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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC 20549
 
                               ----------------
 
                                   FORM 10-K
 
      [X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
         SECURITIES EXCHANGE ACT OF 1934. FOR THE FISCAL YEAR
         ENDED DECEMBER 31, 1998 OR
 
      [_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
         THE SECURITIES EXCHANGE ACT OF 1934. FOR THE
         TRANSITION PERIOD FROM            TO           .
 
                        COMMISSION FILE NUMBER: 0-22419
 
                               ----------------
 
                                 CARDIMA, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                            <C>
                  DELAWARE                                       94-3177883
       (STATE OR OTHER JURISDICTION OF                       (I.R.S. EMPLOYER
       INCORPORATION OR ORGANIZATION)                       IDENTIFICATION NO.)
</TABLE>
 
<TABLE>
<S>                                            <C>
      47266 BENICIA STREET, FREMONT, CA                          94538-7330
  (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                       (ZIP CODE)
</TABLE>
 
      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (510) 354-0300
 
                               ----------------
 
       SECURITIES REGISTERED PURSUANT TO SECTION 12 (B) OF THE ACT: NONE
 
         SECURITIES REGISTERED PURSUANT TO SECTION 12 (G) OF THE ACT:
                         Common Stock, $.001 par value
 
                               ----------------
 
  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) had been subject to
such filing requirements for the past 90 days. [X] Yes  [_] No
 
  Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
 
  The aggregate market value of the voting stock held by non-affiliates of the
registrant was $36,830,437 based on the last reported sales price of the
Common Stock on the Nasdaq National Market on March 10, 1999.
 
  As of March 10, 1999, there were 16,238,021 shares of Registrant's Common
Stock outstanding.
 
                               ----------------
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  The Registrant has incorporated by reference into Part III of this Form 10-K
portions of its Proxy Statement for the Annual Meeting of Stockholders to be
held June 23, 1999.
 
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<PAGE>
 
                                 CARDIMA, INC.
 
                                   FORM 10-K
 
                  For the Fiscal Year Ended December 31, 1998
 
                                     INDEX
 
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                                                                           Page
                                                                           No.
                                                                           ----
 <C>             <S>                                                       <C>
 PART I..................................................................    3
 
        ITEM 1.  BUSINESS...............................................     3
        ITEM 2.  PROPERTIES.............................................    24
        ITEM 3.  LEGAL PROCEEDINGS......................................    24
        ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS....    24
 
 PART II.................................................................   25
 
        ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
                 STOCKHOLDER MATTERS....................................    25
        ITEM 6.  SELECTED FINANCIAL DATA................................    26
        ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                 CONDITION AND RESULTS OF OPERATIONS....................    27
        ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
                 RISK...................................................    34
        ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA............    34
        ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
                 ACCOUNTING AND FINANCIAL DISCLOSURE....................    34
 
 PART III................................................................   35
 
        ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.....    35
        ITEM 11. EXECUTIVE COMPENSATION.................................    36
        ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
                 MANAGEMENT.............................................    36
        ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.........    36
 
 PART IV.................................................................   37
 
        ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
                 FORM 8-K...............................................    37
 
 SIGNATURES..............................................................   39
</TABLE>
 
                                       2
<PAGE>
 
                                    PART I
 
ITEM 1. BUSINESS
 
Overview
 
  Cardima, Inc., (the "Company" or "Cardima"), designs, develops, manufactures
and markets minimally invasive, single-use, microcatheter-based systems for
the mapping and ablation of the two most common forms of cardiac arrhythmias:
atrial fibrillation ("AF") and ventricular tachycardia ("VT"). Arrhythmias are
abnormal electrical heart rhythms that adversely affect the mechanical
activities of the heart and can potentially be fatal. The Company is
developing microcatheter systems designed to provide enhanced access to
arrhythmia causing tissue, to diagnose the arrhythmia by locating its origin
("mapping") and to restore normal heart rhythms by isolating and destroying
the arrhythmia causing sites ("ablation") using radiofrequency ("RF") energy.
The Company's microcatheters incorporate multiple electrodes at the distal end
of the catheter that are designed to record electrical signals for mapping
purposes and, with some products, to emit RF energy for ablation; thereby
allowing physicians to both map and ablate using the same catheter. Cardima's
microcatheters are designed with variable stiffness and a highly flexible
distal tip to allow enhanced access to the vasculature of the heart. In
addition, they are designed to be compatible with existing signal display
systems and RF generators, eliminating the need for significant new investment
in capital equipment. The Company's microcatheter technology was originally
conceived at Advanced Cardiovascular Systems, Inc. ("ACS," now a division of
Guidant Corporation), from 1979 to 1982. Target Therapeutics, Inc. ("Target,"
now a division of Boston Scientific Corporation ("Boston Scientific"))
purchased this technology in 1985 from ACS for use in neurological
applications. In 1993, Target granted Cardima an exclusive, royalty-free
license to use the microcatheter technology in the treatment of
electrophysiological diseases affecting areas other than the central nervous
system.
 
  The Company's Cardima Pathfinder(TM) microcatheter system received 510(k)
clearance from the United States Food and Drug Administration ("FDA") for use
in mapping VT, and in November 1997 the Revelation(TM) microcatheter system
received 510(k) clearance from the FDA for use in mapping AF. These products
are currently being marketed for these applications in the United States,
Europe, Japan, Australia and Canada. The Company has started patient
enrollment of an expanded feasibility study in the United States for the
treatment of AF. The Company intends to further expand this study into a
pivotal study and use this data as the basis for the Premarket approval
application ("PMA") submission with the FDA. The Company received CE Mark to
treat AF in the European Union for the Revelation and Revelation Tx
microcatheters. The Company is currently pursuing approval of an
Investigational Device Exemption ("IDE") in the United States to begin
clinical testing of the Therastream microcatheter system for VT ablation in
the second half of 1999.
 
Discussion of the Heart and Arrhythmic Disorders
 
  The heart is an electromechanical pump that relies on self-generated
electrical signals to contract its muscle fibers and pump blood throughout the
body. It is divided into four chambers: the two upper chambers called the
atria, and the two lower chambers called the ventricles. The heart consists of
two pumps working side by side, each with its own atrium and ventricle. The
pump on the right side collects venous blood from the body and sends it to the
lungs for oxygenation. The pump on the left side receives the oxygenated blood
from the lungs and pumps it through the body. The process is repeated as
venous blood returns to the right side of the heart.
 
  The heart, as with any other organ, requires oxygen and nutrients to
function. Because the heart has large oxygen and nutrient demands, it requires
an extensive, well developed vascular network to bring blood to and carry
blood away from its tissue. This coronary vascular network is located
throughout the majority of the heart's walls to nourish the heart tissue
directly. This network is comprised of an arterial system and a venous system,
both of which originate on the epicardium, or outer surface, of the ventricles
and penetrate into the tissues of the ventricular walls. Thus, the anatomy of
the ventricular walls consists of a thick mass of contracting muscle cells
with a framework of coronary blood vessels.
 
 
                                       3
<PAGE>
 
  The heart's pumping action is controlled by an electrical conduction system
comprised of a specialized network of cells within the heart muscle tissue.
This conduction system allows electrical signals to propagate through the
heart in a systematic and organized way. These specialized conduction cells
are placed throughout the walls of the chambers, from just underneath the
inner, or endocardial, surface of the heart to the outer, or epicardial,
surface. In a systematically timed sequence, this conduction system carries
electrical signals to the muscle cells throughout the heart. This electrical
conduction cycle results in a normal heart beat that starts in the right
atrium, which contains a specialized group of cells called the Sino-Atrial
("SA") node.
 
  The SA node is the heart's "natural pacemaker," regularly discharging an
electrical signal that, under normal circumstances, is responsible for setting
the heart rate, usually 60 to 100 beats per minute. The signal generated in
the SA node is propagated through the atria until it is delayed in the Atrio-
Ventricular ("AV") node. This delay provides enough time for the atria to fill
the ventricles with blood before they contract.
 
  Once the electrical signal exits the AV node, it is rapidly conducted down
the His Bundle, and is distributed widely throughout both ventricles via the
Purkinje Fibers, delivering the electrical signal to both ventricles at the
same time, causing them to contract in unison. Since the ventricles pump blood
to the lungs and the body (while the atria only pump blood to the ventricles),
the ventricles are composed of a larger amount of muscle tissue than the
atria. The left ventricle, in particular, is the stronger of the two
ventricles, generating higher pressure and working harder in order to pump
oxygenated blood through the entire body against a high vascular resistance.
In the normal heart, the four chambers work in rhythm with each other to
ensure that properly oxygenated blood is delivered throughout the body.
 
 Arrhythmias
 
  Arrhythmias are abnormal electrical heart rhythms that adversely affect the
mechanical activities of the heart. Arrhythmias result in insufficient blood
flow, which may cause dizziness, inadequate function of important organs in
the body, stroke or even death. Arrhythmias have numerous causes, including
congenital defects, tissue damage from heart attacks or arteriosclerosis and
other conditions that accelerate, delay or redirect the normal transmission of
electrical activity, thereby disrupting the normal coordinated contractions of
heart muscle cells. There are two general types of arrhythmias: tachycardia, a
fast resting heart rate, typically more than 100 beats per minute, and
bradycardia, a slow resting heart rate, typically less than 60 beats per
minute. Tachycardias fall into one of two major categories: supraventricular
tachycardia ("SVT"), which has its origin above the ventricles (typically in
the atria) with AF being the most common form of SVT, and VT, which has its
origin in the wall of the ventricles. Generally, arrhythmias degenerate and
worsen over time.
 
 Atrial Fibrillation
 
  AF is characterized by the irregular and very rapid beating of the heart and
results when the normal electrical conduction system of the atria
malfunctions, leading to irregular and chaotic electrical signals. During AF,
the regular pumping action of the atria is replaced by irregular, disorganized
and quivering spasms of atrial tissue. Symptoms of AF typically include a
rapid and irregular heartbeat, palpitations, discomfort and dizziness. This
malfunction results in the failure of the atria to fill the ventricles
completely and, consequently, the failure of the heart to pump adequate
amounts of blood to the body. Once AF becomes symptomatic, it is typically
associated with significant morbidity related to reduced blood flow. Often,
the greatest concern is that the reduced cardiac output can lead to blood
pooling in the atria and the formation of blood clots. Blood clots in the left
atrium can dislodge and travel through the bloodstream to the brain, resulting
in stroke and even death.
 
  In the United States, AF affects an estimated two million people, with
approximately 160,000 new cases being diagnosed each year. It is estimated
that about 1.5 million outpatient hospital visits per year in the United
States are associated with AF and there are more than 200,000 admissions to
hospitals for AF each year. The American Heart Association estimates that AF
is responsible for over 70,000 strokes each year in the United States. The
Company estimates that the cost of treating these patients is more than $3.6
billion annually. The cost of drug treatment for AF alone is estimated to be
in excess of $400 million worldwide each year.
 
                                       4
<PAGE>
 
  AF is routinely diagnosed using an electrocardiogram, in which electrodes
are placed on the skin to record the irregular beating of the heart. However,
electrocardiograms are unable to locate the origin, or focus, of the AF.
Another diagnostic method, called mapping, involves placing catheters with
electrodes inside the chambers of the heart to record the electrical signals
generated by the heart in order to locate the focus of the arrhythmia. Since
AF is an arrhythmia that typically affects both the right and left atria at
the same time, the Company believes that optimal mapping of AF requires the
simultaneous evaluation of electrophysiological information from both atria.
The Company believes electrophysiologists do not routinely map all forms of AF
because currently available catheters are inadequate to map either the entire
right or left atrium, or both simultaneously.
 
  Current AF treatments are directed at trying to reestablish a normal
heartbeat and prevent stroke, and are primarily supportive and palliative.
Antiarrhythmic and anticoagulant drugs, the most common treatment for AF, are
typically used to attempt to control AF by restoring the heart's natural
rhythm and limiting the natural clotting mechanism of the blood. However,
antiarrhythmic drug therapy often becomes less effective over time, with
approximately half of the patients eventually developing resistance. In
addition, antiarrhythmic drugs can have severe side effects, including
pulmonary fibrosis and impaired liver function. Another palliative procedure
for AF is external cardioversion, or the application of strong electrical
current under general anesthesia. This treatment is usually effective for a
limited period of time as well. Implantable atrial defibrillators are being
investigated to detect the onset of AF internally and then deliver an
electrical shock to convert the heart back to normal rhythm. Although the
preliminary results of clinical studies indicate that this approach may be
feasible, AF is not cured with this approach. There are significant problems
including pain tolerance, reversion to AF and creation of VT as a result of
the electrical shock. Purposeful destruction of the AV node followed by
implantation of a pacemaker is typically a treatment of last resort for AF
patients, but does not cure or treat the AF itself. The patient also is
dependent on the pacemaker for life. Since atrial function remains poor
following the procedure, chronic anticoagulant therapy is generally required.
 
  The Company believes that the only curative therapy for AF used today is an
open heart operation. The most common procedure is the "maze" procedure, in
which a surgeon makes several slices through the wall of the atrium with a
scalpel and then sews the cuts back together creating a scar pattern. The
scars isolate and contain the chaotic electrical impulses to control and
channel the electrical signal emanating from the SA node. This open heart
operation is expensive and associated with long hospital stays and high
morbidity and mortality. Although this approach is not commonly used because
it is highly invasive, containing the movement of the chaotic impulses in the
atrium through scar creation is generally considered effective in controlling
AF.
 
  Electrophysiologists are also experimenting with less invasive, catheter-
based ablation procedures that attempt to mimic the results of the maze
procedure. Although these procedures offer the benefit of a minimally invasive
approach, they are difficult to perform because of the shortcomings of
existing catheter technology and appear unable to create lesions that
effectively isolate portions of the atria where the arrhythmia causing tissue
is located.
 
 Ventricular Tachycardia
 
  VT is a life-threatening condition in which heartbeats are improperly
initiated from within the ventricular wall, rather than from the SA node, thus
bypassing the heart's normal conduction system. The typical VT patient has
experienced a myocardial infarction, or heart disease, which leads to the
formation of a scar or electrical barrier inside the ventricular wall,
resulting in improper electrical conduction in the cells immediately bordering
the scar. During episodes of VT, the ventricles beat at such an abnormally
rapid rate that they are unable to fill completely with blood, thus impairing
the ventricles' ability to pump oxygenated blood throughout the body. The
resulting reduction in the amount of oxygen transported to the tissues and
organs of the body can cause dizziness and loss of consciousness. VT can often
progress into ventricular fibrillation ("VF"), which is an irregular, chaotic
and ineffective spasming of the ventricles. VF is fatal within a few minutes
of its occurrence, unless orderly contractions of the ventricles are restored.
 
 
                                       5
<PAGE>
 
  It is estimated that more than 300,000 people in the United States suffer
from sudden cardiac death each year. Of these, approximately 50,000 people
survive, primarily through emergency defibrillation. These survivors are at
risk of developing VT or subsequently VF. The Company estimates that each year
over 100,000 people in the United States who have never suffered VF are
diagnosed with symptomatic VT. The American Heart Association estimates that
approximately 1.5 million people in the United States suffer myocardial
infarctions each year, of which approximately one million survive.
Approximately 30% of the survivors of a myocardial infarction suffer an
episode of VT within the following year. The Company believes all of these
individuals are potential candidates for a safe and cost-effective mapping and
ablation procedure.
 
  VT may be diagnosed using a standard electrocardiogram in a manner similar
to the diagnosis of AF. The cardiac electrophysiologist typically attempts to
map VT to locate the focus of the arrhythmia within the heart's structure.
However, locating the arrhythmia causing tissue, which can occur at any point
in the thickness of the ventricular wall, from the endocardium, or inner
surface of the heart wall, to the intramyocardium, inside of the heart wall
itself, to the epicardium, or outer surface of the heart wall, can be
difficult.
 
  Similar to AF, current treatments for VT are primarily supportive and
palliative. Antiarrhythmic drugs are the most common treatment, although these
drugs have been shown to have a number of unwanted side effects, and in some
circumstances may actually induce VT. The Multicenter Automatic Defibrillator
Implantation Trial ("MADIT") has demonstrated that the implantable cardiac
defibrillator is a more effective treatment for VT than antiarrhythmic drugs,
but it also is a palliative treatment and is associated with a number of
undesirable characteristics, such as patient reliance on an implantable device
with a limited battery life, the high cost of the implantation procedure and
the risks associated with implanting foreign objects. In addition, the
implantable cardioverter is only palliative and does not cure the VT or
destroy the arrhythmia causing tissue.
 
  Similar to the treatment of AF, electrophysiologists are also experimenting
with less invasive, catheter-based ablation procedures for the treatment of
VT. However, catheter size limitations and shortcomings of existing
endocardial catheter technology for ablation have limited the use of catheter
technology to treat VT.
 
 Limitations of Current Catheter-Based Diagnosis and Therapy
 
  The demonstrated medical benefits and cost efficiency of minimally invasive
surgical procedures have encouraged electrophysiologists to seek a means of
employing new, minimally invasive techniques for the diagnosis and treatment
of arrhythmias. In the case of AF, electrophysiologists are experimenting with
a treatment technique, often referred to as the "drag and burn procedure," in
which conventional RF ablation catheters are dragged along the inside surface
of an atrium while applying RF energy. However, creating continuous, linear,
transmural lesions to isolate portions of the atria using this experimental
procedure with standard catheters has proven time consuming and difficult.
Endocardial catheter technology is also being tested for the treatment of VT.
The Company believes that an endocardial approach is suboptimal because the
muscle tissue of the ventricles is significantly thicker than the muscle
tissue in the atria, requiring the use of large amounts of RF energy. As a
consequence, the endocardial approach generates larger, less focused lesions,
increasing the amount of ventricular tissue destroyed in the procedure.
 
  The Company believes that the disadvantages of existing catheter based
approaches for AF and VT are attributable not to the minimally invasive
approach of the procedure, but instead to existing catheter technology. The
catheters currently used are relatively large (typically six to eight French
in diameter) and stiff, increasing the risk of trauma to the heart during the
procedure, and restricting access primarily to the chambers of the heart. When
attempting to diagnose and treat VT using standard electrophysiology
catheters, the electrophysiologist is unable to access smaller blood vessels
within the ventricular wall. As a result, generally only signals generated
within one to two millimeters of the inner wall can be recorded. The current
technology is inadequate because the normal ventricular wall is five to 20
millimeters thick, and arrhythmia causing tissue, especially tissue causing
VT, can reside anywhere within that thickness. In addition, the information
generated by the endocardial diagnostic procedure is limited, as the
electrophysiologist can observe and evaluate only a limited number of signals
in a confined area. In order to observe more signals, the user must
mechanically manipulate the catheter
 
                                       6
<PAGE>
 
to change its location. As a result, the standard endocardial
electrophysiology procedure is extremely laborious and time consuming, in some
cases requiring up to 15 or more RF energy deliveries per treatment. Although
there are endocardial basket-type catheters in development that enable the
electrophysiologist to record information from multiple points in the
ventricle at once, the Company believes that these catheters suffer the same
access limitations to arrhythmia causing tissue located in the intramyocardium
and epicardium as standard endocardial catheters and often require additional
investments in capital equipment.
 
  Based on experience with standard endocardial catheters,
electrophysiologists recognize the need to record and evaluate a greater
amount of electrical information from various areas in the heart
simultaneously during AF or VT procedures. In the case of AF, the Company
believes there is a need for catheters that are able to map both right and
left atria at the same time, if warranted, and then immediately and
appropriately ablate the AF causing tissue. In the case of VT, the Company
believes there is a need for catheters that are able to map safely the entire
thickness of the ventricular wall, not just the endocardial surface, and
appropriately ablate the VT causing tissue with minimal trauma to normal
conducting heart tissue.
 
The Cardima Microcatheter System Solution
 
  The primary clinical goal in the diagnosis and treatment of AF and VT is
precise mapping and effective, less destructive ablation. To achieve this, the
electrophysiologist must be able to access areas of the heart that are
currently inaccessible, using techniques that are easy to perform and that do
not increase the trauma to the patient. The Company is working to achieve this
goal by designing microcatheter systems which provide enhanced access to the
arrhythmia causing tissue, by mapping the location of the arrhythmia and then
ablating the arrhythmia causing tissue using RF energy to cure the patient,
all in one procedure using the same catheter. The Company's microcatheter
systems are designed to offer the following advantages:
 
  .  Minimally invasive approach. The Cardima microcatheter systems are
     designed to provide better access in a minimally invasive procedure to
     treat both AF and VT. This increased access results in decreased
     procedure time, shorter hospital stays, lower procedure costs and fewer
     complications than the surgical procedures currently in use.
 
  .  Single catheter for rapid mapping and ablation. By using microcatheters
     that can map, as well as ablate, the Company believes the
     electrophysiologist need only access the arrhythmia causing tissue once
     in order to map it, verify that it is causing the arrhythmia and then,
     using the same device, ablate the tissue to cure the patient. The
     Company believes this single catheter, dual function characteristic of
     its microcatheter systems will decrease procedure times and improve
     treatment of both AF and VT.
 
  .  Enhanced access to the vasculature of the heart. Cardima's
     microcatheters feature a significantly smaller diameter than standard
     electrophysiology catheters, and incorporate Target variable stiffness
     technology and a highly flexible distal tip. As a result, the Company's
     microcatheters are more flexible and torqueable than standard
     electrophysiology catheters and have varying degrees of flexibility at
     the distal end to allow enhanced access to the vasculature of the heart,
     to conform easily to the contours of the heart wall and to maintain
     controlled, regular contact even in a fast beating heart.
 
  .  Ability to gather more information. The Company's microcatheter system
     designs include a large number (up to 16) of narrow electrodes, while
     maintaining a high degree of flexibility. The Company believes that this
     design permits the electrophysiologist to acquire and evaluate far more
     information in a mapping procedure than is available using standard
     electrophysiology catheters, which typically incorporate fewer
     electrodes. The increased amount of information recorded using the
     microcatheter approach should enable the electrophysiologist to target
     the arrhythmia causing tissue with greater precision, in order to permit
     effective ablation.
 
  .  Curative treatment for AF. The Cardima Revelation and Revelation Tx
     microcatheter systems are designed to treat AF by creating long, thin,
     continuous, linear, transmural lesions in both the right and left atria
     to isolate and contain the arrhythmia causing tissue, thereby restoring
     normal electrical function by controlling and reorganizing the random,
     chaotic electrical activity that characterizes AF.
 
                                       7
<PAGE>
 
     In animal studies, the Company's microcatheter systems have required
     less RF energy and created significantly thinner lesions than standard
     electrophysiology catheters, preserving a greater amount of atrial
     tissue following the procedure. The Company believes these thinner
     lesions will result in a significant improvement in atrial function and
     a reduction in the risk of blood clotting, reducing or possibly
     eliminating the need for chronic anticoagulant therapy. The Company
     believes this approach has the potential to offer the effectiveness of
     the open heart surgical cure for AF, but with significantly less trauma,
     fewer complications, reduced pain, shorter hospital stays and lower
     procedure costs.
 
  .  Curative approach for VT. The Company's microcatheter systems for the
     mapping and ablation of VT are designed for use inside the vasculature
     of the heart wall, facilitating access to arrhythmia causing tissue
     through the venous system. Cardima believes that at least half of VT
     foci are located in the intramyocardium and the epicardium, areas that
     are ineffectively accessed using standard endocardial catheters or
     basket type catheters in development. The intravascular approach to VT
     ablation should permit the microcatheters to be positioned in close
     proximity to the arrhythmia causing tissue, facilitating the creation of
     smaller, more focused lesions. The Company believes that this approach
     has the potential to be more effective than standard endocardial
     ablation procedures, with reduced destruction of surrounding healthy
     tissue, thus maximizing and optimizing the normal function of the heart
     after the procedure. The Company is not aware of any epicardial mapping
     catheters other than the Cardima Pathfinder and Tracer under
     development.
 
  .  Compatible with existing capital equipment. The Company's microcatheter
     systems are designed to be compatible with leading electrophysiology
     signal display systems and RF generators, in order to eliminate the need
     for significant new investment in additional capital equipment. By
     facilitating the rapid and precise location of the arrhythmia causing
     tissues with a system that is compatible with standard laboratory
     equipment, the Company believes its products will be rapidly adopted by
     electrophysiologists.
 
  .  Reduced procedure and radiation exposure times. The Company believes
     that its microcatheter systems will reduce procedure times and thereby
     decrease cumulative x-ray exposure to both patients and lab personnel.
     Standard electrophysiology procedures, in many cases, expose both the
     patient and the lab personnel to over one hour of accumulated x-ray time
     during fluoroscopy, which is used to visualize the placement of the
     catheters. The Company believes that the total procedure and fluoroscopy
     time associated with the use of its microcatheter systems are less due
     to shorter procedure times than those using standard electrophysiology
     catheters, thereby reducing procedure costs and the risk of disease
     resulting from extended exposure to x-ray fluoroscopy.
 
Strategy
 
  Cardima's objective is to establish its microcatheter systems as the
standard of electrophysiological care for mapping and ablating AF and VT. To
achieve its objective, the Company is pursuing the following strategies:
 
  Develop microcatheter technology to address unmet clinical needs for both
mapping and ablation. Cardima is developing microcatheter systems to address
clinical needs that are not adequately addressed by current technology.
Cardima is focused on both endocardial access for AF and intravascular access
for VT, and provides a microcatheter systems approach to addressing AF and VT.
Cardima is designing systems which incorporate variable stiffness technology
originally developed at Target, including guiding catheters, fixed-wire and
over-the-wire systems, in order to optimize the physician's ability to access
the areas of interest in the heart easily and safely. By using microcatheters
that can map as well as ablate, the Company believes the electrophysiologist
need only access the arrhythmia causing tissue once in order to map it, verify
that it is causing the arrhythmia and then ablate the tissue using the same
catheter.
 
  Provide microcatheter systems that lower the cost of treating
electrophysiological disorders. The Company's microcatheter systems are
designed to reduce the average time required for AF and VT diagnostic and
therapeutic procedures significantly. As a result, time spent in high cost
electrophysiology laboratories
 
                                       8
<PAGE>
 
should be reduced, lowering the overall cost of AF or VT treatments. The
shorter procedure time that the Company believes will result from the use of
its microcatheter systems should enable physicians to perform a greater number
of AF or VT procedures and reduce the overall cost per procedure. In addition,
the Company intends to use data derived from its clinical studies to establish
reimbursement for AF and VT procedures using the Company's microcatheter
systems. The Company believes that its microcatheter systems will appeal to
patients and third party payors seeking a cost-effective solution to the
diagnosis and treatment of AF and VT.
 
  Accelerate acceptance and adoption of the Company's microcatheter systems by
leading electrophysiologists. The Company has formed relationships with
leading medical centers in the United States, and is developing relationships
with medical centers in Europe and Japan, to perform clinical trials of its
microcatheter systems for the diagnosis and treatment of AF and VT. Based on
the initial feasibility results, Cardima has obtained FDA approval to expand
to a larger multi-center trial with eight investigative centers. Cardima
believes that successful acceptance and adoption of these systems by widely
recognized experts in the field of electrophysiology is a critical step in the
overall market acceptance of its microcatheter systems. In addition, the
Company has established a Scientific Advisory Board composed of leading
electrophysiologists at medical centers in the United States to consult with
the Company concerning the pre-clinical and clinical development of the
Company's microcatheter systems. The Company intends to continue to work with
leading physicians and medical centers and to initiate clinical trials to
demonstrate the safety and effectiveness of its microcatheter systems and
ultimately to establish broad market acceptance. In addition, Cardima intends
to accelerate physician education and adoption through peer-reviewed
publications concerning the clinical trials of the Company's microcatheter
systems.
 
  Build market leadership through staged introduction of microcatheter
systems. In the United States, the Company has introduced microcatheter
systems for mapping while it continues to develop its microcatheter systems
for ablating AF and VT. The Company received 510(k) premarket clearances for
its Cardima Pathfinder microcatheter system for VT mapping and for its
Revelation microcatheter system for AF mapping. The Company expects to
establish the benefits of its microcatheter systems by encouraging their use
initially as a diagnostic complement to standard ablation catheters. As a
result, the Company's strategy is to establish the utility of these diagnostic
systems in advance of regulatory approval for the Company's microcatheter
systems for the treatment of AF and VT.
 
  Increase sales by further penetrating international markets. The Company
intends to devote significant resources to further penetrate international
markets, given their substantial size and the relatively lower regulatory
barriers. The Company received ISO 9001 (EN 46001) Quality Systems
certification, as well as the right to affix the CE Mark to a number of its
products. The Company received regulatory approval in the United States,
Europe, Japan, Australia and Canada for the Cardima Pathfinder microcatheter
system for mapping VT and has received regulatory approval in the United
States, Europe, Japan and Australia for the Cardima Revelation microcatheter
system for mapping AF. In addition, Cardima received approval for marketing
the Revelation and Revelation Tx ablation microcatheter systems to treat AF in
the European Union in August 1998 and December 1998, respectively.
 
Products
 
  Cardima is developing microcatheter systems for the diagnosis and treatment
of AF and VT. These systems are designed, in the case of AF, to access both
the right and left atria and, in the case of VT, to be positioned within the
coronary vasculature using a guiding catheter in a system similar to that used
in angioplasty procedures. Cardima's microcatheter systems are designed to be
used endocardially in the atria to map and then ablate AF through the creation
of long, thin, continuous, linear, transmural lesions. For VT, these systems
are designed to provide intravascular access to the heart to map and ablate
within the wall of the ventricles. All of the Company's microcatheters are
available with a variety of electrode numbers, electrode spacing
configurations and outer diameters. The series of electrodes at the distal
ends can both receive electrical signals for mapping and emit RF energy for
ablation. In addition, these microcatheter systems are smaller in diameter and
are
 
                                       9
<PAGE>
 
designed to be more flexible and torqueable than standard electrophysiology
catheters, providing better steerability for the electrophysiologist. The
Company's microcatheters are designed for single use. The Company is designing
its products to be used with existing electrophysiology recording systems and
RF ablation generators. The Company's ancillary products, including guiding
catheters, guidewires, electrical switch boxes and connecting cables, support
these microcatheter systems.
 
  The following table describes the Company's products and their intended
indications and regulatory status:
 
<TABLE>
<CAPTION>
                                                                         U.S. Regulatory              International
    AF Products            Description            Indication               Status(/1/)            Regulatory Status(/1/)
 ------------------ ------------------------   ----------------- ------------------------------- ------------------------
 <C>                <S>                        <C>               <C>                             <C>
 Revelation         Fixed-wire multi-          Mapping           510(k) clearance obtained.      Approved in European
                    electrode microcatheter                                                      Union (CE Mark) and
                    system designed to map                                                       Japan.
                    in both right and left
                    atria.
 
                    Also can be used for       Ablation                                          Approved in the European
                    ablation in approved                                                         Union (CE Mark) for
                    markets.                                                                     ablation.
 
 Revelation Tx      Fixed-wire multi-          Mapping and       Phase II IDE approved;          Approved in European
                    electrode microcatheter    Ablation          clinical trial in progress.     Union (CE Mark).
                    system with temperature
                    sensors designed to map
                    and create long, thin,
                    continuous, linear,
                    transmural lesions in
                    the right atrium.
 
    VT Products
 ------------------
 Cardima Pathfinder Fixed-wire multi-          Mapping           510(k) clearance obtained.      Approved in European
                    electrode microcatheter                                                      Union (CE Mark) and
                    system designed for                                                          Japan.
                    accessing coronary sinus
                    vasculature to locate
                    arrhythmia causing
                    tissue.
 
 Pathfinder mini    Smallest Cardima           Mapping           510(k) clearance obtained.      Approved in European
                    Pathfinder microcatheter                                                     Union (CE Mark) and
                    (1.5 French) designed to                                                     Japan.
                    provide access to more
                    distal, smaller coronary
                    veins
 
 Tracer             Over-the-wire multi-       Mapping           510(k) pending review,          Approved in European
                    electrode microcatheter                      expect in first half            Union (CE Mark) and
                    system designed to be                        of 1999.                        Japan.
                    used in the veins of the
                    heart wall over a
                    guidewire.
 
 Therastream        Over-the-wire multi-       Ablation          IDE submitted for feasibility   No studies planned.
                    electrode microcatheter                      trial, pending approval,
                    system designed for                          expected in first half of 1999.
                    mapping and ablation
                    from within the veins of
                    the heart wall.
 
  Support Products
 ------------------
 Venaport           Coronary sinus guiding     Venous access     510(k) clearance obtained.      Approved in European
                    catheters with a family                                                      Union (CE Mark) and
                    of curve shapes and                                                          Japan.
                    lengths. Designed to
                    deliver Cardima
                    microcatheters.
 
 Vueport            Balloon-tipped coronary    Venous access,    510(k) clearance obtained.      Approved in European
                    sinus guiding catheter     delivery of EP                                    Union (CE Mark).
                    designed to facilitate     catheters,
                    delivery of                venography
                    electrophysiology (EP)
                    catheters and provide
                    occlusive venography.
 
 Naviport           Deflectable guiding        EP catheter       510(k) submission under         Approved in European
                    catheter designed to       delivery and      review, expected in first       Union (CE Mark).
                    facilitate delivery of     support           half of 1999.
                    EP catheters.
 
 EP Select          Switch box designed to     Connectivity      510(k) clearance obtained.      Approved in European
                    interface with existing    for pacing and                                    Union (CE Mark).
                    electrophysiology lab      electrophysiology
                    equipment and multi-       recording.
                    electrode catheters.
 
 Tx Select          Switch box designed to     Connectivity                                      Approved in European
                    interface with existing    for pacing,                                       Union (CE Mark).
                    electrophysiology lab      electrophysiology
                    equipment and multi-       recording
                    electrode catheters.       and radio
                                               frequency
                                               ablation.
</TABLE>
 
                                      10
<PAGE>
 
--------
(1) The regulatory status of the Company's microcatheter systems reflects the
    Company's current estimates of the timing of regulatory submission in the
    United States, Europe and Japan. See "-- Government Regulation." The
    actual submission times could differ materially from those anticipated in
    these forward-looking statements as a result of certain factors, including
    failure to complete development of microcatheter systems or to demonstrate
    safety or effectiveness in clinical studies, as well as the other factors
    set forth under the Company's "Management's Discussion and Analysis of
    Financial Condition and Results of Operations Factors Affecting Future
    Results" and elsewhere in this Annual Report on Form 10-K.
 
 Products Designed for Mapping and Ablating AF
 
  The Company believes its microcatheter systems can access the right and left
atria in a minimally invasive procedure and are designed to effectively ablate
AF by creating long, thin, continuous, linear, transmural lesions in the
atria.
 
  Cardima Revelation for AF Mapping. The Revelation microcatheter system is
designed to facilitate mapping of the atria. The Revelation is a thin,
flexible, eight electrode microcatheter. The Revelation microcatheter system
is a 3.3 French diameter microcatheter that incorporates variable stiffness
technology that permits access to any area of the atria and has three
millimeter long platinum coil electrodes for added flexibility to enhance
contact to surrounding heart tissue. This microcatheter system is being sold
for mapping AF in the United States, Europe and Japan. The Revelation is also
approved for treatment of AF in the European Union.
 
  The Company believes that mapping prior to ablation may be useful to
identify different segments of the AF population, each of which could require
slightly different ablation procedures. For example, some electrophysiologists
believe most AF patients will need to be mapped and ablated in both the left
and right atria, while others believe only right atrial intervention is
warranted. The Company believes that its products will have clinical utility
in either of these situations.
 
  Cardima Revelation Tx for AF Ablation. The Revelation Tx is a thin,
flexible, eight electrode microcatheter. The Revelation Tx microcatheter
system is a 3.7 French diameter microcatheter that incorporates variable
stiffness technology that permits access to any area of the atria and has six
millimeter long platinum coil electrodes for added flexibility to enhance
contact to surrounding heart tissue. The Revelation Tx also has temperature
sensing thermocouples placed between each coiled electrode to monitor tissue
temperature during ablation. The eight electrodes are closely grouped and can
be used to create a continuous lesion that extends through the thickness of
the atrial wall. The Company believes that the electrophysiologist will be
able to use the Revelation Tx microcatheter system to create long, thin,
continuous, linear, transmural lesions in both the right and left atria,
thereby restoring normal electrical function in the atria by isolating the
arrhythmia causing tissue in a manner similar to the open heart surgical maze
procedure, without the associated risk and expense. Unlike other catheter-
based ablation techniques, such as the "drag and burn" approach, the Cardima
approach does not involve resetting the catheter position during the linear
ablation procedure. As a result, the Revelation Tx may have the ability to
more effectively and rapidly isolate the arrhythmia causing tissue.
 
  The Revelation Tx microcatheter is designed with narrow electrodes that are
able to deliver ablation energy to the atrial tissue at much lower power
settings than documented with standard electrophysiology catheters. The
Company's animal studies have demonstrated the ability of the Revelation Tx to
create the thin continuous transmural linear lesions. The Company has designed
its Revelation Tx microcatheter system to be used with leading cardiac
electrophysiology RF generators and electrophysiology mapping computer
systems. The Company submitted an IDE for an expanded feasibility study to
treat AF in the United States and received approval in December 1998. The
Company believes that PMA approval will be required before the Cardima
Revelation Tx can be marketed in the United States to treat AF. See "--
Government Regulation."
 
 Products Designed for Mapping and Ablating VT
 
  The Company's intravascular approach allows its microcatheters to be
positioned in close proximity to the VT causing tissue and provides stable
positioning within the vascular system. The Company believes this
 
                                      11
<PAGE>
 
approach will result in greater accuracy of diagnosis and more effective
treatment. The Company is not aware of any other epicardial mapping catheters
in development.
 
  Cardima Pathfinder and Tracer for VT Mapping. The Company's microcatheter
systems used for diagnosing VT are designed to be positioned within the
coronary vasculature using a guiding catheter or guidewire, similar to those
used in angioplasty procedures, and which have a series of electrodes at their
distal ends in order to perform as electrophysiology catheters. The Cardima
Pathfinder and Tracer microcatheter systems can be used to subselect vessels
and access the small veins located at the apex (lower tip) of the heart. The
Cardima Pathfinder microcatheter systems are configured with either four,
eight or 16 electrodes, which enable the physician to perform a narrow focus
evaluation using a smaller number of electrodes, if there is reason to believe
the VT causing tissue is located in a specific area, or a wider focus
evaluation using larger number of electrodes, if there is little indication
regarding the location of the VT causing tissue.
 
  The Company received 510(k) clearance and CE Mark approval for the Cardima
Pathfinder microcatheter system for mapping VT. The Company currently sells
the Cardima Pathfinder for VT mapping in the United States, Europe, Japan,
Australia and Canada. The Cardima Pathfinder can safely map VT via the
coronary veins and up to four Cardima Pathfinders have been placed in various
vessels of the coronary system simultaneously, thereby aiding in the diagnosis
of VT.
 
  Pathfinder mini for VT Mapping. The Pathfinder mini, the Company's smallest
microcatheter system, was developed for VT mapping in the venous system. The
Pathfinder mini is 1.5 French in diameter (the typical catheter is six to
eight French) and provides more distal access to smaller vasculature of the
heart. Similar to the Pathfinder microcatheter, the Pathfinder mini
microcatheter is constructed around a finely ground core-wire to provide the
steerability necessary to access distal vasculature. The Pathfinder mini
microcatheter has a flexible platinum tip coil and contains a variable number
of electrodes with different spacing options. The Company received 510(k)
clearance for this product in July 1998.
 
  Therastream for VT Ablation. The Company's epicardial approach to VT
ablation is intended to address the shortcomings of standard endocardial
ablation catheters. Once a VT focus has been identified as being epicardial or
intramyocardial, the electrophysiologist must decide whether or not to attempt
to ablate that focus from the endocardial side of the heart wall. Physicians
using existing ablation systems are faced with a fundamental problem: the
further the VT focus is from the endocardial side of the heart wall, the
larger the lesion size necessary to cure the condition. Traditionally,
electrophysiologists have had to use catheters and generators capable of
making larger lesions since they can only ablate the arrhythmia causing tissue
from the endocardial side. A large number of VT ablation cases required
multiple endocardial RF energy deliveries (up to 30 or more in one
electrophysiology study). Increased endocardial RF energy in ablation may
result in greater risk that the patient will develop blood clots, which may
dislodge and travel to the brain causing stroke and decreased cardiac output.
Cardima's microcatheter systems are intended to offer an alternative approach
to current ablation techniques by facilitating access to the arrhythmia
causing tissue and providing greater ablation accuracy using less RF energy.
The Company is not aware of any epicardial RF ablation catheter other than its
Therastream microcatheter system under development.
 
  The Therastream microcatheter tracks over a guidewire in the coronary veins
and can access the important distal vasculature regions of the heart and
deliver RF energy to the epicardium. The Therastream is designed to map,
locate and ablate the VT focus using RF energy directly applied through the
veins. The Company has completed animal studies to demonstrate the ability of
the Therastream to access the distal venous system and safely deliver RF
energy with no damage to the adjacent arteries. In these experiments the
Therastream has required significantly less energy to ablate VT than standard
endocardial catheters.
 
  The Company anticipates approval of an IDE for the Therastream microcatheter
system in the second half of 1999 and plans to begin clinical trials if the
IDE is approved. The Company must receive PMA approval before the Therastream
can be marketed in the United States for VT ablation. See "-- Government
Regulation."
 
                                      12
<PAGE>
 
  The Company's intravascular electrophysiology catheters are coated with a
hydrophilic coating. This coating has been used on Target's products designed
to access the vessels of the brain. The Company believes the coating
significantly improves product functionality. The Company has an exclusive
license to use the hydrophilic coating technology in products designed to map
and ablate cardiac arrhythmias while positioned within coronary vasculature.
 
  The Cardima Pathfinder and Pathfinder mini microcatheter systems for venous
mapping of VT have received 510(k) clearances from the FDA, as well as the
Venaport and Vueport families of guiding catheters. The Company's other
microcatheter systems for mapping or ablation of VT have not received FDA
clearance or approval for marketing and distribution in the United States. The
Company's microcatheter systems for ablation are at an early stage of testing.
There can be no assurance that the results of the Company's human clinical
ablation studies will validate the results of its animal studies. The Company
has not received approval to begin clinical trials of its microcatheter system
for VT ablation and there can be no assurance that any such approval will be
received. See "-- No Assurance of Obtaining, Required Regulatory Approvals;
Government Regulation."
 
Research and New Product Development
 
  The Company believes its future success will depend in large part on its
ability to develop and introduce clinically advanced diagnostic and
therapeutic systems that are effective, easy to use, safe and reliable. The
Company's research and new product development department focuses on the
continued development and refinement of its existing diagnostic devices,
systems and procedures, as well as on the development of new devices, systems
and procedures for treating cardiac arrhythmias. The Company's primary
research and development programs involve completing the development of
microcatheter systems for AF and VT ablation and developing smaller second
generation microcatheter systems for multi-catheter mapping of VT.
 
  Research and development expenses for the years ended December 31, 1998,
1997 and 1996, were $7.2 million, $5.3 million and $3.3 million, respectively.
The Company announced a workforce reduction in January 1999 which affected all
functional areas, including research and development. The Company has focused
its efforts on specific projects, which will have the effect of reducing
research and development expenses for 1999.
 
Marketing and Distribution
 
  The Company markets and sells its microcatheter systems through a direct
sales force in the United States, France and Germany, and medical device
distributors in other countries. The Company believes there are between 500
and 600 hospitals in the United States and an additional 600 hospitals
internationally that perform electrophysiology procedures on a routine basis.
Further, the Company believes there are over 600 board certified
electrophysiologists in the United States, and an equal number of practicing
electrophysiologists internationally. The Company believes that a small sales
force can serve its target market effectively due to the relatively small
number of physicians performing a significant percentage of electrophysiology
procedures. However, there can be no assurance that the Company will be able
to commercialize its products through these channels in the future.
 
 United States
 
  The Company currently sells the Cardima Pathfinder microcatheter for VT
mapping and Revelation microcatheter for AF mapping through a direct sales
force in the United States consisting of four sales representatives.
 
  The Company intends to continue to develop relationships with key academic
institutions and physicians who are well recognized in the field of
electrophysiology for the quality of their research and their ability to
influence medical opinion. The Company intends to utilize these product
champions in the United States, as it does internationally, to assist it in
gaining broad market acceptance and adoption of its products. Several of these
 
                                      13
<PAGE>
 
physicians have been involved in the development of the Company's products,
and the Company intends to continue to build these relationships through its
Scientific Advisory Board, participation in regional training centers and
physician-oriented symposia. There can be no assurance that such relationships
will be established, or if established, maintained, or that such relationships
will result in market acceptance of our products.
 
 International
 
  The Company's international distributors have experience selling
cardiovascular products and many have prior experience in electrophysiology.
The Company has a European Director who manages the Company's direct sales
organization and the European distributors. The Company's products are also
distributed in other countries in Europe and the Pacific Rim. The direct sales
and distributor organizations are supported by two European Clinical
specialists.
 
  The Company operates under written distribution agreements in the United
Kingdom, Japan, Brazil, and Portugal. These agreements grant the respective
distributor exclusive rights to sell the Company's products within a defined
territory for periods up to three years. These agreements generally reserve
for the Company the right to terminate the distribution agreement for cause,
which includes failure to meet specified minimum performance obligations, or
the failure of the distributor to obtain required governmental approvals to
distribute the Company's products in the territory. The Company has retained
the right to terminate these distribution agreements should the distributor
begin to market medical devices that compete directly with those of the
Company. In Italy and Spain, the Company is currently negotiating distribution
agreements on similar terms; however, there can be no assurance that the
Company will be able to complete these negotiations and enter into agreements
with these distributors on commercially reasonable terms. In other countries
where the Company's products are sold, the Company's distributors operate
under other written or oral arrangements. In the territories where the Company
does not have written agreements with its exclusive distributors, the terms of
the arrangements, such as the duration of the arrangements and minimum
purchase obligations are uncertain. In addition, the laws in certain
international jurisdictions may make it difficult for the Company to terminate
such distribution arrangements absent specific written termination terms.
These distributors also sell medical products manufactured by other companies.
Distributors typically purchase the Company's products at a discount to list
price and resell the products to hospitals and physicians at a price
determined by the distributor. Sales to the international distributors are
denominated in U.S. dollars.
 
  The Company currently has a limited international sales organization. The
Company currently has two sales representatives in Germany and is in the
process of hiring sales representatives to support France, Belgium and the
Netherlands. The Company's Vice President of World Wide Sales, in conjunction
with the European Director, manage distributor relationships on a worldwide
basis.
 
  Establishing a sales organization with the ability to support sales in
significant volumes will require significant management and financial
resources. To date, the Company has not established all of the international
distribution alliances necessary to fully market these products on a worldwide
basis, nor does the Company have written distribution agreements with all of
its international distributors. There can be no assurance the Company will be
able to enter into written agreements with existing distributors or that any
such distributors will devote adequate resources to selling the Company's
products.
 
  Since the Company introduces its products initially in foreign markets, the
Company expects to continue to derive a significant portion of its revenues
from international sales. The Company expects that international sales will
continue to account for a significant portion of the Company's total revenues
for the foreseeable future. As a result, a significant portion of the
Company's revenues will be subject to the risks associated with international
sales. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- there are risks associated with international sales
of our products."
 
                                      14
<PAGE>
 
Manufacturing
 
  The Company fabricates certain proprietary components of its products and
assembles, inspects, tests and packages most components into finished
products. Designing and manufacturing its products from raw materials allows
the Company to maintain greater control of quality and manufacturing process
changes and the ability to limit outside access to its proprietary technology.
 
  The Company believes its custom-designed, proprietary process equipment is
an important component of its manufacturing strategy. In some cases, the
Company has developed proprietary enhancements for existing production
machinery to facilitate the manufacture of its products to exacting standards.
The Company has also developed core manufacturing technologies and processes,
including proprietary extrusion techniques and equipment, polymer processing
capabilities, including composite lamination, welding of dissimilar materials,
balloon forming and proprietary precision guidewire grinding techniques
enabling fabrication of a large variety of guidewire core profiles.
Furthermore, the Company's technological expertise includes braiding,
hydrophilic coating, material cleaning and surface preparation.
 
  Catheter manufacturing involves complex operations with a number of separate
processes and components. Catheters are assembled and tested by the Company
prior to sterilization. The manufacturing process for the connecting cable
consists primarily of testing and packaging purchased units. If the Company
receives additional FDA clearance or approval for its products, it will need
to expend significant capital resources and develop additional manufacturing
expertise to establish large-scale manufacturing capabilities. The Company has
no experience manufacturing its products in the volumes that will be necessary
for the Company to achieve significant commercial sales, and there can be no
assurance that reliable, high-volume manufacturing capacity can be established
or maintained at commercially reasonable costs.
 
  Components and raw materials are purchased from various qualified suppliers
and subjected to stringent quality specifications. The Company expects to
conduct supplier quality audits and is establishing a supplier certification
program. A number of the components such as laminate tubing, core wire
mandrels, connector components and hydrophilic coating are provided by sole
source suppliers. For certain of these components, there are relatively few
alternative sources of supply, and establishing additional or replacement
suppliers for such components, particularly laminate tubing, could not be
accomplished quickly, which would have a material adverse effect on the
Company's ability to manufacture products and therefore on its business,
financial condition and ability to test or market its products on a timely
basis. The Company plans to qualify additional suppliers if and as future
production volumes increase. Because of the long lead time for some components
which are currently available from a single source, a supplier's inability to
supply such components in a timely manner could have a material adverse effect
on the Company's ability to manufacture products and therefore on its
business, financial condition and ability to test or market its products on a
timely basis.
 
  The Company's manufacturing facilities are subject to periodic inspection
from regulatory authorities, and its operations must undergo QSR and ISO 9001
(EN 46001) compliance inspections conducted by the FDA and TUV, a notified
body (a regulatory agency) in the European Union ("EU"), respectively. The
Company has obtained ISO 9001 (EN 46001) Quality Systems certification from
TUV and has obtained the right to affix the CE Mark to certain of its
electrophysiology mapping and ablation catheters and accessories. The Company
is subject to periodic inspections by the FDA and California Department of
Heath Services. The Company's facilities and manufacturing processes have
recently undergone a successful annual reinspection by TUV in December 1998.
There can be no assurance that the Company's manufacturing facilities will
meet such compliance standards or if met, maintain such standards. See "--
Government Regulation."
 
Patents and Proprietary Rights
 
  The Company's success will depend in part on its ability to obtain patent
and copyright protection for its products and processes, to preserve its trade
secrets and to operate without infringing or violating the proprietary rights
of third parties. The Company's strategy is to actively pursue patent
protection in the United States and
 
                                      15
<PAGE>
 
foreign jurisdictions for technology it believes to be proprietary and which
offers a potential competitive advantage for its products. The Company has
filed and intends to continue to file patent applications, both in the United
States and selected international markets, to seek protection for proprietary
aspects of the technology. The Company holds 13 issued United States patents
and has filed 17 pending United States patent applications, of which five have
been allowed. The Company has also filed 47 patent applications in major
international markets. No assurance can be given that these patent
applications will provide competitive advantages for the Company's products or
that any patent application filed by the Company will issue as a patent. In
addition, there can be no assurance any of the Company's patents or patent
applications will not be challenged, invalidated, or circumvented in the
future. There can also be no assurance that competitors, many of whom have
greater resources than the Company and have substantial investments in
competing technologies, will not apply for and obtain patents which will
prevent, limit or interfere with the Company's ability to make, use, or sell
its products either in the United States or internationally.
 
  The Company has also obtained rights to certain technology by entering into
license arrangements. Pursuant to a license agreement with Target (the
"License Agreement"), the Company obtained an exclusive, royalty-free,
worldwide license under certain patents issued in the United States and
corresponding international patents to use Target's technology and to make,
use and sell or otherwise distribute products for the diagnosis and treatment
of electrophysiological diseases in the body, other than in the central
nervous system, including the brain. The exclusive license applies to any
Target technology developed through May 1996 and will terminate on April 23,
2013, the expiration date of the last-to-issue licensed patents issued prior
to May 21, 1996. In addition to this exclusive license to use Target's
technology to develop products for electrophysiological diseases, the Company
has obtained a non-exclusive license to use Target's technology, provided it
has made a substantial improvement on such technology, for the diagnosis or
treatment of diseases of the heart other than by balloon angioplasty. As
defined in the License Agreement, a substantial improvement is any
modification, improvement or enhancement of Target technology that results in
a material change in the function, purpose or application of a particular
product incorporating Target technology. The Company believes that the
incorporation of electrodes in its microcatheter systems, together with other
modifications, satisfies the substantial improvement requirement, although the
Company has not confirmed this belief in writing with Target.
 
  Under the License Agreement, Cardima granted back to Target an exclusive,
royalty-free, worldwide license to use technology developed by Cardima through
May 1996 in the fields of neurology, interventional neuroradiology,
interventional radiology, reproductive disorders and vascular prostheses (the
"Target Field"). In addition, the Company agreed not to conduct material
research and development, acquire corporate entities or make or sell products
in the Target Field or to sell products, other than products utilizing
Target's technology, for use in diagnosis or treatment of diseases related to
the production of electrical current in tissue located in areas of the body
other than the heart, without first notifying Target and negotiating a
distribution agreement. Cardima also agreed that it would not sell products
utilizing Target's technology for use in diagnosis or treatment of diseases
related to the production of electrical current in tissue located in areas of
the body other than the heart without, if selling to a distributor, first
notifying Target and offering Target the right of first refusal with respect
to the terms of the distribution, or if selling directly to the consumer,
paying to Target an amount equal to 40% of the gross profit for such product.
 
  Target is a subsidiary of Boston Scientific and, as a result of the
acquisition, Boston Scientific exercises control over approximately 9.3% of
the Company's outstanding Common Stock as of December 31, 1998. Accordingly,
Boston Scientific may be able to exercise influence over the business and
financial affairs of the Company. Boston Scientific develops, markets and
sells cardiac electrophysiology products that compete directly with the
microcatheter products being developed by the Company. There can be no
assurance that Boston Scientific will not take actions or engage in activities
that could have a material adverse effect on the Company's business, financial
condition or results of operations.
 
  The Company obtained rights to its biocompatible hydrophilic coating
material and process through an exclusive, royalty bearing license to use the
hydrophilic coating technology in products designed to map and
 
                                      16
<PAGE>
 
ablate cardiac arrhythmias while positioned within the coronary arteries and
coronary veins. The license will terminate upon the later of 15 years from
first commercial sale of catheters treated with the coating material or the
expiration of the last-to-issue licensed patent, unless terminated earlier for
material breach.
 
  In addition to patents and licenses, the Company also relies upon trade
secrets, technical know-how and continuing technical innovation to develop and
maintain its competitive position. The Company typically requires its
employees, consultants, and advisors to execute confidentiality and assignment
of invention agreements in connection with their employment, consulting or
advisory relationships with the Company. There can be no assurance, however,
that the agreements will not be breached or that the Company will have
adequate remedies for any breach. Furthermore, no assurance can be given that
competitors will not independently develop substantially equivalent
proprietary information and techniques or otherwise gain access to the
Company's proprietary knowledge, or that the Company can meaningfully protect
its rights in unpatented proprietary technology.
 
  Patent applications are maintained in secrecy until patents issue or, in the
case of patent applications in foreign countries for a period of 18 months
from the priority date. Publication of discoveries in the scientific or patent
literature tend to lag behind actual discoveries and related patent
applications, and the large number of patents and applications and the fluid
state of the Company's development activities make comprehensive patent
searches and analysis impractical or not cost-effective. Although the Company
has made patent and publication searches in the United States and in foreign
countries to determine whether materials, processes or designs used by it or
its potential products infringe or will infringe third-party patents, such
searches have not been comprehensive. Patents issued and patent applications
filed relating to medical devices are voluminous and there can be no assurance
that current and potential competitors and other third parties have not filed
or will not file applications for, or have not received or will not receive,
patents and will not obtain additional proprietary rights relating to
products, materials or processes used or proposed to be used by the Company.
 
  The medical device industry has been characterized by extensive litigation
regarding patents and other intellectual property rights, and companies in the
medical device industry have employed intellectual property litigation to gain
a competitive advantage. Although there are no claims against the Company, any
such claims, with or without merit, could be time-consuming and expensive to
respond to and could divert the Company's technical and management personnel.
If any third party patent claims are upheld as valid and enforceable in any
litigation or administrative proceeding, the Company could be prevented from
practicing the subject matter claimed in such patents, or could be required to
obtain licenses from the patent owners of each patent, or redesign its
products or processes to avoid infringement. There can be no assurance such
licenses will be available or, if available, will be available on terms
acceptable to the Company or that the Company will be successful in any
attempt to redesign its products or processes to avoid infringement.
Accordingly, an adverse determination in a judicial or administrative
proceeding or failure to obtain necessary licenses could prevent the Company
from manufacturing and selling its products, which would have a material
adverse effect on the Company's business, financial condition, and results of
operations. The Company intends to vigorously protect and defend its
intellectual property. Costly and time-consuming litigation brought by the
Company may be necessary to enforce patents issued to the Company, to protect
trade secrets or know-how owned by the Company or to determine the
enforceability, scope and validity of the proprietary rights of others.
 
  The validity and breadth of claims in medical technology patents involve
complex legal and factual questions and, therefore, may be highly uncertain.
There can be no assurance that any issued patent or patents based on pending
patent applications or any future patent application will exclude competitors
or provide competitive advantages to the Company, that any of the Company's
patent or patents in which it has licensed rights will be held valid if
subsequently challenged or that others will not claim rights in or ownership
of the patents and other proprietary rights held or licensed by the Company.
There can be no assurance that others have not developed or will not develop
similar products, duplicate any of the Company's products or design around any
patents issued to or licensed by the Company or that may be issued in the
future to the Company. Since patent applications in the United States are
maintained in secrecy until the patent issues, the Company also
 
                                      17
<PAGE>
 
cannot be certain that others did not first file applications for inventions
covered by the Company's pending patent applications, nor can the Company be
certain that it will not infringe any patents that may issue to others on such
applications. The Company periodically reviews the scope of patents of which
it is aware. Although the Company does not believe that it infringes patents
known to it, the question of patent infringement involves complex legal and
factual issues and there can be no assurance that any conclusion reached by
the Company regarding infringement will be consistent with the resolution of
any such issues by a court.
 
  In addition, the United States patent laws exempts medical practitioners and
related health care entities from infringement liability for medical and
surgical procedures in certain circumstances. The Company cannot predict
whether this exception might have a material adverse effect on the Company's
ability to protect its proprietary methods and procedures.
 
Competition
 
  The Company believes it currently has the only intravascular approach to
diagnosing and treating VT. The Company considers its primary competitors to
be companies engaged in the development and marketing of more established, but
the Company believes, less effective therapies for the treatment of AF and VT,
such as drugs, external electrical cardioversion and defibrillation,
implantable defibrillators, open heart surgery and purposeful destruction of
the AV node, followed by implantation of a pacemaker. Several competitors are
also developing new approaches and new products for the mapping and ablation
of AF and VT. These approaches include mapping systems using contact mapping,
single-point spacial mapping and non-contact, multi-site electrical mapping
technologies and ablation systems using ultrasound, microwave, laser and
cryoablation technologies. In addition, companies are developing surgical
procedures that could potentially be used by physicians to perform the open
heart surgical maze procedure in a minimally invasive manner. If any of these
new approaches or new products prove to be safe and effective, the Company's
products could be rendered uncompetitive or obsolete, which could have a
material adverse effect on the Company's business, financial condition and
results of operations.
 
  Many of the Company's competitors have an established presence in the field
of interventional cardiology and electrophysiology, including Boston
Scientific, C.R. Bard, Inc., Johnson & Johnson, through its Cordis division,
St. Jude Medical, Inc., through its Daig division, and Medtronic, Inc. These
competitors have substantially greater financial and other resources than the
Company, including larger research and development staffs and more experience
and capabilities in conducting research and development activities, testing
products in clinical trials, obtaining regulatory approvals, and
manufacturing, marketing and distributing products. Other companies are
developing proprietary systems for the diagnosis and treatment of cardiac
arrhythmias, including Biosense, Inc., a division of Johnson & Johnson,
Cardiac Pathways, Inc. and Endocardial Solutions, Inc. Other companies
develop, market and sell alternative approaches to the treatment of AF and VT,
including Guidant, Medtronic, Inc., and Ventritex Inc., a subsidiary of St.
Jude Medical Inc., manufacturers of implantable defibrillators. There can be
no assurance that the Company will succeed in developing and marketing
technologies and products that are more clinically effective and cost-
effective than the more established treatments or the new approaches and
products being developed and marketed by its competitors. Furthermore, there
can be no assurance that the Company will succeed in developing new
technologies and products that are available prior to its competitors'
products. Failure of the Company to demonstrate the competitive advantages of
its products would have a material adverse effect on the Company's business,
financial condition and results of operations.
 
  In the market for cardiac mapping and ablation devices, the Company believes
that the primary competitive factors are safety, clinical effectiveness, ease
of use and overall cost to the health care system. In addition, the length of
time required for products to be developed and to receive regulatory and, in
some cases, reimbursement approval is an important competitive factor. The
medical device industry is characterized by rapid and significant
technological change. Accordingly, the Company's success will depend in part
on its ability to respond quickly to medical and technological changes through
the development and introduction of new products. Product
 
                                      18
<PAGE>
 
development involves a high degree of risk and there can be no assurance that
the Company's new product development efforts will result in any commercially
successful products. The Company believes it competes favorably with respect
to these factors, although there is no assurance that it will be able to
continue to do so.
 
Government Regulation
 
  The preclinical and clinical testing, manufacturing, labeling, distribution
and promotion of the Company's products are subject to extensive and rigorous
government regulation in the United States and other countries. Noncompliance
with applicable requirements can result in enforcement action by the FDA or
comparable foreign regulatory bodies including, among other things, fines,
injunctions, civil penalties, recall or seizure of products, refusal to grant
premarket clearances or approvals, withdrawal of marketing approvals and
criminal prosecution.
 
 United States
 
  A medical device may be marketed in the United States only with the FDA's
prior authorization. Devices classified by the FDA as posing less risk are
placed either in Class I or II. All class II and some class I devices require
510(k) clearance from the FDA prior to marketing. Such clearance generally is
granted when submitted information establishes that a proposed device is
"substantially equivalent" in intended use and safety and effectiveness to a
Class I or II device already legally on the market or to a "preamendment"
Class III device (i.e., one that has been in commercial distribution since
before May 28, 1976) for which the FDA has not called for PMA applications.
The FDA recently has been requiring a more rigorous demonstration of
substantial equivalence than in the past, including in some cases requiring
clinical trial data. During this process, the FDA may determine that it needs
additional information or that a proposed device is precluded from receiving
clearance because it is not substantially equivalent to a legally marketed
Class I or II device. After a device receives 510(k) clearance, any
modification that could significantly affect its safety or effectiveness, or
would constitute a major change in the intended use of the device, will
require a new 510(k) submission. The Company believes that it usually takes
from four to 12 months from the date of submission to obtain 510(k) clearance,
but it may take longer, and there can be no assurance that 510(k) clearance
will ever be obtained.
 
  The Company believes that its current mapping products, including the
Cardima Pathfinder, will be Class II devices and will require 510(k) clearance
prior to marketing. To date, the Company has received 510(k) clearances from
the FDA for its Cardima Pathfinder and Pathfinder mini microcatheter systems
for mapping VT and Revelation microcatheter system for mapping AF. In
addition, 510(k) clearance has been received for marketing its line of
Venaport and Vueport guiding catheters used for introducing electrophysiology
catheters into the heart. Section 510(k) notifications have also been
submitted for the Tracer, an over-the-wire diagnostic microcatheter, as well
as for the Naviport deflectable guiding catheter. These submissions may need
to include clinical trial data, which could lengthen the time necessary to
prepare a 510(k) submission and the time in which the Company could receive
510(k) clearance. There can be no assurance that any of these products will
receive 510(k) clearance in a timely fashion, or at all. Delays in market
introduction resulting from the 510(k) clearance process would have a material
adverse effect on the Company's business, financial condition and results of
operation.
 
  A device that does not qualify for 510(k) clearance is placed in Class III,
which is reserved for devices classified by the FDA as posing the greatest
risk (e.g., life-sustaining, life-supporting or implantable devices, or
devices that are not substantially equivalent to a legally marketed Class I or
Class II device). A Class III device generally must receive PMA approval,
which requires the manufacturer to establish the safety and effectiveness of
the device to the FDA's satisfaction. A PMA application must provide extensive
preclinical and clinical trial data and also include information about the
device and its components regarding, among other things, manufacturing,
labeling and promotion. As part of the PMA review, the FDA will inspect the
manufacturer's facilities for compliance with the Quality System Regulation
("QSR"), which includes elaborate testing, design control, documentation and
other quality assurance procedures.
 
                                      19
<PAGE>
 
  Upon submission, the FDA determines if the PMA application is sufficiently
complete to permit a substantive review, and, if so, the application is
accepted for filing. The FDA then commences an in-depth review of the PMA
application, which the Company believes typically takes one to three years,
but may take longer. The review time is often significantly extended as a
result of the FDA asking for more information or clarification of information
already provided. The FDA also may respond with a "not approvable"
determination based on deficiencies in the application and require additional
clinical trials that are often expensive and time consuming and can delay
approval for months or even years. Recently, the FDA has heightened its
scrutiny of clinical trial data submitted in support of PMA applications.
During the review, an FDA advisory committee, typically a panel of clinicians,
likely will be convened to review the application and recommend to the FDA
whether, or upon what conditions, the device should be approved. Although the
FDA is not bound by the advisory panel decision, the panel's recommendation is
important to the FDA's overall decision making process.
 
  If the FDA's evaluation of the PMA application is favorable, the FDA
typically issues an "approvable letter" requiring the applicant's agreement to
comply with specific conditions (e.g., changes in labeling) or to supply
specific additional data (e.g., longer patient follow up) or information
(e.g., submission of final labeling) in order to secure final approval of the
PMA application. Once the approvable letter conditions are satisfied, the FDA
will issue a PMA for the approved indications, which can be more limited than
those originally sought by the manufacturer. The PMA can include postapproval
conditions that the FDA believes necessary to ensure the safety and
effectiveness of the device including, among other things, restrictions on
labeling, promotion, sale and distribution. Failure to comply with the
conditions of approval can result in enforcement action, including withdrawal
of the approval, which in turn would have a material adverse effect on the
Company. The PMA process can be expensive and lengthy, and no assurance can be
given that any PMA application will ever be approved for marketing. Even after
approval of a PMA, a new PMA or PMA supplement generally is required for any
modification to the device, its labeling or its manufacturing process.
 
  The Company anticipates that its ablation products, including the Cardima
Revelation Tx and Therastream, will be Class III devices requiring PMA
approval. There can be no assurance that a PMA application will be submitted
for any such products or that, once submitted, the PMA application will be
accepted for filing, found approvable, or, if found approvable, will not take
longer than expected to obtain, or will not include unfavorable restrictions.
 
  A clinical trial in support of a 510(k) submission or PMA application
generally requires an IDE application approved in advance by the FDA for a
specific number of patients. The IDE application must be supported by
appropriate data, such as animal and laboratory testing results. Clinical
trials may begin if the IDE application is approved by the FDA and by the
appropriate institutional review boards at the clinical trial sites. During a
clinical trial, the Company would be permitted to sell products used in the
study for an amount that does not exceed recovery of the costs of manufacture,
research, development and handling. The Company's failure to adhere to
regulatory requirements generally applicable to clinical trials and to the
conditions of an IDE approval could result in a material adverse effect on the
Company, including termination of the IDE and an inability to obtain marketing
clearance or approval for its products.
 
  The Company received 510(k) clearance for Revelation microcatheter system
for mapping of AF. The Company also received conditional approval to begin an
expanded clinical trial with the Cardima Revelation Tx product for ablation in
January 1998. An additional IDE for its Therastream VT ablation microcatheter
system has been submitted to the FDA in December 1998. The Company believes
this IDE will be approved in the second half of 1999. These studies are not
expected to supply pivotal evidence of safety and effectiveness; rather, they
are intended to generate data to help finalize the device's design and
determine its potential for further development, if any. Additional clinical
trials will be necessary to support PMA applications by the Company. There can
be no assurance that any clinical study proposed by the Company will be
approved by the FDA, will be completed or, if completed, will provide data and
information that supports PMA approval or additional clinical investigations
of the type necessary to obtain PMA approval.
 
 
                                      20
<PAGE>
 
  Any devices manufactured or distributed by the Company pursuant to FDA
clearances or approvals will be subject to pervasive and continuing regulation
by the FDA and certain state agencies. The Company is subject to inspection by
the FDA and the California Department of Health Services and has to comply
with various other regulatory requirements that usually apply to medical
devices marketed in the United States, including labeling regulations, the
QSR, the Medical Device Reporting ("MDR") regulation (which requires that a
manufacturer report to the FDA certain types of adverse events involving its
products), and the FDA's prohibitions against promoting approved products for
unapproved ("off-label") uses. In addition, Class II devices, such as the
Company's mapping products, can be subject to additional special controls
(e.g., performance standards, postmarket surveillance, patient registries, and
FDA guidelines) that do not apply to Class I devices. The Company's failure to
comply with applicable regulatory requirements could result in enforcement
action by the FDA, which could have a material adverse effect on the Company.
 
  Unanticipated changes in existing regulatory requirements, failure of the
Company to comply with such requirements or adoption of new requirements could
have a material adverse effect on the Company. The Company also is subject to
numerous federal, state and local laws relating to such matters as safe
working conditions, good manufacturing practices, environmental protection,
fire hazard control and hazardous substance disposal. There can be no
assurance the Company will not be required to incur significant costs to
comply with such laws and regulations in the future or that such laws or
regulations will not have a material adverse effect upon the Company's
business, financial condition and results of operations.
 
 International
 
  In order for the Company to market its products in Europe and certain other
foreign jurisdictions, the Company must obtain required regulatory approvals
and clearances and otherwise comply with extensive regulations regarding
safety and manufacturing processes and quality. These regulations, including
the requirements for approvals or clearance to market and the time required
for regulatory review, vary from country to country. In addition, there may be
foreign regulatory barriers other than premarket approval. There can be no
assurance the Company will obtain regulatory approvals in such countries or
that it will not be required to incur significant costs in obtaining or
maintaining its foreign regulatory approvals. Under certain circumstances, FDA
approval is required for the Company to export its products. Delays in receipt
of approvals to market the Company's products, failure to receive these
approvals or loss of previously received approvals could have a material
adverse effect on the Company's business, financial condition and results of
operations.
 
  The EU has promulgated rules that require medical products to bear the CE
Mark by mid-1998. The CE Mark is recognized by the EU as a symbol of adherence
to strict quality systems requirements set forth in the ISO 9001 (EN 46001)
quality standards, as well as compliance with 93/42/EEC, the Medical Device
Directive. A CE Mark allows the Company to avoid the costly and cumbersome
requirements to obtain approvals in each EU country. The Company received ISO
9001 (EN 46001) Quality Systems certification for its manufacturing facilities
in Fremont, California. In December 1998, the Company received ISO 9001 re-
certification. This certification is required in order to affix the CE Mark to
applicable products.
 
  The Company has received CE Mark for the Revelation and Revelation Tx
microcatheters for treatment of AF. The Company intends to seek international
approvals for its other ablation products, however, there can be no assurance
the Company will be successful in obtaining such approvals. Failure to receive
approval to affix the CE Mark would prohibit the Company from selling these
products in member countries of the EU, and would require significant delays
in obtaining individual country approvals. There can be no assurance that such
approvals will ever be obtained. In such event, the Company would be
materially and adversely affected.
 
 
                                      21
<PAGE>
 
Third-Party Reimbursement
 
  In the United States, health care providers, including hospitals and
physicians, that purchase medical products for treatment of their patients,
generally rely on third-party payors, principally federal Medicare, state
Medicaid and private health insurance plans, to reimburse all or a part of the
costs and fees associated with the procedures performed using these products.
The Company's success will be dependent upon, among other things, the ability
of health care providers to obtain satisfactory reimbursement from third-party
payors for medical procedures in which the Company's products are used. Third-
party payors may deny reimbursement if they determine that a prescribed device
has not received appropriate regulatory clearances or approvals, is not used
in accordance with cost-effective treatment methods as determined by the
payor, or is experimental, unnecessary, inappropriate or used for a
nonapproved indication. If FDA clearance or approval is received, third-party
reimbursement would also depend upon decisions by the United States Health
Care Financing Administration ("HCFA") for Medicare, as well as by individual
health maintenance organizations, private insurers and other payors.
Government agencies, private insurers and other payors determine whether to
provide coverage for a particular procedure based on its medical necessity for
the patient in question. The Federal Medicare Program, many state Medicaid
programs and other payors reimburse health care providers for medical
treatment at a fixed rate based on, or adapted from the diagnosis-related
group ("DRG") established by the HCFA. The fixed rate of reimbursement is
typically based on the patient's diagnosis and the procedure performed, and
unrelated to the specific type or number of devices used in a procedure. There
can be no assurance that reimbursement for the Company's products will be
available in sufficient amounts if, at all, or that future reimbursement
policies of payors will not adversely affect the Company's ability to sell its
products on a profitable basis.
 
  In addition, Medicare traditionally has considered items or services
involving devices that have not been approved or cleared for marketing by FDA
to be precluded from Medicare coverage. However, under a policy which has been
in effect since November 1, 1995, Medicare coverage will not be precluded for
items and related services involving devices that have been classified by FDA
as "non-experimental / investigational" (Category B) devices and that are
furnished in accordance with the FDA-approved IDE governing clinical trials.
Even with items or services involving Category B devices, however, Medicare
coverage may be denied if any other coverage requirements are not met, for
example if the treatment is not medically needed for the specific patient.
There can be no assurance that the Company's systems will be covered when they
are used in clinical trials and, if covered, whether the payment amounts for
their use will be considered to be adequate by hospitals and physicians. If
the devices are not covered or the payments are considered to be inadequate,
the Company may need to bear additional costs to sponsor such trials, and such
costs could have a material adverse effect on the Company's business,
financial condition and results of operations.
 
  There is also proposed federal legislation that would change the traditional
Medicare payment system by creating a new visit-based payment system called
ambulatory patient groups ("APG") that establishes fixed payments for specific
medical procedures that are performed on an outpatient basis. If the Company's
products increase the cost per procedure above the fixed rate under the APG
system, market acceptance of such products could be impaired, which would have
a material adverse effect on the Company's business, financial condition and
results of operations.
 
  Reimbursement systems in international markets vary significantly by country
and by region within some countries, and reimbursement approvals must be
obtained on a country-by-country basis. Many international markets have
government managed health care systems that control reimbursement for new
products and procedures. In most markets, there are private insurance systems
as well as government managed systems. Market acceptance of the Company's
products will depend on the availability and level of reimbursement in
international markets targeted by the Company. There can be no assurance that
the Company will obtain reimbursement in any country within a particular time,
for a particular time, for a particular amount, or at all.
 
  Regardless of the type of reimbursement system, the Company believes that
physician advocacy of the Company's products will be required to obtain
reimbursement. The Company believes that less invasive procedures generally
provide less costly overall therapies as compared to conventional drug,
surgery and other
 
                                      22
<PAGE>
 
treatments. In addition, the Company believes that a patient's underlying
arrhythmia should typically not recur after treatment with the Company's
procedures. The Company anticipates that hospital administrators and
physicians would justify the use of the Company's products by the attendant
cost savings and clinical benefits that the Company believes would be derived
from the use of its products. However, there can be no assurance this will be
the case. There can be no assurance reimbursement for the Company's products
will be available in the United States or in international markets under
either government or private reimbursement systems, or that physicians will
support and advocate reimbursement for procedures using the Company's
products. Failure by hospitals and other users of the Company's products to
obtain reimbursement from third-party payors, or changes in government and
private third-party payors' policies toward reimbursement for procedures
employing the Company's products, would have a material adverse effect on the
Company's business, financial condition and results of operations.
 
PRODUCT LIABILITY AND INSURANCE
 
  The development, manufacture and sale of the Company's microcatheter systems
may expose the Company to product liability claims. Although to date no claim
has been asserted against the Company, there can be no assurance that the
Company will not experience losses due to product liability claims in the
future. Although the Company currently has general liability insurance with
coverage in the amount of $1.0 million per occurrence, subject to a $2.0
million annual limitation, and product liability insurance with coverage in
the amount of $5.0 million per occurrence, subject to a $5.0 million annual
limitation, there can be no assurance that such coverage will be available to
the Company in the future on reasonable terms, if at all. In addition, there
can be no assurance that all of the activities encompassed within the
Company's business are or will be covered under the Company's policies.
Although the Cardima Pathfinder and Tracer products are labeled for single use
only, the Company is aware that some physicians are reusing such products.
Moreover, despite labeling of the Company's microcatheters for diagnostic use
only, the Company believes physicians are using such mapping microcatheters
for ablation. Multiple use or "off-label" use of the Company's microcatheters
could subject the Company to increased exposure to product liability claims,
which could have a material adverse effect on the Company's business,
financial condition and results of operations. The Company may require
additional product liability coverage if the Company significantly expands
commercialization of its products. Such additional coverage is expensive,
difficult to obtain and may not be available in the future on acceptable
terms, if at all. Any claims or series of claims against the Company,
regardless of their merit or eventual outcome, could have a material adverse
effect on the Company's business, financial condition and results of
operations.
 
EMPLOYEES
 
  At December 31, 1998, the Company had 115 employees, 31 of whom were engaged
directly in research and new product development, 15 in regulatory affairs,
quality assurance and clinical activities, 31 in manufacturing, 22 in sales
and marketing and 16 in finance and administration.
 
  On January 14, 1999, the Company reduced its workforce by approximately 30%
in order to align available cash resources and projected expenses. The
reductions affected all functional areas of the Company. As a result of the
reduced workforce and normal attrition, the Company had 76 full-time employees
at January 31, 1999, 15 of whom were engaged directly in research and new
product development, 10 in regulatory affairs, quality assurance and clinical
activities, 23 in manufacturing, 15 in sales and marketing and 13 in finance
and administration.
 
  The Company maintains compensation, benefits, equity participation, and work
environment policies intended to assist in attracting and retaining qualified
personnel. The Company believes the success of its business will depend, in
significant part, on its ability to attract and retain such personnel. No
employee of the Company is represented by a collective bargaining agreement,
nor has the Company experienced any work stoppage. The Company considers its
relations with its employees to be good. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- We are dependent
upon our key personnel and will need to hire additional key personnel in the
future."
 
                                      23
<PAGE>
 
ITEM 2. PROPERTIES
 
  The Company leases approximately 44,000 square feet in Fremont, California.
The Company's facility includes a 4,000 square foot cleanroom, a machine shop
for prototyping and tooling, extrusion and braiding capability, wire grinding
operations, general assembly / test / inspection areas, and a materials area.
The facility is leased through November 1999, at which time the Company has
the option to extend the lease for up to an additional five-year term. The
Company believes this facility will be adequate to meet its requirements for
the foreseeable future.
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is not a party to any material legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  No matters were submitted to a vote of security holders of the Company,
through solicitation of proxies or otherwise, during the last quarter of the
Company's fiscal year ended December 31, 1998.
 
  On December 9, 1998, the Company requested an exception to the National
Association of Security Dealers (the "NASD"), requirement (NASD rule
4460(i)(2), to submit the proposed issuance of shares of the Company's Common
Stock to existing shareholders. The Company was granted an exception to rule
4460(i)(2) by the NASD on December 21, 1998 and issued a total 7,854,806
shares of common stock on January 25, 1999 and February 5, 1999.
 
                                      24
<PAGE>
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  The Common Stock of the Company has been traded on the Nasdaq National
Market under the symbol CRDM since the Company's initial public offering in
June 1997. Prior to that time there was no public market for the Common Stock.
The following table sets forth for the periods indicated the high and low sale
prices of the Common Stock.
 
<TABLE>
<CAPTION>
                                                                  High    Low
                                                                 ------- ------
   <S>                                                           <C>     <C>
   Year Ended December 31, 1998
   First Quarter...............................................  $ 5.875 $3.125
   Second Quarter..............................................    5.750  2.500
   Third Quarter...............................................   10.875  2.125
   Fourth Quarter..............................................    6.500  1.750
 
<CAPTION>
                                                                  High    Low
                                                                 ------- ------
   <S>                                                           <C>     <C>
   Year Ended December 31, 1997
   Second Quarter (from June 6, 1997)..........................  $ 7.500 $5.750
   Third Quarter...............................................    7.380  5.000
   Fourth Quarter..............................................    6.380  3.750
</TABLE>
 
  As of March 10, 1999, there were approximately 4,200 holders of record of
the Common Stock.
 
  The Company has never declared or paid cash dividends on its capital stock.
The Company currently expects to retain its future earnings for use in the
operation and expansion of its business and does not anticipate paying any
cash dividends in the foreseeable future.
 
Use of Proceeds
 
  On June 6, 1997, a Registration Statement on Form S-1 (No. 333-23209) was
declared effective by the SEC pursuant to which the Company issued 2,275,000
shares of common stock. The shares were sold for the account of the Company at
a price of $7.00 per share, generating $15.9 million in gross proceeds to the
Company. The initial public offering was managed by Bear Stearns & Company.
 
  From the effective date of the Registration Statement to December 31, 1998,
the Company incurred approximately $1.1 million in underwriting discounts and
commissions and approximately $1.2 million of expenses paid to or for the
underwriters and other related expenses. The net proceeds of the offering,
after deducting the foregoing expenses, were approximately $13.6 million.
 
  From the effective date of the Registration Statement to December 31, 1998,
the Company has used approximately $13.6 million to fund ongoing operations.
 
 
                                      25
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA
 
  The data set forth below should be read in conjunction with the financial
statements and related notes attached to this report on Form 10-K as pages F-1
through F-17.
 
<TABLE>
<CAPTION>
                                        Year Ended December 31,
                              -----------------------------------------------
                                1998      1997      1996      1995     1994
                              --------  --------  --------  --------  -------
                                (In thousands except per share amounts)
<S>                           <C>       <C>       <C>       <C>       <C>
Statements of Operations
 Data:
Net sales.................... $  2,499  $  1,261  $    593  $    362  $    86
Cost of goods sold...........    2,962     2,011     1,413       830      211
                              --------  --------  --------  --------  -------
  Gross profit (loss)........     (463)     (750)     (820)     (468)    (125)
Operating expenses:
  Research and development...    7,230     5,320     3,319     2,581    2,205
  Selling, general and
   administrative............    8,556     6,656     3,690     2,046    1,309
                              --------  --------  --------  --------  -------
    Total operating
     expenses................   15,786    11,976     7,009     4,627    3,514
                              --------  --------  --------  --------  -------
Operating loss...............  (16,249)  (12,726)   (7,829)   (5,095)  (3,639)
Interest and other income....      359       602       132        12       15
Interest expense.............     (296)     (148)      (57)     (117)     (31)
                              --------  --------  --------  --------  -------
Net loss..................... $(16,186) $(12,272) $ (7,754) $ (5,200) $(3,655)
                              ========  ========  ========  ========  =======
Basic and diluted net loss
 per share(1)................ $  (1.96) $  (2.64) $(107.69) $ (83.87) $(85.00)
                              ========  ========  ========  ========  =======
Shares used in computing
 basic and diluted net loss
 per share(1)................    8,239     4,642        72        62       43
                              ========  ========  ========  ========  =======
 
<CAPTION>
                                             December 31,
                              -----------------------------------------------
                                1998      1997      1996      1995     1994
                              --------  --------  --------  --------  -------
                                            (In thousands)
<S>                           <C>       <C>       <C>       <C>       <C>
Balance Sheets Data:
Cash, cash equivalents and
 short-term investments...... $    645  $ 12,848  $    907  $  2,993  $   713
Working capital (deficit)....   (1,614)   11,609    (2,150)    2,647      571
Total assets.................    7,283    17,674     3,964     4,735    2,284
Capital lease obligation,
 noncurrent portion..........    1,120       840       722       317      308
Line of credit obligation,
 noncurrent portion..........    2,183        --        --        --       --
Accumulated deficit..........  (46,608)  (30,422)  (18,150)  (10,396)  (5,196)
Total stockholders' equity
 (net capital deficiency).... $ (1,176) $ 14,444  $(10,368) $ (2,675) $ 1,316
</TABLE>
--------
(1) The basic and diluted net loss per share amounts prior to 1997 have been
    restated as required to comply with Statement of Financial Standards No.
    128, "Earnings per Share" and Staff Accounting Bulletin No. 98. See Note 1
    of the Notes to Financial Statements.
 
                                      26
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
  This discussion and analysis contains statements of a forward-looking nature
relating to future events or the future financial performance of the Company.
Such statements are only predictions and the actual events or results may
differ materially from the results discussed in the forward-looking
statements. Factors that could cause or contribute to such differences
include, but are not limited to, those discussed in "-- Factors Affecting
Future Results" as well as those discussed elsewhere in this Annual Report on
Form 10-K. The historical results set forth in this discussion and analysis
are not necessarily indicative of trends with respect to any actual or
projected future financial performance of the Company. This discussion and
analysis should be read in conjunction with the Financial Statements and the
related Notes thereto included elsewhere in the Annual Report on Form 10-K.
 
Overview
 
  Since its incorporation in November 1992, Cardima has been engaged in the
design, research, development, manufacturing and testing of microcatheter
systems for the mapping (diagnosis) and ablation (treatment) of cardiac
arrhythmias. Cardima has generated revenues of approximately $4.8 million from
inception to December 31, 1998. Until January 1997, these revenues were
primarily in Europe and Japan from sales of the Cardima Pathfinder and Tracer
microcatheter systems for diagnosing VT and the Revelation microcatheter
system for diagnosing AF, as well as ancillary products such as the Venaport
guiding catheters. In January 1997, the Company received a 510(k) clearance in
the United States and began to market and sell the Cardima Pathfinder system
for diagnosing VT. As a result, the Company has derived a majority of its
revenues in 1997 and 1998 in the United States from sales of the Cardima
Pathfinder for diagnosis of VT. In November 1997, the Company received a
510(k) clearance in the United States and began to market and sell the
Revelation microcatheter for diagnosing AF. To date, the Company's
international sales have been made primarily through distributors who sell the
Company's products to physicians and hospitals.
 
  The Company has obtained the right to affix the CE Mark to its Cardima
Pathfinder, Pathfinder mini and Tracer microcatheter systems for mapping VT
and its Revelation and Revelation Tx microcatheter systems for both mapping
and ablation of AF, permitting the Company to market these products in the
member countries of the EU. The Company received 510(k) clearances for the
Revelation microcatheter for mapping of AF and the Pathfinder mini
microcatheter for mapping VT and for the Vueport balloon guiding catheter in
July 1998. The Company currently is seeking 510(k) clearance for its Tracer
mapping catheter and its Naviport deflectable tip guiding catheter. The
Company will be required to conduct clinical trials, demonstrate safety and
effectiveness and obtain PMA approval from the FDA in order to sell any of the
Company's products designed for treatment of AF or VT in the United States.
Specifically, PMA approval will be required prior to the introduction in the
United States of the Revelation Tx microcatheter system for treatment of AF or
Therastream microcatheter system for treatment of VT.
 
  The Company has a limited history of operations and has experienced
significant operating losses since inception. The Company expects that its
operating losses will continue for the foreseeable future as the Company
continues to invest substantial resources in product development, preclinical
and clinical trials, obtaining regulatory approval, sales and marketing and
manufacturing.
 
Results of Operations--Years Ended 1998 and 1997
 
 Net Sales
 
  Net sales for 1998 increased 98% to $2,499,000 from $1,261,000 for 1997. The
majority of the increase in sales in 1998 is attributable to sales in the
United States and Europe. United States sales for 1998 increased 91% to
$1,722,000 from $902,000 in 1997. The increase in United States sales is due
primarily to the sales of Cardima Pathfinder and Revelation lines of
microcatheters for diagnosis of VT and AF following FDA 510(k) clearance and
sales of two new products, the Vueport, a balloon occlusion guiding catheter
and the Pathfinder mini
 
                                      27
<PAGE>
 
microcatheter for diagnosis of VT following FDA 510(k) clearance in July 1998.
European sales for 1998 increased 147% to $554,000 from $224,000 for 1997. The
increase in European sales is due primarily to sales of the Cardima Revelation
microcatheter for treatment of AF following receipt of CE Marking in August
1998.
 
 Cost of Goods Sold
 
  Cost of goods sold primarily includes raw materials costs, catheter
fabrication costs, system assembly, test costs and manufacturing overhead.
Cost of goods sold for 1998 increased 47% to $2,962,000 from $2,011,000 for
1997. The increase in cost of goods sold is due primarily to the growth of the
Company's sales and associated manufacturing staff additions. In addition,
product costs were higher due to training personnel on new products and
installation of new equipment and related depreciation. The Company has
purchased several pieces of capital equipment to manufacture some components
in-house, rather than purchase from outside vendors. When this new equipment
is fully functional, which is projected to be in the second half of 1999, the
Company expects costs to decrease as it transitions from outside vendors to
its internal production. In addition, the internal production will provide
greater flexibility in production of its microcatheter systems.
 
 Research and Development Expenses
 
  Research and development expenses for 1998 increased 36% to $7,230,000 from
$5,320,000 in 1997. The increase in research and development expenses is due
primarily to expenses associated with staff additions in research and
development and clinical and regulatory areas for product testing and
approvals which were incurred as the Company increased expenses to meet
development program goals and increased clinical trial activity in both Europe
and the United States.
 
 Selling, General and Administrative Expenses
 
  Selling, general and administrative expenses for 1998 increased 29% to
$8,556,000 from $6,656,000 in 1997. Selling expenses for 1998 increased 46% to
$3,788,000 from $2,600,000 in 1997. The increase is due primarily to costs
associated with the expansion of the Company's United States sales force, the
ongoing establishment of a direct sales force in several major markets in
Europe and the commencement of clinical trials, which requires training of
participating physicians by sales and clinical specialists. General and
administrative expenses for 1998 increased 20% to $2,844,000 from $2,370,000
in 1997. The increase is due primarily to additional staff and expenses
related to the requirements of a public company. Marketing expenses for 1998
increased 14% to $1,924,000 from $1,686,000 in 1997. The increase is due
primarily to expenses related to the development of marketing materials and
programs to address new product introductions.
 
 Interest and Other Income, Interest Expense
 
  Interest and other income for 1998 decreased by $243,000 to $359,000 from
$602,000 in 1997. The decrease is due primarily to lower cash, cash equivalent
and short-term investment balances. Interest expense for 1998 increased by
$148,000 to $296,000 from $148,000 in 1997. The increase is due primarily to
higher borrowing levels for purchases of capital equipment and interest
expense associated with the Company's $3.0 million line of credit.
 
Results of Operations--Years Ended 1997 And 1996
 
 Net Sales
 
  Net sales for 1997 increased 113% to $1,261,000 from $593,000 for 1996. The
increase in net sales is due primarily to United States sales of the Cardima
Pathfinder line of microcatheters for diagnosis of ventricular tachycardia
following FDA clearance in January 1997. Net sales in 1997 were lower than the
Company expected in Europe due to the termination of distribution arrangements
in major European markets.
 
                                      28
<PAGE>
 
 Cost of Goods Sold
 
  Cost of goods sold primarily includes raw materials costs, catheter
fabrication costs, system assembly, test costs and manufacturing overhead.
Cost of goods sold for 1997 increased 42% to $2,011,000 from $1,413,000 for
1996. The increase in cost of goods sold is due primarily to the growth of the
Company's sales and vertical integration whereby many components formerly
produced by outside vendors have been brought in-house. Product costs were
initially higher due to the set-up and training of personnel to utilize the
new equipment and related depreciation.
 
 Research and Development Expenses
 
  Research and development expenses for 1997 increased 60% to $5,320,000 from
$3,319,000 in 1996. The increase in research and development expenses is due
primarily to staff additions and associated expenses in research and
development and clinical and regulatory areas (product testing and approvals)
incurred as the Company increased human resources to meet program goals and
clinical objectives.
 
 Selling, General and Administrative Expenses
 
  Selling, general and administrative expenses for 1997 increased 80% to
$6,656,000 from $3,690,000 in 1996. The increase in selling, general and
administrative expenses is due primarily to costs associated with the
establishment and expansion of the Company's United States sales force, which
occurred in fourth quarter 1996 and third quarter 1997, respectively. The
Company has incurred expenses relating to the termination of several
distribution arrangements, the establishment of a direct sales force in
several major markets in Europe and the commencement of clinical trials, which
require some training from sales and clinical specialists. In addition, the
increase in general and administrative expenses is due primarily to additional
staffing and expenses to meet the growth of the Company and expenses related
to the requirements of a public company. The increase in marketing expenses is
due primarily to additional staffing, marketing materials and programs to meet
new product introductions.
 
 Interest and Other Income, Interest Expense
 
  Interest and other income for 1997 increased to $602,000 from $132,000 in
1996. The increase is due primarily to larger cash, cash equivalent and short-
term investment balances as a result of the Company's initial public offering
in June 1997. Interest expense for 1997 increased to $148,000 from $57,000 in
1996. The increase is due primarily to higher borrowing levels for purchases
of capital equipment.
 
Liquidity and Capital Resources
 
  The Company has financed its operations to date principally through private
placements of equity securities, which had yielded net proceeds of $32,300,000
as of December 31, 1998, an initial public offering of Common Stock in June
1997, which resulted in net proceeds of approximately $13,600,000, together
with interest income on such proceeds, and equipment leases, to finance
certain capital equipment which have provided proceeds in the amount of
$3,700,000. As of December 31, 1998, the Company had approximately $645,000 in
cash, cash equivalents and short-term investments.
 
  Net cash used in operating activities was approximately $16,000,000,
$12,500,000 and $6,700,000 for the years ended December 31, 1998, 1997 and
1996, respectively, resulting primarily from operating losses incurred. Net
cash provided by investing activities was $4,249,000 for the year ended
December 31, 1998 is attributable primarily to maturities of short-term
investments. Net cash used in investing activities was $5,150,000 and $388,000
for the years ended December 31, 1997 and 1996, respectively, attributable
primarily to purchases of short-term investments and capital expenditures,
respectively. Net cash provided by financing activities was approximately
$3,800,000, $25,300,000 and $5,000,000 for the years ended December 31, 1998,
1997 and 1996, respectively, resulting primarily from the Company's initial
public offering, the sale of equity securities in private placement
transactions and proceeds from bridge loans and the line of credit during such
periods.
 
                                      29
<PAGE>
 
  In February 1998, the Company entered into an equipment lease that permits
the Company up to $1.5 million of financing for the purchase of office and
manufacturing equipment, software and custom-built equipment. In June 1998,
the Company secured a $3.0 million line of credit which may be used for
general working capital purposes. As of December 31, 1998, the equipment lease
line has expired and the Company has drawn the entire $3.0 million line of
credit. In January and February 1999, the Company sold a total of 7,500,000
shares of common stock at $2.00 per share in a private placement transaction
to accredited investors. As commission, the Company issued 354,806 shares of
its common stock to the placement agent and paid $490,388. In addition the
Company issued 750,000 warrants, exercisable for 750,000 shares of common
stock at an exercise price of $2.20 as a commission for the transaction. The
Company's net proceeds, after expenses of the placement, were $14.4 million.
The Company's future liquidity and capital requirements will depend upon
numerous factors, including sales and marketing activities, the progress of
the Company's product development efforts, the progress of the Company's
clinical trials, actions relating to regulatory matters, the costs and timing
of expansion of product development, manufacturing, the extent to which the
Company's products gain market acceptance, and competitive developments. The
Company believes that available cash along with proceeds from the private
placement completed in January and February 1999 will be sufficient to meet
the Company's cash requirements through 1999. There can be no assurance,
however, that the Company will not require additional financing during that
period, or that if required, such additional financing will be available on
terms acceptable to the Company, if at all. The Company may seek to raise
additional funds through public or private financing, collaborative
relationships or other arrangements. There can be no assurance that such
additional capital will be available on terms acceptable to the Company, or at
all. Furthermore, any additional equity financing is expected to be dilutive
to stockholders, and debt financing, if available, may involve restrictive
covenants. Collaborative arrangements, if necessary to raise additional funds,
may require the Company to relinquish its rights to certain of its
technologies, products or marketing territories. The failure of the Company to
raise capital when needed will have a material adverse effect on the Company's
business, financial condition and results of operations.
 
Factors Affecting Future Results
 
 We have a history of losses. Our ability to achieve or, if achieved, sustain
profitability, is highly uncertain.
 
  We have experienced losses since we began our operations and we expect to
experience substantial net losses for the foreseeable future. To date, sales
of our microcatheter systems have been limited. We had net losses of
approximately $16.2 million, $12.3 million and $7.8 million for the fiscal
years ended 1998, 1997 and 1996, respectively. As of December 31, 1998, we had
an accumulated deficit of approximately $46.6 million. We expect to incur
substantial net operating losses for the foreseeable future as a result of
research and product development, clinical trials, manufacturing, sales,
marketing and other expenses expected to be incurred as we further develop,
seek regulatory approvals, test and distribute our products. Our limited
operating history makes accurate prediction of future operating results
difficult or impossible. There can be no assurance that we will ever generate
substantial revenue or achieve profitability on a sustained basis. Our failure
to generate substantial revenues would have a material adverse effect on our
business, results of operations and financial condition.
 
 We will need to raise capital in the future. Future financings could have a
dilutive effect on our stockholders.
 
  Our future capital uses and requirements will depend on numerous factors,
including:
 
  .  the progress of our clinical research and product development programs,
 
  .  the time required to obtain and the receipt of regulatory clearances and
     approvals,
 
  .  the costs and timing of product development, manufacturing and sales and
     marketing activities,
 
  .  the extent to which our products gain market acceptance,
 
  .  competitive developments, and
 
  .  the cost of filing, prosecuting, and enforcing patent claims and other
     intellectual property rights.
 
                                      30
<PAGE>
 
  In order to commercialize our products, we will require additional capital
that may not be available on terms acceptable to us, or at all. In addition,
if unforeseen difficulties arise in the course of developing our products,
performing clinical trials, obtaining necessary regulatory clearances and
approvals or other aspects of our business, we may be required to spend
greater-than-anticipated funds. As a consequence, we will be required to raise
additional capital through public or private equity or debt financings,
collaborative relationships, bank facilities or other arrangements. There can
be no assurance that such additional capital will be available on terms
acceptable to us, or at all. Any additional equity financing is expected to be
dilutive to stockholders, and debt financing, if available, may involve
restrictive covenants. We have financed our operations to date primarily
through private sales of equity securities, proceeds from our initial public
offering in June 1997, and loan-facilities. As of February 28, 1999, cash,
cash equivalents, short-term investments and long-term restricted cash totaled
$12.0 million. We believe that our existing cash, cash equivalents and short-
term investments along with cash generated from the sales of our products and
from financings, will be sufficient to fund our operating expenses, debt
obligations and capital requirements through December 31, 1999.
 
  Our future capital uses and requirements depend on numerous factors,
including:
 
  .  our ability to establish collaborative arrangements,
 
  .  the level of product revenues,
 
  .  the possible acquisition of new products and technologies, and
 
  .  the development of commercialization activities.
 
  There can be no assurance that additional funding will be available for us
to finance our ongoing operations when needed or that adequate funds for our
operations, whether from financial markets, collaborative or other
arrangements with corporate partners or from other sources, will be available
when needed, if at all, or on terms attractive to us. Our inability to obtain
sufficient funds may require us to delay, scale back or eliminate some or all
of our research and product development programs, to limit the marketing of
our products, or to license to third parties the rights to commercialize
products or technologies that we would otherwise seek to develop and market
ourselves. This would have a material adverse effect on our business,
financial condition and results of operations.
 
 Our stock price may be volatile.
 
  Prior to June 1997, there was no public market for our common stock. There
can be no assurance that there will be an active trading market for our common
stock or that the market price of the common stock will not decline below its
present market price. The market prices for securities of biotechnology
companies have been, and are likely to continue to be, highly volatile.
Factors that have had, and are expected to continue to have, a significant
impact on the market price of our common stock include:
 
  .  announcements regarding the results of regulatory approval filings,
 
  .  our clinical studies or other testing,
 
  .  our technological innovations or new commercial products or those of our
     competitors,
 
  .  government regulations, developments concerning proprietary rights,
 
  .  public concern as to safety of technology, and
 
  .  variations in operating results.
 
 We do not intend to pay cash dividends on our stock.
 
  We have never paid cash dividends on our capital stock and do not anticipate
paying cash dividends in the foreseeable future. Instead, we intend to retain
future earnings for reinvestment in our business. Our credit agreement
requires the approval of our bank to declare or pay cash dividends.
 
                                      31
<PAGE>
 
 Our operating results may fluctuate from period to period in the future.
 
  We believe that a quarter to quarter or annual comparison of our operating
results is not a good indication of our future performance. It is likely that
at some future time our results will be below market expectations. As a
result, our common stock price will likely fall. Our results of operations
have fluctuated significantly in the past and we expect them to vary
significantly from quarter to quarter or year to year depending upon a number
of factors, including:
 
  .  actions relating to regulatory matters,
 
  .  progress of pre-clinical and clinical trials,
 
  .  the extent to which our products gain market acceptance,
 
  .  the scale-up of manufacturing capabilities,
 
  .  the expansion of sales and marketing activities,
 
  .  competition,
 
  .  the timing of new product introductions by us or our competitors,
 
  .  our ability to successfully market our products in the United States and
     internationally, and
 
  .  general economic conditions and economic conditions specific to the
     biotechnology field.
 
  Although all microcatheter systems are labeled for single use only, we are
aware that some physicians are reusing these products. Reuse of our
microcatheter systems would reduce revenues from product sales and could have
a material adverse effect on our future performance and periodic operating
results. Due to such fluctuations in operating results, period to period
comparisons of our revenues and operating results are not necessarily
meaningful and should not be relied upon as indicators of likely future
performance or annual operating results.
 
 There are risks associated with international sales of our products.
 
  A number of risks are inherent in international transactions. International
sales may be limited or disrupted by
 
  .  the imposition of government product or currency controls,
 
  .  export license requirements,
 
  .  economic or political instability,
 
  .  domestic or international trade restrictions,
 
  .  changes in tariffs,
 
  .  exchange rate fluctuation, or
 
  .  difficulties in staffing and management.
 
  The financial condition, expertise and performance of our international
distributors and any future international distributors could affect sales of
our products internationally and could have a material adverse effect on our
business, financial condition and results of operations. The regulation of
medical devices in a number of such jurisdictions, particularly in the EU,
continues to develop, and there can be no assurance that new laws or
regulations will not have a material adverse effect on our business, financial
condition and results of operations. Foreign regulatory agencies often
establish product standards different from those in the United States and any
inability to obtain foreign regulatory approvals on a timely basis could have
a material adverse effect on our international business and our financial
condition and results of operations. In addition, the laws of certain foreign
countries do not protect our intellectual property rights to the same extent
as do the laws of the United States. There can be no assurance that we will be
able to successfully manage a remote sales force, comply with such foreign
laws or regulations, or protect our intellectual property. There also can be
no assurance that we will
 
                                      32
<PAGE>
 
be able to successfully commercialize any of our current microcatheter
products, including the Cardima Pathfinder, Pathfinder mini, Revelation,
Revelation Tx and Tracer microcatheter systems, or any future products in any
foreign market, which could have a material adverse effect on our business,
financial condition and results of operations.
 
 The adoption of the Euro presents uncertainties for our international
business.
 
  In January 1999, the new "Euro" currency was introduced in certain European
countries that are part of the European Monetary Union ("EMU"). Beginning in
2003, all EMU countries are expected to be operating with the Euro as their
single currency. A significant amount of uncertainty exists as to the effect
the Euro will have on the marketplace generally. In particular, the
participating countries' adoption of a single currency may likely result in
greater price transparency, making the EMU a more competitive environment for
our products. In addition, some of the rules and regulations relating to the
governance of the currency have not yet been defined and finalized. As a
result, companies operating in or conducting business in Europe will need to
ensure that their financial and other software systems are capable of
processing transactions and properly handling the Euro.
 
  We are currently assessing the effect the introduction of the Euro will have
on our internal accounting systems and the potential sales of our products. We
will take appropriate corrective actions based on the results of such
assessment. We have not yet determined the costs related to addressing this
issue. This issue and its related costs could have a material adverse effect on
our business, financial condition and results of operations.
 
 We are dependent upon our key personnel and will need to hire additional key
personnel in the future.
 
  Our ability to operate successfully depends in significant part upon the
continued service of certain key scientific, technical, clinical, regulatory
and managerial personnel, and our continuing ability to attract and retain
additional highly qualified personnel in these areas. Competition for such
personnel is intense, especially in the San Francisco Bay Area. There can be no
assurance that we can retain such personnel or that we can attract or retain
other highly qualified scientific, technical, clinical, regulatory and
managerial personnel in the future, including key sales and marketing
personnel.
 
 Impact of the Year 2000 Issue on the Company's Operations
 
  Many existing computer programs use only two digits to identify a year in the
date field. These programs were designed and developed without considering the
impact of the upcoming change in the century. If not corrected, many computer
applications could fail or create erroneous results by or at the Year 2000 (the
"Year 2000 Issue"). The Company is in the process of performing an assessment
of the potential impact of the Year 2000 Issue on its operations. The Company
has evaluated its financial and accounting and inventory tracking systems and
concluded that they are not materially affected by the Year 2000 Issue. The
extent, if any, of the impact of the Year 2000 Issue on the other systems and
equipment is unknown. A corporate-wide inventory of computer applications has
been performed by the Company and the Company has remedied any issues. The
Company's facilities manager has determined that there is no impact on building
security and related equipment. There can be no assurance that all third
parties will address the Year 2000 Issue in a timely fashion, if at all. Any
Year 2000 Issue compliance problems of either the Company, its business
partners or its customers could have a material adverse effect on the Company's
business, operating results and financial condition.
 
  The Company has utilized only internal resources to test and replace software
for Year 2000 modifications. All of the replacement software were upgrades
being purchased for other reasons. Therefore the Company has not incurred any
additional costs in researching and resolving any Year 2000 issues.
 
  The Company currently has no contingency plans in place in the event it does
not complete all phases of the Year 2000 program. The Company plans to evaluate
the status of completion in April 1999 and determine whether such a plan is
necessary.
 
                                       33
<PAGE>
 
 Year 2000 Disclosure Chart
 
                               Resolution Phases
 
<TABLE>
<CAPTION>
                                Assessment        Remediation      Testing     Implementation
---------------------------------------------------------------------------------------------
  <S>                     <C>                    <C>            <C>            <C>
  Information Technology  100% Complete          100% Complete  100% Complete  100% Complete
---------------------------------------------------------------------------------------------
  Operating Equipment     100% Complete          100% Complete  100% Complete  100% Complete
  with Embedded
  Chips or Software
---------------------------------------------------------------------------------------------
  Products                Not Applicable         Not Applicable Not Applicable Not Applicable
---------------------------------------------------------------------------------------------
  3rd Party               100% Complete for      100% Complete  100% Complete  100% Complete
                          system                  for system    for system     for system
                          interface; 60%         interface      interface      interface
                          Complete for
                          all other material
                          exposures.
                          Expected completion
                          date
                          for surveying all
                          third
                          parties, April 1999
</TABLE>
 
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  Not Applicable
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The Company's financial statements and the report of independent auditors
appear on pages F-1 through F-17 of this report.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
  Not applicable.
 
                                      34
<PAGE>
 
                                   PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The response to this item is contained in part below and the remainder is
contained in the Company's Proxy Statement for the Annual Meeting of
Stockholders to be held on June 23, 1999 (the "1998 Proxy Statement") under
the caption "Election of Directors" and is incorporated herein by reference.
 
  The executive officers of the Company are elected annually by the Board of
Directors of the Company (the "Board") and serve at the discretion of the
Board.
 
  Mr. Phillip Radlick, Ph.D. (age 61) has been the President, Chief Executive
Officer and a Director of Cardima since November 1994. Prior to joining the
Company, from November 1992 until October 1994, Mr. Radlick was the President
and Chief Executive Officer of Hepatix, Inc., a start-up medical device
company. From November 1986 until November 1992, Mr. Radlick was the President
of Edwards Cardiovascular Surgery Division, a division of Baxter Healthcare
responsible for the development, manufacture and sale of cardiovascular
products. Mr. Radlick received a B.S. in Chemistry and a Ph.D. in Organic
Chemistry from University of California, Los Angeles.
 
  Mr. Gabriel Vegh (age 59), the founder of the Company, has been a Director
of Cardima since November 1992. Mr. Vegh has been the Chief Operating Officer
of Cardima since November 1994, and the Executive Vice President since January
1995. From May 1993 until November 1994, Mr. Vegh was the Company's President,
and from May 1993 until July 1996, he served as the Company's Chief Financial
Officer. Prior to joining the Company, from August 1985 until May 1993, Mr.
Vegh was the Vice President, Operations of Target, and from February 1983
until August 1985, Mr. Vegh was General Manager, Pilot Operations of Advanced
Cardiovascular Systems. Mr. Vegh received a B.S. in Mechanical Engineering
from the New Jersey Institute of Technology.
 
  Mr. Allan Abati, Ph.D. (age 54) has been the Vice President, Regulatory
Affairs, Clinical Programs and Quality Assurance of Cardima since February
1996. Prior to joining the Company, from February 1992 until February 1996,
Mr. Abati was the Vice President, Regulatory Affairs and Quality Assurance of
Johnson & Johnson Professional, Inc., a manufacturer of neurosurgical and
orthopedic medical devices. From August 1989 until February 1992, Mr. Abati
was the Director, Regulatory and Clinical Affairs of Shiley Inc., a Pfizer
company and manufacturer of interventional cardiology products. From June 1986
until August 1989, Mr. Abati was the Manager, Regulatory Affairs and Clinical
Programs, and from November 1982 until June 1986 he was Senior Regulatory and
Clinical Affairs Specialist, of Edwards Critical-Care Division, a division of
Baxter Healthcare responsible for the development, manufacture and sale of
critical care and interventional cardiology products. Mr. Abati received a
B.S. in Zoology and an M.A. in Biology from California State University, Long
Beach and a Ph.D. in Physiology from Rutgers University.
 
  Mr. Omar Amirana, M.D. (age 34) has been the Vice President, New Business
Development and Chief Technical Officer of Cardima since October 1998. From
September 1995 to October 1998, Mr. Amirana was the Vice President of
Marketing, from June 1993 until September 1995, he was the Company's Director
of Marketing, and from March 1993 until June 1993, he served as a consultant
to the Company. Prior to joining the Company, from May 1992 until November
1992, Mr. Amirana was the Program Manager of the Advanced Development Group of
EP Technologies, Inc. ("EPT"), an electrophysiology catheter manufacturer that
was acquired by Boston Scientific in January 1996. Mr. Amirana received a B.S.
in Mechanical Engineering from Tufts University and an M.D. from Eastern
Virginia Medical School.
 
  Mr. Victor J. Barajas (age 35) has been the Vice President of Operations of
Cardima since August 1997 and is responsible for all operations and
manufacturing activity. From September 1995 until August 1997, Mr. Barajas was
the Director of Operations, from May 1994 until September 1995, Mr. Barajas
was the Manager of Operations, and from June 1993 until May 1994, Mr. Barajas
was a senior engineer for Cardima. Prior to joining the company, from 1990
until June, 1993, Mr. Barajas was Process Development Engineer and then
Project Leader and Manager of the Engineering Department for Target
Therapeutics, Inc. From 1988 until 1990,
 
                                      35
<PAGE>
 
Mr. Barajas was employed by Critikon, Inc. as an R&D/Manufacturing Engineer in
the medical disposables area. Mr. Barajas received his B.S. degree in
Industrial Technology from San Jose State University.
 
  Mr. Ronald Bourquin (age 48) has been the Vice President and Chief Financial
Officer of Cardima since July 1996. Prior to joining the Company, from July
1993 until July 1996, Mr. Bourquin was the Corporate Controller of EPT, and
from April 1993 until July 1993, he served as a consultant to EPT. From
December 1991 until February 1993, Mr. Bourquin was the Controller of the
Endoscopy Division of Stryker Corporation, a medical instrument company. From
January 1979 until December 1991, Mr. Bourquin held various positions of
increasing responsibility at Coherent, Inc., a manufacturer of lasers,
ultimately serving as the Director of Finance of the Medical Group from
November 1985 to December 1991. Mr. Bourquin is a Certified Management
Accountant and received a B.A. in Accounting and a M.B.A. in Finance from
Golden Gate University.
 
  Mr. Eric Chan, Ph.D. (age 40) has been the Vice President of Product
Development of Cardima since June 1998. Prior to joining the Company, from
August 1991 to March 1993, Mr. Chan was the Director of Engineering and from
April 1993 to May 1998, Vice President of Engineering at Arrhythmia Research
Technology, Inc. where he coordinated and directed the development of
computerized cardiac electrophysiology, high resolution ECG and cathlab
systems. Mr. Chan received his B.S.E.E. from Purdue University, his M.S.E. in
Biomedical Engineering from the University of Texas at Austin, and his Ph.D.
in Biomedical Engineering from the University of Texas at Austin.
 
  Mr. David Smith (age 45) has been the Vice President, World Wide Sales of
Cardima since March 1996. Prior to joining the Company, from January 1994
until December 1995, Mr. Smith was the Director of Marketing of Baxter
Healthcare, International Cardiology Division, a manufacturer and distributor
of interventional cardiology products. From June 1991 until December 1993, Mr.
Smith was the Business Unit Manager, Germany, and from April 1990 until May
1991, he was the National Sales Manager, Endovascular Products, of Baxter
Healthcare, Less Invasive Surgery Division. Mr. Smith has a B.S. in Business
Administration from Michigan State University.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The response to this item is contained in the Proxy Statement under the
caption "Compensation of Directors" and "Compensation of Executive Officers,"
and is incorporated herein by reference.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The response to this item is contained in the 1998 Proxy Statement under the
caption "Common Stock Ownership of Certain Beneficial Owners and Management,"
and is incorporated herein by reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The response to this item is contained in the 1998 Proxy Statement under the
caption "Transactions with Management," and is incorporated herein by
reference.
 
                                      36
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
  (a) 1. FINANCIAL STATEMENTS
 
    The Company's financial statements are indexed on page F-1.
 
  (a) 2. FINANCIAL STATEMENT SCHEDULES
 
    All applicable information is readily determinable from the notes to the
  Company's financial statements or the schedule is not applicable,
  therefore, the schedules have been omitted.
 
  (a) 3. LISTING OF EXHIBITS
 
<TABLE>
<CAPTION>
   Exhibit #                             Description
   ---------                             -----------
   <C>       <S>
    3.1(1)   Certificate of Incorporation, as amended, of the Registrant.
    3.2(1)   Bylaws of Registrant.
             Form of Amended And Restated Certificate of Incorporation of
    3.3(1)   Registrant.
    4.1(1)   Form of Common Stock Certificate.
   10.1(1)   1993 Stock Option Plan.
   10.2(1)   1997 Directors' Stock Option Plan.
   10.3(1)   1997 Employee Stock Purchase Plan.
   10.4(1)   Form of Indemnification Agreement.
   10.5(1)   Fourth Amended and Restated Stockholders' Rights Agreement dated
             March 7, 1997, between Registrant and certain stockholders of
             Registrant.
   10.6(1)   License Agreement dated May 21, 1993, between Registrant and
             Target Therapeutics, Inc.
   10.7(1)   Lease dated April 25, 1994, between Registrant and State of
             California Public Employees' Retirement System.
   10.8(1)   Sublease dated November 14, 1996, between Registrant and Target
             Therapeutics, Inc.
   10.9(2)   Master Lease Agreement dated January 26, 1996, between Registrant
             and Comdisco, Inc., together with Equipment Schedules VL-1, VL-2
             and VL-3.
   10.10(1)  Warrant Purchase Agreement dated December 9, 1993, between
             Registrant and Target Therapeutics, Inc., together with the Series
             A Preferred Stock Warrant.
   10.11(1)  Series A Preferred Stock Warrant dated June 10, 1994, issued to
             Silicon Valley Bank.
   10.12(1)  Warrant Purchase Agreement dated July 1, 1994, between Registrant
             and California Public Employees' Retirement System, together with
             the Common Stock Warrant.
   10.13(1)  Series A Preferred Stock Warrant dated October 26, 1994, issued to
             Silicon Valley Bank.
   10.14(1)  Form of Series A Preferred Stock Warrant issued to certain
             investors in December 1994.
   10.15(1)  Series D Preferred Stock Warrant dated October 31, 1995, issued to
             Silicon Valley Bank.
   10.16(1)  Form of Common Stock Warrant issued to certain investors from
             April 1995 to December 1995.
   10.17(1)  Warrant Agreement dated January 23, 1996, between Registrant and
             Comdisco, Inc., together with the Series D Preferred Stock
             Warrant.
   10.18(1)  Electrophysiology Catheter License Agreement dated May 17, 1994,
             between Registrant and BSI Corporation, together with the Credit
             Pool Agreement of same date.
   10.19(1)  Distribution Agreement dated June 15, 1995, between Registrant and
             Paramedic Co., Ltd.
   10.20(1)  Distribution Agreement dated July 14, 1995, between Registrant and
             Werfen Distribution AG, together with the May 15, 1996 letter
             amendment.
   10.21(1)  Employment Agreement dated May 21, 1993, between Registrant and
             Gabriel B. Vegh.
   10.22(1)  Employment Letter Agreement dated October 31, 1994, between
             Registrant and Phillip C. Radlick, Ph.D.
   10.23(1)  Warrant Agreement dated April 7, 1997, between Registrant and
             Comdisco, Inc.
</TABLE>
 
                                       37
<PAGE>
 
<TABLE>
   <C>      <S>
   10.24(1) Distribution Agreement dated April 1, 1997, between Registrant and
            Cardiologic, GmbH.
   10.25(3) Master Loan and Security Agreement dated June, 1998 between
            Registrant and Transamerica Business Credit Corp.
   23.1     Consent of Ernst & Young LLP, Independent Auditors.
   24.1     Power of Attorney.
   27.1     Financial Data Schedule.
</TABLE>
--------
(1) Incorporated by reference to the same exhibits filed with the Registrant's
    Registration Statement on Form S-1 (File No. 33-23209) declared effective
    on June 5, 1997.
(2) Equipment Schedule VL-3 dated February 13, 1998 to the Master Lease
    Agreement dated January 23, 1996 is filed with this Annual Report on Form
    10-K.
(3) Incorporated by reference to the same exhibit filed with the Registrant's
    Statement on Form 10-Q (File No. 000-22419) dated June 30, 1999.
 
                                      38
<PAGE>
 
                                   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.
 
Date: March 19, 1999                      Cardima, Inc.
 
                                          /s/ Phillip C. Radlick, Ph.D.
                                          _____________________________________
                                          PHILLIP C. RADLICK, Ph.D.
                                          President, Chief Executive Officer
                                           and Director
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
 
           Name                         Title                      Date
 
  /s/ Phillip C. Radlick,    President, Chief Executive      March 19, 1999
           Ph.D.             Officer and Director         ---------------------
---------------------------  (Principal Executive
 Phillip C. Radlick, Ph.D.   Officer)
 
  /s/ Ronald E. Bourquin     Vice President and Chief        March 19, 1999
---------------------------  Financial Officer            ---------------------
    Ronald E. Bourquin       (Principal Financial and
                             Accounting Officer)
 
 /s/ Michael J.F. Du Cros    Director                        March 19, 1999
---------------------------                               ---------------------
   Michael J.F. Du Cros
 
 /s/ Neville J. Jeharajah    Director                        March 19, 1999
---------------------------                               ---------------------
   Neville J. Jeharajah
 
    /s/ Gabriel B. Vegh      Executive Vice President,       March 19, 1999
---------------------------  Chief Operating Officer      ---------------------
      Gabriel B. Vegh        and Director
 
 /s/ Charles P. Waite, Jr.   Director                        March 19, 1999
---------------------------                               ---------------------
   Charles P. Waite, Jr.
 
                                       39
<PAGE>
 
                                 CARDIMA, INC.
 
                         INDEX TO FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
<S>                                                                        <C>
Report of Ernst & Young LLP, Independent Auditors........................  F-2
Balance Sheets at December 31, 1998 and 1997.............................  F-3
Statements of Operations for the years ended December 31, 1998, 1997, and
 1996....................................................................  F-4
Statements of Changes in Redeemable Convertible Preferred Stock and
 Stockholders' Equity (Net Capital Deficiency) for the years ended
 December 31, 1998, 1997, and 1996.......................................  F-5
Statements of Cash Flows for the years ended December 31, 1998, 1997, and
 1996....................................................................  F-6
Notes to Financial Statements............................................  F-7
</TABLE>
 
                                      F-1
<PAGE>
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
The Board of Directors and Stockholders
 Cardima, Inc.
 
  We have audited the accompanying balance sheets of Cardima, Inc. as of
December 31, 1998 and 1997, and the related statements of operations, changes
in redeemable convertible preferred stock and stockholders' equity (net
capital deficiency), and cash flows for each of the three years in the period
ended December 31, 1998. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Cardima, Inc. as December
31, 1998 and 1997, and the results of its operations and its cash flows for
each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles.
 
                                          /s/ ERNST & YOUNG LLP
 
Palo Alto, California
February 3, 1999
 
                                      F-2
<PAGE>
 
                                 CARDIMA, INC.
 
                                 BALANCE SHEETS
                    (In thousands except per share amounts)
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1998      1997
                                                            --------  --------
<S>                                                         <C>       <C>
ASSETS
Current assets:
  Cash and cash equivalents................................ $    645  $  8,578
  Short-term investments...................................       --     4,270
  Accounts receivable, net of allowances for doubtful
   accounts of $41 and $40 at December 31, 1998 and 1997,
   respectively............................................      512       268
  Inventories..............................................    1,977       532
  Other current assets.....................................      366       261
                                                            --------  --------
    Total current assets...................................    3,500    13,909
Property and equipment, net................................    2,998     2,488
Restricted cash............................................      105       192
Other assets...............................................      680     1,085
                                                            --------  --------
                                                             $ 7,283  $ 17,674
                                                            ========  ========
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL
 DEFICIENCY)
Current liabilities:
  Accounts payable......................................... $  2,286  $    898
  Accrued compensation.....................................    1,032       753
  Other current liabilities................................       76        55
  Notes payable............................................       --         7
  Capital lease obligation--current portion................      903       587
  Line of credit obligation--current portion...............      817        --
                                                            --------  --------
    Total current Liabilities..............................    5,114     2,300
  Deferred rent............................................       42        90
  Capital lease obligation--noncurrent portion.............    1,120       840
  Line of credit obligation--noncurrent portion............    2,183        --
Commitments
Stockholders' equity (net capital deficiency):
  Common stock, $0.001 par value; 25,000,000 shares
   authorized, 8,352,296 shares issued and outstanding at
   December 31, 1998, 8,103,875 as of December 31, 1997; at
   amount paid in..........................................   45,910    45,597
  Deferred compensation....................................     (478)     (731)
  Accumulated deficit......................................  (46,608)  (30,422)
                                                            --------  --------
    Total stockholders' equity (net capital deficiency)....   (1,176)   14,444
                                                            --------  --------
                                                            $  7,283  $ 17,674
                                                            ========  ========
</TABLE>
 
 
                 See accompanying notes to financial statements
 
                                      F-3
<PAGE>
 
                                 CARDIMA, INC.
 
                            STATEMENTS OF OPERATIONS
                    (In thousands, except per share amounts)
 
<TABLE>
<CAPTION>
                                                  Year Ended December 31,
                                                 ----------------------------
                                                   1998      1997      1996
                                                 --------  --------  --------
<S>                                              <C>       <C>       <C>
Net sales....................................... $  2,499  $  1,261  $    593
Cost of goods sold..............................    2,962     2,011     1,413
                                                 --------  --------  --------
  Gross profit (loss)...........................     (463)     (750)     (820)
Operating expenses:
  Research and development......................    7,230     5,320     3,319
  Selling, general and administrative...........    8,556     6,656     3,690
                                                 --------  --------  --------
    Total operating expenses....................   15,786    11,976     7,009
                                                 --------  --------  --------
Operating loss..................................  (16,249)  (12,726)   (7,829)
Interest and other income.......................      359       602       132
Interest expense................................     (296)     (148)      (57)
                                                 --------  --------  --------
Net loss........................................ $(16,186) $(12,272) $ (7,754)
                                                 ========  ========  ========
Basic and diluted net loss per share............ $  (1.96) $  (2.64) $(107.69)
                                                 ========  ========  ========
Shares used in computing basic and diluted net
 loss per share.................................    8,239     4,642        72
                                                 ========  ========  ========
</TABLE>
 
 
 
                 See accompanying notes to financial statements
 
                                      F-4
<PAGE>
 
                                 CARDIMA, INC.
      Statements of Changes in Redeemable Convertible Preferred Stock and
                 Stockholders' Equity (Net Capital Deficiency)
              (In thousands, except share and per share amounts)
 
<TABLE>
<CAPTION>
                                                           Stockholders' Equity (Net Capital Deficiency)
                                            ----------------------------------------------------------------------------
                     Series D    Series E                                                                      Total
                    Redeemable  Redeemable   Series A    Series B    Series C                              Stockholders'
                    Convertible Convertible Convertible Convertible Convertible         Deferred Accumu-      Equity
                     Preferred   Preferred   Preferred   Preferred   Preferred  Common  Compen-   lated    (Net Capital
                       Stock       Stock       Stock       Stock       Stock     Stock   sation  Deficit    Deficiency)
                    ----------- ----------- ----------- ----------- ----------- ------- -------- --------  -------------
<S>                 <C>         <C>         <C>         <C>         <C>         <C>     <C>      <C>       <C>
Balances at
December 31,
1995..............    $ 6,182    $     --     $ 2,949      $ --       $ 4,764   $     8  $  --   $(10,396)   $ (2,675)
Issuance of
703,128 shares of
Series D
redeemable
convertible
preferred stock to
investors for cash
and cancellation
of notes payable
at $5.11 per
share, net of
issuance costs of
$35...............      3,558          --          --        --            --        --     --         --          --
Issuance of 2,206
shares of common
stock for cash
upon exercise of
employee stock
options at $0.56-
$2.10 per share...         --          --          --        --            --         7     --         --           7
Deferred
compensation
related to grant
of certain stock
options...........         --          --          --        --            --       580    580         --          --
Amortization of
deferred
compensation......         --          --          --        --            --        --     54         --          54
Net Loss..........         --          --          --        --            --        --     --     (7,754)     (7,754)
                      -------    --------     -------      ----       -------   -------  -----   --------    --------
Balances at
December 31,
1996..............      9,740          --       2,949        --         4,764       595   (526)   (18,150)    (10,368)
Issuance of
2,356,741 shares
of Series E
redeemable
convertible
preferred stock to
investors for cash
and conversion of
bridge loans at
$5.74 per share,
net of issuance
costs of $90......         --      13,442          --        --            --        --     --         --          --
Issuance of
2,275,000 shares
of common stock at
$7.00 per share
through the
initial public
offering, net of
commissions and
issuance costs of
$2,286............         --          --          --        --            --    13,639     --         --      13,639
Conversion of
redeemable
convertible and
convertible
preferred stock in
connection with
the Company's
initial public
offering..........     (9,740)    (13,442)     (2,949)       --        (4,764)   30,895     --         --      23,182
Issuance of 27,338
shares of common
stock for cash
upon exercise of
employee stock
options at $0.56-
$1.75 per share...         --          --          --        --            --        36     --         --          36
Deferred
compensation
related to grant
of stock options..         --          --          --        --            --       432   (432)        --          --
Amortization of
deferred
compensation......         --          --          --        --            --        --    227         --         227
Net Loss..........         --          --          --        --            --        --     --    (12,272)    (12,272)
                      -------    --------     -------      ----       -------   -------  -----   --------    --------
Balances at
December 31,
1997..............         --          --          --        --            --    45,597   (731)   (30,422)     14,444
Issuance of 78,409
shares of common
stock for net
issuance exercise
of warrants at
$1.05 per share...         --          --          --        --            --        --     --         --          --
Issuance of 37,301
shares of common
stock for exercise
of warrants at
$1.05 per share...         --          --          --        --            --        39     --         --          39
Issuance of 94,289
shares of common
stock for cash
upon exercise of
employee stock
options at $0.56-
$1.75 per share...         --          --          --        --            --       121     --         --         121
Issuance of 38,423
shares of common
stock for cash in
employee stock
purchase plan at
$4.25 and $3.56
per share.........         --          --          --        --            --       153     --         --         153
Amortization of
deferred
compensation......         --          --          --        --            --        --    253         --         253
Net Loss..........         --          --          --        --            --        --     --    (16,186)    (16,186)
                      -------    --------     -------      ----       -------   -------  -----   --------    --------
Balances at
December 31,
1998..............    $    --    $     --     $    --      $ --       $    --   $45,910  $(478)  $(46,608)   $ (1,176)
                      =======    ========     =======      ====       =======   =======  =====   ========    ========
</TABLE>
 
                See accompanying notes to financial statements
 
                                      F-5
<PAGE>
 
                                 CARDIMA, INC.
 
                            STATEMENTS OF CASH FLOWS
                                 (In thousands)
 
<TABLE>
<CAPTION>
                                                    Year Ended December 31,
                                                   ---------------------------
                                                     1998      1997     1996
                                                   --------  --------  -------
<S>                                                <C>       <C>       <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss.......................................... $(16,186) $(12,272) $(7,754)
Adjustments to reconcile net loss to net cash
 provided by operations:
  Depreciation and amortization...................      928       703      403
  Amortization of deferred compensation...........      253       227       54
  Loss on disposal of assets......................        6        --       15
  Loss on sale/leaseback of capital equipment.....       --        --       95
  Changes in operating assets and liabilities:
    Accounts receivable...........................     (244)     (200)     (18)
    Inventories...................................   (1,445)     (155)    (109)
    Other current assets..........................     (105)      (32)    (111)
    Restricted cash...............................       87        83       70
    Notes receivable..............................      (19)     (301)      --
    Other assets..................................     (905)     (446)    (526)
    Accounts payable..............................    1,388      (257)     896
    Accrued employee compensation.................      279       240      314
    Other current liabilities.....................       21         3        1
    Deferred rent.................................      (48)      (49)      10
                                                   --------  --------  -------
      Net cash used in operating activities.......  (15,990)  (12,456)  (6,660)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments...............     (517)   (4,270)      --
Maturities and sales of short-term investments....    4,786        --       --
Capital expenditures..............................      (45)     (883)    (388)
Proceeds from disposal of assets..................       25         3       --
                                                   --------  --------  -------
    Net cash (used)provided in investing
     activities...................................    4,249    (5,150)    (388)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of preferred stock.....       --    10,158    2,984
Proceeds from issuance of bridge loans............       --     1,610    1,674
Principal payments under capital leases...........     (745)     (469)    (286)
Payments under notes payable......................       (7)       --       --
Proceeds under line of credit.....................    3,000        --       --
Net proceeds from sale of common stock............      313    13,675        7
Proceeds from sale/leaseback of capital
 equipment........................................    1,247       303      583
                                                   --------  --------  -------
    Net cash provided by financing activities.....    3,808    25,277    4,962
                                                   --------  --------  -------
NET INCREASE(DECREASE) IN CASH AND CASH
 EQUIVALENTS......................................   (7,933)    7,671   (2,086)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR......    8,578       907    2,993
                                                   --------  --------  -------
CASH AND CASH EQUIVALENTS, END OF YEAR............ $    645  $  8,578  $   907
                                                   ========  ========  =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION
Cash paid during the year for interest............ $    298  $    122  $    49
                                                   ========  ========  =======
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND
 FINANCING ACTIVITIES
Equipment acquired under capital leases........... $  1,341  $    845  $   746
                                                   ========  ========  =======
Conversion of various related party payables,
 bridge loans and capital lease obligations and
 related accrued interest to convertible preferred
 stock............................................       --        --  $   574
                                                   ========  ========  =======
</TABLE>
 
                 See accompanying notes to financial statements
 
                                      F-6
<PAGE>
 
                                 CARDIMA, INC.
 
                         NOTES TO FINANCIAL STATEMENTS
 
1. Nature of Business and Summary of Significant Accounting Policies
 
 Nature of Business
 
  Cardima, Inc., (the "Company" or "Cardima"), was incorporated in the State
of Delaware on November 12, 1992. The Company designs, develops, manufactures
and markets minimally invasive, single use, microcatheter-based systems for
the mapping and ablation of the two most common forms of cardiac arrhythmias:
atrial fibrillation and ventricular tachycardia. The Company has licensed its
microcatheter technology for use in the treatment of electrophysiological
diseases affecting areas other than the central nervous system from a major
stockholder, Target.
 
  The Company has incurred continuing operating losses and expects such losses
to continue over the next several years. Management plans to continue to
finance the operations with a combination of stock sales, product revenue and
other financing facilities. In January and February 1999, the Company sold a
total of 7,500,000 shares of common stock at $2.00 per share in a private
placement transaction to accredited investors. As commission, the Company
issued 354,806 shares of its common stock to the placement agent and paid
$490,388. In addition the Company issued 750,000 warrants, exercisable for
750,000 shares of common stock at an exercise price of $2.20 as a commission
for the transaction. The Company's net proceeds, after expenses of the
placement were $14.4 million.
 
 Use of Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
 
 Revenue Recognition
 
  Revenues are recognized when products are shipped. To date, product sales
have been direct to customers in the United States and to distributors
primarily in Europe, Japan and South America. No one distributor or direct
customer accounted for more than 10% of the Company's net sales and export
sales represented 31% of net sales for the year ended December 31, 1998. Of
the export sales in 1998, 23% were to Japan, 71% were to Europe and 6% were to
the rest of the world. Essentially all of the Company's sales from inception
to December 31, 1996 were export sales. Provisions for doubtful accounts were
$29,000 and $119,000 for the years end December 31, 1998 and 1997,
respectively. When necessary, estimated provisions for product returns are
recorded.
 
<TABLE>
<CAPTION>
                                                     Year Ended December 31,
                                                          (In thousands)
                                                  ------------------------------
                                                     1998       1997      1996
                                                  ---------- ---------- --------
   <S>                                            <C>    <C> <C>    <C> <C>  <C>
   United States................................. $1,722 69% $  902 71% $  2  0%
   Europe........................................    554 22%    224 18%  401 68%
   Japan.........................................    177  7%    123 10%  190 32%
   Rest of World.................................     46  2%     12  1%    0  0%
                                                  ------     ------     ----
     TOTAL NET SALES............................. $2,499     $1,261     $593
                                                  ======     ======     ====
</TABLE>
 
 Research and Development
 
  Research and development costs, which include clinical and regulatory costs,
are charged to expense as incurred.
 
 
                                      F-7
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 Net Loss Per Share
 
  In 1997, the Company adopted Financial Accounting Standards Board Statement
No. 128, "Earnings Per Share." SFAS 128 requires the presentation of basic
earnings (loss) per share and diluted earnings per shares, if more dilutive,
for all periods presented.
 
  In accordance with SFAS128, basic net loss per share has been computed using
the weighted average number of shares of common stock outstanding during the
period. The Company has excluded all convertible debt, convertible preferred
stock, warrants, and stock options from the computation of basic and diluted
earnings per share because all such securities are anti-dilutive for all
periods presented.
 
  The following table sets forth the computation of basic and diluted net loss
per share (in thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                       Year Ended December
                                                               31,
                                                      ------------------------
                                                       1998    1997     1996
                                                      ------  ------  --------
   <S>                                                <C>     <C>     <C>
   Net loss.......................................... $6,186  $2,272  $  7,754
                                                      ======  ======  ========
     Weighted average shares of common stock
      outstanding....................................  8,239   4,642        72
     Weighted average unvested common shares issued
      subject to repurchase agreements...............     --      --        --
                                                      ------  ------  --------
   Shares used to compute basic and diluted net loss
    per share........................................  8,239   4,642        72
                                                      ======  ======  ========
   Basic and diluted net loss per share.............. $(1.96) $(2.64) $(107.69)
                                                      ======  ======  ========
</TABLE>
 
  Pro forma net loss per share for 1997 has been computed as described above
and also gives effect, pursuant to SEC staff policy, to the conversion of
convertible preferred shares not included above that were converted upon
completion of the Company's initial public offering (using the "if converted"
method) from the original date of issuance.
 
  Pro forma basic and diluted net loss per share information is as follows
  (in thousands except per share data):
 
<TABLE>
<CAPTION>
                                                        Year Ended December 31,
                                                        -----------------------
                                                                 1997
                                                                 ----
<S>                                                     <C>
  Shares used in computing basic and diluted net loss
   per share...........................................          4,642
                                                                ------
  Adjusted to reflect assumed conversion of preferred
   stock from the date of issuance through the initial
   public offering in June 1997........................          1,454
                                                                ------
  Shares used in computing pro forma basic and diluted
   loss per share......................................          6,096
                                                                ------
  Pro forma basic and diluted net loss per share.......         $(2.01)
                                                                ======
</TABLE>
 
 Cash, Cash Equivalents and Short-Term Investments
 
  The Company considers investments in highly liquid instruments purchased
with an original maturity of three months or less to be cash equivalents. All
of the Company's cash equivalents and short-term investments, consisting
principally of commercial paper and government securities, are classified as
available-for-sale as of December 31, 1997. There were no equity or debt
securities outstanding at December 31, 1998. There were no realized gains or
losses experienced in each of the years ended December 31, 1998, 1997 and
1996. The fair value of investments is based on quoted market prices at
December 31, 1997. The fair value of these securities
 
                                      F-8
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
approximated the amortized cost at December 31, 1997. Cash, cash equivalents
and short-term investments at December 31, 1997 consist of the following (in
thousands):
 
<TABLE>
   <S>                                                                   <C>
   Cash and cash equivalents:
     Cash............................................................... $  310
     Money market funds.................................................  3,044
                                                                         ------
                                                                          3,354
     Available for sale securities commercial paper.....................  5,224
                                                                         ------
       Total cash and cash equivalents.................................. $8,578
                                                                         ======
   Short-term investments:
   Commercial paper..................................................... $2,233
   Corporate notes......................................................  1,278
                                                                         ------
     Available for sale securities......................................  3,511
   Certificate of deposit...............................................    759
                                                                         ------
     Total short-term investments....................................... $4,270
                                                                         ======
   Restricted investments:
     Restricted certificate of deposit.................................. $  192
                                                                         ======
</TABLE>
 
  The restricted certificate of deposit is being held as collateral by a
financial institution against a letter of credit for the Company's primary
facilities in Fremont, California.
 
 Inventory
 
  Inventories are stated at the lower of cost or market. Cost is based on
actual costs computed on a first-in, first-out basis. Inventories consist of
the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                      December
                                                                         31,
                                                                     -----------
                                                                      1998  1997
                                                                     ------ ----
   <S>                                                               <C>    <C>
   Inventories:
     Raw materials.................................................. $  502 $209
     Work-in-process................................................    217  119
     Finished goods.................................................  1,258  204
                                                                     ------ ----
                                                                     $1,977 $532
                                                                     ====== ====
</TABLE>
 
 Property and Equipment
 
  Property and equipment, including equipment under capital leases, are
carried at cost less accumulated depreciation and amortization. Property and
equipment are depreciated using the straight-line method over the estimated
useful lives, generally three to five years. Leasehold improvements are
amortized using the straight-line method over the shorter of the estimated
useful life of the asset or the remaining term of the lease. Depreciation
expense includes amortization of capital leases and leasehold improvements.
 
 
                                      F-9
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
  Property and equipment consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1997
                                                               -------  -------
   <S>                                                         <C>      <C>
   Property and equipment:
     Equipment................................................ $ 5,054  $ 3,715
     Leasehold improvements...................................     107       99
                                                               -------  -------
                                                               $ 5,161  $ 3,814
     Less accumulated depreciation............................  (2,163)  (1,326)
                                                               -------  -------
                                                               $ 2,998  $ 2,488
                                                               =======  =======
</TABLE>
 
  Property and equipment financed under a capital leases were $3,660,000 and
$2,357,000 at December 31, 1998 and 1997, respectively. Accumulated
amortization related to leased assets was $1,764,000 and $1,072,000 at
December 31, 1998 and 1997, respectively. Amortization related to capital
leases are included in depreciation expense.
 
 Long-Lived Assets
 
  The Company examines the carrying value of its long-lived assets to
determine whether there are any impairment losses. If indicators of impairment
are present in long-lived assets used in operations and future cash flows were
not sufficient to recover the assets' carrying amount, an impairment loss
would be charged to expenses in the period identified. No event has been
identified that would impair the value of long-lived assets recorded in the
accompanying financial statements.
 
 Concentrations of Risk
 
  The Company purchases certain key components of its products, including the
hydrophilic coating for certain of its microcatheters, from sole, single or
limited source supplies. For certain of these components, there are relatively
few alternative sources of supply. Establishing additional or replacement
suppliers for any of the numerous components used in the Company's products,
if required, may not be accomplished quickly and could involve significant
additional costs. Any supply interruption from vendors or failure of the
Company's products would limit the Company's ability to manufacture its
products and would have a material adverse effect on the Company's business,
financial condition and results of operations.
 
 Patents
 
  Patent costs deemed to have future benefits are capitalized and amortized
using the straight-line method over estimated useful lives of seven years,
beginning at their effective dates or over the remainder of such periods from
the dates acquired.
 
  The Company examines the carrying value of its patents to determine whether
there are any impairment losses. If indicators of impairment are present in
these assets used in operations, and future cash flows were not sufficient to
recover the assets' carrying amount, an impairment loss would be charged to
expenses in the period identified. No event has been identified that would
impair the value of patents recorded in the accompanying financial statements.
 
 Recent Accounting Pronouncements
 
  The Company adopted Statement of Financial Accounting Standards No. 131,
"Disclosure about Segments of an Enterprise and Related Information ("SFAS
131"), at December 31, 1998. SFAS 131 establishes annual
 
                                     F-10
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
and interim reporting standards for an enterprise's operating segments and
related disclosures about its products, services, geographic areas and major
customers. Under SFAS 131, the Company's operations are treated as one
operating segment as it only reports profit and loss information on an
aggregate basis to chief operating decision makers of the Company.
 
  In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative
Financial Instruments and for Hedging Activities, which provides a
comprehensive and consistent standard for the recognition and measurement of
derivatives and hedging activities. SFAS No. 133 is effective for years
beginning after June 15, 1999 and is not anticipated to have a significant
impact on the Company's results of operations or financial condition when
adopted.
 
2. Leases
 
  The Company leases facilities under an operating lease which commenced in
August 1994 and expires November 1999. The Company also leases certain
equipment under noncancelable capital leases (see Note 6). Following is a
schedule of future minimum lease payments under both operating and capital
leases at December 31, 1998 (in thousands):
 
<TABLE>
<CAPTION>
                                                              Operating Capital
                                                                Lease   Leases
                                                              --------- -------
   <S>                                                        <C>       <C>
   Year ending December 31;
     1999....................................................   $394    $1,075
     2000....................................................     --       662
     2001....................................................     --       405
     2002....................................................     --       196
                                                                ----    ------
   Total minimum payments required...........................   $394    $2,338
                                                                ====
   Less amount representing interest.........................             (315)
                                                                        ------
   Present value of future lease payments....................            2,023
   Less current portion......................................             (903)
                                                                        ------
   Noncurrent portion........................................           $1,120
                                                                        ======
</TABLE>
 
  Rent expense, net of rental income, was approximately $363,000 in 1998,
$316,000 in 1997 and $295,000 in 1996. In connection with its facilities lease
arrangements, the Company issued letters of credit to lessors which are
collateralized by certificates of deposit totaling approximately $105,000 at
December 31, 1998. Accordingly, this restricted cash amount has been
classified as a noncurrent asset.
 
3. Stockholders' Equity
 
 Initial Public Offering
 
  In June of 1997, upon completion of the Company's initial public offering,
Series A, B, C, D and E preferred stock converted into 5,726,538 shares of
common stock.
 
  In March and June 1997, the Company amended and restated its certificate of
incorporation to increase the total number of shares authorized to 30,000,000.
Of the shares authorized, 25,000,000 are designated for issuance of common
stock and 5,000,000 are designated for issuance of preferred stock.
 
 
                                     F-11
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 Common Stock
 
  In June 1997, the Company completed its initial public offering and issued
2,275,000 shares of its Common Stock at a price of $7.00 per share. The
Company received approximately $13.6 million in cash, net of underwriting
discounts, commission and other offering costs.
 
 1993 Stock Option Plan
 
  During 1993, the board of directors adopted the 1993 Stock Option Plan (the
"Plan") and, as amended, has reserved 1,300,000 shares of common stock for
issuance under the Plan. The Plan provides for both incentive and nonstatutory
stock options to be granted to employees, directors and consultants.
Exercisability, option price, fair value and other terms are determined by the
board of directors; however, the exercise price of each incentive stock option
shall be not less than 100% of the fair market value of the stock issuable
upon exercise of the option on the date the option is granted. The exercise
price of each nonstatutory stock option shall be not less than 85% of the fair
market value of the stock subject to the option on the date the option is
granted. All options granted prior to the initial public offering shares are
generally exercisable upon grant, but shares received upon exercise prior to
vesting are subject to repurchase upon the stockholder's termination of
service to the Company. Subsequent to the initial public offering, only fully
vested shares are exercisable. Shares purchased upon exercise of options
generally vest at the rate of 12.5% after six months from the date of grant,
and monthly thereafter over the following 48 months. No option shall have a
maximum term in excess of ten years from the grant date and no option granted
to a 10% stockholder shall have a maximum term in excess of five years from
the grant date.
 
  Activity under the 1993 Stock Option Plan is as follows:
 
<TABLE>
<CAPTION>
                                                Outstanding Options
                                       --------------------------------------
                                                                 Weighted-
                             Shares    Number of     Price        Average
                            Available   Shares     Per Share   Exercise Price
                            ---------  ---------  ------------ --------------
   <S>                      <C>        <C>        <C>          <C>
   Balance at December 31,
    1995...................  111,220     148,255  $0.56--$2.10    $0.9705
   Additional shares
    reserved...............  640,079          --            --         --
   Options granted......... (733,778)    733,778  $0.56--$1.75    $1.2485
   Options exercised.......       --      (4,708) $0.56--$2.10    $1.2534
   Options forfeited.......   66,635     (66,635) $0.56--$2.10    $1.2534
                            --------   ---------
   Balance at December 31,
    1996...................   84,156     810,690  $0.56--$2.10    $1.2534
   Additional shares
    reserved...............  396,825          --            --         --
   Options granted......... (438,162)    438,162  $1.75--$7.00    $4.2533
   Options exercised.......       --     (27,338) $0.56--$7.00    $2.3861
   Options forfeited.......   80,899     (80,899) $0.56--$5.88    $2.3681
                            --------   ---------
   Balance at December 31,
    1997...................  123,718   1,140,615  $0.56--$5.88    $2.3681
   Additional shares
    reserved...............  243,117          --            --         --
   Options granted......... (290,508)    290,508  $2.88--$5.56    $4.3818
   Options exercised.......       --     (94,289) $0.56--$1.75    $1.2841
   Options forfeited.......   59,742     (59,742) $0.56--$7.00    $3.5926
                            --------   ---------
   Balance at December 31,
    1998...................  136,069   1,277,092  $0.56--$7.00    $2.8650
                            ========   =========
</TABLE>
 
  From April 1996 to April 1997, options to purchase a total of 835,928 shares
were granted at prices ranging from $0.56 to $5.74 per share. Deferred
compensation of approximately $1,012,000 was recorded for these option grants
based on the deemed fair value of common stock (ranging from $1.00 to $8.00
per share).
 
                                     F-12
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 
  At December 31, 1998, 1997 and 1996 approximately 881,606, 827,920 and
810,685 options, respectively, were exercisable under the Plan. Of the options
granted in 1998, 60,275 were granted above fair value and 230,233 were granted
at fair value.
 
 1997 Directors' Stock Option Plan
 
  In March 1997, the board of directors adopted the 1997 Directors' Stock
Option Plan. A total of 200,000 shares of common stock have been reserved for
issuance under this plan. This Plan provides for the grant of nonstatutory
stock options to nonemployee directors of the Company. At December 31, 1998 no
options had been granted under this plan.
 
 1997 Employee Stock Purchase Plan
 
  In March 1997, the board of directors adopted the 1997 Employee Stock
Purchase Plan (the "Purchase Plan"). A total of 250,000 shares of common stock
has been reserved for issuance under the Purchase Plan. As of December 31,
1998, 38,423 shares had been issued under this purchase plan.
 
 Warrants
 
  At December 31, 1998, the Company had the following warrants outstanding:
warrants to purchase 308,512 shares of common stock at $1.05 per share issued
to certain investors in connection with bridge loans; warrants to purchase
1,428 shares of common stock at $7.00 per share issued in connection with the
facility lease; warrants to purchase 1,905 shares of common stock at $7.00 per
share and 2,142 shares of common stock at $5.11 per share issued in connection
with a letter of credit; warrants to purchase 23,776 shares of common stock at
$5.11 per share and 13,937 shares of common stock at $5.74 per share issued in
connection with a capital lease; warrants to purchase 17,543 shares of common
stock at $7.00 per share issued to certain investors in connection with bridge
financings and warrants to purchase 75,000 shares of common stock at $4.00 per
share issued in connection with a line of credit. These warrants are
exercisable immediately and expire at the earliest of (i) between 3 to 10
years after the date of grant or (ii) the closing of the Company's sale of all
or substantially all of its assets or (iii) the acquisition of the Company by
another entity by means of a merger or other transaction.
 
  In December 1994, the Company also issued warrants to Target to purchase
24,610 shares of the Company's Series C preferred stock at $10.50 per share in
connection with a guarantee of a letter of credit. These warrants were
exercised in March 1995 for cash. Also in connection with a capital lease line
agreement, the Company issued to Target in December 1993 a warrant for $766 to
purchase 10,427 shares of the Company's common stock at $7.00 per share. This
warrant expired on December 9, 1998.
 
  The Company has reserved 444,243 shares of common stock for issuance upon
exercise of the warrants described above.
 
 Accounting for Stock-Based Compensation
 
  The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair-value accounting provided for under FASB
Statement No. 123, ("Statement 123") "Accounting for Stock-Based
Compensation," requires use of option valuation models that were not developed
for use in valuing employee stock options. Under APB 25, because the exercise
price of the Company's employee stock options equals the market price of the
underlying stock on the date of grant as determined by the Company's Board of
Directors, no compensation expense is recognized.
 
                                     F-13
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 
  Pro forma information regarding net loss and loss per share is required by
Statement 123, which also requires that the information be determined as if
the Company had accounted for its employee stock options granted subsequent to
December 31, 1994 under the fair value method of that Statement. The fair
value for these options was estimated at the date of grant using the minimum
value method for 1996 and the Black Scholes option pricing model for 1997 and
1998 with the following weighted-average assumptions for 1998, 1997 and 1996,
respectively; risk-free interest rates of approximately 6.0%, 6.0% and 7.0%;
dividend yields of 0.0%, volatility factors of the expected market price of
the Company's common stock of 0.6, 0.6 and 0.0 (as the Company was not public
in 1996); and a weighted-average expected life of the options of four years.
 
  The option valuation models were developed for use in estimating the fair
value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a
reliable single measure of the fair value of its employee stock options.
 
  For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The
Company's pro forma information follows:
 
<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                  ----------------------------
                                                    1998      1997      1996
                                                  --------  --------  --------
                                                  (In thousands, except per
                                                         share data)
   <S>                                            <C>       <C>       <C>
   Net loss--as reported......................... $(16,186) $(12,272) $ (7,754)
                                                  ========  ========  ========
   Net loss--pro forma........................... $(16,439) $(12,526) $ (7,776)
                                                  ========  ========  ========
   Net loss per share--as reported............... $  (1.96) $  (2.64) $(107.69)
                                                  ========  ========  ========
   Net loss per share--pro forma................. $  (2.00) $  (2.70) $(108.00)
                                                  ========  ========  ========
</TABLE>
 
  The following table summarizes information about stock options outstanding
at December 31, 1998:
 
<TABLE>
<CAPTION>
                         Options Outstanding            Options Exercisable
                -------------------------------------- ---------------------
                                             Weighted-             Weighted-
   Range of      Number of  Weighted-Average  Average   Number of   Average
   Exercise       shares       Remaining     Exercise    shares    Exercise
    Prices      Outstanding Contractual Life   Price   Exercisable   Price
   --------     ----------- ---------------- --------- ----------- ---------
<S>             <C>         <C>              <C>       <C>         <C>
$0.56 -- $1.05     205,787        6.49        $0.7885    205,787    $0.7885
 1.40 --  1.40     396,760        7.41         1.4000    396,760     1.4000
 1.75 --  3.75     222,116        9.10         2.6434    115,816     2.2161
 4.63 --  4.63       9,870        9.12         4.6300      6,215     4.6300
 5.00 --  5.00     255,000        8.59         5.0000    112,919     5.0000
 5.25 --  7.00     187,559        9.21         5.5095     44,109     5.5271
                 ---------                               -------
$0.56 -- $7.00   1,277,092        8.07        $2.8650    881,606    $2.0548
                 =========                               =======
</TABLE>
 
4. Notes Receivable
 
  In December 1997, the Company entered into a $300,000 note receivable
agreement with Phillip C. Radlick, Ph.D., its President and Chief Executive
Officer to facilitate the purchase of a principal residence in the Bay Area.
The note bears interest at the minimum Applicable Federal Rate of 6.45% at the
time the note was issued and is due and payable in a single lump sum forty-
eight months from the note date. As security for the note,
 
                                     F-14
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
Dr. Radlick granted Cardima a security interest in his vested stock options.
At December 31, 1998, approximately $20,000 of interest has accrued. The note
receivable and accrued interest are included in the accompany balance sheet.
 
5. Income Taxes
 
  As of December 31, 1998 and December 31, 1997, the Company had federal net
operating loss carryforwards of approximately $44,400,000 and $29,500,000,
respectively. The Company also had federal research and development tax credit
carryforwards of approximately $500,000 and $200,000 as of December 31, 1998
and 1997. The net operating loss and credit carryforwards will expire
beginning in 2008 through 2018, if not utilized.
 
  Utilization of the net operating losses and credits may be subject to a
substantial annual limitation due to the "change in ownership" provisions of
the Internal Revenue Code of 1986 and similar state provisions. The annual
limitation may result in the expiration of net operating losses and credits
before utilization.
 
  Significant components of the Company's deferred tax assets for federal and
state income taxes as of December 31 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                               1998      1997
                                                             --------  --------
   <S>                                                       <C>       <C>
   Net operating loss carryforwards......................... $ 16,100  $ 10,800
   Research credits carryforwards (federal and state).......      800       500
   Manufacturing investment credit carryforwards............      100        --
   Capitalized research and development.....................      500       300
   Other, net...............................................      600       300
                                                             --------  --------
   Total deferred tax assets................................   18,100    11,900
   Valuation allowance for deferred tax assets..............  (18,100)  (11,900)
                                                             --------  --------
                                                             $     --  $     --
                                                             ========  ========
</TABLE>
 
  The net valuation allowance increased by $4,400,000 and $3,050,000 during
the year ended December 31, 1997 and 1996, respectively.
 
6. Related Party Transactions
 
 License Rights
 
  In May 1993, in exchange for an equity interest in the Company, Target
granted the Company an exclusive royalty-free worldwide license to use
Target's technology and to make, use and sell or otherwise distribute products
for the diagnosis and treatment of electrophysiological diseases in the body,
other than in the central nervous system, including the brain. The exclusive
license grant applied to any Target technology developed through May 1996 and
will expire upon the expiration of the last of the patents relating to the
Target technology. Under the License Agreement, Cardima granted back to Target
an exclusive royalty-free license to use technology developed through May 1996
in the fields of neurology, interventional neuroradiology, interventional
radiology, reproductive disorders and vascular prostheses (the "Target
Field"). Such license will expire upon the expiration of the last of the
patents relating to the Target technology. Target granted the Company a
nonexclusive, royalty-free license to use Target technology to make, use and
sell or otherwise distribute the Company's products for use within the
cardiology field, provided the Company's products represent a substantial
improvement. A substantial improvement is any modification, improvement or
enhancement by the Company of Target technology in a particular product that
results in a material change in the function, purpose or application
 
                                     F-15
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
of such product. The Company believes that the incorporation of electrodes in
its microcatheter systems, together with other modifications, satisfies the
substantial improvement requirements. As part of the same agreement, the
Company granted to Target an exclusive, royalty-free license to use the
Company's technology to make, have made, use and sell or otherwise distribute
products within the Target Field.
 
  In addition, the Company agreed not to conduct material research and
development, acquire corporate entities or make or sell products in the Target
Field or to sell products, other than products utilizing Target's technology,
for use in diagnosis or treatment of diseases related to the production of
electrical current in tissue located in areas of the body other than the
heart, without first notifying Target and negotiating a distribution
agreement. Cardima also agreed that it would not sell products utilizing
Target's technology for use in diagnosis or treatment of diseases related to
the production of electrical current in tissue located in areas of the body
other than the heart without, if selling to a distributor, first notifying
Target and offering Target the right of first refusal with respect to the
terms of the distribution, or if selling directly to the consumer, paying to
Target an amount equal to 40% of the gross profit for such product.
 
 Stock Transactions
 
  In February 1996, the Company issued 112,374 shares of common stock to
Target at $5.11 per share in exchange for the conversion of outstanding
capital lease obligations.
 
 Operations and Facilities
 
  In May 1993, in the Company entered into an agreement with Target whereby
Target agreed to supply and manufacture such products and components necessary
to proceed with research and development activity pursuant to the license
mentioned above. This Agreement expired in May 1996.
 
  The Company paid $1,000 per month for each employee using Target's
facilities, as well as other miscellaneous administrative expenses incurred by
Target on the Company's behalf.
 
  As of December 31, 1998, nothing has been paid and nothing is owed to Target
under these arrangements (approximately $28,000 and $234,000 was paid and
nothing owed and $38,000 owed at December 31, 1997 and 1996, respectively.
 
  Target had sublet certain facilities from the Company which can be renewed
annually. Net monthly rental income was approximately $4,500. In November
1997, this sublease arrangement was terminated. In January 1998, the Company
refunded Target their $7,500 security deposit held in connection with the
sublease.
 
 Capital Lease Arrangement
 
  In connection with a lease line agreement, the Company issued to Target a
warrant to purchase 10,427 shares of the Company's common stock. In December
1995 and February 1996, the outstanding capital lease obligation, plus accrued
interest, was converted into shares of Series D convertible preferred stock,
which was converted into 254,403 shares of common stock upon completion of the
Company's initial public offering.
 
7. Subsequent Events
 
  In January 1999, the Company reduced its full-time workforce by
approximately 30% and its temporary workforce by 75% in order to align
available cash resources and projected expenses. The reductions affected all
functional areas of the Company. The restructuring cost were approximately
$300,000.
 
 
                                     F-16
<PAGE>
 
                                 CARDIMA, INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
  Additionally in January and February 1999, the Company sold a total of
7,500,000 shares of common stock at $2.00 per share in a private placement
transaction to accredited investors. As commission, the Company issued 354,806
shares of its common stock to the placement agent and paid $490,388. In
addition the Company issued 750,000 warrants, exercisable for 750,000 shares
of common stock at an exercise price of $2.20 as a commission for the
transaction. The Company's net proceeds, after expenses of the placement were
$14.4 million.
 
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