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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, 1998, 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)

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<S>                                                  <C>
       MICHIGAN                                                  38-2163045
(State of incorporation)                             (I.R.S. Employer Identification No.)
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                             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 3, 1999, computed by reference
to the Nasdaq closing price on such date, was approximately $30,961,000.

         The number of outstanding shares of the Registrant's common stock, as
of March 3, 1999, was 6,237,097.

                      DOCUMENTS INCORPORATED BY REFERENCE

         Portions of the Proxy Statement for the 1999 Annual Meeting of 
Shareholders, scheduled to be held on May 13, 1999, are incorporated by 
reference into Part III.

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                            MECHANICAL DYNAMICS, INC.

                                    FORM 10-K
                                TABLE OF CONTENTS

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<CAPTION>
                                                                                                   PAGE
                                                        PART I
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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.....  43
         
                                             PART III
Item 10. Directors and Executive Officers of the Registrant.......................................  43
Item 11. Executive Compensation...................................................................  44
Item 12. Security Ownership of Certain Beneficial Owners and Management...........................  44
Item 13. Certain Relationships and Related Transactions...........................................  44
         
                                             PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K..........................  45
           
SIGNATURES........................................................................................  47

INDEX TO EXHIBITS.................................................................................  48
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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., a provider of
engineering software and services for product design and development, primarily
to Ford Motor Company.

         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.

         ADAMS(R) and the Company's logo are registered trademarks of the
Company. ADAMS/Animation, ADAMS/Car, ADAMS/Controls, ADAMS/Driver,
ADAMS/Exchange, ADAMS/Flex, ADAMS/Linear, ADAMS/Pre, ADAMS/Rail, ADAMS/Solver,
ADAMS/Tire, ADAMS/View, AutoDOE, 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.


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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 kinematic 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 $25,000 per
license depending upon configuration. The U.S. list prices for the Company's
additional software products typically range from $3,000 to $20,000. 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 $66,000. 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 this 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, 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 AB
Volvo, Audi AG, BMW, Nissan Motor Co., Renault and Rover Group P.L.C. 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/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.

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

         - AutoDOE is a software package used for creating statistically defined
design of experiments programs. Design of experiments 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. With design of experiments, product designs can be optimized more
quickly than through the traditional process of testing one factor at a time.


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    - 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.

   Visualization Option

    - 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 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/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/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.

    - 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 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 the AutoCAD and Mechanical Desktop
product lines from Autodesk, Inc. Similar embedded ADAMS simulation capabilities
for SolidWorks 97 from SolidWorks Corp. have been developed by the Company.

    - 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


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motion paths, locate lock-up positions, detect interferences, establish
work-space envelopes and calculate joint reaction forces.

ADAMS OEM PRODUCTS

OEM Products are kinematic 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., Tecnomatix Technologies Ltd., and Applicon, 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

    The Company provides consulting, training and technical support 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.

    In addition to its consulting services, the Company also provides training
to enable its customers to more easily integrate virtual prototyping technology
into their design and quality control processes.

    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 1998,
1997 or 1996.

    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 16.3%, 15.9%,
and 16.2% of the Company's total revenue was realized from maintenance contracts
in 1998, 1997, and 1996, respectively.

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 1998, 1997, and 1996, automotive-related customers accounted for
approximately 54.7%, 50.5%, and 48.1% of the Company's total revenue,
respectively. No customer accounted for greater than 10% of the Company's total
revenue in 1998. Ford Motor Company accounted for approximately 10.6% and 11.8%
of the Company's total revenue in 1997 and 1996, respectively. No other customer
accounted for greater than 10% of the Company's total revenue in 1997 and 1996.
Segments in 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


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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, approximately 15 value-added resellers
throughout North America, a group of international distributors in over 20
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; San
Francisco, CA; 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 technology, such as ANSYS, Inc., Integrated Systems, Inc., The
MacNeal-Schwendler Corporation, The Mathworks, Inc. and Structural Research &
Analysis Corp. These relationships entail collaborative development to support
interfaces between the software 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 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, 1998 the Company
distributes software products of ANSYS, Inc. in both the United Kingdom and
Canada in addition to providing consulting services related to those products.
Throughout Sweden, the Company distributes MATRIXx, a product of Integrated
Systems, Inc. Revenue from third party software products accounted for
approximately 7.1%, 2.2%, and 3.0% of the Company's total revenue in 1998, 1997
and 1996, respectively.

    The Company has formed relationships with several CAD/CAM companies,
including Applicon, Inc., 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 62.4%, 65.2%, and 67.0% of the Company's total
revenue in 1998, 1997, and 1996, respectively. 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 13.2%, 15.3%,
and 16.5% of the Company's total revenue in 1998, 1997, and 1996, 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


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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's consolidated operations to date have not been materially
adversely affected by the recent uncertainty in the Asian markets. During 1998,
the Company experienced a decrease in revenue from Korea; however, this decrease
was more than offset by revenue growth in Japan. If the economies in Asia
continue to deteriorate in 1999, 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. A summary of the Company's revenue by
geographic area is presented in Note 8 of Notes to Consolidated Financial
Statements.

    The Company generally prices its software products and services in local
currencies in Europe, Canada and Japan. 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 was considerably
less than the impact on revenue. If the U.S. dollar continues to strengthen in
1999 relative to the European, Canadian and 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.
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.


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    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 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.

    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.

    As of December 31, 1998, the Company's research and development group
consisted of 58 full-time employees. During 1998, 1997, and 1996, the Company's
research and development expenses were approximately $5.3 million, $4.7 million,
and $3.6 million, respectively. The Company anticipates that it will commit
substantial resources to research and development in the future.

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 The MacNeal-Schwendler Corporation, and the internal
software development groups of its current or potential customers. Many
companies have their own software development groups that historically have
developed their own software design tools. This has required the Company and
other vendors to compete against these internal groups to sell their products
into these companies. A number of the Company's competitors have


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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 its 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 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 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.


                                       10
<PAGE>   11

    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, 1998, the Company had 283 employees, consisting of 104 in
engineering services, 93 in sales and marketing, 58 in research and development
and 28 in general and administrative capacities. Of these, 152 are located at
the Company's headquarters in Ann Arbor, Michigan, 27 are located at the
Company's domestic offices in Arizona, California, Georgia, Illinois, Indiana,
Maryland, New Mexico, North Carolina, Ohio, Texas, Washington, and Wisconsin, 16
are located at the Company's Canadian subsidiary, 84 are located at the
Company's European and Asian subsidiaries and 4 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.

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 involve
significant transaction-related costs. 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.

    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
recorded in connection with the acquisitions, any of which could negatively
impact results of operations for a given period. In addition, acquisitions may
result in the allocation of purchase price to in-process research and
development. The SEC has recently raised issues regarding the methodologies used
and allocation of purchase price to in-process research and development and has
required some companies to adjust or restate prior periods to reduce allocations
to in-process research and development, thereby increasing intangible assets and
future amortization expense. While the Company believes that its purchase price
allocations are appropriate, if the SEC were to require a change in any of the
allocations, this would result in higher amortization expense, which could have
an adverse effect upon the Company's results of operations.


                                       11
<PAGE>   12

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 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.


                                       12
<PAGE>   13

ITEM 2. PROPERTIES

    The Company occupies approximately 39,000 square feet of space at its
headquarters in Ann Arbor, Michigan. Approximately 3,200 square feet will expire
in December 1999 with the remaining 35,800 square feet expiring in July 2000
(subject to the Company's right to extend the lease for one successive term of
five years). The Company also leases sales offices in Michigan, Texas,
California, Maryland, France, Sweden, England, Germany, Italy, Japan, Canada,
China and India. The Company believes that its existing facilities are adequate
for its needs for the next 12-18 months. Due to continued expansion, the Company
will need to secure additional space after the expiration of its existing
headquarters lease and is currently investigating its options for a new
headquarters.


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, 1998.


                                       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, 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
Year ended December 31, 1997:
  Fourth quarter..........................................................          $10.00            $  6.50
  Third quarter...........................................................            8.63               5.75
  Second quarter..........................................................           10.38               5.81
  First quarter...........................................................           13.75               6.25
</TABLE>

    As of December 31, 1998, there were 203 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, 1998, 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.

    In January 1998, the Company acquired 100% of the outstanding capital stock
of DTI Asia Pte. Ltd. In connection with this purchase, the Company issued
142,540 shares of the Company's common stock, none of which have been registered
under the Securities Act of 1933. The consideration for this transaction was a
cash payment of approximately $563,000 and the issuance of 142,540 shares of the
Company's common stock valued for this purpose at approximately $1.1 million.
These shares were issued in reliance upon the exemption from registration
contained in Section 4(2) of the Securities Act of 1933.


                                       14

<PAGE>   15


ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

    The consolidated statement of income data for the years ended December 31,
1998, 1997, 1996, 1995 and 1994 and the consolidated balance sheet data as of
December 31, 1998, 1997, 1996, 1995 and 1994 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                   1998          1997      1996      1995       1994
-------------------------------------------------------------------------------------------------------
<S>                                                <C>           <C>        <C>       <C>       <C>
CONSOLIDATED STATEMENT OF INCOME DATA:
  Revenue                                          $ 36,575       $30,191   $25,383   $21,256   $ 16,267
  Operating income (loss)                              (556)(1)       965     2,503     1,666        635
  Net income (loss)                                    (217)          744     2,071     1,381        450
  Accretion of value of warrants                         --            --        --       234        664
  Net income (loss) available to common
     shareholders                                      (217)          744     2,071     1,147       (214)
  Pro forma diluted net income (loss) per common
     share                                            (0.04)         0.13      0.41      0.30      (0.06)
</TABLE>


<TABLE>
<CAPTION>
                                                   -------------------------------------------------------------------
                                                                                AS OF DECEMBER 31,
                                                   -------------------------------------------------------------------
In thousands                                            1998            1997          1996         1995       1994
------------------------------------------------------------------------------------------------------------------
<S>                                                 <C>             <C>            <C>           <C>        <C>
CONSOLIDATED BALANCE SHEET DATA (3):
  Cash and cash equivalents......................   $  16,843       $ 20,261       $ 20,570 (4)  $  1,141   $    817
  Total assets...................................       36,247        34,147         29,812         9,338      7,334
  Long-term debt, less current portion...........        --              --             --            --          79
  Redeemable common stock........................        --              --             167           859      1,191
  Shareholders' equity (deficit).................       25,600        23,970         22,185 (4)     1,334        (77)
</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.

RESULTS OF OPERATIONS

   REVENUE
<TABLE>
<CAPTION>

In thousands                     1998    % CHANGE   1997    % CHANGE   1996
------------------------------------------------------------------------------
<S>                             <C>      <C>       <C>      <C>       <C>
Software licenses ...........   $19,659    13.9%   $17,258    18.3%   $14,590
  % of total revenue ........      53.7%              57.2%              57.5%
                               
Services ....................   $16,916    30.8%   $12,933    19.8%   $10,793
  % of total revenue ........      46.3%              42.8%              42.5%
                               
Total revenue ...............   $36,575    21.1%   $30,191    18.9%   $25,383
</TABLE>                       


                                       16
<PAGE>   17
                           
         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. Revenue from the Design
Analysis Group has been in the past, and is expected to be in the future,
derived primarily from sales of third-party software products, professional
services and sales of the Company's software products. The operating results of
the Design Analysis Group have been included in the Company's consolidated
results of operations from the date of acquisition.

         The Company's total revenue increased 21.1% to $36.6 million in 1998
from $30.2 million in 1997. During 1997, total revenue increased 18.9% from
$25.4 million in 1996. The growth in revenue during 1998 resulted primarily from
an increase in services provided to the Company's customers, as well as an
increase in sales of third-party products. The growth in revenue during 1997
resulted from increased sales of the Company's ADAMS Full Simulation Package, as
well as other related software products and services. During both years, the
Company achieved revenue growth in each of its major sales geographies,
including North America, Europe and Asia. A summary of the Company's revenue by
geographic area is presented in Note 8 of Notes to Consolidated Financial
Statements.

         Revenue from international customers accounted for approximately 62.4%,
65.2% and 67.0% of the Company's total revenue in 1998, 1997 and 1996,
respectively. The decrease in international revenue as a percent of total
revenue during 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 HGE. The
revenue shortfall experienced by the Company in Asia during 1998 resulted
primarily from continuing economic pressures facing Japan and Korea, as well as
the strengthening of the dollar relative to the Japanese yen, as described
below. The decrease in international revenue as a percent of total revenue
during 1997, as compared to 1996, was due in part to the strengthening of the
dollar during 1997, as well as increased sales of the Company's software
products and services in North America. If the economies in Asia continue to
deteriorate in 1999, 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 1999. 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
21.3%, 27.8% and 27.6% of the Company's total revenue in 1998, 1997 and 1996,
respectively. The decrease in revenue from distributors and sales
representatives in 1998, as compared to 1997, resulted primarily from increased
revenue from professional services provided directly to the Company's customers
as well as revenue generated from sales of third-party software products. The
Company's Japanese distributor, Information Services International-Dentsu, Ltd.
("ISI-Dentsu"), accounted for approximately 13.2%, 15.3% and 16.5% of the
Company's total revenue in 1998, 1997 and 1996, respectively.

         The Company generally prices its software products and services in
local currencies in Europe, Canada and Japan. The strengthening of the dollar in
1998, relative to the European and Japanese currencies, negatively affected 1998
international revenue by approximately $883,000, including $550,000 from the
Japanese yen. 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 was considerably less than the impact on revenue. If the
U.S. dollar continues to strengthen in 1999 relative to the European, Canadian
and 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 strengthening of the dollar in 1997,
relative to the European and Japanese currencies, negatively affected 1997
international revenue by approximately $1.2 million.

         Revenue from automotive-related customers accounted for approximately
54.7%, 50.5% and 48.1% of the Company's total revenue in 1998, 1997 and 1996,
respectively. No customer accounted for greater than 10% of the Company's total
revenue in 1998. Sales to Ford Motor Company accounted for approximately 10.6%
and 11.8% of the Company's total revenue in 1997 and 1996, respectively. No
other customer accounted for greater than 10% of the Company's total revenue in
1997 and 1996.


                                       17
<PAGE>   18

    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 grew 13.9% over 1997 to approximately
$19.7 million in 1998. The increase resulted from a higher volume of software
licenses sold worldwide, primarily from third party products. In 1997, software
licenses revenue grew 18.3% over 1996 to approximately $17.3 million. Revenue
from third-party products accounted for $2.6 million in revenue in 1998, or 7.1%
of total revenue, compared to $678,000, or 2.2% of total revenue, in 1997.

    Services revenue consists primarily of revenue from software maintenance
agreements and professional services, including consulting, training and funded
research and development. Total services revenue grew 30.8% over 1997 to
approximately $16.9 million in 1998. The overall increase in services revenue
reflects the Company's continued emphasis on providing total solutions to its
customers. Software maintenance revenue grew 23.8% in 1998 to $5.9 million,
while professional services revenue grew 37.8% in 1998 to $10.9 million. Total
services revenue grew 19.8% over 1996 to approximately $12.9 million in 1997.
Both the software maintenance and the professional service components of
services revenue experienced solid growth in 1997. Software maintenance revenue
totaled $4.8 million in 1997, a 16.9% increase over 1996. Professional services
revenue totaled $7.9 million in 1997, a 23.3% increase over 1996.

   COST OF REVENUE
<TABLE>
<CAPTION>

In thousands                                 1998        % CHANGE         1997         % CHANGE         1996
---------------------------------------- ------------- -------------- -------------- -------------- -------------
<S>                                        <C>           <C>            <C>            <C>            <C>      
Cost of software licenses...........       $   2,479       213.4%       $     791         30.5%       $     606
  Gross profit margin on software
    licenses revenue................           87.4%                        95.4%                         95.8%

Cost of services....................       $   9,581        35.6%       $   7,066         14.3%       $   6,183
  Gross profit margin on services
    revenue.........................           43.4%                        45.4%                         42.7%
</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 revenue increased 213.4% from
1997 to approximately $2.5 million in 1998. The increase was 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. In 1997, cost of software licenses revenue increased
30.5% from 1996 to approximately $791,000. The $185,000 absolute dollar increase
was primarily due to additional royalties paid to third parties whose products
are embedded in the Company's ADAMS software.

    Gross profit margin on software licenses revenue was 87.4%, 95.4% and 95.8%
during the years ended December 31, 1998, 1997 and 1996, respectively. The
decline in gross profit margin during 1998, as compared to 1997, was due to the
increased sales of third party software products compared to sales of the
Company's software products.

    Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development. Cost
of services revenue grew 35.6% over 1997 to approximately $9.6 million in 1998.
In 1997, cost of services revenue grew 14.3% over 1996 to approximately $7.1
million. The increases resulted from the hiring of additional employees to
support the growth in services provided to the Company's customers during 1998
and 1997.

    Gross profit margin on services revenue was 43.4%, 45.4% and 42.7% during
the years ended December 31, 1998, 1997 and 1996, respectively. The decline in
gross profit margin during 1998, as compared to 1997, was primarily due to the
increased professional services revenue as a percentage of total services
revenue. Historically, professional services revenue has generated lower profit
margins than revenue from software maintenance agreements.


                                       18
<PAGE>   19

   OPERATING EXPENSES
<TABLE>
<CAPTION>
In thousands                                 1998        % CHANGE         1997         % CHANGE         1996
---------------------------------------- ------------- -------------- -------------- -------------- -------------
<S>                                        <C>           <C>            <C>            <C>            <C>      
Sales and marketing.................       $  14,245        22.3%       $  11,644         21.1%       $   9,612
  % of total revenue................           38.9%                        38.6%                         37.9%

Research and development............       $   5,265        11.3%       $   4,729         29.7%       $   3,647
  % of total revenue................           14.4%                        15.7%                         14.4%

General and administrative..........       $   3,472         8.4%       $   3,202         17.0%       $   2,736
  % of total revenue................            9.5%                        10.6%                         10.8%

Goodwill amortization...............       $     341       227.9%       $     104          8.3%       $      96
  % of total revenue................            0.9%                         0.3%                           --

Acquisition-related costs and
  non-recurring charges.............       $   1,748         3.4%       $   1,690         --          $     --
  % of total revenue................            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 increases in sales and marketing expenses in
1998 and 1997 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 1998, the number of employees in sales and
marketing increased from 75 to 93. The Company expects to continue to expand its
sales organization in the future to meet the growing demand for its products and
services.

    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. The absolute
dollar increases in research and development expenses in 1998 and 1997 primarily
resulted from an increase in personnel and related 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, were 0.7%, 2.7% and 3.6%, of total revenue in 1998, 1997 and
1996, 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 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 management
functions. General and administrative expenses also include an allocation of
overhead expenses incurred by the Company. General and administrative expenses
grew 8.4% over 1997 to approximately $3.5 million in 1998, in support of the
Company's growing operations worldwide. General and administrative expenses grew
17.0% over 1996 to approximately $3.2 million in 1997. 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
227.9% in 1998, as compared to 1997, due to increased goodwill associated with
the Company's 1998 and 1997 acquisitions. 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. Goodwill amortization increased 8.3% in 1997, as
compared to 1996, due to increased goodwill associated with the acquisition of
StatDesign, Inc. ("StatDesign") in October 1997.


                                       19
<PAGE>   20

    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, have developed a plan to jointly enhance and integrate the University's
technology with that of the Company's such that a commercial product is expected
to be available for release in the second half of the year 2000. Costs
associated with the completion of these projects 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 are expected to be consistent with the assumptions
used in the valuation.

    In January 1998, the Company acquired DTI Asia Pte. Ltd. ("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 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. Costs
associated with the completion of these projects were 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


                                       20
<PAGE>   21

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 modulization
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                                 1998        % CHANGE         1997         % CHANGE         1996
---------------------------------------- ------------- -------------- -------------- -------------- -------------
<S>                                          <C>         <C>              <C>          <C>              <C>  
Other income, net.....................        $ 828            4.7%        $ 791            47.6%        $ 536
  % of total revenue..................          2.3%                         2.6%                          2.1%
</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 $828,000, $953,000, and $556,000 in 1998,
1997 and 1996, respectively. 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. Interest income
increased significantly in 1997, primarily as a result of twelve months of
interest earned on the $17.8 million in net proceeds raised from the Company's
initial public offering in May 1996. Foreign currency transaction gain (loss)
amounted to $64,000, ($129,000) and ($31,000) in 1998, 1997 and 1996,
respectively. Gain (loss) on the disposal of property and equipment was
($64,000), ($33,000) and $11,000 in 1998, 1997 and 1996, respectively.

   PROVISION FOR INCOME TAXES

    The Company's effective income tax rates were 176.1%, 57.9% and 31.9% for
1998, 1997 and 1996, 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 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 on certain
acquisitions. These unfavorable differences were partially offset by the benefit
of the Company's foreign sales corporation, and the benefit of tax-exempt
interest income. Excluding the acquisition-related charges, the Company's
effective tax rate for 1998 and 1997 would have been 29.6% and 29.5%.

   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 $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 20.9% to 283 at
December 31, 1998, compared with 234 at December 31, 1997. Reflected in this
increase are new employees who joined the Company as a result of the Company's
acquisitions of DTI and HGE in 1998. Absent the impact of the acquisitions,
employment increased to support the Company's growing operations worldwide.

   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 


                                       21
<PAGE>   22

a system failure or other computer errors. The Company has assessed and
identified risks in four areas of its business and has developed a plan for Year
2000 information systems compliance in each. The areas are: (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.

    Since the Company's products perform few date processing tasks, there is not
a significant risk of a material disruption as a result of the Year 2000. The
Company has completed testing on current versions of the Company's primary
products, including the software delivery and license systems of the products.
No areas of non-compliance were noted which required modification to the
Company's software. The Company's product development group is currently adding
Year 2000 readiness to its quality assurance process for all products to ensure
no Year 2000 problems are introduced during the development of software and
maintenance activities. The Company's primary business management and accounting
systems were replaced by the Company effective 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 have been certified for Year 2000
compliance. The Company's computing and communications infrastructure is
currently being reviewed. An inventory of all infrastructure components has been
established. All critical components of the infrastructure will be migrated to
Year 2000 readiness by the third quarter of 1999. A list of key suppliers to the
Company has been developed. Key suppliers have been contacted and are being
asked to show adequate readiness or alternate vendors will be identified.

    The Company does not expect that the costs to address its Year 2000 needs
will be material to its consolidated financial position or results of
operations. While the Company believes that its efforts to address Year 2000
issues for which it is responsible should be successful, it is possible that
there will 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 this should occur, 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. Because of the
unprecedented nature of litigation in this area, it is uncertain how the Company
may be affected by it. 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
will be 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. During the transition period, public and private
parties may pay for goods and services using either the Euro or the
participating country's former currency. Conversion rates, however, will no
longer be computed directly from one former currency to another.

    The Company is currently evaluating the 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 impact on its results of operations during or
after the transition period.

LIQUIDITY AND CAPITAL RESOURCES

    Cash and cash equivalents were $16.8 million at December 31, 1998, compared
to $20.3 million at December 31, 1997. The decrease in cash and cash equivalents
of $3.4 million was primarily due to the $2.3 million in cash used for capital
expenditures; $2.0 million in cash used in the acquisition of HGE in August
1998; $563,000 in cash used in the acquisition of DTI; and $400,000 in cash used
to purchase certain technology from the University of Iowa. These decreases were
partially offset by the $921,000 in cash generated from operations in 1998 and
$402,000 in proceeds from stock issued by the Company during 1998.


                                       22
<PAGE>   23

    At December 31, 1998, the Company's principal commitments consisted of
obligations under operating leases for facilities and equipment, including
approximately $1.7 million in payments due under noncancelable operating leases
during 1999. The Company had no borrowings under long-term debt arrangements at
December 31, 1998.

    In November 1998, the Board of Directors authorized management of the
Company to repurchase up to 500,000 shares of the Company's common stock. No
shares have been repurchased to date.

    In December 1998, the Company entered into 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, 1998. The Company's
subsidiaries in Italy, Sweden, and France also have line of credit and overdraft
facilities that provide for aggregate borrowing availability of approximately
$260,000. Approximately $105,000 in borrowings were outstanding under these
facilities as of December 31, 1998.

    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 an exclusive perpetual license to jointly develop and market this
technology. See Note 2 of Notes to Consolidated Financial Statements.

    In August 1998, the Company acquired the Design Analysis Group and certain
other assets of HGE, an engineering software and services firm focusing on the
aerospace industry. The aggregate purchase price of approximately $2.2 million
consisted principally of cash. See Note 2 of Notes to Consolidated Financial
Statements.

    In January 1998, the Company acquired 100% of the outstanding capital stock
of 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. See Note 2 of Notes to Consolidated Financial Statements.

    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 1996
through 1998 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,
1999. 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,
1998, the Company had forward foreign currency exchange contracts of $1.2
million (notional amounts). The contracts outstanding at December 31, 1998
mature through June 7, 1999 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,
1998. The Company did not engage in hedging activities prior to 1998.

    Gains and losses on the forward contracts are largely offset by gains and
losses on the underlying exposures. The Company conducts business in
approximately seven foreign currencies, predominantly Japanese yen, German marks
and British pounds. A hypothetical 10% appreciation of the U.S. dollar from
December 31, 1998 market rates would increase the unrealized value of the
Company's existing forward contracts at December 31, 1998 by $105,000.
Conversely, a hypothetical 10% depreciation of the U.S. dollar from December 31,
1998 market rates would decrease the unrealized value of the Company's forward
contracts by $129,000. 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, 1998
and 1997, and the related consolidated statements of income, shareholders'
equity and cash flows for each of the three years in the period ended December
31, 1998. 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 generally accepted auditing
standards. 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, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1998 in conformity with generally accepted accounting principles.



                                                     /s/ ARTHUR ANDERSEN LLP

Detroit, Michigan,
January 29, 1999

                                       25
<PAGE>   26
                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS
                        AS OF DECEMBER 31, 1998 AND 1997


<TABLE>
<CAPTION>
In thousands, except share data                                                               1998           1997
--------------------------------------------------------------------------------------------------------------------
<S>                                                                                         <C>             <C>
                                          ASSETS
Current assets:
   Cash and cash equivalents .......................................................        $ 16,843        $ 20,261
   Accounts receivable, net of allowance for doubtful accounts of $261 and $235 ....           9,893           8,000
   Prepaid and deferred expenses ...................................................           1,873           1,206
                                                                                            --------        --------
       Total current assets ........................................................          28,609          29,467
                                                                                            --------        --------
Property and equipment, net of accumulated depreciation of $3,551 and $2,314 .......           3,674           2,887
Goodwill, net of accumulated amortization of $695 and $354 .........................           3,820           1,498
Other assets .......................................................................             144             295
                                                                                            --------        --------
                                                                                            $ 36,247        $ 34,147
                                                                                            ========        ========
                           LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
   Borrowings under line of credit .................................................        $    105        $     45
   Accounts payable ................................................................           1,781           1,474
   Accrued compensation ............................................................           1,579           1,461
   Other accrued expenses ..........................................................           1,965           2,273
   Deferred revenue ................................................................           4,745           4,462
                                                                                            --------        --------
       Total current liabilities ...................................................          10,175           9,715
                                                                                            --------        --------
Minority interest ..................................................................             472             462
                                                                                            --------        --------
Shareholders' equity:
   Common stock, no par value, 15,000,000 shares authorized, 6,225,206 and 5,984,061
     shares issued and outstanding in 1998 and 1997, respectively ..................          22,332          20,838
   Preferred stock, no par value, 1,000,000 shares authorized, 0 shares issued and
     outstanding ...................................................................              --              --
   Retained earnings ...............................................................           3,073           3,290
   Cumulative translation adjustment ...............................................             195            (158)
                                                                                            --------        --------
       Total shareholders' equity ..................................................          25,600          23,970
                                                                                            --------        --------
                                                                                            $ 36,247        $ 34,147
                                                                                            ========        ========
</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, 1998, 1997 AND 1996


<TABLE>
<CAPTION>
In thousands, except share and per share data                    1998                1997                1996
-----------------------------------------------------------------------------------------------------------------
<S>                                                           <C>                 <C>                 <C>
Revenue:
   Software licenses .................................        $    19,659         $    17,258         $    14,590
   Services ..........................................             16,916              12,933              10,793
                                                              -----------         -----------         -----------
       Total revenue .................................             36,575              30,191              25,383
                                                              -----------         -----------         -----------
Cost of revenue:
   Software licenses .................................              2,479                 791                 606
   Services ..........................................              9,581               7,066               6,183
                                                              -----------         -----------         -----------
       Total cost of revenue .........................             12,060               7,857               6,789
                                                              -----------         -----------         -----------
Gross profit .........................................             24,515              22,334              18,594
                                                              -----------         -----------         -----------
Operating expenses:
   Sales and marketing ...............................             14,245              11,644               9,612
   Research and development ..........................              5,265               4,729               3,647
   General and administrative ........................              3,472               3,202               2,736
   Goodwill amortization .............................                341                 104                  96
   Acquisition-related costs and non-recurring charges              1,748               1,690                  --
                                                              -----------         -----------         -----------
       Total operating expenses ......................             25,071              21,369              16,091
                                                              -----------         -----------         -----------
Operating income (loss) ..............................               (556)                965               2,503
Other income, net ....................................                828                 791                 536
                                                              -----------         -----------         -----------
Income before income taxes and minority interest .....                272               1,756               3,039
Provision for income taxes ...........................                479               1,017                 968
                                                              -----------         -----------         -----------
Income (loss) before minority interest ...............               (207)                739               2,071
Minority interest in net income (loss) of subsidiaries                 10                  (5)                 --
                                                              -----------         -----------         -----------
Net income (loss) ....................................        $      (217)        $       744         $     2,071
                                                              ===========         ===========         ===========

Basic net income (loss) per common share .............        $     (0.04)        $      0.13         $      0.42
                                                              ===========         ===========         ===========
Weighted average common shares .......................          6,186,469           5,805,936           4,990,215
                                                              ===========         ===========         ===========

Diluted net income (loss) per common share ...........        $     (0.04)        $      0.13         $      0.41
                                                              ===========         ===========         ===========
Weighted average common and common equivalent shares .          6,186,469           5,867,753           5,070,028
                                                              ===========         ===========         ===========
</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, 1998, 1997 AND 1996


<TABLE>
<CAPTION>
                                                                 CONVERTIBLE     CLASS A & B     ADDITIONAL
                                                     COMMON       PREFERRED     COMMON STOCK       PAID-IN       RETAINED
In thousands, except share data                      STOCK          STOCK       AND WARRANTS       CAPITAL       EARNINGS
--------------------------------------------------------------------------------------------------------------------------
<S>                                                <C>           <C>           <C>                <C>           <C>
Balance at December 31, 1995.............          $    --        $  265        $     458          $   114      $    475
  Net income.............................               --           --               --              --           2,071
  Foreign currency translation adjustment               --           --               --              --             --
  Issuance of 11,250 shares of Class B
   common stock..........................               --           --               --                3            --
  Exercise of Class A common stock
   warrants and issuance of 81,060 shares
   of Class A common stock...............               --           --              (449)            509            --
  Conversion of 354,932 shares of
   Convertible preferred stock into
   484,758 shares of Class A common stock               --          (265)               2             263            --
  Conversion of 1,178,865 shares of Class
   B common stock and 2,700,772 shares of
   Class A common stock into 3,879,637
   shares of no par common stock.........               900          --               (11)           (889)           --
  Termination of redemption privileges for
   86,486 shares of redeemable common stock             692          --               --              --             --
  Issuance of 1,880,798 shares of common             17,991          --               --              --             --
   stock.................................
  Collections on subscriptions receivable               --           --               --              --             --
                                                   --------       ------        ---------          ------       --------
Comprehensive income.....................

Balance at December 31, 1996.............            19,583          --               --              --           2,546
  Net income.............................               --           --               --              --             744
  Foreign currency translation adjustment               --           --               --              --             --
  Termination of redemption privileges for
   20,843 shares of redeemable common stock             167          --               --              --             --
  Issuance of 223,626 shares of common                1,088          --               --              --             --
   stock.................................          --------       ------        ---------          ------       --------
Comprehensive income.....................

Balance at December 31, 1997.............            20,838          --               --              --           3,290
  Net loss...............................               --           --               --              --            (217)
  Foreign currency translation adjustment               --           --               --              --             --
  Issuance of 241,145 shares of common                1,494          --               --              --             --
   stock.................................          --------       ------        ---------          ------       --------
Comprehensive income.....................

Balance at December 31, 1998.............          $ 22,332       $  --         $     --           $  --        $  3,073
                                                   ========       ======        =========          ======       ========
</TABLE>


<TABLE>
<CAPTION>
                                                                       CUMULATIVE
                                                    SUBSCRIPTIONS     TRANSLATION                     COMPREHENSIVE
In thousands, except share data                      RECEIVABLE        ADJUSTMENT          TOTAL          INCOME
---------------------------------------------------------------------------------------------------------------------
<S>                                                 <C>               <C>                <C>          <C>
Balance at December 31, 1995.............               $ (10)          $    32          $   1,334
  Net income.............................                 --                --               2,071       $ 2,071
  Foreign currency translation adjustment                 --                 24                 24            24
  Issuance of 11,250 shares of Class B
   common stock..........................                 --                --                   3
  Exercise of Class A common stock
   warrants and issuance of 81,060 shares
   of Class A common stock...............                 --                --                  60
  Conversion of 354,932 shares of
   Convertible preferred stock into
   484,758 shares of Class A common stock                 --                --                 --
  Conversion of 1,178,865 shares of Class
   B common stock and 2,700,772 shares of
   Class A common stock into 3,879,637
   shares of no par common stock.........                 --                --                 --
  Termination of redemption privileges for
   86,486 shares of redeemable common stock               --                --                 692
  Issuance of 1,880,798 shares of common                  --                --              17,991
   stock.................................
  Collections on subscriptions receivable                  10               --                  10
                                                        -----           -------          ---------       -------
Comprehensive income.....................                                                                $ 2,095
                                                                                                         =======
Balance at December 31, 1996.............                 --                 56             22,185
  Net income.............................                 --                --                 744       $   744
  Foreign currency translation adjustment                 --               (214)              (214)         (214)
  Termination of redemption privileges for
   20,843 shares of redeemable common stock               --                --                 167
  Issuance of 223,626 shares of common                    --                --               1,088
   stock.................................               -----           -------          ---------       -------
Comprehensive income.....................                                                                $   530
                                                                                                         =======
Balance at December 31, 1997.............                 --               (158)            23,970
  Net loss...............................                 --                --                (217)      $  (217)
  Foreign currency translation adjustment                 --                353                353           353
  Issuance of 241,145 shares of common                    --                --               1,494
   stock.................................               -----           -------          ---------       -------
Comprehensive income.....................                                                                $   136
                                                                                                         =======
Balance at December 31, 1998.............               $ --            $   195          $  25,600
                                                        =====           =======          =========
</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, 1998, 1997 AND 1996


<TABLE>
<CAPTION>
In thousands                                                                     1998            1997            1996
-------------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>              <C>              <C>
Cash flows from operating activities:
   Net income (loss) .................................................        $   (217)        $    744         $  2,071
   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 ...................................           1,726              968              603
     (Gain) loss on disposal of assets ...............................              64               33              (11)
     Minority interest in net income (loss) of subsidiaries ..........              10               (5)              --
     Changes in assets and liabilities, net of effect of acquisitions:
       Accounts receivable ...........................................          (2,245)          (2,304)            (548)
       Prepaid and deferred expenses .................................            (273)             (22)            (179)
       Other assets ..................................................             117              (45)              19
       Accounts payable ..............................................             452              499              102
       Accrued expenses ..............................................            (134)             580              200
       Deferred revenue ..............................................            (327)             551              (19)
                                                                              --------         --------         --------
         Net cash provided by operating activities ...................             921            2,689            2,238
                                                                              --------         --------         --------

Cash flows from investing activities:
   Purchases of property and equipment ...............................          (2,250)          (2,177)            (866)
   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 .......................          (5,253)          (3,551)            (866)
                                                                              --------         --------         --------

Cash flows from financing activities:
   Proceeds from issuance of common stock ............................             402              220           18,054
   Net borrowings (payments) under line of credit agreements .........              60               --              (37)
   Minority investment in consolidated subsidiary and other ..........              --              467               10
                                                                              --------         --------         --------
         Net cash provided by financing activities ...................             462              687           18,027
                                                                              --------         --------         --------
Effect of exchange rate changes on cash ..............................             452             (134)              30
                                                                              --------         --------         --------
Net increase (decrease) in cash ......................................          (3,418)            (309)          19,429
Cash at beginning of year ............................................          20,261           20,570            1,141
                                                                              --------         --------         --------
Cash at end of year ..................................................        $ 16,843         $ 20,261         $ 20,570
                                                                              ========         ========         ========
</TABLE>


<TABLE>
<CAPTION>
Supplemental schedule of non-cash investing and financing
   activities: Details of acquisitions:

                                                                                 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
                                                                               =======          =======
</TABLE>


<TABLE>
<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
$64,000, ($129,000) and ($31,000) in 1998, 1997 and 1996, 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 other
companies' 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.

    Services revenue consists primarily of revenue from software maintenance
agreements and professional services, including consulting, training and funded
research and development. Revenue related to advance payments received under
software maintenance agreements is deferred and amortized over the terms of the
agreements. Revenue from other services is recognized upon performance of the
service.

   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.

                                       30
<PAGE>   31
    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, 1998, the Company had
forward foreign currency exchange contracts of $1.2 million (notional amounts).
The contracts outstanding at December 31, 1998 mature through June 7, 1999 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, 1998. The Company did not engage in hedging activities prior to
1998.

    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

                                       31
<PAGE>   32
Company's international distributor network. The Company generally does not
require collateral upon delivery of its products.

   Net Income (Loss) Per Common Share

    Effective December 31, 1997, the Company adopted Statement of Financial
Accounting Standards No. 128, "Earnings per Share." All prior period per share
data presented has been restated to conform to this new statement. 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,
                                                                             1998           1997         1996
----------------------------------------------------------------------------------------------------------------
<S>                                                                        <C>           <C>          <C>
 Weighted average common shares used in basic net income (loss) per
    common share...................................................        6,186,469     5,805,936    4,990,215
    Effect of stock options........................................              --         61,817       79,813
                                                                           ---------     ---------    ---------
 Weighted average common and common equivalent shares used in
    diluted net income (loss) per common share.....................        6,186,469     5,867,753    5,070,028
                                                                           =========     =========    =========
</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

    Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income," which
establishes standards for reporting and display of comprehensive income and its
components in a full set of financial statements. 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 1998 and 1997 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.

                                       32
<PAGE>   33
   New Accounting Pronouncements

    Effective January 1, 1998, the Company adopted Statement of Position 97-2,
"Software Revenue Recognition," which provides guidance on recognizing revenue
on software transactions. The implementation of this statement did not have an
effect upon the Company's consolidated financial statements or its existing
revenue recognition policies.

     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,
1999. 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.

   Reclassifications

    Certain amounts in the 1997 and 1996 consolidated financial statements have
been reclassified to conform with the 1998 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. The acquisition has been accounted
for under the purchase method of accounting. 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. The remaining 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 a twelve-year period. The operating results of the Design
Analysis Group have been included in the Company's consolidated results of
operations from the date of acquisition.

    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. The acquisition has been accounted for
under the purchase method of accounting. 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. The
remaining excess of the aggregate purchase price over the fair value of the net
assets acquired has been recognized as goodwill and will be amortized over a
five-year period. The operating results of DTI have been included in the
Company's consolidated results of operations from the date of acquisition.

                                       33
<PAGE>   34
    In October 1997, the Company acquired 100% of the outstanding capital stock
of StatDesign, Inc., a company based in Dearborn, Michigan. Since its founding
in 1992, StatDesign, Inc. had worked almost exclusively with the Company's
largest single customer to provide engineering software and services for product
design and development. 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. The acquisition has been
accounted for under the purchase method of accounting. 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. The remaining excess of the aggregate purchase price
over the fair value of the net assets acquired of approximately $530,000 has
been recognized as goodwill and will be amortized over a ten-year period. The
operating results of StatDesign, Inc. have been included in the Company's
consolidated results of operations from the date of acquisition.

 (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, 1998. The agreement expires on June 30, 2000.

    The Company's subsidiaries in Italy, Sweden and France also have line of
credit and overdraft facilities that provide for aggregate borrowing
availability of approximately $260,000, at various fixed and variable interest
rates at December 31, 1998. Borrowings are primarily due on demand and are
collateralized by certain assets of the subsidiaries. Borrowings outstanding
under these agreements were $105,000 and $45,000 at December 31, 1998 and 1997,
respectively.

    No borrowings were outstanding under long-term debt arrangements at December
31, 1998 and 1997. Cash paid for interest was $16,000, $12,000 and $22,000 in
1998, 1997 and 1996, respectively.

 (4) INCOME TAXES

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

<TABLE>
<CAPTION>
                                                                               YEAR ENDED DECEMBER 31,
In thousands                                                               1998           1997         1996
--------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>            <C>           <C>
Income (loss) before provision for income taxes:
  Domestic.........................................................     $    940       $  1,497      $  2,874
  Foreign..........................................................         (668)           259           165
                                                                        --------       --------      --------
                                                                        $    272       $  1,756      $  3,039
                                                                        ========       ========      ========
Domestic provision (benefit) for income taxes:
  Current..........................................................     $    241       $    859      $    973
  Deferred.........................................................           30             42           (92)
Foreign provision for income taxes:
  Current..........................................................          208            116            87
                                                                        --------       --------      --------
Provision for income taxes.........................................     $    479       $  1,017      $    968
                                                                        ========       ========      ========
</TABLE>

                                       34
<PAGE>   35
    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                                                                1998          1997          1996
---------------------------------------------------------------------------------------------------------------
<S>                                                                        <C>          <C>            <C>
Federal statutory provision.........................................       $    92      $   597        $ 1,033
   Meals and entertainment..........................................            33           41             28
   Acquisition-related costs and non-recurring charges..............           402          575           --
   Goodwill amortization............................................            44           35             33
   Reduction in valuation reserve...................................           --           --             (95)
   Foreign losses without tax benefit...............................           --             5              5
   Effect of differences between U.S. and foreign tax rates.........            37          (66)            31
   Tax-exempt interest income.......................................          (121)        (106)           (34)
   Other, net.......................................................            (8)         (64)           (33)
                                                                           -------      -------        -------
Provision for income taxes..........................................       $   479      $ 1,017        $   968
                                                                           =======      =======        =======
</TABLE>

    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                                                                              1998         1997
------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>          <C>
Deferred tax assets:
  Property and equipment............................................................     $   28       $   81
  Employee benefits.................................................................        131          120
  Accounts receivable...............................................................         89           72
  Other.............................................................................         (5)         --
                                                                                         ------       ------
Net deferred tax asset..............................................................     $  243       $  273
                                                                                         ======       ======
</TABLE>

    Income taxes have been provided on all undistributed earnings of foreign
subsidiaries. Cash paid for income taxes was $1.2 million, $764,000 and $753,000
in 1998, 1997 and 1996, respectively.

(5) REDEEMABLE COMMON STOCK AND SHAREHOLDERS' EQUITY

    On April 23, 1996, the shareholders of the Company approved an amendment and
restatement to the Company's articles of incorporation that effected (1) a
1.5-for-1 stock split of the Company's common stock, (2) an increase in the
authorized shares of common stock to 15,000,000 shares, (3) the conversion of
all classes of common stock to no par common stock, (4) an increase in the
authorized number of preferred shares to 1,000,000, and (5) an amendment of the
privileges of the preferred stock. All references in the consolidated financial
statements and accompanying notes have also been adjusted to reflect the
amendment and restatement of the articles of incorporation.

   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.

    In May 1996, the Company completed an initial public offering of its stock,
which resulted in the issuance of 1,500,000 shares of common stock at a price of
$11.00 per share. In June 1996, an additional 354,750 shares were sold by the
Company at $11.00 per share, pursuant to the underwriters' exercise of their
over-allotment option.

    In November 1998, the Board of Directors authorized management of the
Company to repurchase up to 500,000 shares of the Company's common stock. No
shares have been repurchased to date.

                                       35
<PAGE>   36
   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.

   Convertible Preferred Stock

    On February 8, 1996, the Board of Directors authorized the Company to redeem
all outstanding shares of convertible preferred stock. The holders of
convertible preferred shares had the right to convert such shares into shares of
Class A common stock in lieu of accepting cash redemption payments. As of April
11, 1996, all holders of convertible preferred stock exercised their right to
convert their shares into Class A common stock. Based on a formula in the
agreement, each share of convertible preferred stock was converted into
approximately 1.37 shares of Class A common stock.

   Class A and Class B Common Stock

    In April 1996, the Company amended and restated its Articles of
Incorporation to automatically convert each share of Class A common stock and
each share of Class B common stock into one share of common stock.

    In April 1994, the Company purchased all of the outstanding stock of its
distributors in France, Germany, Sweden, Italy and the United Kingdom. In
connection with this acquisition, the Company issued 107,329 shares of Class A
common stock with redemption privileges at $8 per share. During 1997 and 1996,
the redemption privileges associated with 20,843 and 86,486 of these shares
terminated, respectively.

   Class A Common Stock Warrants

    In March 1990, April 1991, and September 1992, 124,155, 23,280, and 14,685
nonnegotiable warrants to acquire Class A common stock of the Company,
respectively, were issued and attached to the Company's subordinated debt. The
Company was notified on March 11, 1996, that the holder of one-half of the
warrants would exercise their right to purchase 81,060 shares of the Company's
Class A common stock at a price of $0.75 per share. The remaining warrants were
redeemed by the Company in 1996 for a cash value of $449,000.

   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 43,340, 33,899 and 17,213 shares
of common stock in 1998, 1997 and 1996, respectively, to various employees.
These shares were issued with a weighted average price per share of $6.37, $5.97
and $11.79 in 1998, 1997 and 1996, respectively. As of December 31, 1998, there
were 205,548 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

                                       36
<PAGE>   37
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 650,000 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, 1995              --                     --               --
  Granted ......................         182,500         $9.00 - $13.50        $   11.47
                                        --------         --------------        ---------
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
                                        ========         ==============        =========
</TABLE>

    There were 68,925 and 82,500 options exercisable under the Stock Option Plan
as of December 31, 1998 and 1997, respectively, with a weighted average exercise
price of $8.21 per share in 1998 and $9.00 per share in 1997. 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, 1998, there were 54,350 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 7.6 years and 4.1 years as of December 31, 1998 and 1997, 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 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 100,000 shares of common stock have been reserved
for issuance under the Director Stock Option Plan.

                                       37
<PAGE>   38
    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, 1995.....................................         --               --                 --
  Granted............................................................     20,000          $ 11.00             $11.00
                                                                          ------          -------             ------
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
                                                                          ======     ===============          ======
</TABLE>

    There were 40,000 and 20,000 options exercisable under the Director Stock
Option Plan as of December 31, 1998 and 1997, respectively, with a weighted
average exercise price of $10.07 per share in 1998 and $11.00 per share in 1997.
Options outstanding under the Director Stock Option Plan have a weighted average
remaining contractual life of 3.4 years and 3.8 years as of December 31, 1998
and 1997, 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 Class A 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, 1995 and 1996         61,671         $   0.93
  Exercised .............................        (19,500)        $   0.93
                                                 -------         --------
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, 1998 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>
      $6.69 - $7.00          356,075             9.56            $  6.75            5,050       $  6.72
      $ 7.01 - $8.00         148,500             3.19            $  7.86           37,125       $  7.86
      $ 8.01 - $9.00          32,250             2.82            $  8.90           26,750       $  8.97
     $ 9.01 - $11.00          91,700             6.38            $  9.63           40,000       $ 10.07
     $ 11.01 - $13.00         21,000             4.61            $ 12.93              --          --
</TABLE>

                                       38
<PAGE>   39
   Stock-Based Compensation

    Using the intrinsic value method of accounting for the value of stock
options granted during 1998 and 1997, 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 1998 and
1997 consistent with the provisions of SFAS 123, net income and net income per
share would have been reduced to the pro forma amounts indicated below:

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

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

    The weighted average estimated fair value of stock options granted during
1998 and 1997 was $4.69 and $3.98, 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>
                                                                                     1998         1997
------------------------------------------------------------------------------------------------------
<S>                                                                                 <C>          <C>
Expected life (years).............................................................   5.0          5.0
Interest rate.....................................................................   5.2%         6.0%
Volatility........................................................................   0.7          0.8
Dividend yield....................................................................   0.0%         0.0%
</TABLE>

(6) COMMITMENTS AND CONTINGENCIES

   Employee Benefit Plans

    The Company maintains a 401(k) plan covering substantially all of its
employees. During 1998, 1997 and 1996, the Company matched 40% of qualified
employee contributions, up to a maximum of 2.4% of eligible compensation. In
1998, 1997 and 1996, the Company contributed $244,000, $180,000 and $150,000,
respectively, to the plan.

   Lease Commitments

    The Company and its subsidiaries lease office space and certain equipment
under noncancelable operating lease agreements. Future minimum lease payments at
December 31, 1998 are as follows:

<TABLE>
<CAPTION>
In thousands
--------------------------------------------------------------------------
<S>                                                            <C>
1999....................................................       $  1,653
2000....................................................            866
2001....................................................            196
2002....................................................            135
2003....................................................             15
Thereafter..............................................             13
                                                               --------
                                                               $  2,878
                                                               ========
</TABLE>

    Total lease expense amounted to approximately $2.0 million in each of the
years ending 1998, 1997 and 1996.

   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 $2.2 million, $612,000 and $480,000 in
1998, 1997 and 1996, respectively.

                                       39

<PAGE>   40
(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.

                                       40
<PAGE>   41
    The following table summarizes selected financial information of the
Company's operations by geographic location:


<TABLE>
<CAPTION>
                                                                     YEAR ENDED DECEMBER 31,
In thousands                                                 1998             1997            1996
------------------------------------------------------------------------------------------------------
<S>                                                        <C>              <C>              <C>
Revenue:
  North America
     United States ................................        $ 12,223         $ 10,340         $  8,250
     Canada and Mexico ............................           1,514              153              128
  Europe
     Germany ......................................           5,108            4,380            4,217
     Other European countries .....................           7,769            5,653            5,535
  Asia/Pacific
     Japan ........................................           7,819            7,324            5,424
     Other Asian countries ........................           2,142            2,341            1,829
                                                           --------         --------         --------
          Total revenue ...........................        $ 36,575         $ 30,191         $ 25,383
                                                           ========         ========         ========

Operating contribution:
  North America
     United States ................................        $  3,827         $  3,229         $  2,940
     Canada and Mexico ............................             186               89               87
  Europe
     Germany ......................................           1,805            1,377            1,315
     Other European Countries .....................           2,672            1,836            1,686
  Asia/Pacific
     Japan ........................................           1,204            2,020            1,953
     Other Asian countries ........................             250              623              658
                                                           --------         --------         --------
          Total operating contribution ............           9,944            9,174            8,639
  Unallocated expenses, net .......................          (9,672)          (7,418)          (5,600)
                                                           --------         --------         --------
          Income before taxes and minority interest        $    272         $  1,756         $  3,039
                                                           ========         ========         ========

Identifiable assets:
  North America
     United States ................................        $ 23,882         $ 26,115         $ 24,744
     Canada .......................................           1,698               --               --
  Europe
     Germany ......................................           1,942            1,124            1,199
     Other European countries .....................           3,430            3,580            2,797
  Asia/Pacific
     Japan ........................................           1,362            1,788               --
     Other Asian countries ........................             114               42               --
                                                           --------         --------         --------
          Total identifiable assets ...............          32,428           32,649           28,740
  Goodwill ........................................           3,819            1,498            1,072
                                                           --------         --------         --------
          Total assets ............................        $ 36,247         $ 34,147         $ 29,812
                                                           ========         ========         ========
</TABLE>

    No customer accounted for greater than 10% of total revenue in 1998. One
customer accounted for approximately 10.6% and 11.8% of total revenue in 1997
and 1996, respectively.

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

                                       41
<PAGE>   42
(9) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

    The following table summarizes selected unaudited quarterly financial
information for 1998 and 1997. 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            1998             1998            1998             1998             1998
---------------------------------------------------------------------------------------------------------------------------
<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>


<TABLE>
<CAPTION>
                                                               THREE MONTHS ENDED                     YEAR ENDED
                                           --------------------------------------------------------  ------------
                                           MARCH 31,      JUNE 30,    SEPTEMBER 30,    DECEMBER 31,  DECEMBER 31,
In thousands, except per share data          1997           1997           1997            1997          1997
-----------------------------------------------------------------------------------------------------------------
<S>                                        <C>            <C>         <C>              <C>           <C>
Revenue .....................              $ 6,701        $ 7,205        $ 7,679        $ 8,606         $30,191
Gross profit ................                4,994          5,358          5,802          6,180          22,334
Operating income (loss) .....                  514            628            693           (870)            965
Net income (loss) ...........                  477            589            649           (971)            744
Basic net income (loss) per
   common share .............              $  0.08        $  0.10        $  0.11        $ (0.16)        $  0.13
Diluted net income (loss) per
   common share .............              $  0.08        $  0.10        $  0.11        $ (0.16)        $  0.13
</TABLE>

                                       42
<PAGE>   43
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 1999 Annual Meeting of
Shareholders scheduled to be held on May 13, 1999.

    The executive officers of the Company as of March 1, 1999 are listed below:

<TABLE>
<CAPTION>
                       NAME                          AGE                           POSITION
-----------------------------------------------------------------------------------------------------------------
<S>                                                  <C>     <S>
Michael E. Korybalski...........................     52      Chief Executive Officer, Chairman of the Board and
                                                                Director
Robert R. Ryan..................................     41      President, Chief Operating Officer and Director
Michael Hoffmann................................     42      Senior Vice President -- Worldwide Sales & Service
David Peralta...................................     31      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 through February 1997. 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.

                                       43
<PAGE>   44
ITEM 11. EXECUTIVE COMPENSATION

    The information required by this Item is incorporated by reference to the
Company's Proxy Statement for the 1999 Annual Meeting of Shareholders scheduled
to be held on May 13, 1999.


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 1999 Annual Meeting of Shareholders scheduled
to be held on May 13, 1999.


ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    None.

                                       44
<PAGE>   45
                                     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, 1998 and 1997
    Consolidated Statements of Income for the Years Ended December 31, 1998,
      1997 and 1996 
    Consolidated Statements of Shareholders' Equity for the Years
      Ended December 31, 1998, 1997 and 1996 
    Consolidated Statements of Cash Flows for the Years Ended December 31,
      1998, 1997 and 1996
    Notes to Consolidated Financial Statements

ITEM 14(a)2. FINANCIAL STATEMENT SCHEDULES

    None.

                                       45
<PAGE>   46
ITEM 14(a)3. EXHIBITS

<TABLE>
<CAPTION>
      NUMBER                                                     EXHIBIT
--------------------------------------------------------------------------------------------------------------------
<S>                  <C>
        (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 KeyBank National Association and the Company dated December 4, 1998

      (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

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

       (21)          Subsidiaries Of The Registrant

      (23.1)         Consent Of Independent Public Accountants

    (27) - 1998      Financial Data Schedule - 1998

    (27) - 1996      Financial Data Schedule - 1996  (Amended for SFAS 128)

  (27) - 1997-Q3     Financial Data Schedule - 1997 - 3rd Quarter  (Amended for SFAS 128)

  (27) - 1996-Q3     Financial Data Schedule - 1996 - 3rd Quarter  (Amended for SFAS 128)
</TABLE>



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, 1998.

                                       46
<PAGE>   47
                                   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 26, 1999                            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 26, 1999
----------------------------------         Chief Executive Officer,
Michael E. Korybalski                      and Director
                                           (Principal Executive Officer)


/s/ Robert R. Ryan                         President, Chief Operating Officer      March 26, 1999
----------------------------------         and Director
Robert R. Ryan


/s/ David Peralta                          Chief Financial Officer                 March 26, 1999
----------------------------------         (Principal Financial and
David Peralta                              Accounting Officer)


/s/ Herbert S. Amster                      Director                                March 26, 1999
----------------------------------
Herbert S. Amster


/s/ David E. Cole                          Director                                March 26, 1999
----------------------------------
David E. Cole


/s/ Joseph F. Gloudeman                    Director                                March 26, 1999
----------------------------------
Joseph F. Gloudeman


/s/ Mitchell I. Quain                      Director                                March 26, 1999
----------------------------------
Mitchell I. Quain
</TABLE>

                                       47
<PAGE>   48
                                INDEX TO EXHIBITS


<TABLE>
<CAPTION>
      NUMBER                                                  EXHIBIT TITLE
---------------------------------------------------------------------------------------------------------------------
<S>                  <C>
        (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 KeyBank National Association and the Company dated December 4, 1998

      (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

       (11)          Statement Re Computation Of Per Share Earnings

       (21)          Subsidiaries Of The Registrant

      (23.1)         Consent Of Independent Public Accountants

    (27) - 1998      Financial Data Schedule - 1998

    (27) - 1996      Financial Data Schedule - 1996  (Amended for SFAS 128)

  (27) - 1997-Q3     Financial Data Schedule - 1997 - 3rd Quarter  (Amended for SFAS 128)

  (27) - 1996-Q3     Financial Data Schedule - 1996 - 3rd Quarter  (Amended for SFAS 128)
</TABLE>

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