<PAGE>   1
                                UNITED STATES
                     SECURITIES AND EXCHANGE COMMISSION
                           Washington, D.C. 20549


                                  FORM 10-Q


(Mark One)
[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934
     For the fiscal period ended:  SEPTEMBER 30, 1997

     OR

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


                      Commission file number:  0-20679



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




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

                           2301 COMMONWEALTH BLVD.
                         ANN ARBOR, MICHIGAN  48105
                               (313) 994-3800
           (Address of principal executive offices, including zip
              code, and telephone number, including area code)


     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



     The number of outstanding shares of the Registrant's common stock, as of
November 7, 1997, was 5,964,561.




<PAGE>   2

                           MECHANICAL DYNAMICS, INC.

                                   FORM 10-Q
                               TABLE OF CONTENTS



                                                                            Page
                                                                            ----
PART I - FINANCIAL INFORMATION

  Item 1.  Financial Statements

           Condensed Consolidated Balance Sheets                             
           September 30, 1997 and December 31, 1996.........................   3
                                                                             
           Condensed Consolidated Statements of Income                       
           Three and Nine Months Ended September 30, 1997 and 1996  ........   4
                                                                             
                                                                             
           Condensed Consolidated Statements of Cash Flows                   
           Nine Months Ended September 30, 1997 and 1996....................   5
                                                                              
           Notes to Condensed Consolidated Financial Statements.............   6
                                                                             
  Item 2.  Management's Discussion and Analysis of Financial                
           Condition and Results of Operations .............................   7

PART II - OTHER INFORMATION

  Item 6.  Exhibits and Reports on Form 8-K.................................  13

SIGNATURES..................................................................  14

INDEX TO EXHIBITS...........................................................  15





                                       2
<PAGE>   3


                       PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                 MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                    CONDENSED CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                           SEPTEMBER 30,     DECEMBER 31,
        in thousands                                           1997             1996
      ===================================================================================
                                                           (Unaudited)
        <S>                                                  <C>              <C>
        ASSETS:
        Current assets:
            Cash and cash equivalents                         $21,038          $20,570
            Accounts receivable                                 6,408            5,019
            Prepaid and deferred expenses                         938            1,074
      -----------------------------------------------------------------------------------
                    Total current assets                       28,384           26,663
      -----------------------------------------------------------------------------------
        Net property and equipment                              2,037            1,643
        Other assets                                            1,543            1,506
      -----------------------------------------------------------------------------------
        Total assets                                          $31,964          $29,812
      ===================================================================================

        LIABILITIES AND SHAREHOLDERS' EQUITY:
        Current liabilities:
            Borrowings under lines of credit                       $0              $45
            Accounts payable                                      817              762
            Accrued expenses                                    2,834            2,982
            Deferred revenue                                    3,700            3,671
      -----------------------------------------------------------------------------------
                    Total current liabilities                   7,351            7,460
      -----------------------------------------------------------------------------------
        Minority interest                                         448                0
        Redeemable common stock                                     0              167
        Shareholders' equity:
            Common stock                                       19,952           19,583
            Preferred Stock                                         0                0
            Retained earnings                                   4,261            2,546
            Cumulative translation adjustment                     (48)              56
      -----------------------------------------------------------------------------------
                    Total shareholders' equity                 24,165           22,185
      -----------------------------------------------------------------------------------
        Total liabilities and shareholders' equity            $31,964          $29,812
      ===================================================================================
</TABLE>

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


                                      3


<PAGE>   4

                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                  CONDENSED CONSOLIDATED STATEMENTS OF INCOME
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                          THREE MONTHS ENDED         NINE MONTHS ENDED
                                                                              SEPTEMBER 30,              SEPTEMBER 30,
                                                                          -----------------------------------------------
        in thousands, except share and per share data                       1997         1996          1997         1996
      ===================================================================================================================
        <S>                                                            <C>         <C>            <C>          <C>
        Revenue:
           Software licenses                                              $4,568       $3,592       $12,484      $11,111
           Services                                                        3,111        3,071         9,101        7,841
      -------------------------------------------------------------------------------------------------------------------
             Total revenue                                                 7,679        6,663        21,585       18,952
      -------------------------------------------------------------------------------------------------------------------
        Cost of revenue:
           Software licenses                                                 271          114           563          472
           Services                                                        1,606        1,733         4,868        4,426
      -------------------------------------------------------------------------------------------------------------------
             Total cost of revenue                                         1,877        1,847         5,431        4,898
      -------------------------------------------------------------------------------------------------------------------
        Gross profit                                                       5,802        4,816        16,154       14,054
      -------------------------------------------------------------------------------------------------------------------
        Operating expenses:
           Sales and marketing                                             3,087        2,450         8,578        7,247
           Research and development                                        1,223          871         3,358        2,626
           General and administrative                                        799          683         2,383        2,052
      -------------------------------------------------------------------------------------------------------------------
             Total operating expenses                                      5,109        4,004        14,319       11,925
      -------------------------------------------------------------------------------------------------------------------
        Operating income                                                     693          812         1,835        2,129
        Other income, net                                                    236          235           592          311
      -------------------------------------------------------------------------------------------------------------------
        Income before income taxes and minority interest                     929        1,047         2,427        2,440
        Provision for income taxes                                           280          334           731          795
      -------------------------------------------------------------------------------------------------------------------
        Net income before minority interest                                  649          713         1,696        1,645
        Minority interest in net income (loss) of subsidiary                   0            0           (19)           0
      -------------------------------------------------------------------------------------------------------------------
        Net income                                                          $649         $713        $1,715       $1,645
      ===================================================================================================================
        Net income per common share                                        $0.11        $0.12         $0.29        $0.34
      ===================================================================================================================
        Common and common equivalent shares                            5,842,828    5,862,102     5,870,694    4,808,581
      ===================================================================================================================
</TABLE>

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




                                      4


<PAGE>   5

                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (UNAUDITED)

<TABLE>
<CAPTION>                                    
                                                                         SEPTEMBER 30,   SEPTEMBER 30,
        in thousands                                                         1997            1996
       ===============================================================================================
        <S>                                                                <C>             <C>
        Cash flows from operating activities:
          Net income                                                         $1,715          $1,645
          Adjustments to reconcile net income to net cash
           provided by operating activities:
            Depreciation and amortization                                       684             410
            Provision (credit) for deferred income taxes                          0             (65)
            (Gain) loss on disposal of assets, net                               28              11
            Minority interest in net income (loss) of subsidiary                (19)              0
            Changes in assets and liabilities:
               Accounts receivable                                           (1,209)            (38)
               Prepaid and deferred expenses                                    202              36
               Other assets                                                     (96)             35
               Accounts payable                                                 (67)           (204)
               Accrued expenses                                                (202)            570
               Deferred revenue                                                 (63)           (108)
       -----------------------------------------------------------------------------------------------
                  Net cash provided by operating activities                     973           2,292
       -----------------------------------------------------------------------------------------------
        Cash flows from investing activities:
          Proceeds from the sale of property and equipment                       48               0
          Purchases of property and equipment                                (1,136)           (494)
       -----------------------------------------------------------------------------------------------
                  Net cash used in investing activities                      (1,088)           (494)
       -----------------------------------------------------------------------------------------------
        Cash flows from financing activities:
          Net borrowings (payments) under line of credit agreements             (45)            (44)
          Proceeds from the issuance of common stock                            202          17,850
          Proceeds from collections on subscriptions receivable                   0              10
          Minority investment in consolidated subsidiary                        467               0
       -----------------------------------------------------------------------------------------------
                  Net cash provided by financing activities                     624          17,816
       -----------------------------------------------------------------------------------------------
        Effect of exchange rate changes on cash                                 (41)             23
       -----------------------------------------------------------------------------------------------
        Net increase in cash and cash equivalents                               468          19,637
        Cash and cash equivalents at beginning of period                     20,570           1,141
       -----------------------------------------------------------------------------------------------
        Cash and cash equivalents at end of period                          $21,038         $20,778
       ===============================================================================================
        Supplemental disclosures of cash flow information:
          Cash paid during the year for:
            Interest                                                            $10             $18
            Income taxes                                                       $673            $444
       ===============================================================================================
</TABLE>

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

                                      5


<PAGE>   6


                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(1) - BASIS OF PRESENTATION

     The accompanying unaudited condensed consolidated financial statements
include the accounts of Mechanical Dynamics, Inc. ("MDI" or the "Company") and
its subsidiaries, and have been prepared in accordance with generally accepted
accounting principles for interim financial information and with Article 10 of
Regulation S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.  The Company believes all adjustments, consisting of
normal recurring adjustments considered necessary for a fair presentation, have
been included.  For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's Form 10-K for the
year ended December 31, 1996.

     Operating results for the three and nine month periods ended September 30,
1997 and 1996 are not necessarily indicative of the results that may be
expected for the full year.

(2) - EARNINGS PER SHARE

     In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings per Share." The
Company will be required to adopt this new standard for the year and the
quarter ended December 31, 1997. Early adoption is not permitted. The primary
requirements of this standard include: (1) the replacement of primary earnings
per share with basic earnings per share, which eliminates the dilutive effect
of stock options and warrants; (2) the use of average share price in applying
the treasury method to compute dilution for stock options and warrants for
diluted earnings per share; and (3) a disclosure reconciling the numerator and
denominator of earnings per share calculations. The Company believes that the
implementation of this standard will not have a material effect on its
consolidated financial statements for the periods presented.

(3) - REDEEMABLE COMMON STOCK AND SHAREHOLDERS' EQUITY

     In July 1997, the redemption privileges associated with the remaining 
20,843 shares of redeemable common stock expired. The redemption privileges on
these shares of redeemable common stock outstanding were exercisable at $8.00
per share between June 15, 1997 and July 14, 1997.
        

(4) - SUBSEQUENT EVENT

     On October 31, 1997, the Company acquired 100% of the outstanding capital 
stock of StatDesign, Inc.  Since its founding in 1992, Stat Design has 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 $2.4 million included cash and
170,227 shares of the Company's common stock.  The acquisition will be
accounted for under the purchase method of accounting.  In connection with the
acquisition, the Company expects to record a one-time charge to operations in
the fourth quarter of 1997 of approximately $1.7 million, associated with the
write-off of in-process research and development acquired in the transaction
that had not reached technological feasibility.  The remaining excess of the
aggregate purchase price over the fair value of the net assets acquired will be
recognized as goodwill and amortized over its estimated useful life.
        



                                      6
<PAGE>   7

ITEM 2.  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 condensed consolidated financial statements and the notes thereto
included in Item 1 of this Form 10-Q.

OVERVIEW

     The Company develops, markets and supports virtual prototyping solutions.  
The Company's virtual prototyping software allows the 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 in the future to be,
derived almost exclusively 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 of 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 or acquisitions, including related
charges, 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.

     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.
        
        

                                      7
<PAGE>   8


RESULTS OF OPERATIONS

 REVENUE

<TABLE>
<CAPTION>
                                                  Three Months Ended September 30,        Nine Months Ended September 30,       
                                                ------------------------------------   -----------------------------------      
   dollars in thousands                            1997        1996     % Change          1997        1996     % Change         
 =========================================================================================================================     
   <S>                                            <C>         <C>          <C>           <C>         <C>          <C>           
   Software licenses                              $4,568      $3,592       27.2%         $12,484     $11,111       12.4%        
     % of total revenue                             59.5%       53.9%                       57.8%       58.6%                   
                                                                                                                                
   Services                                       $3,111      $3,071        1.3%          $9,101      $7,841       16.1%        
     % of total revenue                             40.5%       46.1%                       42.2%       41.4%                   
                                                                                                                                
 -------------------------------------------------------------------------------------------------------------------------     
   Total revenue                                  $7,679      $6,663       15.2%         $21,585     $18,952       13.9%        
 =========================================================================================================================     
</TABLE>

     The Company's total revenue increased 15.2% and 13.9% during the three and
nine month periods ended September 30, 1997, respectively, as compared to
corresponding periods in 1996.  The growth in revenue during the three month
period ended September 30, 1997 resulted primarily from increased sales of the
Company's software products.  The growth in revenue during the nine month
period ended September 30, 1997 resulted from an increase in the services
provided to the Company's customers, as well as from increased sales of the
Company's software products.

     Revenue from international customers accounted for approximately 67.0% and
59.0% of the Company's total revenue during the three months ended September
30, 1997 and 1996, respectively.  International revenue accounted for
approximately 61.5% and 61.1% of total revenue during the nine months ended
September 30, 1997 and 1996, respectively.  The increase in international
revenue as a percent of total revenue during the three month period ended
September 30, 1997, as compared to the corresponding period in 1996, was due
primarily to increased sales of the Company's software products in Asia, and,
to a lesser extent, in Europe.   The absolute increases in international
revenue during the three and nine month periods ended September 30, 1997 were
partially offset by the strengthening of the dollar in 1997 relative to the
European and Japanese currencies.  The strengthening of the dollar negatively
affected the Company's international revenue during the three and nine month
periods ended September 30, 1997 by approximately $340,000 and $940,000,
respectively.  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 dollar continues to strengthen in 1997 relative to the
European 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 revenue will continue to account for a significant portion of its
total revenue in future periods.
        
     Software licenses revenue consists primarily of license fees for the
Company's software products and, to a lesser extent, license fees for third
party software products licensed through the Company's European subsidiaries.
Software licenses revenue increased 27.2% and 12.4% during the three and nine
month periods ended September 30, 1997, respectively, as compared to
corresponding periods in 1996. These increases resulted primarily from a higher
volume of sales of the Company's ADAMS Full Simulation Package and ADAMS/Car
software products, as well as certain other software products sold by the
Company.
        
     Services revenue consists of revenue from software maintenance agreements
and professional services, including consulting, training and funded research 
and development. Services revenue increased 1.3% and 16.1% during the three and
nine month periods ended September 30, 1997, respectively, as compared to
corresponding periods in 1996.  Both the software maintenance and the
professional service components of services revenue have experienced solid
growth during the first nine months of 1997.  The overall increase in services
revenue reflects the Company's continued emphasis on providing total solutions
to its customers.  For the three months ended September 30, 1997, the growth in
services revenue over the corresponding period in 1996 was offset by a $400,000



                                       8
<PAGE>   9
decline in funded research and development revenue.  The majority of this
decline can be attributed to funded research and development revenue generated
during the three months ended September 30, 1996 from the customization of the
Company's ADAMS/Car software product for a single customer in Japan.

 COST OF REVENUE

<TABLE>
<CAPTION>
                                                 Three Months Ended September 30,         Nine Months Ended September 30,       
                                                ------------------------------------   -----------------------------------      
   dollars in thousands                            1997        1996    % Change             1997        1996    % Change        
 =========================================================================================================================     
   <S>                                            <C>         <C>         <C>             <C>         <C>         <C>           
   Cost of software licenses                        $271        $114      137.7%            $563        $472       19.3%        
     % of software licenses revenue                  5.9%        3.2%                        4.5%        4.2%                   
                                                                                                                                
   Cost of services                               $1,606      $1,733       -7.3%          $4,868      $4,426       10.0%        
     % of services revenue                          51.6%       56.4%                       53.5%       56.4%                   
 =========================================================================================================================     
</TABLE>

     Cost of software licenses includes software royalty fees, media costs, 
payroll and other costs attributable to software documentation and
distribution, and an allocation of depreciation, utilities and other overhead
expenses incurred by the Company.  Cost of software licenses increased 137.7%
from the third quarter of 1996 to approximately $271,000 in the third quarter
of 1997.  The $157,000 absolute dollar increase was due to additional royalties
paid to third parties whose products are embedded in the Company's ADAMS
software and higher royalties paid to third parties whose products were
licensed through the Company's European subsidiaries.  The 19.3% increase in
cost of software licenses during the nine month period ended September 30,
1997, as compared to the corresponding period in 1996, was primarily due to
higher royalties paid to third parties whose products were licensed through the
Company's European subsidiaries.

     Cost of services includes payroll and overhead expenses attributable to 
hotline support, consulting, training and funded research and development. 
Cost of services declined 7.3% during the three month period ended September
30, 1997, as compared to the corresponding period in 1996.  The aforementioned
$400,000 decline in funded research and development revenue during the third
quarter of 1997, as compared to the third quarter of 1996, resulted in a
corresponding decline in cost of services of approximately $280,000.   In the
absence of funding, the costs of research and development are included in
operating expenses.  This decrease was partially offset by increased payroll
costs associated with the hiring of additional employees.  The 10.0% increase
in cost of services during the nine month period ended September 30, 1997, as
compared to the corresponding period in 1996, was primarily due to the hiring
of additional employees to support the growth in services provided to the
Company's customers during 1997.


 OPERATING EXPENSES

<TABLE>
<CAPTION>
                                                  Three Months Ended September 30,       Nine Months Ended September 30,        
                                                ------------------------------------   -----------------------------------      
   dollars in thousands                            1997        1996      % Change          1997        1996     % Change        
 =========================================================================================================================     
   <S>                                            <C>         <C>          <C>            <C>         <C>         <C>           
   Sales and marketing                            $3,087      $2,450       26.0%          $8,578      $7,247      18.4%        
     % of total revenue                             40.2%       36.8%                       39.7%       38.2%                   
                                                                                                                                
   Research and development                       $1,223        $871       40.4%          $3,358      $2,626      27.9%        
     % of total revenue                             15.9%       13.1%                       15.6%       13.9%                   
                                                                                                                                
   General and administrative                       $799        $683       17.0%          $2,383      $2,052      16.1%        
     % of total revenue                             10.4%       10.3%                       11.0%       10.8%                   
 =========================================================================================================================     
</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




                                      9
<PAGE>   10


and order fulfillment, and advertising and public relations programs.  Sales
and marketing expenses also include an allocation of overhead expenses incurred
by the Company.  The absolute dollar increase in sales and marketing expenses
during the three and nine month periods ended September 30, 1997, as compared
to corresponding periods in 1996, resulted from the Company's continued
expansion of its worldwide sales and marketing organization.  Total sales and
marketing employees increased to 67 at September 30, 1997, an increase of 45.7%
from 46 at September 30, 1996.  The Company expects to continue to expand its
sales and marketing 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.  Costs
associated with funded research and development projects are included in cost
of services.  The aforementioned $400,000 decline in funded research and
development revenue during the third quarter of 1997, as compared to the third
quarter of 1996, resulted in a corresponding increase in research and
development expenses of approximately $280,000.  Excluding this increase, the
remaining absolute dollar increases in research and development expenses during
the three and nine month periods ended September 30, 1997, as compared to
corresponding periods in 1996, primarily resulted from an increase in personnel
and related costs in support of expanded development efforts.  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
increased 17.0% and 16.1% during the three and nine month periods ended
September 30, 1997, respectively, as compared to corresponding periods in 1996.
The absolute dollar increases in these expenses were primarily due to
additional expenses incurred to support the Company's worldwide growth, as well
as to support the operations of a publicly-traded company.  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.


 OTHER INCOME, NET

<TABLE>
<CAPTION>
                                                  Three Months Ended September 30,        Nine Months Ended September 30,       
                                                ------------------------------------   -----------------------------------      
   dollars in thousands                             1997        1996     % Change           1997        1996    % Change        
 =========================================================================================================================     
   <S>                                              <C>         <C>         <C>             <C>         <C>       <C>           
   Other income, net                                $236        $235        0.4%            $592        $311      90.4%        
     % of total revenue                              3.1%        3.5%                        2.7%        1.6%                   
 =========================================================================================================================     
</TABLE>


     Other income, net consists of net interest income (expense), foreign 
currency transaction gain (loss) and gain (loss) on the disposal of property and
equipment.  The increase in other income, net in the nine month period ended
September 30, 1997, as compared to the corresponding period in 1996, primarily
resulted from interest earned on the $17.8 million in net proceeds raised from
the Company's initial public offering in May 1996, as well as interest earned
on cash generated from operations over the past year.  These increases were
partially offset by increased foreign currency transaction losses incurred and
losses on disposals of property and equipment during 1997.  From time to time,
the Company may enter into forward exchange contracts to hedge exposures
related to significant foreign currency transactions.  The Company does not use
any other types of derivatives to hedge such exposures nor does it speculate in
foreign currency.


  PROVISION FOR INCOME TAXES

     The Company's effective income tax rate was 30.1% and 32.6% for the first
nine months of 1997 and 1996, respectively.  The difference between the
Company's effective rate and the 34.0% statutory federal rate during the 
first nine months of 1997 was primarily due to the benefits of tax-exempt
interest income and the formation of the Company's foreign sales corporation.
        


                                      10
<PAGE>   11

  MINORITY INTEREST IN NET INCOME (LOSS) OF SUBSIDIARY

     In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K., through a joint venture agreement with ISI-Dentsu of
Tokyo, Japan, the distributor of the Company's software in Japan.  The
($19,000) in minority interest in net income (loss) of subsidiary represents
ISI Dentsu's 34% interest in the net loss of Mechanical Dynamics Japan K.K.
since the date of ISI-Dentsu's initial investment.


  EMPLOYEES

     The number of the Company's worldwide employees increased 34.5% to 199 at
September 30, 1997, compared with 148 at September 30, 1996.  Employment
increased significantly to support the Company's growing operations worldwide.


LIQUIDITY AND CAPITAL RESOURCES

     Cash and cash equivalents increased $468,000 during the first nine months
of 1997 to $21.0 million at September 30, 1997, compared with $20.6 million at
December 31, 1996.  Through September 30, 1997, cash and cash equivalents
increased primarily as a result of the $973,000 in cash generated from
operations, $467,000 minority investment made into Mechanical Dynamics Japan
K.K., and $202,000 in proceeds from stock issued under the Company's employee
stock purchase plan.  These increases were partially offset by the $1,136,000
in cash used to purchase property and equipment during 1997.

     On October 31, 1997, the Company acquired 100% of the outstanding capital
stock of StatDesign, Inc.  The aggregate purchase price of approximately $2.4
million includes cash and 170,227 shares of the Company's common stock.  The
acquisition will be accounted for under the purchase method of accounting.  See
Note 4 of Notes to Condensed Consolidated Financial Statements for more
information.
        
     At September 30, 1997, the Company's principal commitments consisted of
obligations under operating leases for facilities and equipment.  The Company
had no borrowings under long-term debt arrangements at September 30, 1997.

     In June 1997, the Company entered into an agreement with its principal 
bank for a $4.0 million line of credit facility.  No borrowings were 
outstanding under this agreement as of September 30, 1997.  The Company's
subsidiaries in Germany, Italy, Sweden, and France also have line of credit and
overdraft facilities that provide for aggregate borrowing availability of up to
$660,000. No borrowings were outstanding under these facilities as of September
30, 1997.
        
     In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K., through a joint venture agreement with ISI-Dentsu of
Tokyo, Japan, the distributor of the Company's software in Japan.  The Company
owns 66% of Mechanical Dynamics Japan K.K., while ISI-Dentsu owns a 34%
minority interest.  Pursuant to the agreement, the Company and ISI-Dentsu made
combined capital contributions of approximately $1,372,000 to Mechanical
Dynamics Japan K.K. through the second quarter of 1997.  Mechanical Dynamics
Japan K.K. will provide consulting and other professional services directly to
customers in Japan, and will support ISI-Dentsu in marketing the Company's
software in Japan.

     In January 1997, the Company announced that the Board of Directors had
authorized the Company to repurchase up to 500,000 shares of its common stock.
As of September 30, 1997, no shares of common stock had been repurchased.

     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




                                      11
<PAGE>   12

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 from
1994 through the third of quarter of 1997 and intends to continue its policy of
retaining earnings to finance future growth.


                                     12
<PAGE>   13



PART II - OTHER INFORMATION

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

EXHIBITS


  NUMBER                        EXHIBIT
--------------------------------------------------------------------------------
    (11)     Statement Re Computation of Per Share Earnings


    (27)     Financial Data Schedule




(B) REPORTS ON FORM 8-K

    No reports on Form 8-K were filed by the Company during the three months 
    ended September 30, 1997.


                                      13
<PAGE>   14


                                  SIGNATURES

     Pursuant to the requirements 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: November 13, 1997                MECHANICAL DYNAMICS, INC.
                                        (Registrant)



                                  By:  /s/ Michael E. Korybalski     
                                       --------------------------------------
                                       Michael E. Korybalski 
                                       Chairman of the Board and  
                                       Chief Executive Officer 
                                       (Principal Executive Officer) 



                                  By:  /s/ David Peralta                     
                                       --------------------------------------
                                       David Peralta   
                                       Vice President and 
                                       Chief Financial Officer         
                                       (Principal Financial and 
                                       Accounting Officer)       
          


                                       14
<PAGE>   15



                              INDEX TO EXHIBITS


  NUMBER                                        EXHIBIT TITLE
--------------------------------------------------------------------------------
    (11)        Statement Re Computation of Per Share Earnings


    (27)        Financial Data Schedule





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