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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                                  FORM 10-KSB
 
[X]ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
   1934 For the fiscal year ended September 30, 1996
 
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
   EXCHANGE ACT OF 1934
 
                        Commission File Number: 0-27234
 
                             PHOTON DYNAMICS, INC.
       (Exact name of small business issuer as specified in its charter)
 
<TABLE>
<S>                                            <C>
                 CALIFORNIA                                      94-3007502
       (State or other jurisdiction of                        (I.R.S. Employer
       incorporation or organization)                       Identification No.)
</TABLE>
 
                               6325 SAN IGNACIO
                              SAN JOSE, CA 95119
                   (Address of principal executive offices)
 
                                (408) 226 9900
                          (Issuer's telephone number)
 
        Securities registered under Section 12(b) of the Exchange Act:
                                     NONE
 
        Securities registered under Section 12(g) of the Exchange Act:
                                 COMMON STOCK
 
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the last 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. YES [X] NO
 
Check if there is no disclosure of delinquent filers in response to Item 405
of Regulation S-B is not contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-
KSB or any amendment to this Form 10-KSB. [_]
 
Revenue for the year ended September 30, 1996 was $24,763,000.
 
  The aggregate market value of the voting stock held by non-affiliates of the
Registrant, based on the closing price of the Common Stock on December 27,
1996, as reported on the Nasdaq National Market was approximately $43,361,000
Shares of Common Stock held by each officer and director and by each person
who owns 5% or more of the outstanding Common Stock have been excluded from
this computation in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive
determination for other purposes.
 
As of December 27, 1996 the Registrant had outstanding 6,955,037 shares of
Common Stock.
 
Transitional small business Disclosure Format (check one) Yes      No X [X]
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Registrant's Proxy Statement for its 1997 Annual Meeting of
Shareholders and the Registrants Annual Report to Shareholders for its fiscal
year ended September 30, 1996 are incorporated by reference in Part I, II and
III of this Form 10-KSB report.
 
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                                    PART I
 
ITEM 1: DESCRIPTION OF BUSINESS
 
THE COMPANY
 
  Photon Dynamics, Inc. is a leading worldwide supplier of test, inspection
and repair systems for the flat panel display ("FPD") industry. The Company's
systems are used to control, monitor and refine the manufacturing process to
increase the yield of FPDs, to reduce materials loss, to transition new FPD
designs from research and development to commercial production and to assist
in the rapid start-up of new FPD manufacturing facilities. While certain
aspects of the manufacturing processes for FPDs are similar to manufacturing
processes for semiconductor devices, materials costs represent a substantially
higher percentage of the cost of an FPD as compared with semiconductor
devices. As a result, the need for test and inspection of FPDs goes beyond the
need to improve yields as FPD manufacturers seek to identify defects early in
the manufacturing process to either avoid investment of further materials cost
or to repair the defect before further manufacturing steps make it less
accessible. The Company believes that more of its systems have been used by
manufacturers of active matrix liquid crystal displays ("AMLCDs") and other
advanced FPDs to test, inspect and repair more VGA and other higher resolution
FPDs than any other currently available competitive system and that this
experience has enabled it to become a leading technical innovator of test,
inspection and repair equipment for advanced FPD manufacturers.
 
  Photon Dynamics offers a suite of products to inspect virtually all current
types of FPDs and to address all key areas of AMLCD test, inspection and
repair throughout all major stages of the manufacturing life cycle, from
research and development to commercial production. The Company's test products
include array test systems that locate, count and characterize electrical
array faults, contamination and other defects on partially completed flat
panel display substrates. The Company's repair product performs array laser
cut and weld repair functions based upon information generated by its test and
inspection products. Its inspection products perform flat panel cell and
module inspection to detect and locate optical defects in FPDs. All of the
Company's product lines interface with one another through software systems
used to store data and generate reports and other information used by FPD
manufacturers to increase their yields.
 
  The Company's products incorporate proprietary technologies that provide FPD
manufacturers with the ability to obtain information critical to yield
improvement and management of manufacturing processes that had not previously
been readily available to FPD manufacturers. The Company's proprietary Voltage
Imaging(TM) and N-Aliasing(TM) technologies, in conjunction with its
proprietary software programs, permit non-contact, full characterization and
image evaluation of virtually all commercially produced FPD displays,
regardless of panel size or the FPD technology employed. All of the Company's
product lines are currently being used with VGA and SVGA displays and are
designed for use with next generation XGA and SXGA displays.
 
PRODUCTS
 
  Photon Dynamics offers a suite of products to inspect virtually all types of
FPDs. All of the Company's systems use similar software based controls,
processing and graphical user interfaces. Products can be networked together
so FPD defect data can be stored, analyzed and used throughout the
manufacturing process. All of the Company's systems are capable of providing
fully automated functionality through robotics incorporated into the systems
by Photon Dynamics or purchased from third party vendors.
 
                                       2
<PAGE>
 
  The following table lists the Company's products:
 
<TABLE>
<CAPTION>
            FIRST
          COMMERCIAL                   COMPATIBLE FPD
 PRODUCT   SHIPMENT     FUNCTION         TECHNOLOGY     STATE OF FPD MANUFACTURE
 -------  ----------    --------       --------------   ------------------------
 <C>      <C>        <C>             <C>                <S>
 IPT-E       1994      Array test          AMLCD        Research and development
                                                             Pre-production
 IPT-MPS     1995      Array test          AMLCD        Research and development
                                                             Pre-production
                                                               Production
 FIS-200*    1993    VGA inspection         ALL         Research and development
                                                             Pre-production
                                                               Production
 FIS-250     1995    SVGA inspection        ALL         Research and development
                                                             Pre-production
                                                               Production
 FIS-300     1995    XGA inspection         ALL         Research and development
                                                             Pre-production
                                                               Production
 ILW(TM)     1993        Repair          AMLCD and             Production
                                     passive matrix LCD
</TABLE>
--------
*  Superseded by the FIS-250
 
 In-Process Test Systems (IPT Systems)
 
  The Company's In-Process Test (IPT) systems use the Company's proprietary
Voltage Imaging(TM) technology to detect, locate, quantify and characterize
electrical, contamination and other defects in AMLCD arrays after the
completion of the first major step of production, the construction of the
transistor array on the glass substrate. The systems incorporate a computer
workstation and proprietary image processing software to display pixel images
and information which not only allows manufacturers to determine whether
individual pixels or lines of pixels are functional, but also allows them to
find more subtle defects such as individual pixel voltage variations early in
the production process. In addition, these systems generate point and line
defect data files specifying the exact location of each defect, which data can
then be used for statistical process control or downloaded to the Company's
ILW(TM) system to effect repairs. The systems also perform key procedures
involved in the testing process, including running test sequences and loading,
unloading and sorting substrates. The IPT systems can be adapted to test
different panel sizes in less than three hours, as compared with systems using
probe card technology which the Company estimates can require up to 16 hours.
The currently available IPT-MPS system is an enhanced version of the IPT
system that uses optimized processing software, graphical user interface and
materials transport features. These features have been designed to enable the
IPT-MPS system to achieve throughput rates that are comparable to conventional
probe card based systems while providing the same functionality, flexibility
and cost-efficient features of the earlier IPT system.
 
 Flat Panel Inspection Systems (FIS Systems)
 
  The Company's Flat Panel Inspection (FIS) systems use the Company's
proprietary N-Aliasing(TM) technology to inspect virtually any type and size
of commercially available FPD panel for optical defects after the completion
of the second major stage of production, the construction of color cells
comprising individual pixels. FIS systems are also designed to perform
inspection after final module assembly of FPD panels. The systems use a single
high-resolution camera and workstation driven by the Company's N-Aliasing(TM)
software to quantitatively measure critical optical qualities such as
contrast, luminance and color balance and to precisely
 
                                       3
<PAGE>
 
locate mura, line, cluster and individual pixel defects. Test data generated
by the systems is displayed on a video monitor to provide immediate visual
interpretation and can be stored or sent to a repair system to effect repairs.
FIS systems comprise a family of products that offer different levels of
resolution and flexibility to suit customers needs. The FIS-250 and the FIS-
300 test FPD panels with VGA, SVGA and XGA resolution, respectively. They can
currently be configured to perform as many as 100 individual tests and are
adaptable to panel sizes ranging from 0.75 to 15 inches. The systems are
available either as stand-alone units or as modular systems designed to be
integrated with manufacturers' material handling equipment.
 
 Integrated Laser Weld System (ILWS(TM) System)
 
  The Company's Integrated Laser Weld (ILW(TM)) system uses a laser to repair
opens and shorts in AMLCD and passive LCD panels. The ILW(TM) can use defect
files downloaded from the Company's IPT or FIS systems to automatically locate
the defects in the panel so that the operator can decide whether or not to
repair them. This capability saves operator time searching for the defects
among the hundreds of thousands of pixels on a display. The ILW(TM) repairs
shorts by cutting away excess material and opens by welding a new connection
to a recovery ring. New model ILW(TM) systems shipped in 1996 featured unique
BeamBlender(TM) laser technology. The feature allows manufacturers to blend
two laser frequencies in certain ratios for cutting or welding new materials
used in low-temperature polysilicon thin-film transistors.
 
INTELLECTUAL PROPERTY
 
  The Company has been issued over 21 U.S. patents with respect to its FPD
test, inspection and repair technologies and has certain U.S. and foreign
applications pending. The Company has a number of U.S. patents related to its
Voltage Imaging(TM) technology and has applied for U.S., Japanese and Korean
patents related to this technology as well as its N-Aliasing(TM) technology.
No patents are scheduled to expire before 2010, subject to payment of
applicable maintenance fees. In addition, Photon Dynamics and IHI have jointly
filed patent applications in Japan relating to certain aspects of the IPT
systems.
 
  The Company frequently reviews its inventions and attempts to determine
which inventions will provide substantial differentiation between the
Company's products and those of its competitors. In certain cases, the Company
may also choose to keep an invention or a process as a trade secret. Trade
secrets are routinely employed in the Company's manufacturing processes. The
Company has entered into non-disclosure agreements to protect its proprietary
technology with its employees and consultants, and in some instances with its
suppliers, its customers and IHI. Because of rapid technological developments
in the electronics and FPD industries and the broad and rapidly developing
patent coverage in such industries, the patent position of any manufacturer,
including the Company, is subject to uncertainties and may involve complex
legal and factual issues. Consequently, although the Company holds certain
patents and is currently prosecuting additional patent applications, there can
be no assurance that patents will issue from any pending applications or that
claims allowed by any existing or future patents will issue from any pending
applications or that claims allowed by any existing or future patents issued
to the Company will not be challenged, invalidated, or circumvented, or that
any rights granted thereunder will provide adequate protection to the Company.
Furthermore, there can be no assurance that others will not develop
technologies that are similar or superior to the Company's technology,
duplicate the Company's technology or design around the patents owned by the
Company. In addition, effective copyright and trade secret protection may be
unavailable or limited in certain foreign countries. There can be no assurance
that the steps taken by the Company will prevent misappropriation of its
technology. In addition, litigation may be necessary in the future to enforce
the Company's patents and other intellectual property rights, to protect the
Company's trade secrets, to determine the validity and scope of the
proprietary rights of others or to defend against claims of infringement or
invalidity. Such litigation could result in substantial costs and diversion of
resources and could have a material adverse effect on the Company's results of
operations or financial condition. Moreover, the Company may be required to
participate in interference proceedings to determine the priority of
inventions, which also could result in substantial cost to the Company. See
"Factors That May Affect Future Results."
 
 
                                       4
<PAGE>
 
RESEARCH AND DEVELOPMENT
 
  The market for FPD test, inspection and repair systems is characterized by
rapid and continuous technological development and product innovation. The
Company believes that continued and timely development of new products and
enhancements to existing products is necessary to maintain its competitive
position. Accordingly, the Company devotes a significant portion of its
personnel and financial resources to research and development programs and
seeks to maintain close relationships with customers to remain responsive to
their product needs. Photon Dynamics' current research and development efforts
are directed to increasing the performance of its flat panel inspection and
test systems and expanding the application of its inspection systems for use
in other related markets. Because the software incorporated by the Company
into its products represents a significant portion of the value added by these
products, over one-third of the Company's research and development personnel
are focused on software development.
 
  The Company's research and development expenses were $4.0 million and $1.7
million in fiscal 1996 and fiscal 1995, respectively, or 16.1% and 9.1% of
revenue, respectively. Research and development expenses consist primarily of
salaries, project materials and other costs associated with the Company's
ongoing efforts. In addition to research and development expenses incurred for
product development, the Company spent $1.0 million in fiscal 1996 and $4.6
million in fiscal 1995 in performance of its obligations under development
contracts.
 
  The Company has obtained substantial development funding from IHI with
respect to the Company's IPT systems. IHI has provided funding for initial
feasibility studies and development of the first prototypes of the IPT
systems, and since 1990 IHI has provided to the Company in excess of $6.3
million in research and development funding with respect to the IPT systems.
At present, the Company and IHI are parties to a development agreement
pursuant to which IHI is providing up to $1.5 million to Photon Dynamics to
fund continuing development and improvement of the IPT-MPS systems. Under
these agreements IHI is granted certain licenses and joint ownership rights to
the developed technology, which rights are consistent with IHI's manufacturing
and sales rights under the Company's existing agreements with IHI.
 
  The Company has entered into contracts from the U.S. government and private
companies including IHI, to develop products which Photon Dynamics is then
able to sell with certain restrictions. Photon Dynamics generally owns all of
the intellectual property developed under these contracts, although the
Company has licensed certain rights to its IPT technology to the U.S.
government which may transfer its license to a third party for use in products
sold to U.S. customers in the event the Company becomes unable to delivery IPT
systems to U.S. customers.
 
CUSTOMERS, SALES AND SERVICE
 
  The Company sells its products to leading FPD manufacturers worldwide. Sales
to Sharp Corp. represented 5% and 25% of revenue in fiscal 1996 and fiscal
1995. Sales to LG Electronics, Inc represented 19% and 24% of revenue in
fiscal 1996 and fiscal 1995. Overall, the Company's top six customers
contributed 78% of revenue in fiscal 1996. International sales accounted for
88% and 63% of revenue in fiscal 1996 and 1995, respectively.
 
  Under its agreements with IHI, the Company has granted certain exclusive
sales rights to IHI with respect to its IPT systems, including the IPT-MPS,
for Japan, Korea and a number of other Asian countries. These exclusive rights
continue until June 1997 and may be renewed by IHI and the Company for
subsequent periods. In the event these exclusive sales and marketing rights of
IHI are not renewed, IHI will retain a non-exclusive right to manufacture and
sell IPT systems in the IHI territory. The sales and marketing provisions of
the Company's relationship with IHI provide that IHI is entitled to sell IPT
systems in Japan, Korea and the rest of the IHI territory and that the Company
will assist IHI in a sales agent capacity in exchange for a commission. At
present, IHI and Photon Dynamics share sales responsibility for Photon
Dynamics manufactured IPT systems in Japan, and Photon Dynamics is directly
selling all IPT systems outside Japan, which IHI has contractually agreed to
allow Photon Dynamics to do through December 31, 1996. IHI performs all
support and service for system
 
                                       5
<PAGE>
 
units in Japan, while Photon Dynamics provides support and service in the
balance of the IHI territory. To the extent IHI determines in the future to
exercise fully its contractual rights to manufacture and sell these systems
for the IHI territory, such action would reduce revenue of the Company
attributable to these IHI manufactured IPT systems and may have an adverse
effect on the Company's results of operations. In the event IHI should
determine to reduce its internal budgets, staffing levels, research and
development funding or other allocations of its resources for development,
manufacture, sale and support of IPT systems in its territory, such action by
IHI could have a material adverse effect on the Company's ability to compete
in these markets and on the Company's results of operations.
 
  The Company primarily sells its products directly to end users, other than
sales through IHI. Photon Dynamics believes that using a direct sales force
provides it with a significant competitive advantage as well as control over
pricing and customer satisfaction. In Taiwan, Photon Dynamics sells through a
direct sales force supported by an independent sales representative. In the
U.S., the Company sells direct. Sales in Europe are supported from the
Company's U.S. offices.
 
  In the U.S., the Company maintains its sales and service office at its
headquarters in San Jose, California. In Asia, the Company has subsidiaries in
Tokyo, Japan and Seoul, Korea that provide direct sales and service support.
The Asian sales and service operations are staffed by direct marketing, sales
and service personnel located in Japan and Korea. In addition, in Japan the
Company's IPT systems are serviced by IHI.
 
  The Company generally sells its products on net 30-day terms to its
customers, with a small portion held back until final acceptance. However, a
substantial portion of its customers, primarily foreign, remit payments on
significantly longer terms. The Company generally warrants its products for a
period of one year from acceptance by customers within 30 days of installation
for material and labor to repair the product. Installation is generally
included in the price of the product. The Company's field engineers provide
customers with repair and maintenance services. Customers may enter into
repair and maintenance service contracts covering the Company's products. The
Company provides customer training for a fee to enable its customers to
perform routine service and provides telephone consultation services generally
free of charge. The Company does not consider its business to be seasonal in
nature, but it may become cyclical with respect to the capital equipment
procurement practices of major FPD manufacturers.
 
MANUFACTURING AND SUPPLIERS
 
  The Company's principal manufacturing activities take place in San Jose,
California and consist primarily of assembling and testing components and
subassemblies which are acquired from third party vendors and then integrated
into Photon Dynamics finished products. Certain of the components and
subassemblies included in the Company's systems are obtained from a single
source or a limited group of suppliers. For example, the Company has obtained
all of the high speed image processing systems, materials handling platforms
and ultra-high resolution cameras used in its products from single source
suppliers, including Kodak Corporation and Anorad Corporation. The Company has
not entered into any formal agreements with such suppliers, other than long
term purchase orders and, in some cases, volume pricing agreements. The
partial or complete loss of such suppliers could increase the Company's
manufacturing costs or delay product shipments while the Company qualifies a
new supplier, could require redesigning the Company's products and could
therefore have an adverse effect on the Company's results of operations and
damage customer relationships. Further, a significant increase in the price of
one or more of the components supplied by such suppliers could adversely
affect the Company's results of operations.
 
  The Company schedules production based upon firm customer commitments and
anticipated orders during the planning cycle. The Company generally expects to
be able to accept a customer order, build the required machinery and ship to
the customer within 16 weeks. Quality control is maintained through incoming
inspection of components, in-process inspection during equipment assembly and
final inspection and operation of all manufactured equipment prior to
shipment. The Company works in close collaboration with its employees,
customers and suppliers and trains all of its employees in basic quality
skills and regularly participates in quality
 
                                       6
<PAGE>
 
sharing meetings with other equipment manufacturers and customer quality
audits of procedures and personnel. The Company conducts final testing of its
systems and assembles certain components under limited clean room conditions,
but most manufacturing is done in standard manufacturing space. The Company
believes that additional manufacturing space to respond to higher demand is
therefore readily available.
 
  The Company has granted certain exclusive rights to IHI to manufacture IPT
systems, including the IPT-MPS, for Japan, Korea and the rest of the IHI
territory. Under the terms of the Company's agreements with IHI, Photon
Dynamics retains the right to manufacture certain critical components for the
IPT systems and to sell these components to IHI at prices that are established
annually, and IHI has the right to manufacture and assemble the balance of the
IPT systems to be sold in its territories. To date, IHI has allowed Photon
Dynamics to manufacture all IPT systems for IHI, which has acted as a
distributor in Japan and performed customization of the IPT systems for the
Japanese market and its individual customers in that market. To the extent IHI
determines in the future to exercise fully its contractual right to
manufacture and sell these systems for the IHI territory, such action would
reduce revenue of the Company attributable to these IHI manufactured IPT
systems and may have a material adverse effect on the Company's results of
operations.
 
BACKLOG
 
  As of September 30, 1996, the Company's backlog was approximately $4.9
million as compared to approximately $5.4 million as of September 30, 1995. In
addition, approximately 82% of the Company's backlog at fiscal 1996 year-end
was comprised of orders from three customers. The Company's backlog consists
of those customer orders for which it has accepted purchase orders and
assigned shipment dates within the next 12 months. All orders are subject to
delay or cancellation with limited or no penalty. Because of possible changes
in product delivery schedules and cancellation of product orders, because
orders received by the Company in any particular quarter may vary
significantly and because the Company's sales will often reflect orders
shipped in the same quarter they are received, the Company's backlog may vary
significantly and at any particular date is not necessarily indicative of
actual sales for any succeeding period.
 
COMPETITION
 
  The FPD equipment industry is highly competitive. The Company faces the
prospect of substantial future competition from established companies, some of
which are expected to be larger companies, or parts thereof, some of which are
expected to have greater financial, engineering and manufacturing resources
than the Company and some of which are expected to have larger service
organizations and long-standing customer relationships with major FPD
manufacturers. In the event that the Company's agreements with IHI are not
extended in 1997, IHI may compete with the Company selling the Company's IPT
systems in Japan, Korea and the rest of the IHI territory. The Company also
expects it may face additional competition from new entrants into the FPD
equipment industry and from competitors utilizing new technologies. The
Company's competitors can be expected to continue to improve the design and
performance of their products and to introduce new products with competitive
price/performance characteristics. In addition, the Company's customers may
choose to develop proprietary technology and FPD equipment which may obviate
or lessen their need to purchase the Company's products. The Company's
customers may also use multiple technologies and solutions, including
competitors' products, to replicate the functionality of the Company's
systems. Competitive pressures may necessitate price reductions which could
adversely affect the Company's results of operations. Although the Company
believes that it has certain technological and other advantages over its
competitors, realizing and maintaining such advantages will require a
continued high level of investment by the Company in engineering, research and
development, marketing and customer service and support. There can be no
assurance that the Company will have sufficient resources to continue to make
such investments or that the Company will be able to make the technological
advances necessary to maintain such competitive advantages.
 
                                       7
<PAGE>
 
EMPLOYEES
 
  As of September 30, 1996, the Company employed 104 persons, all full time.
Many of the Company's employees are highly skilled, and the Company's success
will depend in part upon its ability to attract and retain such employees, who
are in great demand. The Company has never had a work stoppage or strike and
no employees are represented by a labor union or covered by a collective
bargaining agreement. The Company considers its employee relations to be good.
 
                    FACTORS THAT MAY AFFECT FUTURE RESULTS
 
FACTORS AFFECTING EARNINGS AND STOCK PRICE
 
  The statements contained in this report on Form 10-KSB that are not purely
historical are forward looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934, including statements regarding the Company's expectations, hopes,
intentions or strategies regarding the future. All forward looking statements
included in this document are based on information available to the Company on
the date hereof, and the Company assumes no obligation to update any such
forward looking statements. It is important to note that the Company's actual
results could differ materially from those in such forward looking statements.
You should consult the risk factors listed from time to time in the Company's
reports on Form 10-QSB, and annual reports to shareholders. Among the factors
that could cause actual results to differ materially are the following risk
factors:
 
VARIABILITY OF QUARTERLY RESULTS OF OPERATIONS; LIMITED HISTORY OF
PROFITABILITY
 
  The Company has experienced and expects to continue to experience
significant fluctuations in its quarterly results of operations. The Company
derives substantially all of its revenue from the sale of a relatively small
number of systems, which typically range in price from $400,000 to $1,500,000.
As a result, the timing of the sale of a single system could have a
significant impact on the Company's quarterly revenue and results of
operations. The failure to receive anticipated orders or delays in shipments
in a particular quarter, due, for example, to unanticipated shipment
reschedulings, cancellations by customers or unexpected manufacturing
difficulties, may cause revenue for that quarter to fall significantly below
the Company's expectations, which would have a material adverse effect on the
Company's results of operations for such quarter. The Company's backlog at the
beginning of each quarter is not necessarily indicative of actual sales for
any succeeding period. All orders are subject to delay or cancellation with
limited or no penalty. The Company's sales will often reflect orders shipped
in the same quarter that they are received. Other factors which may have an
influence on the Company's results of operations in a particular quarter
include the volume, mix and timing of the receipt of orders from major
customers, competitive pricing pressures, costs of components and subsystems,
the Company's ability to design, manufacture and introduce new products on a
cost effective and timely basis, the delay between incurrence of expenses to
further develop marketing and service capabilities and realization of benefits
from such improved capabilities, fluctuations in foreign exchange rates, the
timing of recognition of revenue under development contracts, the introduction
and announcement of new products by the Company's competitors and changing
conditions in the FPD ( "Flat Panel Display")market worldwide. In particular,
due to substantial differences in gross margin for the Company's products,
changes in the mix of products sold could result in substantial fluctuations
in the Company's gross margin. Accordingly, the Company's results of
operations are subject to significant variability from quarter to quarter.
 
DEPENDENCE ON RECENTLY INTRODUCED AND NEW PRODUCTS
 
  The markets for the Company's products are characterized by rapidly changing
technologies, extensive research and new product introductions. The Company
believes that its future success will depend in part upon its ability to
continue to enhance its existing products and to develop and manufacture new
products. As a result, the Company expects to continue to make a significant
investment in engineering, research and development. There can be no assurance
that the Company will be successful in the introduction, marketing and cost
effective
 
                                       8
<PAGE>
 
manufacture of any of its new or recently introduced products or that the
Company will be able to develop and introduce new products or enhancements to
its existing products and processes in a timely manner which satisfy customer
needs, achieve market acceptance or address technological changes in the FPD
industry. In order to develop new products successfully, the Company is
dependent upon close relationships with its customers and the willingness of
those customers to share information with the Company. The failure to develop
products and introduce them successfully and in a timely manner could
adversely affect the Company's competitive position and results of operations.
The Company's future results of operations are highly dependent on the
continuing market introduction, marketing and cost-effective manufacture of
its In-Process Test Mass Production System (IPT-MPS), which first shipped in
September 1995. The Company continues to perform research and development work
with respect to the IPT-MPS system to attain additional throughput levels
requested by the Company's customers and other performance parameters sought
by manufacturers of active matrix liquid crystal displays ("AMLCDs") for their
volume production environments. The Company has experienced delays in
implementing the software necessary to achieve throughput rates. No assurance
can be given that development efforts related to other performance parameters
will be successful. The Company believes that future orders of IPT-MPS systems
will be dependent on its ability to attain requested throughput levels and
other performance parameters. The Company has experienced delays in obtaining
final acceptance and final payment on some products. If products have
performance, reliability or quality problems or shortcomings, then the Company
may experience reduced orders, higher manufacturing costs, continued delays in
collecting accounts receivable and additional warranty and service expenses
which may have an adverse effect on the Company's results of operations. In
addition, future growth in sales of the Company's products will depend upon
the acceptance of the Company's IPT or FIS technologies by a broader group of
customers, including additional international customers and FPD manufacturers
who currently do not perform the type of FPD test or inspection offered by the
Company's products or utilize alternative technologies for, or methods of,
inspection, such as "open/short" testing and human visual inspection. Because
of the large capital commitment involved in the construction and operation of
an FPD manufacturing facility, the decision by an FPD manufacturer to purchase
the Company's IPT or FIS systems involves a significant technological and
financial commitment as compared to current alternatives such as human
inspection and open/short testers. While the Company is actively promoting the
acceptance of these technologies, there can be no assurance that the Company
will be successful in obtaining broader acceptance of its IPT or FIS
technologies. Failure to achieve broader acceptance would have an adverse
effect on the Company's results of operations.
 
DEPENDENCE ON PRINCIPAL CUSTOMERS
 
  The FPD industry is extremely concentrated, with virtually all major FPD
manufacturers and many of the Company's principal customers located in Asia.
Although the composition of the Company's largest customers has changed from
year to year, direct sales to the Company's top six in fiscal 1996 and top
four in fiscal 1995 end user customers accounted for approximately 78% and
71%, respectively, of the Company's total revenue. The Company currently has
no long-term purchase commitments with any of its customers and sales are
generally made pursuant to purchase orders. All orders are subject to delay or
cancellation with limited or no penalty. A reduction, delay, or cancellation
of orders from one or more of its significant customers, or the loss of one or
more of such customers, could have a material adverse effect on the Company's
results of operations.
 
DEPENDENCE ON SINGLE OR LIMITED SUPPLIERS
 
  Certain of the components and subassemblies included in the Company's
systems are obtained from a single source or a limited group of suppliers. For
example, the Company has obtained all of the high speed image processing
systems, materials handling platforms and ultra-high resolution cameras used
in its products from single source suppliers, including Kodak Corporation and
Anorad Corporation. The Company has not entered into any formal agreements
with such suppliers, other than long term purchase orders and, in some cases,
volume pricing agreements. The partial or complete loss of such suppliers
could increase the Company's manufacturing costs or delay product shipments
while the Company qualifies a new supplier, could require redesigning the
 
                                       9
<PAGE>
 
Company's products and could therefore have an adverse effect on the Company's
results of operations and damage customer relationships. Further, a
significant increase in the price of one or more of the components supplied by
such suppliers could adversely affect the Company's results of operations.
 
RELATIONSHIP WITH IHI
 
  The Company has granted certain exclusive manufacturing and sales rights to
Ishikawajima-Harima Heavy Industries Co., Ltd. ("IHI") with respect to its IPT
systems, including the IPT-MPS, for Japan, Korea, a number of other Asian
countries, Saudi Arabia, Australia, New Zealand, India and Sri Lanka. Under
the terms of this relationship the Company reserves the rights to manufacture
certain critical components and to sell the components to IHI for inclusion in
IPT systems to be sold by IHI in its territory. The agreements between IHI and
the Company further provide for the Company to assist IHI in its sales efforts
in these countries in exchange for a commission. This relationship continues
on an exclusive basis for the IHI territory until June 1997, and, if such
exclusivity is not renewed, IHI will have non-exclusive manufacturing and
sales rights in its territory in periods thereafter. In exchange for these
rights, IHI has provided and continues to provide significant funding for
development of the IPT systems, which funding substantially enhanced the
Company's ability to complete development of these systems in a timely
fashion. To date, IHI has allowed Photon to manufacture all IPT systems sold
by IHI in the IHI territory, and the Company expects that many, if not all, of
the IPT systems that will be sold in IHI's territory will be manufactured by
the Company. At present, IHI and Photon share sales responsibility for Photon
manufactured IPT systems in Japan, and IHI has agreed to allow Photon to sell
directly all IPT systems outside Japan through December 31, 1996. IHI performs
all support and service for system units in Japan, while Photon provides
support and service in the balance of the IHI territory. To the extent IHI
determines in the future to exercise fully its contractual rights to
manufacture and sell these systems in the IHI territory, such action would
reduce revenue of the Company attributable to these IHI manufactured IPT
systems and may have a material adverse effect on the Company's results of
operations. Given the concentration of FPD manufacturers in the IHI territory,
the Company is highly dependent on IHI and the success of the Company's
relationship with IHI to market and sell the IPT systems, including the IPT-
MPS, in these critical markets. In the event IHI should determine to reduce
its internal budgets, staffing levels, research and development funding or
other allocations of its resources for the development, manufacture, sale and
support of IPT systems in its territory, such action by IHI could have a
material adverse effect on the Company's ability to compete in these markets
and on the Company's results of operations. While the Company believes that
both it and IHI have obtained significant mutual benefit from their continuing
relationship, no assurance can be given that the IHI relationship will
continue to provide such benefits to the Company or that the Company's results
of operations will not be adversely impacted in the future based on its
dependency on IHI for the manufacture, sales and support of IPT systems in
Japan and other important Asian markets in the IHI territory.
 
INTERNATIONAL OPERATIONS
 
  Approximately 88% of the Company's total revenue for fiscal 1996 was
attributable to sales outside the U.S. The Company expects that international
sales will continue to represent a significant portion of its total sales.
Sales to customers outside the U.S. are subject to risks, including the
imposition of governmental controls, the need to comply with a wide variety of
foreign and U.S. export laws, political and economic instability, trade
restrictions, changes in tariffs and taxes, longer payment cycles typically
associated with international sales, and the greater difficulty of
administering business overseas as well as general economic conditions.
Although substantially all of the Company's direct international sales are
denominated in U.S. dollars, both direct sales by the Company and sales
through IHI may be affected by changes in demand resulting from fluctuations
in interest and currency exchange rates. To the extent the Company's sales are
denominated in foreign currency, the Company's revenue and results of
operations may also be directly affected by fluctuations in foreign currency
exchange rates. Furthermore, although the Company endeavors to meet technical
standards established by foreign regulatory bodies, there can be no assurance
that the Company will be able to comply with changes in foreign standards in
the future. The inability of the Company to design products to comply with
foreign standards could have a material adverse effect on the Company. In
addition, the laws of certain foreign countries may not protect the Company's
intellectual property to the same extent as do the laws of the U.S.
 
                                      10
<PAGE>
 
DEPENDENCE ON JAPANESE MARKET
 
  The future performance of the Company will be dependent, in part, upon its
ability to continue to compete successfully in the Japanese market, one of the
largest markets for FPD test, inspection and repair equipment. The Company's
ability to compete in this market in the future is dependent upon continuing
free trade between Japan and the U.S., the continuing ability of the Company
to develop products in a timely manner that meet the technical requirements of
its Japanese customers and the continuing ability of the Company to maintain
satisfactory relationships with leading companies in the Japanese FPD
industry. The Company believes that the Japanese companies with which it
competes may have a competitive advantage in Japan because of the preference
of some Japanese customers for Japanese equipment suppliers because such
customers may have longer standing or closer business relationships with such
competitors. The Company's sales to Japan and results of operations will also
be affected by the overall health of the Japanese economy, including the
effects of currency exchange rate fluctuations on the global competitiveness
of Japanese FPD manufacturers.
 
RAPID AND FUNDAMENTAL TECHNOLOGICAL CHANGE
 
  The FPD industry is an evolving industry characterized by extensive research
and development which has and is expected to continue to lead to rapid
technological change. The development by others of new or improved products or
technologies may make the Company's current or proposed products obsolete or
less competitive. Although the Company devotes significant efforts and
financial resources to further develop and enhance its existing products,
there can be no assurance that advances in other or alternative technologies
will not make the Company's products obsolete or less competitive. Currently,
the predominant technology used in the FPD industry is liquid crystal display
("LCD") technology. Although the Company has installed its products or has
entered into discussions with manufacturers utilizing virtually all of the
alternative FPD technologies which the Company believes are commercially
viable FPD technologies, its revenue is derived primarily from sales of
products related to a variant of LCD technology used in a substantial portion
of all FPDs, AMLCD technology. An industry shift away from AMLCD technology or
the emergence of new competing technologies could have a material adverse
effect on the Company's business and results of operations.
 
COMPETITION
 
  The FPD equipment industry is highly competitive. The Company faces the
prospect of substantial future competition from established companies, some of
which are expected to be larger companies, or parts thereof, some of which are
expected to have greater financial, engineering and manufacturing resources
than the Company and some of which are expected to have larger sales and
service organizations and long-standing customer relationships with major FPD
manufacturers. In the event that the Company's agreements with IHI are not
extended in 1997, IHI may compete with the Company in selling the Company's
IPT systems in Japan, Korea and the rest of the IHI territory. The Company
also expects it may face additional competition from new entrants into the FPD
equipment industry and from competitors utilizing new technologies. The
Company's competitors can be expected to continue to improve the design and
performance of their products and to introduce new products with competitive
price/performance characteristics. In addition, the Company's customers may
choose to develop proprietary technology and FPD equipment which may obviate
or lessen their need to purchase the Company's products. The Company's
customers may also use multiple technologies and solutions, including
competitors' products, to provide the functionality of the Company's systems.
Competitive pressures may necessitate price reductions which could adversely
affect the Company's results of operations. Although the Company believes that
it has certain technological and other advantages over its competitors,
realizing and maintaining such advantages will require a continued high level
of investment by the Company in engineering, research and development,
marketing and customer service and support. There can be no assurance that the
Company will have sufficient resources to continue to make such investments or
that the Company will be able to make the technological advances necessary to
maintain such competitive advantages.
 
                                      11
<PAGE>
 
FLAT PANEL DISPLAY INDUSTRY DOWNTURNS OR SLOWDOWNS
 
  The Company's business depends in large part upon the capital equipment
expenditures of FPD manufacturers, which in turn depend on the current and
anticipated market demand for FPDs and products utilizing FPDs. For example,
the Company believes that historical shortages of supplies of semiconductor
components may have in the past temporarily limited the quantities of laptop
computers that were manufactured, which in turn may have reduced demand from
laptop computer manufacturers for certain FPDs. Should these conditions have
continued for an extended period, the resulting reduced long-term demand for
FPDs suitable for laptop computers could adversely affect the level of capital
expenditure by FPD manufacturers. Although to date the FPD industry has had a
relatively steady growth rate, the FPD industry may, like the semiconductor
industry, become highly cyclical and experience periodic downturns or
slowdowns in growth, which may have a material adverse effect on capital
equipment expenditures by FPD manufacturers and in turn adversely affect the
Company's results of operations. No assurance can be given that the Company's
results of operations would not be adversely affected if such downturns or
slowdowns in the FPD industry were to occur in the future. In addition, the
need for continued investment in engineering, research and development and
marketing required to penetrate targeted foreign markets and maintenance of
extensive worldwide customer service and support capabilities will limit the
Company's ability to reduce expenses during downturns or slowdowns in growth
in the FPD industry.
 
PATENTS AND PROPRIETARY RIGHTS
 
  The Company's future success and competitive position are dependent in part
upon its proprietary technology, and the Company relies on patent, trade
secret, trademark and copyright law to protect its intellectual property.
There can be no assurance that any patent owned or licensed by the Company
will not be invalidated, circumvented, challenged or licensed to others, that
the rights granted thereunder will provide competitive advantages to the
Company or that any of the Company's pending or future patent applications
will be issued with the scope of the claims sought by the Company, if at all.
Furthermore, there can be no assurance that others will not develop
technologies that are similar or superior to the Company's technology,
duplicate the Company's technology or design around the patents owned by the
Company. In addition, effective copyright and trade secret protection may be
unavailable or limited in certain foreign countries. There can be no assurance
that the steps taken by the Company will prevent misappropriation of its
technology. In addition, litigation may be necessary in the future to enforce
the Company's patents and other intellectual property rights, to protect the
Company's trade secrets, to determine the validity and scope of the
proprietary rights of others or to defend against claims of infringement or
invalidity. Such litigation could result in substantial costs and diversion of
resources and could have a material adverse effect on the Company's results of
operations.
 
  Competitors in both the U.S. and foreign countries, many of which have
substantially greater resources and have made substantial investments in
competing technologies, may have applied for or obtained, or may in the future
apply for and obtain, patents that will prevent, limit or interfere with the
Company's ability to manufacture and sell its products. The Company has not
conducted an independent review of patents issued to third parties. Although
the Company believes that its products do not infringe the patents or other
proprietary rights of third parties, there can be no assurance that other
third parties will not assert infringement claims against the Company or that
such claims will not be successful. Even successful defense of patent suits
are both costly and time-consuming. An adverse outcome in the defense of a
patent suit could subject the Company to significant liabilities to third
parties, require disputed rights to be licensed from third parties or require
the Company to cease selling its products.
 
MANAGEMENT OF GROWTH
 
  The Company has recently experienced and may continue to experience growth
in the number of its employees and the scope of its operations, resulting in
increased responsibilities for management personnel. To manage recent and
potential future growth effectively, the Company will need to continue to
implement and improve its operational, financial and management information
systems and to hire, train, motivate and manage
 
                                      12
<PAGE>
 
a growing number of employees. The future success of the Company also will
depend on its ability to attract and retain qualified technical, marketing and
management personnel, particularly highly skilled software engineers, for whom
competition is intense. In particular, the current availability of qualified
engineers is limited, and competition among companies for skilled and
experienced engineering personnel is very strong. The Company is currently
attempting to hire a number of engineering personnel and has experienced
delays in filling such positions. The Company expects to experience continued
difficulty in filling its needs for qualified engineers and other personnel.
There can be no assurance that the Company will be able to achieve or manage
effectively any such growth, and failure to do so could delay product
development cycles or otherwise have a material adverse effect on the
Company's results of operations.
 
DEPENDENCE ON KEY EMPLOYEES
 
  The future success of the Company is dependent, in part, on its ability to
retain certain key personnel. The Company also needs to attract additional
skilled personnel in all areas of its business to continue to grow. While many
of the Company's current employees have many years of service with the
Company, there can be no assurance that the Company will be able to retain its
existing personnel or attract additional qualified employees in the future.
 
POSSIBLE VOLATILITY OF COMMON STOCK PRICE
 
  Many factors such as, but not limited to, announcements of technological
innovations or new products by the Company, its competitors or third parties,
as well as quarterly variations in the Company's actual or anticipated results
of operations, may cause the market price of the Company's Common Stock to
fluctuate significantly. Furthermore, the stock market has experienced extreme
price and volume fluctuations, which have particularly affected the market
prices of many high technology companies and which have often been unrelated
to the operating performance of such companies. These broad market
fluctuations may adversely affect the market price of the Company's Common
Stock.
 
ITEM 2: DESCRIPTION OF PROPERTY.
 
  The Company's main headquarters, located in San Jose, California consists of
a 50,000 square foot facility. The current monthly base rental under the lease
for the facility is approximately $49,000. The lease expires in 2001. The
Company also leases office space for its sales and service operations in
Seoul, Korea and Tokyo, Japan.
 
ITEM 3: LEGAL PROCEEDINGS.
 
  The Company is not a party to any material litigation.
 
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
  No matters were submitted to a vote of security holders during the fourth
quarter ended September 30, 1996.
 
                                      13
<PAGE>
 
                                    PART II
 
ITEM 5: MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
 
  The information required by this Item is incorporated by reference from page
24 of the Company's 1996 Annual Report to Stockholders.
 
ITEM 6: MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
 
  The information required by this Item is incorporated by reference from
pages 6-10 of the Company's 1996 Annual Report to Stockholders.
 
ITEM 7: FINANCIAL STATEMENTS.
 
  The information required by this Item is incorporated by reference from
pages 11-22 of the Company's 1996 Annual Report to Stockholders.
 
ITEM 8: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
    AND FINANCIAL DISCLOSURE.
 
  Not applicable
 
                                      14
<PAGE>
 
                                   PART III
 
  Certain information required by Part III is omitted from this Report in that
the Registrant will file a definitive proxy statement within 120 days after
the end of its fiscal year pursuant to Regulation 14A (the "Proxy Statement")
for its 1997 Annual Meeting of Stockholders to be held February 12, 1997 and
the information included therein is incorporated herein by reference.
 
ITEM 9: DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
        COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.
 
  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1997 Annual Meeting of Stockholders under
the Heading "Management
 
ITEM 10: EXECUTIVE COMPENSATION.
 
  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1997 Annual Meeting of Stockholders under
the Heading "Management
 
ITEM 11: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
 
  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1997 Annual Meeting of Stockholders under
the Heading "Security Ownership Of Certain Beneficial Owners And Management"
 
ITEM 12: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
 
  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1997 Annual Meeting of Stockholders under
the Heading "Certain Relationships And Related Transactions"
 
ITEM 13: EXHIBITS AND REPORTS ON FORM 8-K.
 
  (a) The following documents are filed as part of this Form 10-KSB Report:
 
      (1) Financial Statements
 
      (2) Exhibits: See index to Exhibits. The Exhibits listed in the
          accompanying Index to Exhibits are filed as incorporated by
          references as part of this report.
 
  (b) Reports on Form 8-K. No reports on Form 8-K were filed during the
      fourth quarter of 1996.
 
                                      15
<PAGE>
 
                                  SIGNATURES
 
  In accordance with Section 13 or 15(d) of the Securities and Exchange Act of
1932 as amended (the "Exchange Act"), the registrant caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
 
                                       PHOTON DYNAMICS, INC.
 
Date: December 30, 1996                /s/ Vincent Sollitto
                                       ---------------------------------------
                                       Vincent Sollitto
                                       Chief Executive Officer and Director
                                       (Principal Executive Officer)
 
  KNOW ALL PERSONS BY THESE PRESENTS, THAT EACH PERSON WHOSE SIGNATURE APPEARS
BELOW CONSTITUTES AND APPOINTS VINCENT F. SOLLITTO JR. AND HOWARD M. BAILEY,
AND EACH OF THEM, ACTING INDIVIDUALLY, AS HIS OR HER ATTORNEY-IN-FACT, EACH
WITH FULL POWER OF SUBSTITUTION AND RESUBSTITUTION, FOR HIM AND IN HIS NAME,
PLACE AND STEAD, IN ANY AND ALL CAPACITIES, TO SIGN ANY AND ALL AMENDMENTS TO
THIS ANNUAL REPORT ON FORM 10-KSB, AND TO FILE THE SAME, WITH ALL EXHIBITS
THERETO, AND OTHER DOCUMENTS IN CONNECTION THEREWITH, WITH THE SECURITIES AND
EXCHANGE COMMISSION, GRANTING UNTO SAID ATTORNEYS-IN-FACT AND AGENTS, AND EACH
OF THEM, FULL POWER AND AUTHORITY TO DO AND PERFORM EACH AND EVERY ACT AND
THING REQUISITE AND NECESSARY TO BE DONE IN CONNECTION THEREWITH AND ABOUT THE
PREMISES, AS FULLY TO ALL INTENTS AND PURPOSES AS HE MIGHT OR COULD DO IN
PERSON, HEREBY RATIFYING AND CONFIRMING ALL THAT SAID ATTORNEYS-IN-FACT AND
AGENTS, OR ANY OF THEM, OR THEIR OR HIS SUBSTITUTE OR SUBSTITUTES, MAY
LAWFULLY DO OR CAUSE TO BE DONE BY VIRTUE HEREOF.
 
  PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1932, THIS ANNUAL
REPORT ON FORM 10-KSB HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED:
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Chief Executive Officer and          /s/ Vincent Sollitto
                   Director (Principal Executive   _________________________________
                   Officer)                                 Vincent Sollitto
</TABLE>
 
 
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Chief Financial Officer and            /s/ Howard Bailey
                   Secretary (Principal Financial  _________________________________
                   and Accounting Officer)                   Howard Bailey
</TABLE>
 
 
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Chief Technical Officer,              /s/ Francois Henley
                   Director                        _________________________________
                                                            Francois Henley
</TABLE>
 
 
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Chairman of the Board                 /s/ E. Floyd Kvamme
                                                   _________________________________
                                                            E. Floyd Kvamme
</TABLE>
 
 
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Director                                 /s/ Barry Cox
                                                   _________________________________
                                                               Barry Cox
</TABLE>
 
 
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Director                                /s/ Michael Kim
                                                   _________________________________
                                                              Michael Kim
</TABLE>
 
 
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Director                          /s/ Dr. Malcolm J. Thompson
                                                   _________________________________
                                                        Dr. Malcolm J. Thompson
</TABLE>
 
 
 
<TABLE>
<S>                <C>                             <C>
December 30, 1996  Director                               /s/ Steve Krausz
                                                   _________________________________
                                                              Steve Krausz
</TABLE>
 
                                      16
<PAGE>
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
 NUMBER                           EXHIBIT                             REFERENCE
 ------                           -------                             ---------
 <C>    <S>                                                           <C>
 3.1    Form of Amended and Restated Articles of Incorporation of        A
        the Registrant.
 3.2    Bylaws of the Registrant and amendments thereto.                 A
 4.1    Reference is made to Exhibits 3.1 and 3.2.                       A
 10.1   First Amended and Restated Investor Rights Agreement             A
        between Registrant and the shareholders set forth therein
        dated May 11, 1994.
 l0.2   Fourth Amended Shareholders Agreement for Photon Dynamics,       A
        Inc. between the Registrant and the shareholders set forth
        therein dated May 11, 1994.
 10.3   Form of Indemnification Agreement between the Registrant         A
        and each of its executive officers and directors.
 10.4   1987 Stock Option Plan and Form of Stock Option Agreement.       A,B
 10.5   1995 Stock Option Plan and Forms of Stock Option                 A,B
        Agreements.
 10.6   1995 Employee Stock Purchase Plan.                               A,B
 10.7   Lease agreement between Berg & Berg Developers and Photon
        Dynamics, Inc. Dated August 6, 1996.
 10.8   Sales Agent Agreement between the Registrant, K.K. Photon        A
        Dynamics and Ishikawajima-Harima Heavy Industries Co., Ltd.
        dated June 1, 1992, the amendment thereto dated November
        17, 1993 and the modification agreement related thereto
        dated January 1, 1995.
 10.9   License Agreement between the Registrant and Ishikawajima-       A
        Harima Heavy Industries Co., Ltd. dated June 1, 1992 and
        the addendum thereto dated November 11, 1993.
 10.10  Commercialization Agreement between the Registrant and           A
        Ishikawaima-Harima Heavy Industries Co., Ltd. dated June 1,
        1992 and the amendment thereto dated November 17, 1993.
 10.11  Form of Agreements Regarding Change of Control between the       A,B
        Registrant and each of Francois J. Henley, Howard M.
        Bailey, Jeffrey Hawthome and Alan Nolet.
 10.12  Agreement Regarding Change of Control between the
        Registrant Donald Jerome dated July 1, 1996.
 10.13  Form of Amendment to First Amended and Restated Investor         A
        Rights Agreement.
 10.14  Agreement Regarding Change of Control between the
        Registrant and Vincent Sollitto dated July 1, 1996.
 11.1   Statement re: computation of earnings per share.
 13.1   Registrants Annual Report to Stockholders for the year
        ended September 30, 1996 (only such portions as necessary
        to satisfy Form 10-KSB requirements).
 2l.1   Subsidiaries of the Registrant.
 23.1   Consent of Ernst & Young LLP, Independent Auditors
 27.1   Financial Data Schedules
 Key to Exhibits:
 (A)    Incorporated by reference to Registrants' Registration
        Statement on Form SB-2 filed with the Securities and
        Exchange Commission on November 15, 1995
 (B)    Management contract or compensatory plan or arrangements
        required to filed as an exhibit to this report on Form 10-
        KSB pursuant to Item 13(a)
        of this report.
</TABLE>