<PAGE>

                       SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C.  20549

                                   Form 10-Q


[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934

    For the quarterly period ended July 3, 1999

                                       OR

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934

   For the transition  period from ____________ to _____________

   Commission File number 0-21667

                           PHOTOELECTRON CORPORATION
--------------------------------------------------------------------------------
             (Exact Name of Registrant as Specified in its Charter)



MASSACHUSETTS                                               04-3035323
--------------------------------------------------------------------------------
(State or Other Jurisdiction of                         (I.R.S. Employer
Incorporation or Organization)                          Identification No.)


5 FORBES ROAD, LEXINGTON, MASSACHUSETTS                       02421
--------------------------------------------------------------------------------
    (Address of Principal Executive Offices)               (Zip code)


                                 (781) 861-2069
--------------------------------------------------------------------------------
              (Registrant's Telephone Number, Including Area Code)

                             ____________________

Indicate by check mark whether the registrant: (1) has filed all documents and
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.  Yes  [X]  No

                             ____________________

7,754,254 shares of Common Stock, $.01 par value, were outstanding as of
August 6, 1999.
<PAGE>

                           PHOTOELECTRON CORPORATION
--------------------------------------------------------------------------------

                         QUARTERLY REPORT ON FORM 10-Q
                       FOR THE PERIOD ENDED JULY 3, 1999

                               TABLE OF CONTENTS
--------------------------------------------------------------------------------

PART I -        FINANCIAL INFORMATION                                 Page

Item 1          Consolidated Financial Statements                       1

                CONSOLIDATED BALANCE SHEETS AT
                 JULY 3, 1999 AND JANUARY 2, 1999                       1

                CONSOLIDATED STATEMENTS OF OPERATIONS FOR
                 THE THREE AND SIX MONTHS ENDED
                 JULY 3, 1999 AND JULY 4, 1998                          2

                CONSOLIDATED STATEMENTS OF CASH FLOWS FOR
                 THE SIX MONTHS ENDED
                 JULY 3, 1999 AND JULY 4, 1998                          3

                NOTES TO CONSOLIDATED FINANCIAL STATEMENTS              4

Item 2          Management's Discussion and Analysis of Financial
                 Condition and Results of Operations                    5

PART II -       OTHER INFORMATION
                -----------------

Item 5          Other Information                                       10

Item 6          Exhibits and Reports on Form 8-K                        18
<PAGE>

                   PHOTOELECTRON CORPORATION AND SUBSIDIARY
                         (A DEVELOPMENT STAGE COMPANY)
                          CONSOLIDATED BALANCE SHEET

<TABLE>
<CAPTION>
                                                                                             JULY 3,             January 2,
                                                                                               1999                 1999
                                                                                       --------------------  -------------------
                                                                                           (UNAUDITED)
<S>                                                                                    <C>                   <C>
                                       ASSETS
CURRENT ASSETS:
  Cash and cash equivalents.....................................................           $    809,318         $  3,686,457
  Accounts receivable ..........................................................                 57,281              260,000
  Inventories...................................................................              1,773,520            1,454,706
  Prepaid expenses..............................................................                260,978              336,287
  Investments Held to Maturity..................................................                998,091            1,993,056
  Other current assets..........................................................                 16,934              115,803
                                                                                           ------------         ------------
     Total current assets.......................................................              3,916,122            7,846,309
                                                                                           ------------         ------------

PROPERTY AND EQUIPMENT
  Computer equipment............................................................                943,121              899,085
  Lab and production equipment..................................................                974,517              926,352
  Clinical site equipment.......................................................                858,572              720,798
  Sales demo equipment..........................................................                 88,582               81,167
  Furniture and fixtures                                                                        177,883              165,898
  Leasehold improvements........................................................                805,886              804,263
                                                                                           ------------         ------------
PROPERTY, PLANT, EQUIPMENT AND LEASEHOLD IMPROVEMENT, Less                                    3,848,561            3,597,563
                                                                                           ------------         ------------
ACCUMULATED DEPRECIATION AND AMORTIZATION ......................................              2,607,872            2,308,683
                                                                                           ------------         ------------
                                                                                              1,240,689            1,288,880
                                                                                           ------------         ------------
     Total assets...............................................................           $  5,156,811         $  9,135,189
                                                                                           ============         ============

                LIABILITIES AND SHAREHOLDERS' (DEFICIT) EQUITY
CURRENT LIABILITIES
  Accounts payable..............................................................           $    297,402         $    346,363
  Accrued expenses..............................................................                179,132              357,650
  Accrued payroll and benefits..................................................                 62,291               55,409
  Accrued warranty expense......................................................                216,000              204,000
  Current portion of convertible subordinated notes.............................                733,413              719,100
                                                                                           ------------         ------------
     Total current liabilities..................................................              1,488,238            1,682,522
                                                                                           ------------         ------------

SHAREHOLDERS' EQUITY
  Preferred stock, $0.01 par value
     Authorized - 7,500,000
     Issued and outstanding - none at July 3, 1999 and January 2, 1999, respectively.                 -                    -
  Common stock, $0.01 par value -
     Authorized  15,000,000
     Issued and outstanding  7,754,254 and 7,704,254 at July 3, 1999 and
     January 2, 1999, respectively...............................................                77,542               77,042
  Capital in excess of par value - preferred stock...............................                     -                    -
  Capital in excess of par value - common stock..................................            38,575,102           38,324,377
  Deferred compensation..........................................................               (29,913)             (29,913)
  Subscription receivable........................................................                     -               (5,842)
  Deficit accumulated during development stage...................................           (34,954,158)         (30,912,997)
                                                                                           ------------         ------------
     Total shareholders' equity..................................................             3,668,573            7,452,667
                                                                                           ------------         ------------
     Total liabilities and shareholders' equity..................................          $  5,156,811         $  9,135,189
                                                                                           ============         ============
</TABLE>

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

                                      -1-
<PAGE>

                   PHOTOELECTRON CORPORATION AND SUBSIDIARY
                         (A DEVELOPMENT STAGE COMPANY)
                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>

                                                      Three Months Ended            Six Months Ended               Period
                                                      ------------------            ----------------           from Inception
                                                     July           July           July           July         (January 4, 1989
                                                    3, 1999        4, 1998        3, 1999        4, 1998       to July 3, 1999)
                                                  -----------    -----------    -----------    -----------     ----------------
                                                 (Unaudited)    (Unaudited)    (Unaudited)    (Unaudited)
<S>                                            <C>            <C>             <C>           <C>                <C>
Revenues.....................................    $         --   $         --    $   272,134   $         --       $  1,675,508
Cost of Goods Sold...........................              --             --        124,420             --            764,207
                                                  -----------    -----------    -----------    -----------       ------------
Gross Margin.................................              --             --        147,714             --            911,301
Operating Expenses
  Research and Development expenses..........     $ 1,298,939    $ 1,264,044    $ 2,237,677    $ 2,617,769       $ 25,547,806
  Sales, general and administrative
    expenses.................................         702,145        789,970      2,031,980      1,440,680         11,068,703
                                                  -----------    -----------    -----------    -----------       ------------
  Total operating expenses...................       2,001,084      2,054,014      4,269,657      4,058,449         36,616,509
                                                  -----------    -----------    -----------    -----------       ------------
  Operating loss.............................      (2,001,084)    (2,054,014)    (4,121,943)    (4,058,449)       (35,705,208)
                                                  -----------    -----------    -----------    -----------       ------------
  Interest income............................          44,285        158,303        109,509        345,496          1,927,650
  Interest expense...........................         (14,157)       (24,099)       (28,727)       (48,205)        (1,176,600)
                                                  -----------    -----------    -----------    -----------       ------------
  Interest income, net.......................          30,128        134,204         80,782        297,291            751,050
                                                  -----------    -----------    -----------    -----------       ------------
     Net loss................................     $(1,970,956)   $(1,919,810)   $(4,041,161)   $(3,761,158)      $(34,954,158)
                                                  ===========    ===========    ===========    ===========       ============
     Basic and diluted net loss per share....          $(0.25)        $(0.26)        $(0.52)        $(0.51)
                                                  ===========    ===========    ===========    ===========
     Weighted average basic and diluted
       shares................................       7,742,702      7,374,262      7,738,980      7,370,221

</TABLE>

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

                                      -2-
<PAGE>

                   PHOTOELECTRON CORPORATION AND SUBSIDIARY
                         (A DEVELOPMENT STAGE COMPANY)
                      CONSOLIDATED STATEMENTS OF CASH FLOW
<TABLE>
<CAPTION>
                                                                                                                   Period
                                                                                                                from Inception
                                                                                        Six Months Ended       (January 4, 1989
                                                                                  July 3, 1999   July 4, 1998   to July 3, 1999)
                                                                                  -------------  -------------  ----------------
                                                                                   (Unaudited)    (Unaudited)
<S>                                                                               <C>            <C>            <C>
Cash flows from operating activities:
   Net loss......................................................................  $(4,041,161)   $(3,761,158)     $(34,954,158)
   Adjustments to reconcile net loss to net cash used in
      Operating activities --
      Depreciation and amortization..............................................      299,189        373,834         2,616,463
      Noncash interest converted to subordinated notes ..........................           --         48,200         1,060,558
      Noncash salary converted to common stock ..................................           --             --           250,000
      Noncash research and development expense converted to subordinated notes...           --             --             9,000
      Noncash compensation expense ..............................................           --             --         1,179,815
Changes in current accounts --
Inventories......................................................................     (318,814)      (739,622)       (1,773,250)
Accounts receivable..............................................................      202,719             --           202,719
Prepaid expenses.................................................................       75,309         30,881            47,222
Other current assets.............................................................       98,869        (26,680)         (196,723)
Accounts payable.................................................................      (48,961)        75,736           297,402
Accrued expenses.................................................................     (159,636)      (145,115)          256,475
                                                                                   -----------    -----------      ------------
   Net cash used in operating activities.........................................   (3,892,486)    (4,143,924)      (31,004,477)
                                                                                   -----------    -----------      ------------
Cash flows from investing activities:
  (Purchases) Maturation of held to maturity investments.........................      994,965      2,968,100          (998,091)
   Purchases of equipment and leasehold improvements.............................     (250,998)      (410,854)       (3,823,715)
   Loan to officer...............................................................           --             --           (80,211)
   Proceeds from sale of equipment and leasehold improvements ...................           --             --             9,845
                                                                                   -----------    -----------      ------------
     Net cash (used in) provided by investing activities ........................      743,967      2,557,246        (4,892,172)
                                                                                   -----------    -----------      ------------

Cash flows from financing activities:
   Proceeds from issuance of common stock........................................      257,067         28,918        18,523,935
   Proceeds from issuance of preferred stock.....................................           --             --        13,385,370
   Proceeds from issuance of subordinated convertible notes......................           --             --         5,322,000
   Proceeds from issuance of warrants............................................           --             --           236,453
   Offering expenses.............................................................           --             --          (473,006)
   Payments under capital lease obligations......................................           --             --           (40,735)
   Payments of subordinated notes................................................       14,313             --          (248,050)
                                                                                   -----------    -----------      ------------
     Net cash provided by (used in) financing activities.........................      271,380         28,918        36,705,967
                                                                                   -----------    -----------      ------------

Increase (decrease) in cash and cash equivalents.................................   (2,877,139)    (1,557,760)          809,318
                                                                                   -----------    -----------      ------------
Cash and cash equivalents, beginning of period...................................    3,686,457      2,286,583                --
                                                                                   -----------    -----------      ------------
Cash and cash equivalents, end of period.........................................      809,318        728,823           809,318
                                                                                   ===========    ===========      ============

Noncash financing activities:
  Conversion of salary expense to common stock...................................  $             $                 $    250,000
                                                                                   ===========   ============      ============
  Conversion of convertible subordinated notes to common stock ..................  $             $                 $  5,278,892
                                                                                   ===========   ============      ============
  Conversion of common stock to preferred stock..................................  $             $                 $  3,846,015
                                                                                   ===========   ============      ============
  Capital lease obligation incurred for equipment................................  $             $                 $     40,383
                                                                                   ===========   ============      ============
  Conversion of preferred stock to common stock..................................  $             $                 $     28,923
                                                                                   ===========   ============      ============
  Conversion of convertible subordinated notes to warrants.......................  $             $                 $     47,000
                                                                                   ===========   ============      ============
</TABLE>

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

                                      -3-
<PAGE>

                           PHOTOELECTRON CORPORATION
                         (A DEVELOPMENT STAGE COMPANY)
              NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS


1.  UNAUDITED RESULTS - The interim unaudited consolidated financial statements
    contained herein have been prepared in accordance with generally accepted
    accounting principles for interim financial information.  Accordingly, they
    do not include all of the information and footnotes required by generally
    accepted accounting principles for complete financial statements.  In
    management's opinion, the unaudited information includes all adjustments
    (consisting of normal recurring accruals) necessary for a fair presentation
    of the financial position, results of operations, and cash flows for the
    periods presented.  The results of operations for the interim periods shown
    on this report are not necessarily indicative of the results expected for
    the full year.  The interim financial statements should be read in
    conjunction with the financial statements and notes for the year ended
    January 2, 1999 included in the Company's Form 10-K filing with the
    Securities and Exchange Commission.

2.  NET LOSS PER SHARE  During the second six months of 1999 and 1998, basic and
    diluted net loss per share were calculated as follows:

<TABLE>
<CAPTION>
                                                     Six Months Ended                     Three Months Ended
                                              July 3, 1999       July 4, 1998       July 3, 1999       July 4, 1998
                                           ------------------  -----------------  -----------------  -----------------
<S>                                        <C>                 <C>                <C>                <C>
Basic:
     Net loss                                    $(1,970,956)       $(1,919,810)       $(4,041,161)       $(3,761,158)
     Weighted average shares                       7,742,702          7,374,262          7,738,980          7,370,221
     Basic net loss per share                    $     (0.25)       $     (0.26)       $     (0.52)       $     (0.51)

Diluted:
     Net loss                                    $(1,970,956)       $(1,919,810)       $(4,041,161)       $(3,761,158)
     Weighted average shares                       7,742,702          7,374,262          7,738,980          7,370,221
     Diluted net loss per share                  $     (0.25)       $     (0.26)       $     (0.52)       $     (0.51)
</TABLE>

    The computation of diluted earnings per share for July 3, 1999 and
    July 4, 1998 excludes the effect of assuming the exercise of certain
    outstanding stock options and the conversion of convertible securities
    because the effect would be anti-dilutive, due to the Company's net loss
    during the year. As of July 3, 1999, there were 896,792 of such options
    outstanding, with exercise prices ranging from $0.40 - $9.75 per share with
    expiration dates ranging from December 11, 1999 to May 10, 2009.

3.  COMPREHENSIVE INCOME During the first quarter of 1998, the Company adopted
    Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting
    Comprehensive Income." This pronouncement sets forth requirements for
    disclosure of the Company's comprehensive income and accumulated other
    comprehensive income. There were no items of other comprehensive income
    therefore comprehensive income equals net income.

                                      -4-
<PAGE>

PART I:     FINANCIAL INFORMATION
ITEM 2:     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
            Results of Operations.

OVERVIEW

     Certain statements contained in this Quarterly Report on Form 10-Q,
including, without limitation, statements containing the words "expects,"
"anticipates," "believes" and words of similar import, constitute "forward
looking statements" within the meaning of the Private Securities Litigation
Reform Act of 1995.  These forward looking statements are subject to various
risks and uncertainties, including those referred to herein, that could cause
actual future results and events to differ materially from those currently
anticipated.  Readers are cautioned not to place undue reliance on these
forward-looking statements.

     The Company is engaged in the development and commercialization of the
Photon Radiosurgery System ("PRS"), a proprietary, therapeutic device for the
treatment of cancerous tumors through the application of radiation directly into
a tumor. To date, the Company has received only limited revenue from the sale of
its current PRS400 model.

     The Company has experienced significant operating losses since its
inception, due primarily to substantial research and development expenditures.
As of July 3, 1999, the Company had an accumulated deficit totaling
approximately $35.0 million and expects to continue to incur losses until such
time as its commercialization efforts yield offsetting revenues. There can be no
assurance that the PRS will ever gain acceptance, or that the Company will ever
generate significant revenues or achieve profitability. The Company's ability to
achieve profitable operations will depend in large part on whether it can
successfully commercialize the PRS and make the transition to a manufacturing
and marketing company.

     The Company does not expect to be able to generate sufficient revenue in
the near future for it to continue operations without raising additional capital
or entering into a strategic relationship with another company. The Company
expects that its available cash will permit it to continue operations through
December 31, 1999. Should the necessary funds or a strategic relationship not be
available to the Company on acceptable terms, there is substantial doubt that
the Company will be able to continue as a going concern.

     In May 1999, the Company underwent a significant restructuring. There were
three key objectives to this restructuring:

1.  A reduction in operating costs;
2.  A re-focusing of development efforts on key products; and
3.  A remodelling of the Company's approach to sales and marketing.

     The reduction in operating costs was achieved primarily by reducing staff
numbers by 50% and by modifying the Company's approach to sales and marketing.
In the second quarter of 1999, the Company laid off approximately twenty-five
employees, including substantially all of its sales and marketing staff, and now
intends to market and distribute its products through collaborative

                                      -5-
<PAGE>

arrangements with strategic partners that have established distribution channels
in domestic and international markets.

     During the second quarter of 1999, the Company engaged the investment
banking firm of Needham & Company, Inc. as the Company's exclusive financial
advisor to evaluate various strategic alternatives for the Company. The
strategic alternatives include, but are not limited to, raising additional
capital to assist in the growth of the Company's operations or a joint venture,
strategic merger or other transaction with another company to assist and advise
the Company on financial alternatives.

     The Company's development efforts are now focused on key products to
supplement the Company's established product range. The developmental product
line of particular significance is based on intraoperative radiotherapy using
the x-ray source with applicators to treat the inside of a cavity after removal
of a tumor. This new type of treatment will greatly enhance the range of
commercially approved clinical applications of the PRS. The developments involve
engineering efforts and regulatory issues. The objective is to bring this
product line to market during the fourth quarter of 1999 and the program is
progressing according to plan. In June 1999, the applicators were granted an
Investigational Device Exemption ("IDE") by the United States Food and Drug
Administration (the "FDA"), allowing the applicators to be used at a number of
sites in the United States. Significantly, based on clinical trial data obtained
in the United Kingdom, the IDE permits the PRS to be used for investigational
purposes at locations outside of the cranium. The Company is currently preparing
an application with the FDA to receive 510(k) clearance for the applicators.

     Clinical trials using the x-ray source, with and without applicators, are
continuing throughout the world. Treatments of breast and colo-rectal tumors are
taking place in the United Kingdom. The recent grant by the FDA of an IDE for
the applicators will now enable these trials and those involving other clinical
conditions to be extended to U.S. hospitals. Clinical trials at Massachusetts
General Hospital and Cleveland Clinic should begin during the third quarter of
1999. Clinical trials using the PRS for treatment of certain skin tumors (basal
cell, squamous cell carcinomas and Kaposi's sarcoma) are continuing at New York
Medical College. The Company expects to submit a 510(k) application to the FDA
for surface treatments during the first quarter of 2000.

     In September 1997, the Company received ISO 9001 registration for operating
a quality management system. In May 1998, following a successful assessment by
the British Standards Institution, the Company was certified as compliant with
Annex II of the European Union Medical Device Directive.  The Company may now
self-certify and affix the CE Mark to the Company's products, subject to ongoing
compliance with the Medical Device Directive. The Company also expects to comply
with the current Good Manufacturing Practice standards as required by the FDA.


RESULTS OF OPERATIONS

THREE MONTHS ENDED JULY 3, 1999 AND JULY 4, 1998

     Revenue. The Company had revenue of $0 in the second three months of 1999,
as compared with $0 in the second three months of 1998.

                                      -6-
<PAGE>

     Research and development expenses. The Company's research and development
expenses increased by $34,895 from $1,264,044 in the second three months of 1998
to $1,298,939 in the second three months of 1999. Due to the low level of
manufacturing activity in the second quarter of 1999, the Company elected not to
absorb all manufacturing cost into inventory.  These unabsorbed manufacturing
expenses, totaling $527,525, were reclassified as research and development
expenses.

     Selling, general and administrative expenses. The Company's selling,
general and administrative expenses decreased by $87,825 from $789,970 in the
second three months of 1998 to $702,145 in the second three months of 1999. The
decrease is primarily attributable to a reduction in the Company's personnel in
the second quarter of 1999.

     Interest income. Interest income decreased by $114,018 from $158,303 in the
second three months of 1998 to $44,285 in the second three months of 1999. The
decrease resulted from the continued expenditure of the proceeds of the
Company's initial public offering.


SIX MONTHS ENDED JULY 3, 1999 AND JULY 4, 1998

     Revenue. The Company had revenues of $272,134 in the first six months of
1999, as compared with $0 in the first six months of 1998. The 1999 revenue is
primarily the result of a sale of the PRS to Tecnologie Avanzate, Torino, Italy.
The PRS400 was subsequently installed at Saint Bortolo Hospital in Vicenza,
Italy.

     Research and development expenses. The Company's research and development
expenses decreased by $380,092 from $2,617,769 in the first six months of 1998
to $2,237,677 in the first six months of 1999. The primary reason for the
decrease in the six months of 1999 was a shift in focus from research and
development to a manufacturing and marketing effort for the PRS400.

     Selling, general and administrative expenses. The Company's selling,
general and administrative expenses increased by $591,300 from $1,440,680 in the
first six months of 1998 to $2,031,980 in the first six months of 1999. This
increase is primarily attributable to (1) the Company's sales and marketing
department beginning operation, and (2) costs of approximately $367,500
associated with the resignation of the former Vice-President and Chief Operating
Officer of the Company in the first three months of the year.

     Interest income. Interest income decreased by $235,987 from $345,496 in the
first six months of 1998 to $109,509 in the first six months of 1999. The
decrease resulted from the continued expenditure of the proceeds of the
Company's initial public offering.


LIQUIDITY AND CAPITAL RESOURCES

     In February 1997, the Company completed an initial public offering of
2,275,000 shares of Common Stock at a price of $8.50 per share. Net proceeds
from the offering to the Company were approximately $16,818,854.

     Consolidated working capital was approximately $2.4 million at July 3,
1999, compared with $6.2 million at January 2, 1999. Included in working capital
are cash and cash equivalents of $0.8

                                      -7-
<PAGE>

million at July 3, 1999, compared with $3.7 million at January 2, 1999. During
the six months ended July 3, 1999, $3.9 million of net cash was used for
operating activities.

     The Company used $250,998 of cash in the six months ended July 3, 1999 for
fixed assets and leasehold improvements.

     The Company maintains medical product liability insurance policies with
respect to its clinical trials, which the Company believes contain reasonable
deductibles and other ordinary and customary provisions. The Company believes
that these policies cover such risks in such amounts as are reasonable and
prudent under the circumstances, and the Company does not anticipate that claims
under these policies, if any, will have a material adverse impact on the
Company's liquidity or capital resources. The Company has obtained product
liability insurance covering the commercial use of its products.

     The Company anticipates that it will be necessary to seek financing in the
second half of 1999 or enter into a strategic relationship with another company
if the Company is to continue operations beyond December 31, 1999. There is no
assurance that the Company will be able to obtain such financing or negotiate
such strategic relationship on acceptable terms or at all. If the Company raises
additional funds through the issuance of equity securities, dilution to existing
shareholders will occur.

OTHER MATTERS-YEAR 2000 DISCLOSURE:

  The Company is continuing to address the Year 2000 ("Y2K") problem. The
Company has put together a project team and budget to handle the tasks required
ensuring that Company is Y2K compliant. The project team is headed by the
Company's Information Systems ("IS") department and includes members from all
functional departments of the Company. The Company has broken the project into
five areas of concern: Internal Information Technology ("IT") systems, internal
non-IT systems (embedded processors), Company products, outside significant
third parties (suppliers, financial institutions, customers, vendors), and
contingency planning.

  The Company plans to complete the Y2K readiness project with a six-phase
approach to dealing with the five areas of concern mentioned above. The phases
will be as follows:

     1) Identification-the Company has identified each and every issue it
  believes it needs to address in accordance with the concerns set forth above.

     2) Detailed Assessment-the Company is conducting a detailed assessment of
  the issues identified so it can document all specific areas to address.

     3) Corrective Action Plans-the Company has defined the proper changes
  including upgrades, retirements, or new systems.

     4) Testing and Certification-the Company will fully test the proposed
     changes and certify the results.

     5) Implementation-the Company will implement the proper changes that were
     tested and certified.

                                      -8-
<PAGE>

     6) Contingency Planning-the Company will define contingencies for all areas
     of concerns.

  The Company defines the phrase "Y2K compliance" as follows: "That all our
business processes have been tested to our satisfaction so we can state that the
year 2000 date rollover will not affect our ability to manufacture our products
and properly report the financial status of our company". The Company
anticipates that it will be Y2K compliant by the end of third quarter in 1999.

  IT SYSTEMS-90% completed. The Company has spent the last year upgrading its
Personal Computers ("PCs") and servers and has only a few PCs left to upgrade.
The Company is currently in the final testing phase of the upgrade project of
its Enterprise Resource Planning software. The Company anticipates completing
that project by the end of September, 1999. The Company has upgraded to
compliant versions for most of our desktop applications, with only a few
applications left to research.

  NON IT SYSTEMS-60% completed. The Company has identified many embedded
processors that are in use around the Company. The Company has not yet performed
any investigation regarding the processors' Y2K compliance.

  COMPANY PRODUCTS

  The embedded software in the PRS400 Treatment System is fully Y2K compliant.
This was a design requirement established during the development of the
software. Additionally, Y2K compliance is formally tested as part of the
software validation testing. The Company completed the validation testing in
November of 1998.

  The software used to run the Company's Water Phantom System is fully Y2K
compliant. The software does not use any dates for calculations or comparisons.
It is written in a Y2K compliant version of Labview. It runs on a PC with the
Windows 3.1 operating system, which is not Y2K compliant. Currently a project is
underway to convert the software to run on Windows 95, which is a Y2K compliant
operating system. The Company completed this project at the end of June 1999.

  OUTSIDE THIRD PARTIES

  The Company has identified many of the outside parties that it will survey for
Y2K compliance. The Company has completed a first draft plan of how the Company
will perform the analysis and survey. The Company has sent to its most critical
partners a survey by mail and is following up with them by a phone call or a
schedule site visit. The Company expects to complete this process by the end of
the third quarter of 1999.

  CONTINGENCY PLANNING

  The Company plans on completing the Y2K risk analysis before creating a
contingency plan. Although the Company is dedicating substantial resources
towards attaining Y2K readiness, there is no assurance it will be successful in
its efforts to identify and address all Y2K issues. Even if the Company acts in
a timely manner to complete all of its assessments, identify, develop and
implement corrective action plans believed to be adequate, and develop
contingency plans believed to be adequate, some problems may not be identified
or corrected in time to prevent material adverse consequences to the Company.

                                      -9-
<PAGE>

  COST OF COMPLIANCE

  To date, costs incurred in connection with the Y2K issue have not been
material. The Company does not expect total Y2K remediation costs to be
material, but there can be no assurance that the Company will not encounter
unexpected costs or delays in achieving Y2K compliance.


PART II:  OTHER INFORMATION

Item 5:  Other Information

Risk factors that may affect future results

  The Company wishes to caution readers that in addition to the important
factors described elsewhere in this Report, the following important factors,
among others, sometimes have affected, and in the future could affect, the
Company's business, financial condition, or operating results. These factors
could cause the Company's future results to differ materially from those
expressed in any forward-looking statements made by, or on behalf of, the
Company.

THE COMPANY HAS SIGNIFICANT CAPITAL NEEDS AND MAY NOT BE ABLE TO RAISE
ADDITIONAL CAPITAL THAT WOULD ENABLE IT TO CONTINUE AS A GOING CONCERN

  The Company has expended, and will continue to expend, substantial funds on
the following:

 .  Research and development of the PRS and other potential products;

 .  Clinical trials;

 .  Cost of regulatory approvals;

 .  Establishing commercial scale manufacturing in the Company's own facilities
   or in the facilities of others; and

 .  Marketing the PRS and any other products.

  The Company's future capital requirements will depend on a variety of factors,
including the following:

 .  Time and costs involved in obtaining further regulatory approvals;

 .  Results of ongoing clinical trials;

 .  Market acceptance of the PRS and any of the Company's other products;

 .  Expense and results of the Company's continued scientific research and
   development programs;

 .  Time and costs expended in filing, prosecuting, and enforcing patent claims;
   and

                                      -10-
<PAGE>

 .  Development of competing technologies.

  The Company does not expect to be able to generate sufficient revenue in the
near future to continue operations without raising additional capital. If the
necessary funds are not available to the Company on acceptable terms, it is
likely that the Company will not be able to continue as a going concern. The
Company estimates that available cash and cash equivalents, together with
revenues from product sales, if any, will allow it to continue operations
through December 31, 1999.

THE COMPANY IS AN EARLY STAGE COMPANY AND HAS A LIMITED OPERATING HISTORY

  The Company was incorporated in January of 1989 and has thus had a relatively
short operating history. The Company is still in the process of developing and
commercializing the PRS, the Company's primary product. The Company may not
succeed in completing the development and commercialization of the PRS. The
Company has received regulatory approval only from the FDA and clearance from
the European Union to market the PRS in the United States and Europe for the
treatment of brain tumors, and is still waiting for approval from other
countries in which the Company may market the PRS. The Company cannot be sure
that any other countries will grant regulatory approval to market the PRS. In
addition, the Company has only sold three PRS systems and may not be able to
sell any more PRS systems even if the Company receives all necessary regulatory
approvals and completes the development and commercialization of the PRS.

THE COMPANY MAY NOT BE REIMBURSED BY THIRD PARTY PAYORS

  The Company's ability to be reimbursed for the cost of its products and
related treatments from third party payors will have a significant impact on the
Company's ability to commercialize its products. Such third party payors
include, among others, private insurance companies, self-insured employers,
health maintenance organizations, and federal and state sources of payment under
the Medicare and Medicaid programs. There is no uniform policy on reimbursement
among third party payors, and the PRS or any of the Company's other products may
not qualify for reimbursement. In addition, foreign countries have their own
health care reimbursement systems, and the Company may not qualify for
reimbursement from such foreign third party payors.

  In addition, the continuing efforts of many third party payors to reduce the
costs of health care by decreasing reimbursement rates, or limiting or
prohibiting reimbursement for certain services or devices, may have an adverse
effect on the Company's revenues. Furthermore, legislative proposals to reform
government health care insurance programs, including the Medicare and Medicaid
programs, could have a significant impact the purchase of health care services
and products and could result in lower prices and reduced demand for the
Company's products. The Company is unable to predict whether such proposals will
be enacted or whether other health care legislation or regulation affecting the
Company's business may be proposed in the future.

THE COMPANY ONLY MARKETS ONE PRODUCT

  The PRS and its related accessories and components are currently the Company's
only product. The Company's ability to sell the PRS and generate revenue could
be adversely affected by problems such as loss of a patent protection,
unexpected side effects, negative publicity, or the introduction of a new, more
effective treatment that would render the PRS obsolete.

                                      -11-
<PAGE>

THE COMPANY HAS A HISTORY OF SIGNIFICANT OPERATING LOSSES AND ANTICIPATES
FURTHER SUBSTANTIAL LOSSES

  The Company has experienced significant operating losses in each year since
its incorporation, primarily due to the cost of substantial research and
development of the PRS. As of July 3, 1999, the Company had an accumulated
deficit of approximately $35 million and expects to continue to incur losses
until the Company generates revenues to offset the funds spent on
commercializing the PRS. The Company's ability to achieve profitable operations
will depend, in large part, on whether the Company can successfully develop and
commercialize the PRS and/or any other products, and whether the Company can
effectively make the transition to a manufacturing and marketing company. It is
possible that the PRS will never gain commercial acceptance, and the Company may
never generate significant revenues or achieve profitability. For these reasons,
the Company believes it will continue to incur substantial operating losses for
the foreseeable future, and that these losses may be significantly higher than
the Company's current losses.

PRODUCT DEVELOPMENT RISKS; UNCERTAINTIES RELATING TO CLINICAL TRIALS

  The PRS is a new product and, accordingly, its safety and efficacy have not
yet been fully established. The FDA and the European Union have granted the
Company clearance to market the PRS as a treatment only for brain tumors. As a
result, there are several problems the Company may encounter in conducting
clinical trials for other potential uses of the PRS that include, but are not
limited to, the following:

 .  The results obtained from Phase I trials of the PRS as a treatment for
   metastatic brain tumors may not be an accurate indicator of the results in
   subsequent clinical trials or in clinical trials for other specific
   applications for the PRS;

 .  Medical device companies often suffer significant setbacks in Phase II or
   other clinical trials, even after obtaining promising results in Phase I or
   other prior trials;

 .  The Company has conducted and expects to continue to conduct clinical trials
   of the PRS with patients in advanced stages of cancer. These patients could
   die or suffer adverse effects for reasons unrelated to the PRS, but such
   events could nevertheless have an adverse effect on clinical trial results or
   regulatory approvals of the PRS; and

 .  The Company relies upon unaffiliated medical institutions to perform clinical
   trials in accordance with the FDA's approval process. Work carried out at the
   institutions currently performing Phase I or II clinical trials, or at any
   institutions performing clinical trials in the future, may not be
   satisfactory. In addition, such institutions may cancel, suspend, or delay
   such trials.

  Furthermore, the number of patients that have completed the Company's clinical
trials to date has been limited by a number of factors, including the reluctance
of patients or physicians to participate in experimental clinical trials. The
Company's ability to collect randomized data has been impeded by patients who
quit the clinical trials because they wanted to receive the PRS treatment but
were assigned to the trials' non-PRS control groups. Any delays in or
termination of the clinical trials could have a material adverse effect on the
Company's business, financial condition, and results of operations. In addition,
it is possible that the Company's clinical trials will not be successful, that
such

                                      -12-
<PAGE>

clinical trials will be delayed, or that the PRS or any other product will not
be safe or effective or capable of being successfully developed for all their
respective intended applications.

THE COMPANY IS STILL WAITING FOR CERTAIN REGULATORY CLEARANCES IN ORDER TO
MARKET THE PRS IN COUNTRIES OUTSIDE THE U.S. AND EUROPE

  The PRS has not been approved for commercial use in countries outside the U.S.
and Europe, including Japan. The PRS is subject to extensive regulation in the
U.S. by the FDA and, in many instances, by comparable agencies in foreign
countries where the Company plans on manufacturing and/or distributing the PRS.
Sales of medical devices outside the United States are subject to regulatory
requirements that vary widely from country to country. The PRS may not meet the
regulatory standards of countries that have not yet approved the PRS for
commercial use.

  In addition, the length of time the Company will need to wait to obtain
approval for the sale of the PRS in a foreign country may be longer, and the
requirements may be more burdensome or expensive, than that required for FDA
approval. The Company will also need to obtain export licenses from the U.S.
government in order to export its products to certain countries. The U.S.
government may not grant the Company any other export licenses other than those
previously granted for clinical trials in Australia and for clinical trials and
commercial distribution in Europe and Japan, and the corresponding foreign
countries may not grant the Company any import licenses.

  Furthermore, the Company may not receive any necessary regulatory approvals if
the Company develops any additional products in the future, the length of time
for such approvals may be extensive, and the cost of attempting to obtain any
such approvals may be prohibitive. In addition, the Company's inability to
obtain or maintain requisite governmental approvals could delay or preclude the
Company from further developing and marketing the PRS and other products.
Consequently, such delays could impair the Company's ability to generate
revenues and continue as a going concern.

THE PRS IS SUBJECT TO EXTENSIVE ONGOING GOVERNMENT REGULATION

  The FDA has approved the PRS for commercial use in the U.S. only for the
treatment of brain tumors. Because the FDA strictly prohibits the marketing or
sale of approved medical devices for unapproved uses, the Company may only
market and sell the PRS for the approved use. Any possible additional uses of
the PRS may be subject to additional clinical trials and FDA and foreign
regulation and approval. In addition, the FDA imposes strict labeling and
training requirements and may impose other requirements, any of which could
limit the Company's ability to market the PRS.

  The Company may also need to obtain additional approvals from the FDA if the
Company decides to change or modify the PRS. In addition, if the Company fails
to comply with FDA regulatory standards, the FDA could force the Company to
withdraw its products from the market or impose sanctions or fines, each of
which could have a material adverse effect on the Company's business, financial
condition, and results of operations.

  In addition, manufacturers of medical devices are subject to strict federal
regulations regarding quality of manufacturing, including periodic FDA
inspections of manufacturing facilities to determine compliance with FDA
regulations. Such regulations impose certain requirements on, among other
things, the design, testing, production, control, and documentation of products.
The Company may not be able to attain or maintain compliance with cGMP standards
or with ISO Standards. In addition, the

                                      -13-
<PAGE>

Company may not be able to identify and retain manufacturers on commercially
acceptable terms, if at all, and any manufacturers the Company does retain might
not be able to meet all relevant regulatory requirements. Any problems with the
Company's ability to meet regulatory standards could prevent the Company from
marketing the PRS.

RAPID, UNPREDICTABLE, AND SIGNIFICANT TECHNOLOGICAL CHANGE; HIGHLY COMPETITIVE
INDUSTRY

  The medical device industry is subject to rapid, unpredictable, and
significant technological change. The Company's business is subject to
competition in the U.S. and abroad from a variety of sources, including
universities, research institutions, and medical device, chemical, and
biotechnology companies. Many of these potential competitors have substantially
greater technical, financial, and regulatory resources than the Company and are
accordingly better equipped to develop, manufacture, and market their products.
If these companies develop and introduce products and processes competitive with
or superior to the Company's products, the Company may not be able to compete
successfully against such competitors.

THE COMPANY DEPENDS ON ONE PRODUCT

  The PRS and its related accessories and components are currently the Company's
only product. The Company currently expects that the PRS will be the primary
source of revenue, if any, for the foreseeable future. All additional potential
products using the Company's core technology are in their early stages of
development. Any such additional products in development may not be safe or
effective, approved by regulatory authorities, capable of being manufactured in
commercial quantities at acceptable costs, or introduced into the market
successfully.

THE COMPANY HAS LIMITED MARKETING EXPERIENCE

  As the Company makes the transition from a company with products in
development but no product sales to a manufacturing and marketing company, the
Company will require significant additional expenditures, management resources,
and time to develop its sales strategy and to make arrangements for the sale or
lease of its products through third parties. The Company plans to market and
distribute its products primarily through collaborative arrangements with
strategic partners with established distribution channels in domestic and
international markets. The Company may not be able, however, to make adequate
third party arrangements for product marketing and distribution.

ADVERSE EFFECT OF SHORT PATIENT LIFE EXPECTANCIES ON MARKET FOR THE APPROVED
APPLICATION

  To date, the Company has focused substantially all its efforts on one specific
application of the PRS--the treatment of brain tumors. Patients with metastatic
brain tumors already suffer from primary cancer, which is separate from the
metastatic brain tumors. The average life expectancy of patients with metastatic
brain tumors is very short. Although the PRS is designed to provide either
curative or palliative cancer treatment, health care providers and third party
payors may be reluctant to undertake, authorize, or provide reimbursement for
PRS treatment of patients whose anticipated life expectancies are below certain
levels.

  Neither the FDA nor any foreign authorities have approved the PRS for
applications, such as breast, prostate, bladder, or skin cancer, where patient
life expectancies are higher than those for

                                      -14-
<PAGE>

patients with metastatic brain tumors. Accordingly, the Company cannot market
the PRS to treat such other cancers.

UNCERTAIN PROTECTION OF INTELLECTUAL PROPERTY

  The Company's ability to compete effectively in the marketplace will depend,
in part, on the Company's ability to protect its intellectual property rights.
The Company relies on patents, trade secrets, and know-how to establish and
maintain a competitive position in the marketplace. The enforceability of
medical device patents, however, can be highly uncertain. Any limitation or
reduction in the Company's rights to obtain or enforce the Company's patents
could have a material adverse effect on the Company's ability to maintain or
protect its intellectual property rights.

  The Company holds 13 U.S. patents and 4 U.S. patent applications relating to
the PRS. In addition, the Company has filed foreign patent applications in
selected foreign countries, which correspond, to certain of the Company's U.S.
patents and patent applications. Such applications may not result in issued
patents, and the Company cannot be sure that once issued, any issues relating to
the validity and scope of the patents will be resolved in the Company's favor.
In addition, the Company's current or future patents, trade secrets, or know-how
may not protect the Company against competitors with similar technologies or
processes. Also, others may infringe any patents issued to the Company and other
companies may independently develop proprietary technologies or processes, which
are the same as or substantially equivalent to the Company's proprietary
technologies or processes.

  The Company may also become subject to patent infringement claims or
litigation initiated by third parties. The defense and prosecution of such
claims or suits are very costly and time-consuming, and any such proceeding
would result in substantial expense and a significant diversion of effort by
technical and management personnel of the Company. Further, any adverse
determination in such litigation or proceeding could subject the Company to
significant liability and could prevent the Company from manufacturing or
marketing its products.

PETER M. NOMIKOS HAS THE ABILITY TO SIGNIFICANTLY INFLUENCE ALL STOCKHOLDER
VOTES

  As of August 6, 1999, Mr. Peter M. Nomikos, Chairman of the Board and Chief
Executive Officer of the Company beneficially owned approximately 46% of the
issued and outstanding shares of Common Stock, and the Company's principal
stockholders and certain affiliates of the Company (including Mr. Nomikos)
beneficially owned in the aggregate approximately 55% of the issued and
outstanding shares of Common Stock. Certain principal stockholders serve as
directors or have representatives who serve as directors of the Company. Due to
Mr. Nomikos's ownership of Common Stock coupled with the positions he holds in
the Company, Mr. Nomikos, either alone or with the other principal stockholders,
has the ability to significantly influence all matters requiring approval by the
stockholders of the Company, including the election of all directors,
acquisitions, sales of all or substantially all of the Company's stock or
assets, and other extraordinary transactions.

THE COMPANY DEPENDS ON KEY PERSONNEL

  The Company depends on the continued services and performance of its
scientific personnel and senior management. If the Company loses any key
personnel, it could significantly and adversely impact the Company's research
and development efforts or its strategic objectives. In addition, competition
among medical device companies for highly skilled scientific and management
personnel

                                      -15-
<PAGE>

is increasingly intense. In order to achieve and maintain the commercialization
of the PRS, the Company will need to attract and retain additional key
personnel, and the Company cannot be sure that it will be able to do so. The
Company has no employment agreements with any of its employees, nor has the
Company purchased ''key person'' life insurance.

THE COMPANY MAY EXPERIENCE SHORTAGES OF PRS COMPONENTS; THE COMPANY RELIES ON A
SMALL NUMBER OF SUPPLIERS

  The Company manufactures its products based on anticipated product orders. The
different lead times for the supply and delivery of materials and components can
vary significantly, as can the relative availability and cost of those materials
and components. As a result, the Company has built up and maintains an inventory
of certain components for the PRS. The Company also tries to identify, where
feasible, multiple suppliers of materials and components.

  While the Company sometimes negotiates supply contracts with certain key
suppliers, the Company currently purchases its supplies through open purchase
orders. The Company's vendors may not continue to provide supplies on acceptable
terms, if at all. In addition, if the Company's forecasted product orders prove
to be different than actual product orders, the Company may have excess or
inadequate inventory.

  In addition, the Company may not be able to find alternative suppliers for the
PRS components on a timely basis, if at all, in the event that the Company needs
such alternative suppliers. Any significant delay or interruption in the
Company's ability to acquire product components and materials could have an
adverse effect on the manufacture of the Company's products.

PRODUCT LIABILITY RISKS

  The Company will be exposed to the risk of medical product liability claims if
any of its products causes harm or injury. The Company might not have sufficient
resources to satisfy any liability resulting from such claims. The level or
scope of the Company's liability insurance with respect to the clinical testing
of the PRS may not be sufficient to cover potential claims. In addition, medical
product liability insurance may not continue to be available at an acceptable
cost, if at all. As a result, a medical product liability claim could cause the
Company significant financial harm.

ANTI-TAKEOVER PROVISIONS; EFFECTS OF ISSUANCE OF PREFERRED STOCK

  Certain provisions of the Company's Articles of Organization and By-Laws are
intended to enhance the likelihood of continuity and stability in the
composition of the Company's Board of Directors and in the policies formulated
by the Board and to delay or prevent a change in control of the Company if the
Board determines that such a change in control is not in the best interest of
the Company. These provisions could have the effect of discouraging certain
attempts to acquire the Company or to remove incumbent management even if some
or even a majority of the Company's stockholders deem such an attempt to be in
the Company's best interest. As a result, the anti-takeover provisions could
limit the price that investors might be willing to pay in the future for shares
of Common Stock, thereby depriving stockholders of certain opportunities to sell
their stock at temporarily higher prices. In addition, the provisions of Chapter
110F of the Massachusetts General Laws, the Business Combination Statute, cover
the Company. This statute prohibits the Company from engaging in a merger, stock
or asset sale, and other transactions with an "interested stockholder"

                                      -16-
<PAGE>

that would result in a financial benefit to the interested stockholder for a
period of three years after the date of the transaction in which the person
became an interested stockholder, unless the business combination is approved in
a manner set forth in the statute. The application of this statute could have
the effect of delaying or preventing a change of control of the Company.

  In addition, the Board of Directors is authorized, subject to certain
limitations, to cause the Company to issue one or more series of Preferred Stock
and, to the extent permitted by Massachusetts law, to grant different classes of
stock certain rights and preferences. In the event the Board issues any
Preferred Stock, it could be utilized, under certain circumstances, as a method
of discouraging, delaying, or preventing a change of control of the Company. The
Company currently has no current plans to issue any shares of Preferred Stock
but the Board of Directors may elect do so at some time in the future.

YEAR 2000

  As described in this report, the Company is working to address Y2K problems.
If the Company should fail to identify or fix all such problems in the Company's
own operations, or if the Company is affected by the inability of a supplier to
continue operations due to such a problem, it could have a material adverse
effect on the Company's business, financial condition, and results of
operations.

VOLATILE STOCK PRICE

  The trading price of the Company's common stock fluctuates significantly. The
Company's stock price may fluctuate as a result of various factors such as
variations in the Company's financial performance, announcements of
technological innovations by competitors or providers of alternative products,
and changes in the economy, the financial markets, or the health care industry.
In addition, stock market have experienced price and volume fluctuations that
have particularly affected medical device companies and has often been unrelated
to such companies' operating performance. Such broad market fluctuations may
adversely affect the market price of the Company's common stock.

                                      -17-
<PAGE>

ABSENCE OF DIVIDENDS

  The Company has never paid any dividends on its capital stock and does not
anticipate paying any cash dividends to holders of the Company's capital stock
in the foreseeable future.


ITEM 6:  EXHIBITS AND REPORTS ON FORM 8-K.

(A)  EXHIBITS

     Copies of the following Exhibits are furnished with this report.
Additional Exhibits are incorporated herein by reference as reflected in the
Exhibit Index.

     No.                        DESCRIPTION
     ---                        -----------
     27        Financial Data Schedule.

(B)  REPORTS ON FORM 8-K

     No reports on Form 8-K have been filed during the quarter for which this
report is filed.

     Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed by the undersigned thereunto
duly authorized.



                                     PHOTOELECTRON CORPORATION

                                     By:/s/ Euan S. Thomson
                                        --------------------------
                                        Euan S. Thomson
                                        President, Chief Operating Officer


                                     By:/s/ Gerald J. Bojas
                                        --------------------------
                                        Gerald J. Bojas
                                        Chief Financial Officer, Treasurer


Dated:  August 12, 1999



                                      -18-