<PAGE>
 
               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 (the "Exchange Act") for the fiscal year ended
     September 30, 1998.
 
  [_]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)
 
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<S>                                            <C>
                 CALIFORNIA                                      94-3007502
       (State or other jurisdiction of              (I.R.S. Employer Identification No.)
       incorporation or organization)
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                            6325 SAN IGNACIO AVENUE
                              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 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.  [X]
 
Revenue for the year ended September 30, 1998 was $22,420,000.
 
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 9,
1998, as reported on the Nasdaq National Market, was approximately
$23,063,169. 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 9, 1998 the Registrant had outstanding 7,425,415 shares of
Common Stock.
 
Transitional Small Business Disclosure Format (check one)  Yes [_]  No [X]
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the registrant's Proxy Statement for its 1999 Annual Meeting of
Shareholders are incorporated by reference in Part III of this Form 10-KSB
report.
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                             PHOTON DYNAMICS, INC.
 
                          ANNUAL REPORT ON FORM 10-KSB
 
                               TABLE OF CONTENTS
 
                               SEPTEMBER 30, 1998
 
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NO.                                                                                               PAGE
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                                     PART I
 
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Item 1.   Business...............................................................................   3
Item 2.   Properties.............................................................................  15
Item 3.   Legal Proceedings......................................................................  15
Item 4.   Submission of Matters to a Vote of Security Holders....................................  15
 
                                    PART II
 
Item 5.   Market for the Registrant's Common Equity and Related Stockholder Matters..............  16
Item 6.   Management's Discussion and Analysis of Financial Condition and Results of Operations..  18
Item 7.   Consolidated Financial Statements and Supplementary Data...............................  23
Item 8.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...  36
 
                                    PART III
 
Item 9.   Directors and Officers of the Registrant...............................................  37
Item 10.  Executive Compensation.................................................................  38
Item 11.  Security Ownership of Certain Beneficial Owners and Management.........................  38
Item 12.  Certain Relationships and Related Transactions.........................................  38
Item 13.  Exhibits, Financial Statement Schedules and Reports on Form 8-K........................  38
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  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 those discussed under
"Factors That May Affect Future Results" and elsewhere in this Form 10-KSB.
 
                                    PART I
 
ITEM 1: DESCRIPTION OF BUSINESS
 
THE COMPANY
 
  Photon Dynamics, Inc. ("Photon Dynamics" or the "Company") is a leading
worldwide supplier of array 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 array test and inspection of FPDs goes beyond the need to improve yields
as FPD manufacturers seek to identify defects early in the manufacturing
process either to 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 array
test, inspect and repair more VGA and other higher resolution FPDs than any
other currently available competitive system. The Company believes that the
experience it has acquired from the wide use of its systems has enabled it to
become a leading technical innovator of array test, inspection and repair
equipment for advanced FPD manufacturers.
 
  Photon Dynamics offers a suite of products to inspect almost all current
types of commercially produced 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 through commercial production. The
Company's array test products include test systems that locate, count and
characterize electrical array faults, contamination and other defects on
partially completed flat panel display substrates. Its inspection products
perform flat panel cell and module inspection to detect and locate optical
defects in FPDs. The Company's repair product performs array laser cut and
weld repair functions based upon information generated by its array test and
inspection products. 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 enable FPD
manufacturers 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
almost 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, SVGA, XGA and SXGA displays and are designed for use with
next generation UXGA displays.
 
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INDUSTRY BACKGROUND
 
 Overview of Flat Panel Display Market
 
  The market for FPDs has grown significantly in recent years as the result of
the increasing popularity of portable computers and other electronic devices
that display textual or graphical information. The weight and thin form factor
of FPDs enable new display applications not supported by the previously
predominant monitor technology, cathode ray tubes ("CRTs"). Laptop and
notebook computers, personal digital assistants, portable video games, digital
phones and a variety of devices for the automotive, technical, medical and
military markets are examples of electronic products in fast growing markets
which cannot be served by CRT technology.
 
  Different applications for FPDs have varying cost, size and performance
requirements, and alternative FPD technologies have been developed to address
these different applications. Different types of FPDs that are currently being
produced to address certain segments in the broader FPD market include liquid
crystal ("LCD"), plasma ("PDP"), electroluminescent ("EL"), field emissive
displays ("FED"), organic light emitting diode ("OLED"), digital micro-mirror
devices ("DMDs") and mini and micro displays utilizing liquid crystal on
silicon ("LCOS"). Currently the most common type of FPD is the LCD, which
first emerged in the form of watch and calculator displays in the 1970s. The
most advanced form of LCD available today is the thin-film transistor ("TFT")
AMLCD which utilizes three individual emissive transistors at each pixel,
enabling the AMLCD both to produce full color images and to operate at much
faster refresh rates than earlier passive monochrome LCDs. The color
capability, resolution, speed and picture quality of AMLCDs currently make
these displays a preferred choice for high performance portable computers,
multimedia and other applications requiring the display of video and graphics.
The trend toward higher resolution video and graphic displays has been
reflected in the evolution from VGA displays (640 x 480 lines of resolution)
to SVGA displays (800 x 600 lines of resolution) to XGA displays (1,024 x 768
lines of resolution) which in turn are being replaced by next-generation SXGA
displays (1,280 x 1,024 lines of resolution) and soon UXGA displays (1,600 x
1,200 lines of resolution). To achieve higher resolution display capability
and enhanced picture quality, the number of pixels integrated in AMLCDs is
increased, which in turn increases the complexity of the manufacturing
process.
 
 The AMLCD Flat Panel Display Manufacturing Process
 
  The manufacture of AMLCDs is an extremely complex process, which is
developed and refined for different panel sizes and resolutions through
research and development, pre-production prototyping and commercial
production. Manufacturing an AMLCD involves a series of three principal steps.
The first step is to build an active array of thin-film transistors on a
substrate through a photolithography process, which is essentially the same
step used to create electronic circuitry on a semiconductor device. In an
SVGA-quality color AMLCD, there are three transistors (red, green and blue) at
each pixel and typically 1,440,000 transistors in total with geometric line
widths for each transistor of between three and five microns. The next step
involves attaching a color filter to the transistor-embedded substrate and
injecting liquid crystal material between the color filter and the transistor
array. The color filter enables the display to attain color capability by
selectively filtering out the light emissions from each multi-color pixel
array to produce the desired color mix in the displayed image. At this second
step, the "cell" for each pixel is created through the combination of
transistors and a color filter. The last step in the process is to package the
display and attach the necessary "driver" electronics that will interpret and
convert the electronic signals directed by the computer or other electronic
system to the AMLCD and cause it to display the desired text, graphics and
video images. This step also involves sealing the FPD and installing the
interface electronics.
 
 Current Yield and Cost Problems Experienced by FPD Manufacturers
 
  While there are many similarities between the techniques used to manufacture
semiconductor devices and FPDs such as AMLCDs, the manufacture of FPDs is
different in a number of ways that expose the FPD manufacturer to potentially
greater risk from yield loss throughout the manufacturing process. The cost
structure for the manufacture of FPDs is very different from semiconductor
devices in that materials costs represent a
 
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much larger percentage of the total product cost to the FPD manufacturer than
the semiconductor manufacturer. Second, the manufacture of FPDs combines both
electrical manufacturing techniques as well as a number of complex non-
electrical manufacturing steps, such as the manufacture and alignment of the
color filter at exacting physical tolerances, injection of the liquid crystal,
sealing of the FPD and assembly of the driver electronics and circuitry.
Third, because of the visual function performed by FPDs, an FPD must satisfy
certain visual criteria and have consistent resolution, color and quality to
be acceptable to the end user. Certain types of visual deficiencies, such as
variations in screen brightness or color or blurred resolution, are unrelated
to electrical defects and can cause substantial yield losses. These defects,
some types of which are referred to as "mura", cannot be detected by
traditional automated semiconductor array test equipment and are not relevant
to the manufacture of semiconductor devices and other electronic components
where minor defects not affecting the electrical performance of the product do
not result in yield loss. Due to these factors, the AMLCD industry continues
to experience substantial yield losses and to incur significant materials
costs in the manufacture of FPDs.
 
  The ability of FPD manufacturers to improve yields of AMLCDs and other FPDs
depends in large part on their ability to array test and inspect displays
during the manufacturing process and to use array test and inspection data to
refine the manufacturing process. Through inspection, the FPD manufacturer
seeks to identify defects at an early stage in the process to repair and save
the product or to avoid adding more cost to a defective product with continued
manufacturing. The Company estimates that 80% of the overall cost of
manufacturing a typical full color AMLCD is incurred in later stage
manufacturing steps after the primary transistor array has been developed on
the glass substrate. Material costs can be reduced through in-process array
testing if yield defects in the manufacturing process can be properly detected
at earlier stages. In addition, systematized inspection provides qualitative
feedback to the FPD manufacturer and enables it to address yield problems and
enhance the manufacturing process. Because of this critical role of yield in
reducing FPD manufacturing costs, the FPD industry is now generally
recognizing the need for automated FPD array test, inspection and repair
equipment and seeking yield-enhancing solutions at all stages of the FPD
manufacturing process. This need has become much more acute recently as AMLCDs
have become increasingly more complex and the market has evolved from existing
VGA and SVGA standard displays to the higher resolution XGA and SXGA displays.
 
PRODUCTS
 
  Photon Dynamics offers a suite of products to inspect almost all
commercially produced FPDs. All of the Company's systems use similar software
based controls, processing and graphical user interfaces. Products can be
networked together so that 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 purchased from
third party vendors.
 
 Array Test Systems (Test Systems)
 
  The Company's array test 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 repair systems to
effect repairs. The systems also perform key procedures involved in the array
testing process, including running test sequences and loading, unloading and
sorting substrates. The array test 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 ArrayChecker system is an enhanced version of earlier
array test systems that uses optimized processing software, graphical user
interface and materials transport features. These features have been designed
to enable
 
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the ArrayChecker system to achieve throughput rates that are closer to
conventional probe card based systems while providing the same functionality,
flexibility and cost-efficient features of the earlier array test systems.
 
 Flat Panel Inspection Systems (FIS or Inspection Systems)
 
  The Company's Flat Panel Inspection (FIS) systems use the Company's
proprietary N-Aliasing(TM) technology to inspect almost any type and size of
commercially available FPD panel for optical defects after the completion of
the cell stage of production. FIS systems are also designed to perform
inspection after final module assembly of FPD panels. The systems use a single
high-resolution CCD 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 locate blemish,
line, cluster and individual pixel defects. Test data generated by the systems
is displayed on a video monitor to permit immediate visual interpretation and
can be stored or sent to a repair system to effect repairs. Inspection systems
comprise a family of products that offer different levels of resolution,
functionality and flexibility to suit customers' needs. Currently available
systems include the FIS250, PanelMaster 300, SpotLite, Muralook, and
MicroMaster. The systems are available either as stand-alone units or as
modular systems designed to be integrated with manufacturers' material
handling equipment.
 
 Array Repair System (Repair System)
 
  The Company's repair systems use a laser to repair opens and shorts in AMLCD
and passive LCD panels. These repair systems can use defect files downloaded
from the Company's array test or inspection 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 repair systems
repair shorts by cutting away excess material and opens by welding a new
connection to a recovery ring. The latest repair systems feature unique
BeamBlender(TM) laser technology. The feature allows manufacturers to blend
two laser frequencies in certain ratios for cutting or welding.
 
INTELLECTUAL PROPERTY
 
  The Company has been issued 32 U.S. patents with respect to its FPD array
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 Ishikawajima-
Harima Heavy Industries Co., Ltd. ("IHI"), have jointly filed patent
applications in Japan relating to certain aspects of the array test 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 processing 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 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
 
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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--Patents and Proprietary Rights".
 
RESEARCH AND DEVELOPMENT
 
  The market for FPD array 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 array 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, almost one-half of the Company's
research and development personnel are focused on software development.
 
  The Company's research and development expenses were $5.9 million and $7.8
million in fiscal 1998 and fiscal 1997, respectively, or 26% and 32% of
revenue, respectively. Research and development expenses consist primarily of
salaries, project materials and other costs associated with the Company's
ongoing efforts to improve and enhance the Company's products.
 
  The Company has obtained substantial development funding from IHI with
respect to the Company's array test systems. IHI has provided funding for
initial feasibility studies and development of the first prototypes of array
test systems, and since 1990 IHI has provided to the Company in excess of $8
million in research and development funding with respect to the array test
systems. In exchange for this funding IHI has been granted certain licenses
and joint ownership rights to the developed technology. See "Factors That May
Affect Future Results--Relationship with IHI."
 
  The Company has entered into contracts with 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. However the Company
has licensed certain rights to its array test 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 deliver
array test systems to U.S. customers.
 
CUSTOMERS, SALES AND SERVICE
 
  The Company sells its products to leading FPD manufacturers. Sales to LG
Electronics, Inc., an affiliate of the Company, represented 27% and 26% of
revenue in fiscal 1998 and fiscal 1997. Overall, the Company's top four
customers contributed 92% of revenue in fiscal 1998, as compared to 83% of
revenue in fiscal 1997. International sales accounted for 96% and 98% of
revenue in fiscal 1998 and 1997, respectively. See "Factors That May Affect
Future Results Dependence on Principal Customers" and "International
Operations".
 
  Photon's revenue is obtained primarily to flat panel display manufacturers
and to a lesser extent, through value added resellers in Japan and Korea.
During fiscal 1997, the Company entered into an agreement with a Korean
company to be the exclusive value added reseller of the Company's inspection
products in Korea. Sales
 
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to this reseller dropped to $ .5 million in fiscal 1998, from $2.7 million in
1997. During fiscal 1997, the Company also entered into a memorandum of
understanding with IHI, expanding the number of product lines sold and
serviced in Japan by IHI from one to three. Previously the Company marketed
its inspection and repair systems directly through its subsidiary, KKPD. In
the quarter ended June 30, 1997, the Company shipped its first inspection and
repair systems to IHI. During fiscal 1998, the Company continued to work under
the provisions of the memorandum of understanding with IHI. Sales to IHI were
$10.1 million in fiscal 1998 as compared to $6.4 million in fiscal 1997. The
final agreement with IHI is expected to be signed during the next six months.
There can be no assurance that the final agreement will be negotiated on a
timely basis or on terms favorable to the Company. See "Factors That May
Affect Future Results--Relationship with IHI".
 
  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.
Direct marketing, sales and service personnel located in Japan and Korea staff
the Asian sales and service operations. In addition, in Japan the Company's
products are also 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 final acceptance by customers. 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. 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.
Although the Company conducts final testing of its systems and assembles
certain components under limited clean room conditions, most manufacturing
occurs in standard manufacturing space. Therefore the Company believes that it
has the additional manufacturing space to respond to higher demand.
 
  The Company has granted certain exclusive rights to IHI to manufacture array
test systems developed prior to June 1997 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
array test systems
 
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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 array
test systems to be sold in its territories. To date, IHI has allowed Photon
Dynamics to manufacture all array test systems for IHI, which has acted as a
distributor in Japan and performed customization of the array test 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 array
test systems and may have a material adverse effect on the Company's results
of operations. See "Factors That May Affect Future Results--Relationship with
IHI"
 
BACKLOG
 
  As of September 30, 1998, the Company's backlog was approximately $8.3
million as compared to approximately $12.4 million as of September 30, 1997.
In addition, approximately 82% of the Company's backlog at fiscal 1998 year-
end was comprised of orders from one customer. 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 to the customer. 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
substantial competition from established companies, many of which are larger
companies, have greater financial, engineering and manufacturing resources
than the Company and have larger service organizations and long-standing
customer relationships with major FPD manufacturers. Furthermore, in the event
that the Company is unsuccessful in negotiating a new agreement with IHI, IHI
may compete with the Company selling the Company's array test systems in
Japan, Korea and the rest of the IHI Territory. See "Relationship with IHI".
Sales to IHI were $10.1 million in fiscal 1998 and $6.4 million in fiscal
1997. 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 even if sufficient funds are available, the Company
will be able to make the technological advances necessary to maintain such
competitive advantages.
 
EMPLOYEES
 
  As of September 30, 1998, 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 retain such employees and attract new
qualified 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. See "Factors That May Affect Future Results
Dependence on Key Employees".
 
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<PAGE>
 
                    FACTORS THAT MAY AFFECT FUTURE RESULTS
 
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 $1.5
million. 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 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. Furthermore, the Company believes that the current economic conditions
in East Asia and specifically Korea will continue to have a negative impact on
the Company's results of operations. If the Korean Won continues to fall or
remain at current levels against the U.S. dollar, the Company could experience
lower average sales prices for its products in Korea. Moreover, if current
economic conditions in East Asia do not improve, the Company's customers may
fail to place new orders for the Company's equipment. Accordingly, the
Company's results of operations are subject to significant variability from
quarter to quarter.
 
DEPENDENCE ON THE JAPANESE AND KOREAN MARKETS
 
  The future performance of the Company will depend, in part, upon its ability
to continue to compete successfully in the Japanese and Korean markets, the
two largest markets for FPD array test, inspection and repair equipment. The
Company's ability to compete in such markets in the future is dependent upon
continuing free trade between Korea, 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 and Korean customers and the continuing
ability of the Company to maintain satisfactory relationships with leading
companies in the Japanese and Korean FPD industry. The Company believes that
the Japanese and Korean companies with which it competes may have a
competitive advantage in Japan and Korea because of the preference of some
customers for local equipment suppliers because such customers may have longer
standing or closer business relationships with such competitors. The Company's
sales to Japan and Korea and results of operations will also be affected by
the overall health of the Japanese and Korean economies, including the effects
of currency exchange rate fluctuations on the global competitiveness of
Japanese and Korean FPD manufacturers. Furthermore, the Company believes that
the current economic conditions in East Asia and specifically Korea will
continue to have a negative impact on the Company's results of operations. If
the Korean Won continues to fall or remain at current levels against the U.S.
dollar, the Company could experience lower average sales prices for its
products in Korea. Moreover, if current economic conditions in East Asia do
not improve, the Company's customers may fail to place new orders for the
Company's equipment. Accordingly, the Company's results of operations are
subject to significant variability from quarter to quarter.
 
                                      10
<PAGE>
 
INTERNATIONAL OPERATIONS
 
  Approximately 96% of the Company's total revenue for fiscal 1998 was
attributable to sales outside the U.S. The Company expects that international
sales and in particular sales to East Asia 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.
 
DEPENDENCE ON PRINCIPAL CUSTOMERS
 
  The FPD industry is extremely concentrated, with almost 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 four end user customers in
fiscal 1998 and 1997 accounted for approximately 92% and 83%, 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 to the customer. 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.
 
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 have from time to time temporarily limited the quantities of laptop
computers that were manufactured, which in turn may have reduced demand from
laptop computer manufacturers for certain FPDs. If these conditions had
continued for an extended period, the resulting reduced long-term demand for
FPDs suitable for laptop computers could have affected adversely the level of
capital expenditure by FPD manufacturers. 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, which would adversely affect the
company's operating margins.
 
RELATIONSHIP WITH IHI
 
  The Company has granted certain exclusive manufacturing and sales rights to
IHI with respect to its array test systems developed prior to June 1997 for
Japan, Korea, a number of other Asian countries, Saudi Arabia,
 
                                      11
<PAGE>
 
Australia, New Zealand, India and Sri Lanka (the "IHI Territory"). 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
array test systems to be sold by IHI in its territory. In fiscal 1998, 45% of
the Company's revenues were derived from sales to IHI. The agreements between
IHI and the Company provided for the Company to assist IHI in its sales
efforts in these countries in exchange for a commission. This relationship
continued on an exclusive basis for the IHI territory until June 1997. Since
then IHI has had non-exclusive manufacturing and sales rights in its
territory. In exchange for these rights, IHI has provided significant funding
for development of the array test 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 Dynamics to manufacture all
array test systems sold by IHI in the IHI territory. IHI had agreed to allow
Photon Dynamics to sell directly all array test systems outside Japan through
June 1997. Since June 1997, IHI and the Company have been operating under a
memorandum of understanding whereby IHI continues to sell array test systems
in Japan and the Company sells directly outside Japan in the IHI Territory.
IHI and the Company are currently in negotiations for IHI to be the exclusive
reseller of all of the Company's products in Japan, and have been operating
under this premise since June of 1997. Under this new agreement it is intended
that IHI will continue to perform all support and service for system units in
Japan, while Photon will provide support and service in the remainder of the
IHI Territory. There can be no assurance that the Company and IHI will
successfully complete these negotiations on favorable terms to the Company.
 
  To the extent IHI determines to exercise its contractual rights to
manufacture and sell the Company's systems in the IHI Territory, such action
could reduce revenue of the Company attributable to these IHI manufactured
array test 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 array test systems 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 array test systems in Japan, such action by IHI could have a
material adverse effect on the Company's ability to compete in this market 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 sales and support of array test systems in Japan.
 
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 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. 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. In particular, the Company's
future results of operations are highly dependent on the continuing market
introduction, marketing and cost-effective manufacture of the Company's array
test product line, of which a new version, the ArrayChecker, first shipped in
September 1997. The Company continues to perform research and development work
with respect to the array test systems to achieve additional performance
specifications, including increased throughput levels and detection
sensitivity. The Company has experienced delays in the development of
performance specifications required by new and existing customers in the past,
and could experience such delays in the future. No assurance can be given that
development efforts related to other performance parameters will be
successful. The Company believes that future orders of array test systems will
be dependent on its ability to attain requested throughput levels and other
 
                                      12
<PAGE>
 
performance parameters. 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
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, 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 array
test or inspection technologies by a broader group of customers. Such
customers include additional international customers and FPD manufacturers
which currently do not perform the type of FPD array test or inspection
offered by the Company's products or which utilize alternative technologies
for, or methods of, inspection, such as "open/short" array 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 array test or inspection systems
involves a significant technological and financial commitment as compared to
current alternatives such as human inspection and open/short array testers.
There can be no assurance that the Company will be successful in obtaining
broader acceptance of its array test or inspection technologies. Failure to
achieve broader acceptance of such technologies would have an 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. 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.
 
RAPID AND FUNDAMENTAL TECHNOLOGICAL CHANGE
 
  The FPD industry is an evolving industry characterized by extensive research
and development, and rapid and fundamental 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.
Currently, the predominant technology used in the FPD industry is LCD
technology. The company's 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
substantial competition from established companies, many of which are larger
companies, have greater financial, engineering and manufacturing resources
than the Company and have larger service organizations and long-standing
customer relationships with major FPD manufacturers. Furthermore, in the event
that the Company is unsuccessful in negotiating a new agreement with IHI, IHI
may compete with the Company selling the Company's array test systems in
Japan, Korea and the rest of the IHI Territory. See "Relationship with IHI".
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
 
                                      13
<PAGE>
 
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 even if
sufficient funds are available, the Company will be able to make the
technological advances necessary to maintain such competitive advantages.
 
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. There can
be no assurance that third parties will not assert infringement claims against
the Company or that such claims will not be successful. Even successful
defenses 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.
 
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 markets have experienced
extreme price and volume fluctuations, which have particularly affected the
market prices of many high technology companies and which have often been
 
                                      14
<PAGE>
 
unrelated to the operating performance of such companies. These broad market
fluctuations may adversely affect the market price of the Company's Common
Stock.
 
YEAR 2000 COMPUTER SYSTEM COMPLIANCE
 
  The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the
Company's computer programs that have date-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result
in a system failure or miscalculations causing the disruption of operations,
including among other things, a temporary inability to process transactions,
send invoices or engage in similar normal business activities. In addition to
the Company's own systems the Company relies, directly and indirectly, on
external systems of its customers, creditors, financial organizations,
utilities providers and government entities, both domestic and international
(collectively, "Third Parties"). Consequently, the Company could be affected
by disruptions in the operations of Third Parties with which the Company
interacts.
 
  The Company is in the process of addressing internal and external year 2000
issues and has established a task force with this responsibility. To date, the
Company has made several modifications to its product software, its enterprise
software and its network software to ensure Year 2000 compliance. Although the
Company believes that its products and internal systems are currently Year
2000 compliant, there can be no assurance that the Third Parties which the
Company interacts are or will be Year 2000 compliant. Failure of Third Party
enterprises to achieve Year 2000 compliance could have a material adverse
effect on the Company's business, financial condition and results of
operations. The Company continues to evaluate the estimated costs associated
with the efforts to prepare for Year 2000 based on actual experience. While
the efforts will involve additional costs, the Company believes, based on
available information, that it will be able to manage its total Year 2000
transition without any material adverse effect on its business operations,
products or financial prospects. The actual outcomes and results could be
affected by future factors including, but not limited to, the continued
availability of skilled personnel, cost control, the ability to locate and
correct software code problems, critical suppliers and subcontractors meeting
their commitments to be Year 2000 compliant, and timely actions by customers.
The Company anticipates that it will remediate all Year 2000 risks and be able
to conduct normal operations without having to establish a Year 2000
contingency plan; accordingly, the Company does not have a contingency plan
and does not intend to establish one. There is no guarantee, however, that all
problems will be foreseen and corrected or that no material disruption of
business will occur.
 
  Readers are cautioned that forward-looking statements contained in the
preceding paragraphs should be read in conjunction with the Company's
cautionary statement for the purposes of the "safe harbor" provisions of the
Private Securities Litigation Reform Act of 1995 appearing on page 3.
 
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 rent under the lease
for the facility is approximately $55,000. The lease expires in 2002. 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 quarter
ended September 30, 1998.
 
                                      15
<PAGE>
 
                                    PART II
 
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
 
COMMON STOCK
 
  The Company's Common Stock is traded on the Nasdaq National Market under the
symbol "PHTN." The following table shows the range of high and low closing
prices of Photon Dynamics' Common Stock as reported by the Nasdaq National
Market by quarter for 1998 and 1997. Such prices represent inter-dealer prices
and do not include retail mark-ups or mark-downs or commissions and may not
represent actual transactions.
 
                                  FISCAL 1998
 
<TABLE>
<CAPTION>
                                                                       HIGH LOW
                                                                       ---- ----
     <S>                                                               <C>  <C>
     1st Quarter...................................................... 7.13 2.50
     2nd Quarter...................................................... 3.69 2.56
     3rd Quarter...................................................... 5.25 3.38
     4th Quarter...................................................... 3.50 2.13
</TABLE>
 
                                  FISCAL 1997
 
<TABLE>
<CAPTION>
                                                                       HIGH LOW
                                                                       ---- ----
     <S>                                                               <C>  <C>
     1st Quarter...................................................... 8.63 5.25
     2nd Quarter...................................................... 9.25 6.00
     3rd Quarter...................................................... 7.88 4.63
     4th Quarter...................................................... 8.63 6.75
</TABLE>
 
  As of December 11, 1998 there were approximately 7,425,415 holders of record
of the Company's common stock.
 
                                       16
<PAGE>
 
SELECTED CONSOLIDATED FINANCIAL DATA
 
  The following table presents selected financial data of Photon Dynamics,
Inc. This historical data should be read in conjunction with the Consolidated
Financial Statements and the related Notes thereto in Item 7 and "Management's
Discussion and Analysis of Financial Condition and Results of Operations" in
Item 6. No cash dividends were declared in any of the periods presented.
 
<TABLE>
<CAPTION>
                                            YEARS ENDED SEPTEMBER 30,
                                     -----------------------------------------
                                      1998     1997     1996    1995    1994
                                     -------  -------  ------- ------- -------
                                      (IN THOUSANDS EXCEPT PER SHARE DATA)
<S>                                  <C>      <C>      <C>     <C>     <C>
CONSOLIDATED STATEMENT OF
 OPERATIONS DATA
Revenue............................  $22,420  $24,507  $24,763 $18,447 $10,587
Gross margin.......................    9,361   10,718   11,507   6,756   3,902
Operating income (loss)............   (1,589)  (2,695)     563     710  (2,048)
Net income (loss)..................  $(1,465) $(2,481) $   854 $   377 $(2,105)
Basic net income (loss) per share
 (1)...............................  $ (0.20) $ (0.35) $  0.13 $  0.08
Diluted net income (loss) per share
 (1)
 (pro forma for 1995)..............  $ (0.20) $ (0.35) $  0.12 $  0.08
Shares used in computing:
Basic net income (loss) per share..    7,231    7,049    6,548   4,448
Diluted net income (loss) per
 share.............................    7,231    7,049    7,294   5,016
</TABLE>
 
<TABLE>
<CAPTION>
                                                     SEPTEMBER 30,
                                        ---------------------------------------
                                         1998    1997    1996    1995    1994
                                        ------- ------- ------- ------- -------
                                                    (IN THOUSANDS)
<S>                                     <C>     <C>     <C>     <C>     <C>
CONSOLIDATED BALANCE SHEET DATA
Working capital........................ $14,090 $14,769 $17,290 $   709 $   408
Total assets...........................  21,033  23,203  24,958  10,519   6,567
Total shareholders' equity.............  16,489  17,762  19,770   1,857   1,435
</TABLE>
--------
(1) Earnings per share for all periods prior to fiscal 1998 have been restated
    to conform to the requirements of SFAS No. 128, "Earnings Per Share."
 
                UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                                FISCAL QUARTERS ENDED,
                         ---------------------------------------------------------------------
                         DECEMBER 31, 1997 (1) MARCH 31, 1998 JUNE 30, 1998 SEPTEMBER 30, 1998
                         --------------------- -------------- ------------- ------------------
                                                    (IN THOUSANDS)
<S>                      <C>                   <C>            <C>           <C>
Revenue.................        $5,374             $7,362        $5,625          $ 4,059
Gross margin............         2,645              3,049         2,564            1,103
Net income (loss) (1)...            46                221            49           (1,781)
 
<CAPTION>
                                                FISCAL QUARTERS ENDED,
                         ---------------------------------------------------------------------
                         DECEMBER 31, 1996 (2) MARCH 31, 1997 JUNE 30, 1997 SEPTEMBER 30, 1997
                         --------------------- -------------- ------------- ------------------
<S>                      <C>                   <C>            <C>           <C>
Revenue (2).............        $6,246             $5,085        $6,821          $ 6,355
Gross margin............         3,073              2,271         3,366            2,008
Net income (loss).......            52               (973)           27           (1,587)
</TABLE>
--------
(1) Net income in the December quarter includes a one-time legal settlement of
    $350,000 paid to the Company related to the closure of its Defect
    Monitoring Tool (DMT) product line.
(2) Revenue includes a $1 million initial fee paid by a Korean company to be
    the exclusive value added reseller of the Company's inspection products in
    Korea.
 
                                      17
<PAGE>
 
ITEM 6: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
  This 10-KSB Report contains 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. To the extent that this 10-KSB report discusses
financial projections, information or expectations about products or markets
of Photon Dynamics Inc. all such forward-looking statements 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. The Company's results will be
affected, particularly when measured on a quarterly basis, by the volume,
composition and timing of orders for capital equipment by FPD manufacturers.
Other uncertainties include, without limitation, acceptance of new products,
timing of orders received, costs associated with new product introductions and
managing growth, as well as the factors discussed in "Other Factors Affecting
Company Results" above.
 
The following table sets forth certain operating data as a percentage of total
                                   revenue:
 
<TABLE>
<CAPTION>
                                    YEARS ENDED
                                   SEPTEMBER 30,
                                   ---------------
                                    1998     1997
                                   ------   ------
     <S>                           <C>      <C>
     Revenue:
       Product sales.............   100.0%    94.5%
       Non-Product...............     0.0      5.5
                                   ------   ------
                                    100.0    100.0
                                   ------   ------
     Cost of revenue:
       Product sales.............    58.2     56.3
       Non-Product...............     0.0      0.0
                                   ------   ------
                                     58.2     56.3
                                   ------   ------
     Gross margin................    41.8     43.7
                                   ------   ------
     Operating expenses:
       Research and development..    26.4     31.7
       Selling, general and
        administrative...........    24.0     23.0
       Asset recovery related to
        product line disposal....    (1.6)     0.0
                                   ------   ------
         Total operating
          expenses...............    48.8     54.7
                                   ------   ------
     Operating loss..............    (7.0)   (11.0)
     Other income, net...........     1.0      1.0
                                   ------   ------
     Loss before provision for
      income taxes...............    (6.0)   (10.0)
     Provision for income taxes..     0.5      0.1
                                   ------   ------
     NET LOSS....................    (6.5)%  (10.1)%
                                   ======   ======
</TABLE>
 
OVERVIEW
 
  Photon Dynamics develops, manufactures and markets on a worldwide basis a
suite of products to inspect virtually all types of FPDs and to address key
areas of AMLCD test, inspection and repair throughout all major stages of the
manufacturing life cycle, from research and development through commercial
production.
 
  Photon Dynamics' revenue is obtained primarily through sales to FPD
manufacturers and, to a lesser extent, value-added resellers in Japan and
Korea. During fiscal 1997, the Company entered into an agreement with a Korean
company to be the exclusive value added reseller of the Company's inspection
products in Korea. During fiscal 1997, the Company also entered into a non-
binding memorandum of understanding with IHI, expanding the scope of the
Company's existing arrangement with IHI and increasing the number of product
lines sold and
 
                                      18
<PAGE>
 
serviced by IHI from one to three. Previously, the Company had directly
marketed its inspection and repair systems exclusively through its subsidiary,
KKPD. In the quarter ended June 30, 1997, the Company shipped its first
inspection and repair systems to IHI. During fiscal 1998, the Company
continued to work under the provisions of the memorandum of understanding with
IHI. The Company is in the process of negotiating the final agreement with IHI
and expects it to be completed and signed during the first half of fiscal
1999. There can be no assurance that the final agreement will be negotiated on
a timely basis or on terms favorable to the Company.
 
  The Company derives substantially all of its revenue from international
sales in Asia, primarily Japan and Korea, where the majority of volume flat
panel production currently resides. In fiscal 1999, the Company believes that
FPD manufacturers in Taiwan may open new factories and increase commercial
production of FPD's. If so, the Company believes that it is strongly
positioned to reap the benefits of capacity investments by Taiwanese
customers. At present, all worldwide sales are made in US dollars, whether
direct or to value added resellers.
 
  The Company's revenue is derived primarily from the sale of products. The
Company does not expect that service revenue for continuing maintenance of its
products will represent a significant portion of its revenue in fiscal 1999.
 
RESULTS OF OPERATIONS
 
  REVENUE. Revenue decreased 9% from $24.5 million in fiscal 1997 to $22.4
million in fiscal 1998. Revenue from product sales decreased by $0.7 million
from $23.1 million to $22.4 million over the same period. This decrease in
revenue in fiscal 1998 was due to an overall slowdown in FPD capital equipment
purchases in Asia in conjunction with the current financial difficulties in
Korea and Japan, known as the "Asian Crisis." Additionally, in 1998 the
Company's revenues on sales to Japan were lower than expected because of
contractual price reductions based on currency exchange rates throughout the
year. In the future, the Company does not expect to enter into any such
agreements.
 
  International sales accounted for $21.4 million and $24.0 million of revenue
in fiscal 1998 and 1997, respectively. Sales to Japan increased to $10.2
million in fiscal 1998 from $7.2 million in fiscal 1997, while sales in Korea
decreased to $10.3 million in fiscal 1998 from $14.7 million in fiscal 1997.
In fiscal 1998, sales to companies based in Korea represented 46% of total
annual revenue, as compared to 60% in fiscal 1997. With the information
currently available, the Company believes that sales to Korea in fiscal 1999
will be substantially less in both absolute dollars and as a percentage of
total revenue than in fiscal 1998, due to general economic conditions in
Korea.
 
  The Company introduced several new products at the end of fiscal 1997 and
during fiscal 1998, including the ArrayChecker, SpotLite, Muralook and
MicroMaster. Although the Company's new products have significant improvements
in throughput and testing specifications over the last generation of products
and customer satisfaction with the Company's new products has been high, the
Company has experienced a reduction in orders for these new products due to
turmoil in the economies of the Asian countries where the majority of the
Company's customers are located. Because 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 $1.5 million, the timing of the sale
of a single system could have and has had a significant impact on the
Company's revenue in any particular period.
 
  Non-product revenue in fiscal 1997 consisted of a non recurring $1 million
initial fee paid by a Korean company for the rights to be the exclusive value
added reseller of the Company's FIS Flex-P product in Korea.
 
  GROSS MARGIN. Overall gross margin as a percent of revenue decreased to
41.8% in fiscal 1998, from 43.7% in 1997. The gross margin for product sales
increased to 41.8% in fiscal 1998, from 40.5% in fiscal 1997. Unlike 1997, the
Company had no high margin non-product revenue during fiscal 1998. This
accounts for the overall decrease in gross margins. Additionally, product
gross margins will fluctuate on a quarterly basis as the
 
                                      19
<PAGE>
 
Company's product mix changes. Although product gross margins in 1998 were
slightly higher than in 1997, they were below the Company's expectations due
to production inefficiencies associated with the Company's current low revenue
levels and continued investment by the Company in worldwide customer service,
especially in Korea. Additionally, the Company earned lower margins on systems
sold to its partner in Japan, IHI. Sales to IHI typically have a lower gross
margin as IHI is responsible for certain sales and support costs in Japan.
 
  At the end of fiscal 1998, the Company planned a reduction in force that
consisted mainly of manufacturing personnel and decreased overall headcount by
5%. The Company executed this plan in early fiscal 1999. The Company also
plans to initiate engineering programs to decrease the cost of its products
during fiscal 1999.
 
  RESEARCH AND DEVELOPMENT. The Company decreased its research and development
expenses to $5.9 million in fiscal 1998, or 26.4% of revenue, from $7.8
million in fiscal 1997, or 31.7% of revenue. The decrease of research and
development spending in fiscal 1998 reflects the completion of the engineering
projects related to the development of the Company's ArrayChecker system in
fiscal 1997, including a decrease in spending on prototype materials and
outside consultants. The decrease also reflects the Company's efforts to
control discretionary spending in response to the financial uncertainties in
Asia during fiscal 1998. The Company does not expect that product development
expenses will decline in absolute dollar amounts during fiscal 1999.
 
  SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses decreased to $5.4 million, or 24% of revenue, in fiscal 1998 from to
$5.6 million, or 23% of revenue, in fiscal 1997. Selling expenses fluctuate
based on the Company's product and territory sales mix, which have different
sales channels and associated cost structures. In fiscal 1998, the Company
entered into an agreement with a new sales representative in Taiwan. Selling,
general and administrative expenses may increase in absolute dollar amounts in
fiscal 1999 and in future periods depending on various factors, including the
level of the Company's revenue and other operations.
 
  ASSET RECOVERY RELATED TO PRODUCT LINE DISPOSAL. In September 1996, the
Company ceased operations of its DMT product line. The DMT product group
worked exclusively on a single customer project not in the FPD market. As a
result of the cancellation of this project, the Company disposed of the
associated inventory and assets of this product line which were not
transferred to other products. During the quarter ended December 31, 1997, the
Company received a payment of $350,000 in settlement of a dispute related to
the cancellation of its Defect Monitoring Tool (DMT) product line.
 
  INTEREST INCOME/EXPENSE. Interest income in fiscal 1998 decreased to
$245,000 from $348,000 in fiscal 1997 as a result of reduced average cash and
investment balances throughout the fiscal year. Interest expense and other
consists of interest expense and foreign exchange gains and losses.
 
  PROVISION FOR INCOME TAXES. The provision for income taxes in fiscal 1998
was related to taxes by the Company's foreign subsidiary in Korea. US taxes
were minimal in fiscal 1998 and 1997 as a result of the Company's net
operating losses. As of September 30, 1998 the Company had available federal
and state net operating loss carryforwards of approximately $14.3 million and
$0.7 million, respectively. The Company also had federal and state research
and development tax credit carryforwards of approximately $1.2 million and
$0.7 million, respectively. The net operating loss and credit carryforwards
will expire at various times beginning in 1999 through 2013 if not utilized.
As of September 30, 1998, the Company had deferred tax assets of approximately
$9.9 million, for which no benefit has been recorded on the Company's
financial statements, and which consist primarily of net operating loss and
research and development tax credit carryforwards. These deferred tax assets
will be recognized in future periods as taxable income is realized and
consistent profits are reported.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  Cash generated by operating activities was $1.3 million for fiscal 1998.
Working capital items that significantly impacted cash balances were accounts
receivable and inventory. During the period, the Company's
 
                                      20
<PAGE>
 
accounts receivable balance decreased by $3.8 million to $6.0 million. This
was due to lower fourth quarter revenues and collections by the Company of a
large quantity of its older receivables balances throughout the year. The
Company's credit terms to customers typically extend a small portion of the
payment, generally 10%, for a period of months after shipment. During fiscal
1998, the Company exerted a tremendous effort to collect all of its older
outstanding receivables and successfully collected amounts that had previously
been reserved for. In fiscal 1998, inventory levels increased by $1.7 million,
reflecting an increase in raw material, work-in-progress and finished goods
inventory. This increase was due to customer purchase orders that requested
shipments at the beginning of Q1 1999, rather than late in the fourth quarter
of fiscal 1998.
 
  Capital expenditures in fiscal 1998 and fiscal 1997 were $.7 million and
$1.6 million, respectively. Higher spending levels in 1997 resulted from the
Company's relocation to a new facility in the first quarter of fiscal 1997 and
related leasehold improvements costs. Spending levels in 1998 were in line
with the Company's normal annual capital requirements.
 
  The Company has a $5 million line of credit financing from Imperial Bank,
which expires in February 1999. Borrowings under this line of credit bear
interest at the prime rate. This line of credit is secured by substantially
all of the Company's assets and contains certain financial and other
covenants. As of September 30, 1998, no amounts were outstanding under this
line and the Company was in compliance with all its covenants. The Company had
no material outstanding commitments to purchase or lease capital equipment, as
of September 30, 1998.
 
  The Company believes that cash and cash equivalents and cash flows from
operations will be sufficient to satisfy working capital requirements for the
next 12 months. There can be no assurance, however, that changes in the
Company's revenue and operational plans will not result in the expenditure of
such resources before such time, and in any event, the Company is in the
process of negotiating a new line of credit to supplement its capital
resources.
 
  The Company believes that success in its industry requires substantial
capital in order to maintain the flexibility to take advantage of
opportunities as they may arise. The Company may, from time to time, invest in
or acquire complementary businesses, products or technologies. The Company may
effect additional equity or debt financing to fund such activities. The sale
of additional equity or convertible debt could result in additional dilution
to the Company's shareholders. There can be no assurance that such financing
sources will be available on acceptable terms, if at all.
 
YEAR 2000 COMPUTER SYSTEM COMPLIANCE
 
  The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the
Company's computer programs that have date-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result
in a system failure or miscalculations causing the disruption of operations,
including among other things, a temporary inability to process transactions,
send invoices or engage in similar normal business activities. In addition to
the Company's own systems the Company relies, directly and indirectly, on
external systems of its customers, creditors, financial organizations,
utilities providers and government entities, both domestic and international
(collectively, "Third Parties"). Consequently, the Company could be affected
by disruptions in the operations of Third Parties with which the Company
interacts.
 
  The Company is in the process of addressing internal and external year 2000
issues and has established a task force with this responsibility. To date, the
Company has made several modifications to its product software, its enterprise
software and its network software to ensure Year 2000 compliance. Although the
Company believes that its products and internal systems are currently Year
2000 compliant, there can be no assurance that the Third Parties with which
the Company interacts are or will be Year 2000 compliant. Failure of Third
Party enterprises to achieve Year 2000 compliance could have a material
adverse effect on the Company's business, financial condition and results of
operations. The Company continues to evaluate the estimated costs associated
with the
 
                                      21
<PAGE>
 
efforts to prepare for Year 2000 based on actual experience. While the efforts
will involve additional costs, the Company believes, based on available
information, that it will be able to manage its total Year 2000 transition
without any material adverse effect on its business operations, products or
financial prospects. The actual outcomes and results could be affected by
future factors including, but not limited to, the continued availability of
skilled personnel, cost control, the ability to locate and correct software
code problems, critical suppliers and subcontractors meeting their commitments
to be Year 2000 compliant, and timely actions by customers. The Company
anticipates that it will remediate all Year 2000 risks and be able to conduct
normal operations without having to establish a Year 2000 contingency plan;
accordingly, the Company does not have a contingency plan and does not intend
to establish one. There is no guarantee, however, that all problems will be
foreseen and corrected or that no material disruption of business will occur.
 
                                      22
<PAGE>
 
ITEM 7: FINANCIAL STATEMENTS.
 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                                          PAGE
                                                                          ----
<S>                                                                       <C>
Report of Ernst & Young LLP, Independent Auditors........................  24
Consolidated Balance Sheets September 30, 1998 and September 30, 1997....  25
Consolidated Statements of Operations for the years ended September 30,
 1998 and 1997...........................................................  26
Consolidated Statements of Cash Flows for the years ended September 30,
 1998 and 1997...........................................................  27
Consolidated Statements of Shareholders' Equity for the years ended
 September 30, 1998 and 1997.............................................  28
Notes to Consolidated Financial Statements...............................  29
</TABLE>
 
                                       23
<PAGE>
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
The Board of Directors and Shareholders
Photon Dynamics, Inc.
 
  We have audited the accompanying consolidated balance sheets of Photon
Dynamics, Inc. as of September 30, 1998 and 1997, and the related consolidated
statements of operations, shareholders' equity, and cash flows for the years
then ended. 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 consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Photon Dynamics, Inc. as of September 30, 1998 and 1997, and the
consolidated results of its operations and its cash flows for the years then
ended in conformity with generally accepted accounting principles.
 
                                          /s/ Ernst & Young LLP
 
San Jose, California
October 22, 1998
 
                                      24
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                              SEPTEMBER 30,
                                                            ------------------
                                                              1998      1997
                                                            --------  --------
<S>                                                         <C>       <C>
                          ASSETS
Current assets:
  Cash and cash equivalents................................ $  5,562  $  4,831
  Accounts receivable, net of allowance for doubtful
   accounts of $850 ($951 in 1997); including $1,092
   receivable from related parties ($3,093 in 1997)........    6,027     9,785
  Inventories..............................................    6,767     5,076
  Prepaid expenses and other current assets................      276       512
                                                            --------  --------
Total current assets.......................................   18,632    20,204
Property, equipment, and leasehold improvements, net.......    1,798     2,226
Other assets...............................................      603       773
                                                            --------  --------
Total assets............................................... $ 21,033  $ 23,203
                                                            ========  ========
           LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable......................................... $  1,486  $  2,666
  Accrued expenses and other liabilities...................    2,936     2,489
  Customer deposits and deferred revenue...................      116       276
  Current portion of capital lease obligation..............        4         4
                                                            --------  --------
Total current liabilities..................................    4,542     5,435
Noncurrent portion of capital lease obligation.............        2         6
Commitments and contingencies..............................      --        --
Shareholders' equity:
  Preferred stock, no par value, 5,000,000 shares
   authorized, none issued and outstanding.................      --        --
  Common stock, no par value, 20,000,000 shares authorized,
   7,324,615 and 7,147,714 shares issued and outstanding...   38,918    38,573
  Accumulated deficit......................................  (22,147)  (20,682)
  Foreign currency translation adjustment and other........     (197)      (14)
  Notes receivable from shareholders.......................      (85)     (115)
                                                            --------  --------
Total shareholders' equity.................................   16,489    17,762
                                                            --------  --------
Total liabilities and shareholders' equity................. $ 21,033  $ 23,203
                                                            ========  ========
</TABLE>
 
          See accompanying notes to consolidated financial statements
 
                                       25
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                               YEARS ENDED
                                                              SEPTEMBER 30,
                                                             ----------------
                                                              1998     1997
                                                             -------  -------
<S>                                                          <C>      <C>
Revenue:
  Product revenue........................................... $22,420  $23,157
  Non-product revenue.......................................     --     1,350
                                                             -------  -------
                                                              22,420   24,507
Cost of revenue:
  Product revenue...........................................  13,059   13,789
  Non-product revenue.......................................     --       --
                                                             -------  -------
                                                              13,059   13,789
                                                             -------  -------
Gross margin................................................   9,361   10,718
Operating expenses:
  Research and development..................................   5,911    7,776
  Selling, general, and administrative......................   5,389    5,637
  Asset recovery related to product line disposal...........    (350)     --
                                                             -------  -------
Total operating expenses....................................  10,950   13,413
                                                             -------  -------
Operating loss..............................................  (1,589)  (2,695)
Interest income.............................................     245      348
Interest expense and other..................................     (13)    (114)
                                                             -------  -------
Loss before provision for income taxes......................  (1,357)  (2,461)
Provision for income taxes..................................     108       20
                                                             -------  -------
Net loss.................................................... $(1,465) $(2,481)
                                                             =======  =======
Basic and diluted net loss per share........................ $ (0.20) $ (0.35)
Shares used in computing basic and diluted net income loss
 per share..................................................   7,231    7,049
</TABLE>
 
 
          See accompanying notes to consolidated financial statements
 
                                       26
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                               YEARS ENDED
                                                              SEPTEMBER 30,
                                                             ----------------
                                                              1998     1997
                                                             -------  -------
<S>                                                          <C>      <C>
Operating activities:
Net income (loss)........................................... $(1,465) $(2,481)
Adjustments to reconcile net income to net cash provided by
 (used in) operating activities:
  Depreciation and amortization.............................   1,170    1,186
  Changes in operating assets and liabilities:
    Accounts receivable.....................................   3,758   (1,133)
    Inventories.............................................  (1,691)    (951)
    Prepaid expenses and other current assets...............     235        6
    Other assets............................................     171     (133)
    Accounts payable........................................  (1,180)     (77)
    Accrued expenses and other liabilities..................     447      422
    Customer deposits and deferred revenue..................    (160)     (77)
                                                             -------  -------
Net cash provided by (used in) operating activities.........   1,285   (3,238)
Investing activities:
Acquisition of property and equipment, net..................    (742)  (1,563)
Acquisition of short term investments.......................     --    (2,745)
Maturities of short term investments........................     --     6,811
                                                             -------  -------
Net cash provided by (used in) investing activities.........    (742)   2,503
Financing activities:
Principal payments under capital leases.....................      (4)     (15)
Issuance of common stock....................................     345      509
Repayment of notes receivable from shareholders.............      30       27
Issuance of note receivable from shareholder................     --       (56)
                                                             -------  -------
Net cash provided by financing activities...................     371      465
                                                             -------  -------
Effect of exchange rate changes.............................    (183)      (7)
                                                             -------  -------
Net increase (decrease) in cash and cash equivalents........     731     (277)
Cash and cash equivalents at beginning of period............   4,831    5,108
                                                             -------  -------
Cash and cash equivalents at end of period.................. $ 5,562  $ 4,831
                                                             =======  =======
</TABLE>
 
 
          See accompanying notes to consolidated financial statements
 
                                       27
<PAGE>
 
                             PHOTON DYNAMICS, INC.
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                       FOREIGN
                                                      CURRENCY      NOTES
                           COMMON STOCK              TRANSLATION  RECEIVABLE      TOTAL
                          -------------- ACCUMULATED ADJUSTMENT      FROM     SHAREHOLDERS'
                          SHARES AMOUNT    DEFICIT    AND OTHER  SHAREHOLDERS    EQUITY
                          ------ ------- ----------- ----------- ------------ -------------
<S>                       <C>    <C>     <C>         <C>         <C>          <C>
Balance at October 1,
 1996...................  6,888  $38,064  $(18,201)     $  (7)       $(86)       $19,770
Issuance of common
 stock..................    260      509       --         --          --             509
Foreign currency
 translation
 adjustment.............    --       --        --          (7)        --              (7)
Issuance of notes
 receivable.............    --       --        --         --          (56)           (56)
Repayment of notes
 receivable.............    --       --        --         --           27             27
Net loss................    --       --     (2,481)       --          --          (2,481)
                          -----  -------  --------      -----        ----        -------
Balance at September 30,
 1997...................  7,148   38,573   (20,682)       (14)       (115)        17,762
Issuance of common
 stock..................    177      345       --         --          --             345
Foreign currency
 translation
 adjustment.............    --       --        --        (183)        --            (183)
Repayment of notes
 receivable.............    --       --        --         --           30             30
Net loss................    --       --     (1,465)       --          --          (1,465)
                          -----  -------  --------      -----        ----        -------
Balance at September 30,
 1998...................  7,325  $38,918  $(22,147)     $(197)       $(85)       $16,489
                          =====  =======  ========      =====        ====        =======
</TABLE>
 
 
          See accompanying notes to consolidated financial statements
 
                                       28
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Basis of Presentation
 
  The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries after elimination of all material
intercompany balances and transactions.
 
  Photon Dynamics, Inc. is a manufacturer of test, inspection and repair
systems for the flat panel display (FPD) industry.
 
 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 in the financial statements and
accompanying notes. Actual results could differ from those estimates.
 
 Inventories
 
  Inventories are stated at the lower of cost or market, with cost being
determined on a first-in, first-out basis.
 
<TABLE>
<CAPTION>
                                                                  SEPTEMBER 30,
                                                                  -------------
                                                                   1998   1997
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Inventories comprise (in thousands):
    Raw materials................................................ $1,888 $1,376
    Work-in-progress.............................................  2,144  1,677
    Finished goods...............................................  2,735  2,023
                                                                  ------ ------
                                                                  $6,767 $5,076
                                                                  ====== ======
</TABLE>
 
 Property, Equipment and Leasehold Improvements
 
  Property and equipment are recorded at cost. Equipment includes assets
recorded under capital lease obligations. Depreciation is computed using the
straight-line method based upon the estimated useful lives of the assets,
generally three to five years. Equipment recorded under capital leases is
amortized using the straight-line method over the lesser of the lease terms or
the lives of the related assets.
 
<TABLE>
<CAPTION>
                                                                 SEPTEMBER 30,
                                                                 --------------
                                                                  1998    1997
                                                                 ------  ------
   <S>                                                           <C>     <C>
    Property and equipment comprise (in thousands):
    Equipment................................................... $4,455  $3,772
    Office furniture and fixtures...............................    322     330
    Leasehold improvements......................................    510     455
                                                                 ------  ------
                                                                  5,287   4,557
    Less accumulated depreciation and amortization.............. (3,489) (2,331)
                                                                 ------  ------
                                                                 $1,798  $2,226
                                                                 ======  ======
</TABLE>
 
                                      29
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Accrued Liabilities
 
  Accrued expenses and other liabilities consist of the following;
 
<TABLE>
<CAPTION>
                                                                  SEPTEMBER 30,
                                                                  -------------
                                                                   1998   1997
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Accrued liabilities comprise (in thousands):
    Warranty..................................................... $1,105 $1,001
    Compensation.................................................    855    820
    Other accrued expenses.......................................    976    668
                                                                  ------ ------
                                                                  $2,936 $2,489
                                                                  ====== ======
</TABLE>
 
 Foreign Currency Translation
 
  Assets and liabilities of the Company's foreign subsidiaries are translated
into U.S. dollars at year-end exchange rates and revenues and expenses are
translated at average rates prevailing during the year. Translation
adjustments are included in a separate component of shareholders' equity.
Foreign currency transaction gains and losses are included in results of
operations.
 
 Revenue Recognition
 
  The Company generally recognizes revenue from product sales at the time of
shipment, which usually precedes final acceptance. The Company also sells one-
year service contracts, for which revenue is recognized ratably over the
contract period.
 
  Non-product revenue in fiscal 1997 included a non-recurring $1 million
initial fee paid by a Korean company for the rights to be the exclusive value
added reseller of the Company's FIS Flex-P product in Korea.
 
 Concentrations of Credit Risk
 
  The Company markets its products primarily to a limited number of customers
in the Far East, primarily Japan and Korea. The Company is subject to economic
conditions and specifically exchange rate movements affecting its customers
and the countries in which it operates. The Company believes its credit
evaluation and monitoring process mitigates this credit risk and does not
generally require collateral. In 1998, sales to two unaffiliated and one
affiliated customer represented 45%, 27%, and 17% of total revenue. In 1997,
sales to three unaffiliated and one affiliated customer accounted for 26%,
20%, 11% and 26% respectively. International sales accounted for 96% and 98%
of total revenue in 1998 and 1997, respectively.
 
 Warranty and Installation
 
  The Company generally warrants its systems for a period of 12 months from
installation for material and labor to repair and service the system. A
provision for the estimated cost of installation and warranty is recorded upon
shipment.
 
 Fair Value of Financial Instruments
 
  The Company has evaluated the estimated fair value of financial instruments.
The amounts reported for cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses approximate the fair value due to their
short maturities.
 
                                      30
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Net Income (Loss) Per Share
 
  In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards 128, "Earnings per Share." Statement 128
replaced the previously reported primary and fully diluted earnings per share
with basic and diluted earnings per share. Unlike primary earnings per share,
basic earnings per share excludes any dilutive effects of options, warrants,
and convertible securities. The Company's diluted earnings per share are very
similar to the previously reported primary earnings per share. All earnings
per share amounts for all prior periods presented, where necessary, have been
restated to conform to the Statement 128 requirements. As the Company incurred
a loss in fiscal 1998 and 1997, the effect of dilutive securities totaling
approximately 299,234 in 1998 and 434,949 in 1997 have been excluded from the
computation as they are antidilutive.
 
 Stock Based Compensation Plans
 
  The Company accounts for its stock option plans and its employee stock
purchase plan in accordance with the provisions of the Accounting Principles
Board's Opinion No. 25 "Accounting For Stock Issued to Employees" (APB 25).
Pro forma information regarding net income (loss) per share is disclosed as
required by the FASB's Statement No. 123, "Accounting for Stock-Based
Compensation" (FAS 123), see Note 6.
 
 Impact of Recently Issued Accounting Standards
 
  In June 1997, the FASB released Statement of Financial Accounting Standards
No. 130, "Reporting Comprehensive Income" (FAS 130). FAS 130 establishes
standards for the reporting and display of comprehensive income and its
components in a full set of general purpose financial statements. The Company
will adopt the standard in fiscal 1999. The Company believes that adoption of
FAS 130 will not have a material impact on the Company's consolidated
financial statements.
 
  In June 1997, the FASB released Statement of Financial Accounting Standards
No. 131, "Disclosure about Segments of an Enterprise and Related Information"
(FAS 131). This statement establishes standards for the way that public
business enterprises report information about operating segments in annual
financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
stockholders. The Company will adopt the standard in fiscal 1999. The Company
believes that adoption of FAS 131 will not have a material impact on the
Company's consolidated financial statements.
 
 Reclassification
 
  Reclassifications have been made to the prior year's consolidated financial
statements to conform to the current years' presentation.
 
NOTE 2--RELATED PARTIES
 
  During 1998 and 1997 the Company sold approximately $6,157,000 and
$6,341,000 of its systems to LG Electronics, Inc. LG Electronics owns
approximately 8% of the Company's common stock, and warrants to purchase
28,333 shares of Common Stock at an exercise price of $0.60 per share, as well
as a seat on the board of directors. The Company believes its sales to LG
Electronics were made on terms no less favorable than would have been obtained
from unaffiliated parties.
 
                                      31
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 3--ASSET RECOVERY RELATED TO PRODUCT LINE DISPOSAL
 
  In September 1996, the Company ceased operations of its DMT product line.
The DMT product group worked exclusively on a single customer project not in
the FPD market. As a result of the cancellation of this project, the Company
disposed of the associated inventory and assets of this product line which
were not transferred to other products and recorded a $844,000 charge to write
down such inventory and assets in that fiscal year. During the quarter ended
December 31, 1997, the Company received a payment of $350,000 in settlement of
a dispute related to the closure of its Defect Monitoring Tool (DMT) product
line.
 
NOTE 4--SHORT TERM BORROWINGS
 
  The Company has a $5 million line of credit financing from Imperial Bank,
which expires in February 1999. No amounts were outstanding as of September
30, 1998. Borrowings under this line of credit bear interest at the prime
rate. This line of credit is secured by substantially all of the Company's
assets and contains certain financial and other covenants. As of September 30,
1998, the Company was in compliance with these financial covenants.
 
NOTE 5--LEASE OBLIGATIONS AND COMMITMENTS
 
  The Company leases its main facility under a noncancelable operating lease
agreement that expires in fiscal 2002.
 
  Total future minimum lease obligations are as follows (in thousands):
<TABLE>
<CAPTION>
                                                                       OPERATING
                                                                        LEASES
                                                                       ---------
   <S>                                                                 <C>
   1999...............................................................  $  738
   2000...............................................................     753
   2001...............................................................     769
   2002...............................................................     103
   2003...............................................................     --
                                                                        ------
                                                                        $2,363
                                                                        ======
</TABLE>
 
  Rental expense for the years ended September 30, 1998 and 1997 was $719,000
and $781,000, respectively.
 
NOTE 6--SHAREHOLDERS' EQUITY
 
 Warrants
 
  The Company has 148,832 warrants outstanding to purchase shares of Series E
preferred stock, which are currently exercisable in exchange for 49,610 shares
of common stock at $5.40 per share. The warrants expire from 2000 to 2002. The
Company also has 128,055 warrants outstanding to purchase shares of common
stock at $0.60 per share. These warrants expire in 1999.
 
 Stock Reserved for Future Issuance
 
  As of September 30, 1998, the Company has reserved 1,304,698 shares of
common stock for future issuance.
 
 Stock Option and Purchase Plans
 
  Under the Company's stock option plans, the Board of Directors may, at its
discretion, grant incentive or nonqualified stock options to employees and
directors. Options granted under the plans are for periods not to exceed ten
years, at prices at least equal to the fair market value of common stock at
the grant date, and become exercisable generally over a period of four years.
 
                                      32
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The following table summarizes activity under the Plans:
 
<TABLE>
<CAPTION>
                                                   SHARES UNDER WEIGHTED AVERAGE
                                                      OPTION     EXERCISE PRICE
                                                   ------------ ----------------
   <S>                                             <C>          <C>
   Balance at October 1, 1996.....................  1,102,519        $4.58
   Granted........................................    239,933        $6.24
   Exercised......................................   (179,649)       $1.29
   Canceled.......................................   (154,298)       $6.65
                                                    ---------        -----
   Balance at September 30, 1997..................  1,008,505        $5.24
   Granted........................................    424,700        $3.80
   Exercised......................................   (131,639)       $1.05
   Canceled.......................................   (276,200)       $5.43
                                                    ---------        -----
   Balance at September 30, 1998..................  1,025,366        $5.13
                                                    =========        =====
</TABLE>
 
  Options to purchase 279,332 shares of common stock are available for grant
as of September 30, 1998. Options for 485,361 shares are currently exercisable
(options for 452,173 shares at September 30, 1997).
 
  The Company has reserved 200,000 shares of common stock to be issued under
the 1995 Employee Stock Purchase Plan. The plan permits eligible employees to
purchase common stock, through payroll deductions, at 85% of the lower of the
fair market value of the common stock on the date at the beginning of the two-
year offering period or the last day of the purchase period. Substantially all
employees are eligible to participate in the plan. Employees purchased 102,343
shares in fiscal 1998 for $239,227 and 46,924 shares for $289,000 in fiscal
1997. At September 30, 1998, 32,617 shares were available for issuance under
the plan.
 
 Accounting for Stock Based Compensation Plans
 
  In accordance with the provisions of FAS 123, the Company applies APB
Opinion 25 and related Interpretations in accounting for its Stock Option and
Employee Stock Purchase plans and accordingly, does not recognize compensation
expense in the statement of operations because the exercise price of the
employees' stock options equals the market price of the underlying stock on
the date of grant. If the Company had elected to recognize compensation
expense based on the fair value of the options granted at the grant date as
prescribed by FAS 123, net income (loss) and net income (loss) per share would
have been adjusted to the pro forma amounts indicated in the table below:
 
<TABLE>
<CAPTION>
   YEAR ENDED SEPTEMBER 30,                                   1998     1997
   ------------------------                                  -------  -------
   <S>                                                       <C>      <C>
   (in thousands except per share amounts)
   Net income (loss) as reported............................ $(1,465) $(2,481)
   Net income (loss) pro forma.............................. $(2,091) $(3,468)
   Basic and diluted net income (loss) per share--as
    reported................................................ $ (0.20) $ (0.35)
   Basic and diluted net income (loss) per share--pro
    forma................................................... $ (0.28) $ (0.49)
</TABLE>
 
                                      33
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The effects on pro forma disclosures of applying FAS 123 are not likely to
be representative of the effects on pro forma disclosures of future years
because FAS 123 is applicable only to options granted subsequent to October 1,
1995. Compensation expense for the fair value of each stock option grant is
estimated on the date of grant using the Black-Scholes option pricing model
for the multiple option approach with the following weighted average
assumptions:
 
<TABLE>
<CAPTION>
                                                  OPTIONS           ESPP
                                              --------------- ----------------
                                               1998    1997     1998     1997
                                              ------- ------- --------- ------
   <S>                                        <C>     <C>     <C>       <C>
   Expected dividend yield...................   --      --       --       --
   Expected stock price volatility...........  0.80    0.70     0.79     0.70
   Risk free interest rate...................  5.54%   6.01%    5.30%    5.75%
   Expected life of options (from grant
    date).................................... 3 years 3 years 1.5 years 1 year
</TABLE>
 
  The following table summarizes information about stock options outstanding
at September 30, 1998:
 
<TABLE>
<CAPTION>
                                             OPTIONS OUTSTANDING                     OPTIONS EXERCISABLE
                              --------------------------------------------------- --------------------------
                                NUMBER           WEIGHTED             WEIGHTED      NUMBER       WEIGHTED
                              OUTSTANDING    AVERAGE REMAINING        AVERAGE     OUTSTANDING    AVERAGE
   RANGE OF EXERCISE PRICES   AT 9/30/98  CONTRACTUAL LIFE (YEARS) EXERCISE PRICE AT 9/30/98  EXERCISE PRICE
   ------------------------   ----------- -----------------------  -------------- ----------- --------------
   <S>                        <C>         <C>                      <C>            <C>         <C>
   $0.60-$0.90.............       97,321           5.51                $0.74         92,037       $0.75
   $2.40-$3.60.............      312,724           8.92                $3.22         83,237       $3.09
   $4.63-$5.88.............      190,056           8.71                $5.34         56,860       $5.54
   $6.00-$6.75.............      321,242           7.83                $6.65        184,285       $6.64
   $7.20-11.00.............      104,023           7.55                $9.89         68,942       $9.76
                               ---------           ----                -----        -------       -----
   $0.60-$11.00............    1,025,366           8.08                $5.13        485,361       $5.23
</TABLE>
 
  The weighted average grant date fair value of stock options and employee
purchase plan rights granted in fiscal 1998 and 1997 was approximately $1.99
and $3.66, respectively.
 
NOTE 7--NOTES RECEIVABLE FROM SHAREHOLDERS
 
  Notes receivable from shareholders arose from certain employees exercising
their stock options as well as advances to purchase stock on the open market.
The notes bear interest at 6.83% per annum, and are secured by the shares of
common stock.
 
NOTE 8--INCOME TAXES
 
  The provision for income taxes for the year ended September 30, 1998
consists of the following:
 
<TABLE>
<CAPTION>
                                                                    YEAR ENDED
                                                                   SEPTEMBER 30,
                                                                   -------------
                                                                    1998   1997
                                                                   ------ ------
   <S>                                                             <C>    <C>
   In thousands
   Federal current................................................ $  --  $  --
   State current..................................................    --     --
   Foreign current................................................    108     20
                                                                   ------ ------
     Total........................................................ $  108 $   20
                                                                   ====== ======
</TABLE>
 
                                      34
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The provisions for taxes on income differed from the provisions calculated
by applying the federal
statutory rate to income before taxes as follows:
 
<TABLE>
<CAPTION>
                                                                  YEAR ENDED
                                                                   SEPTEMBER
                                                                      30,
                                                                  ------------
                                                                  1998   1997
                                                                  -----  -----
   <S>                                                            <C>    <C>
   In thousands
   Expected provision (benefit) at statutory rate................ $(475) $(868)
   Foreign taxes.................................................   108     20
   Alternative minimum taxes.....................................    28    --
   Benefit of operating loss carryforwards.......................   --     --
   Unbenefited current year loss.................................   447    868
                                                                  -----  -----
                                                                  $ 108  $  20
                                                                  =====  =====
</TABLE>
 
  As of September 30, 1998, the Company has federal and state net operating
loss carryforwards of approximately $14,300,000 and $700,000, respectively.
The Company also has federal and state research and development tax credit
carryforwards of approximately $1,200,000 and $670,000, respectively. The net
operating loss and credit carryforwards will expire at various times beginning
in 1999 through 2013, if not utilized.
 
  Under certain provisions of the Internal Revenue Code of 1986, as amended,
the availability of the Company's net operating loss and tax credit
carryforwards may be subject to limitation if it should be determined that
there has been a change in ownership of more than 50% of the value of the
Company's stock. Such determination could limit the utilization of net
operating loss and tax credit carryforwards.
 
  Deferred tax assets reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes, net operating loss and
credit carryforwards.
 
  Significant components of the Company's deferred tax assets are as follows:
 
<TABLE>
<CAPTION>
                                                                 YEAR ENDED
                                                                SEPTEMBER 30,
                                                               ----------------
                                                                1998     1997
   In thousands                                                -------  -------
   <S>                                                         <C>      <C>
   Deferred tax assets:
     Net operating loss carryforwards......................... $ 4,902  $ 5,043
     Research credit carryforwards............................   1,698    1,551
     Capitalized research costs...............................     538      424
     Inventory writedowns.....................................     715      851
     Depreciation.............................................     613      220
     Other individually immaterial items......................   1,446    1,101
                                                               -------  -------
   Total deferred tax assets..................................   9,912    9,190
     Valuation allowance......................................  (9,912)  (9,190)
                                                               -------  -------
   Net deferred tax assets.................................... $   --   $   --
                                                               =======  =======
</TABLE>
 
                                      35
<PAGE>
 
                             PHOTON DYNAMICS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 9--STATEMENTS OF CASH FLOWS DATA
 
<TABLE>
<CAPTION>
                                                                       1998 1997
   (In thousands)                                                      ---- ----
   <S>                                                                 <C>  <C>
   Supplemental disclosure of cash flow information:
   Interest paid...................................................... $ 9  $ 4
   Income taxes paid..................................................  21   20
</TABLE>
 
NOTE 10--SUBSEQUENT EVENTS (UNAUDITED)
 
  On November 27, 1998, the Company presented its employees with the
opportunity to exchange stock option grants with an exercise price in excess
of $5.00 per share for prorated stock option grants with an exercise price of
$4.50 per share. Under this program, employees exchanged 431,833 old option
grants for 353,464 new option grants.
 
ITEM 8:  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE.
 
  Not applicable
 
                                      36
<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 1998 Annual Meeting of Stockholders to be held January 26, 1999 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.
 
  With the exception of the table below, the information required by this Item
is incorporated by reference from the Company's Proxy Statement for the 1999
Annual Meeting of Stockholders.
 
  The following table sets forth certain information concerning the executive
officers of the Company.
 
<TABLE>
<CAPTION>
     NAME                     AGE POSITION(S)
     ----                     --- ----------
     <S>                      <C> <C>
     Vincent Sollitto........  50 Chief Executive Officer
     Carl J. Meurell.........  38 Vice President, Marketing and Business Development
     Jeffrey Hawthorne.......  41 Vice President, Development
     Vincent DePalma.........  48 Vice President, Technology
     William Pratt ..........  61 Chief Technical Officer
     Rick Dissly.............  54 Chief Financial Officer and Vice President of Operations
</TABLE>
 
  MR. SOLLITTO joined the Company as Chief Executive Officer in June 1996 and
became a member of the Board of Directors of the Company in July 1996. From
August 1993 to 1996, Mr. Sollitto was the General Manager of Business Unit
Operations for Fujitsu Microelectronics, Inc. From April 1991 to August 1993,
he was the Executive Vice President of Technical Operations at Supercomputer
Systems, Incorporated. Mr. Sollitto spent 21 years in various positions,
including Director of Technology and Process at International Business
Machines Corporation, before joining Supercomputer Systems, Incorporated. Mr.
Sollitto serves as a director of Irvine Sensors Corp. Mr. Sollitto is a
graduate of Tufts College where he received a B.S.E.E. in 1970.
 
  MR. MEURELL joined the Company in May of 1996. From April 1995 to May1996,
he served as a director of Teradyne's Low Cost Logic Tester Line for the
Megatest division of Teradyne. From October 1993 to April 1995, Mr. Meurell
was with Catapult Software Training Centers, an IBM company, for which he
served as General Manager in the New York Metropolitan region. From December
1980 to October 1993, he held various sales management positions at the
Megatest Corporation. Mr. Meurell received a B.S. in electrical engineering
from the University of Massachusetts and an M.B.A. degree from Union College.
 
  MR. HAWTHORNE joined the Company in November 1991 as Senior Applications
Engineer, FIS Products. He was promoted to Project Manager FIS Products and
then General Manager and Vice President Inspection Division in August 1992 and
in September 1994, respectively. From June 1990 to November 1991, he was a
consultant with Display Tech, which provided consulting services in the area
of liquid crystal displays. He received a B.S. in engineering physics from the
University of Colorado in 1987 and an M.S. in optical engineering from the
University of Rochester in 1990.
 
  DR. DEPALMA joined the Company in October 1997 as Vice President of
Technology. His responsibilites include R&D for the laser-repair products,
manufacturing operations, certain technologies, and intellectual property.
Prior to joining PDI, Dr. DePalma was employed by International Business
Machines Corporation (IBM). From 1991 to 1997, Dr. DePalma served in a number
of executive positions with IBM in the area of semiconductor development, disk
storage development, intellectual property, and OEM component development and
sales. From 1978 to 1991, Dr. DePalma held a number of scientific and
managerial assignments in semiconductor, disk drive, and printer development.
Dr. DePalma received a B.S. in Chemistry and Mathematics in 1973 and a Ph.D.
in Physical Chemistry in 1977 from the University of Pittsburgh. As of
September 11, 1998, Dr. DePalma resigned as Vice President, Technology.
 
                                      37
<PAGE>
 
  DR. PRATT joined the Company in October 1996 as Chief Technical Officer for
Software. From 1988 through 1994 he was Director of Multimedia and Imaging
Technology at Sun Microsystems, Inc. In 1993, he founded Pixelsoft, Inc., a
start-up image processing software development company. Dr. Pratt received a
B.S. degree in electrical engineering from Bradley University and an M.S. and
a Ph.D. in electrical engineering the University of Southern California. Dr.
Pratt holds five patents and is the author of several books on image
processing.
 
  MR. DISSLY joined the Company in November 1998 as Chief Financial Officer
and Vice President of Operations. He has more than 20 years of experience in
establishing profitable business models and systems with several rapidly
growing international electronics companies. Prior to joining Photon Dynamics,
Mr. Dissly was the CFO of Semaphore Communications, CrossCheck Technology,
AwardSoftware, and Megatest Corporation. His responsibilities have included
managing operations, strategic planning, MIS, finance, human resources, and
facilities. Mr. Dissly has an MBA from Santa Clara University and is a
licensed CPA.
 
  The information required by this Item concerning compliance with section
16(a) of the Exchange Act is incorporated by reference from the Company's
Proxy Statement for the 1999 Annual Meeting of Stockholders under the heading
"Section 16(a) Beneficial Ownership Reporting Compliance."
 
ITEM 10: EXECUTIVE COMPENSATION.
 
  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1999 Annual Meeting of Stockholders under
the heading "Executive Compensation."
 
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 1999 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 1999 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: See Index to Financial Statements.
 
    (2) Exhibits: See Index to Exhibits. The Exhibits listed in the
  accompanying Index to Exhibits are incorporated by reference as part of
  this report.
 
  (b) Reports on Form 8-K. No reports on Form 8-K were filed during the
quarter ended September 30, 1998.
 
                                      38
<PAGE>
 
                                  SIGNATURES
 
  In accordance with Section 13 or 15(d) of 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 16, 1998                   By: /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 Richard Dissly, 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 1933, this Annual
Report on Form 10-KSB has been signed by the following persons in the
capacities and on the dates indicated:
 
<TABLE>
 <C>                <S>                        <C>
 December 16, 1998  Chief Executive Officer         /s/ Vincent Sollitto
                    and Director               -------------------------------
                    (Principal Executive              Vincent Sollitto
                    Officer)
 December 16, 1998  Chief Financial Officer          /s/ Richard Dissly
                    (Principal Financial and   -------------------------------
                    Accounting Officer)                Richard Dissly

 December 16, 1998  Chairman of the Board            /s/ E. Floyd Kvamme
                                               -------------------------------
                                                       E. Floyd Kvamme

 December 16, 1998  Director                         /s/ Francois Henley
                                               -------------------------------
                                                       Francois Henley

 December 16, 1998  Director                            /s/ Barry Cox
                                               -------------------------------
                                                          Barry Cox

 December 16, 1998  Director                           /s/ Michael Kim
                                               -------------------------------
                                                         Michael Kim

 December 16, 1998  Director                     /s/ Dr. Malcolm J. Thompson
                                               -------------------------------
                                                   Dr. Malcolm J. Thompson

 December 16, 1998  Director                          /s/ Steve Krausz
                                               -------------------------------
                                                        Steve Krausz
</TABLE>
 
 
                                      39
<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   Amended and Restated Bylaws of the Registrant
  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        C
        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
        Ishikawajima-Harima Heavy Industries Co., Ltd. dated June
        1, 1992 and the amendment thereto dated November 17, 1993.
 10.13  Form of Amendment to First Amended and Restated Investor         A
        Rights Agreement.
 10.14  Agreement Regarding Change of Control between the                C
        Registrant and Vincent Sollitto dated July 1, 1996.
 21.1   Subsidiaries of the Registrant.
 23.1   Consent of Ernst & Young LLP, Independent Auditors
 27.1   Financial Data Schedule
</TABLE>
--------
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 be
    filed as an exhibit to this report on Form 10-KSB pursuant to Item 13(a)
    of this report.
(C) Incorporated by reference to Registrant's Form10-KSB for the year ended
    September 30, 1996
 
                                      40
<PAGE>
 
                                                                      1455-AR-99