,514            153
  Europe
     Germany....................................................          5,473           5,108          4,380
     Other European countries...................................          9,573           7,769          5,653
  Asia/Pacific
     Japan......................................................          7,706           7,819          7,324
     Other Asian countries......................................          2,070           2,142          2,341
                                                                      ---------       ---------      ---------
          Total revenue.........................................      $  40,255       $  36,575      $  30,191
                                                                      =========       =========      =========

Operating contribution:
  North America
     United States..............................................      $   3,263       $   3,827      $   3,229
     Canada and Mexico..........................................            196             186             89
  Europe
     Germany....................................................          1,845           1,805          1,377
     Other European Countries...................................          2,872           2,672          1,836
  Asia/Pacific
     Japan......................................................          1,342           1,204          2,020
     Other Asian countries......................................            339             250            623
                                                                      ---------       ---------      ---------
          Total operating contribution..........................          9,857           9,944          9,174
  Unallocated expenses, net.....................................         (9,003)         (9,672)        (7,418)
                                                                      ---------       ---------      ---------
          Income before taxes and minority interest.............      $     854       $     272      $   1,756
                                                                      =========       =========      =========

Identifiable assets:
  North America
     United States..............................................      $  23,550       $  23,882      $  26,115
     Canada.....................................................          2,287           1,698             --
  Europe
     Germany....................................................          2,384           1,942          1,124
     Other European countries...................................          4,466           3,430          3,580
  Asia/Pacific
     Japan......................................................          1,917           1,362          1,788
     Other Asian countries......................................            149             114             42
                                                                      ---------       ---------      ---------
          Total identifiable assets.............................         34,753          32,428         32,649
  Goodwill......................................................          3,436           3,819          1,498
                                                                      ---------       ---------      ---------
          Total assets..........................................      $  38,189       $  36,247      $  34,147
                                                                      =========       =========      =========
</TABLE>

     No customer accounted for greater than 10% of total revenue in 1999 and
1998. One customer accounted for approximately 10.6% of total revenue in 1997.

     Unallocated expenses, net, consist of general corporate expenses, internal
research and product development expense, goodwill amortization expense,
interest expense, and interest income. In 1998 and 1997, these expenses also
include acquisition and related costs of approximately $1.7 million.


                                       40
<PAGE>   41


(9) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

     The following table summarizes selected unaudited quarterly financial
information for 1999 and 1998. The Company believes all adjustments, consisting
of normal recurring adjustments considered necessary for a fair presentation,
have been included in the selected quarterly information:

<TABLE>
<CAPTION>
                                                               THREE MONTHS ENDED                             YEAR ENDED
                                          --------------------------------------------------------------    ---------------
                                            MARCH 31,        JUNE 30,     SEPTEMBER 30,    DECEMBER 31,       DECEMBER 31,
In thousands,  except per share data          1999            1999            1999            1999               1999
---------------------------------------------------------------------------------------------------------------------------
<S>                                        <C>             <C>            <C>              <C>                <C>
Revenue......................              $  10,366       $   9,158       $   9,729       $  11,002          $  40,255
Gross profit.................                  6,809           5,509           6,061           7,097             25,476
Operating income (loss)......                    501            (835)             69             605                340
Net income (loss)............                    474            (503)            640             484              1,095
Basic net income (loss) per
   common share..............              $    0.08       $   (0.08)      $    0.10       $    0.08          $    0.18
Diluted net income (loss) per
   common share..............              $    0.08       $   (0.08)      $    0.10       $    0.08          $    0.18
</TABLE>


<TABLE>
<CAPTION>
                                                               THREE MONTHS ENDED                           YEAR ENDED
                                          --------------------------------------------------------------  ---------------
                                            MARCH 31,        JUNE 30,     SEPTEMBER 30,    DECEMBER 31,     DECEMBER 31,
In thousands,  except per share data          1999            1999            1999            1999              1999
---------------------------------------------------------------------------------------------------------------------------
<S>                                       <C>             <C>             <C>             <C>                <C>
Revenue......................             $   8,735       $   8,905       $   8,180       $  10,755          $  36,575
Gross profit.................                 6,027           6,327           5,077           7,084             24,515
Operating income (loss)......                  (554)            847            (939)             90               (556)
Net income (loss)............                  (613)            733            (586)            249               (217)
Basic net income (loss) per
   common share..............             $   (0.10)      $    0.12       $   (0.09)      $    0.04          $   (0.04)
Diluted net income (loss) per
   common share..............             $   (0.10)      $    0.12       $   (0.09)      $    0.04          $   (0.04)
</TABLE>




                                       41
<PAGE>   42


ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

    None.

                                    PART III

     Certain information required by Part III is omitted from this report in
that the Registrant will file a definitive proxy statement pursuant to
Regulation 14A (the "Proxy Statement") not later than 120 days after the end of
the fiscal year covered by this report and certain information included therein
is incorporated herein by reference. Only those sections of the Proxy Statement
that specifically address the items set forth herein are incorporated by
reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     Information with respect to the directors of the Company is incorporated by
reference to the Company's Proxy Statement for the 2000 Annual Meeting of
Shareholders scheduled to be held on May 11, 2000.

     The executive officers of the Company as of March 1, 2000 are listed below:

<TABLE>
<CAPTION>
                       NAME                           AGE                           POSITION
--------------------------------------------------- -------- -------------------------------------------------------
<S>                                                   <C>     <C>
Michael E. Korybalski...........................      53      Chief Executive Officer, Chairman of the Board and
                                                                 Director
Robert R. Ryan..................................      42      President, Chief Operating Officer and Director
Michael Hoffmann................................      43      Senior Vice President -- Worldwide Sales & Service
David Peralta...................................      32      Vice President, Chief Financial Officer and Treasurer
</TABLE>

     Michael E. Korybalski, a co-founder of MDI, is currently Chief Executive
Officer, Chairman of the Board and a director of the Company. From 1984 to
February 1997, Mr. Korybalski served as President of the Company. From 1977 to
1984, Mr. Korybalski served as Vice President and General Manager of the
Company. From 1973 to 1977, he was employed as a product engineer with Ford
Motor Company. Mr. Korybalski holds B.S.E. and M.S.E. degrees in mechanical
engineering, as well as an M.B.A., from the University of Michigan.

     Robert R. Ryan became the President of the Company in February 1997 and
since 1991 has served as the Chief Operating Officer of the Company. Dr. Ryan
was elected a director of the Company in May 1997. Dr. Ryan served as the
Company's Executive Vice President from 1991 to February 1997. From 1988 through
1991, Dr. Ryan served as the Company's Vice President of Product Development.
Before joining the Company, Dr. Ryan held various positions in sales and
engineering services at Structural Dynamics Research Corporation, and served
briefly on the engineering faculty at the University of Michigan. Dr. Ryan holds
a B.S. degree from the University of Cincinnati and M.S. and Ph.D. degrees in
applied mechanics from Stanford University.

     Michael Hoffmann became the Company's Senior Vice President -- Worldwide
Sales and Service in November 1997. Dr. Hoffmann served as the Company's Vice
President -- European Operations from November 1996 to November 1997. Dr.
Hoffmann served as the Company's Managing Director -- European Operations from
1994 to November 1996. From 1993 through 1994, Dr. Hoffmann served as Managing
Director of TEDAS Mechanical Systems GmbH, a shareholder of the Company. From
1991 through 1992, he served as Technical Director of TEDAS GmbH. Dr. Hoffmann
holds masters and doctorate degrees in civil engineering from the Technological
University of Darmstadt.

     David Peralta became the Company's Vice President, Chief Financial Officer
and Treasurer in February 1997, and served as Controller of the Company from
1993 to February 1997. From 1992 to 1993, Mr. Peralta served as Assistant
Corporate Controller at OVAKO Ajax, Inc. From 1989 through 1992, he served as an
auditor at Coopers & Lybrand. Mr. Peralta is a licensed Certified Public
Accountant in the State of Michigan. Mr. Peralta holds a bachelors degree in
accounting from the University of Michigan.


                                       42
<PAGE>   43


ITEM 11. EXECUTIVE COMPENSATION

     The information required by this Item is incorporated by reference to the
Company's Proxy Statement for the 2000 Annual Meeting of Shareholders scheduled
to be held on May 11, 2000.


ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information required by this Item is incorporated by reference to the
Company's Proxy Statement for the 2000 Annual Meeting of Shareholders scheduled
to be held on May 11, 2000.


ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     None.


                                       43

<PAGE>   44


                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

ITEM 14(A)1. FINANCIAL STATEMENTS

    Report of Independent Public Accountants
    Consolidated Balance Sheets as of December 31, 1999 and 1998
    Consolidated Statements of Income for the Years Ended December 31, 1999,
    1998 and 1997
    Consolidated Statements of Shareholders' Equity for the Years Ended
    December 31, 1999, 1998 and 1997
    Consolidated Statements of Cash Flows for the Years Ended December 31, 1999,
    1998 and 1997
    Notes to Consolidated Financial Statements

ITEM 14(A)2. FINANCIAL STATEMENT SCHEDULES

    None.



                                     44
<PAGE>   45


ITEM 14(a)3. EXHIBITS

      NUMBER                                EXHIBIT
-------------------------------------------------------------------------------

     (2)       Joint Venture Agreement between Mechanical Dynamics, Inc. and
               Information Services International-Dentsu, Ltd., incorporated
               herein by reference to Exhibit 2 to the Company's previously
               filed Form 10-Q for the quarter ended March 31, 1997

     (3.1)     Restated Articles of Incorporation, incorporated herein by
               reference to Exhibit 3.2 to the Company's previously filed
               Registration Statement on Form S-1, Registration No. 333-2900

     (3.2)     Restated Bylaws, incorporated herein by reference to Exhibit 3.4
               to the Company's previously filed Registration Statement on Form
               S-1, Registration No. 333-2900

     (4.2)     Line of Credit Demand Note between the Company and KeyBank
               National Association dated August 6, 1999, incorporated herein by
               reference to Exhibit 4.2 to the Company's previously filed Form
               10-Q for the quarter ended September 30, 1999

     (10.1)    Employment Agreement between the Company and Michael E.
               Korybalski, as amended

     (10.2)    Employment Agreement between the Company and Robert R. Ryan, as
               amended

     (10.3)    Employment Agreement between the Company and David Peralta, as
               amended

     (10.18)   Lease Agreement between the Company and First Martin Corporation
               dated August 5, 1999, incorporated herein by reference to Exhibit
               10.18 to the Company's previously filed Form 10-Q for the quarter
               ended September 30, 1999

     (11)      Statement Re Computation Of Per Share Earnings Per Share

     (21)      Subsidiaries Of The Registrant

     (23.1)    Consent Of Independent Public Accountants

     (27)      Financial Data Schedule - 1999



ITEM 14(b). REPORTS ON FORM 8-K

     No reports on Form 8-K were filed by the Company during the year ended
December 31, 1999.



                                       45
<PAGE>   46


                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

Dated: March 17, 2000                            MECHANICAL DYNAMICS, INC.
                                                 (Registrant)


                                             By: /s/ Michael E. Korybalski
                                                --------------------------------
                                                Michael E. Korybalski
                                                Chairman of the Board

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
            SIGNATURES                                            TITLE                              DATE
            ----------                                            -----                              ----
<S>                                                         <C>                                  <C>


/s/ Michael E. Korybalski                                   Chairman of the Board,               March 17,2000
------------------------------------------------------      Chief Executive Officer,
Michael E. Korybalski                                       and Director
                                                            (Principal Executive Officer)

/s/ Robert R. Ryan                                          President, Chief Operating Officer   March 17, 2000
------------------------------------------------------      and Director
Robert R. Ryan


/s/ David Peralta                                           Chief Financial Officer              March 17, 2000
------------------------------------------------------      (Principal Financial and
David Peralta                                               Accounting Officer)

/s/ Herbert S. Amster                                       Director                             March 17, 2000
------------------------------------------------------
Herbert S. Amster


/s/ David E. Cole                                           Director                             March 17, 2000
------------------------------------------------------
David E. Cole


/s/ Joseph F. Gloudeman                                     Director                             March 17, 2000
------------------------------------------------------
Joseph F. Gloudeman


/s/ Mitchell I. Quain                                       Director                             March 17, 2000
------------------------------------------------------
Mitchell I. Quain

</TABLE>


                                       46
<PAGE>   47


                                INDEX TO EXHIBITS


      NUMBER                         EXHIBIT
-------------------------------------------------------------------------------

     (2)       Joint Venture Agreement between Mechanical Dynamics, Inc. and
               Information Services International-Dentsu, Ltd., incorporated
               herein by reference to Exhibit 2 to the Company's previously
               filed Form 10-Q for the quarter ended March 31, 1997

     (3.1)     Restated Articles of Incorporation, incorporated herein by
               reference to Exhibit 3.2 to the Company's previously filed
               Registration Statement on Form S-1, Registration No. 333-2900

     (3.2)     Restated Bylaws, incorporated herein by reference to Exhibit 3.4
               to the Company's previously filed Registration Statement on Form
               S-1, Registration No. 333-2900

     (4.2)     Line of Credit Demand Note between the Company and KeyBank
               National Association dated August 6, 1999, incorporated herein by
               reference to Exhibit 4.2 to the Company's previously filed Form
               10-Q for the quarter ended September 30, 1999

     (10.1)    Employment Agreement between the Company and Michael E.
               Korybalski, as amended

     (10.2)    Employment Agreement between the Company and Robert R. Ryan, as
               amended

     (10.3)    Employment Agreement between the Company and David Peralta, as
               amended

     (10.18)   Lease Agreement between the Company and First Martin Corporation
               dated August 5, 1999, incorporated herein by reference to Exhibit
               10.18 to the Company's previously filed Form 10-Q for the quarter
               ended September 30, 1999

     (11)      Statement Re Computation Of Per Share Earnings Per Share

     (21)      Subsidiaries Of The Registrant

     (23.1)    Consent Of Independent Public Accountants

     (27)      Financial Data Schedule - 1999



                                       47