<PAGE>
 
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-K
     (Mark One)
        [X]      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
             OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]

                  For the fiscal year ended DECEMBER 31, 1996
                                      OR

        [ ]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
           OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

          For the transition period from ______________ to __________

                          Commission File No. 1-13638
                                 TOY BIZ, INC.
             (Exact name of Registrant as specified in its charter)

       DELAWARE                                          13-3711775
(State of incorporation)                 (I.R.S. employer identification number)

                              333 EAST 38TH STREET
                            NEW YORK, NEW YORK 10016
          (Address of principal executive offices, including zip code)

                                 (212) 682-4700
              (Registrant's telephone number, including area code)

          ____________________________________________________________

          Securities registered pursuant to Section 12(b) of the Act:
                 CLASS A COMMON STOCK, PAR VALUE $.01 PER SHARE
          Securities registered pursuant to Section 12(g) of the Act:
                                      None

Indicate by check mark whether the Registrant:  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes  X   No
                                               ---     ---

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [X]

The approximate aggregate market value of the voting stock held by non-
affiliates of the Registrant as of March 28, 1997 was $63,403,257, based on a
price of $9.50 per share, the closing sales price for the Registrant's Class A
Common Stock as reported in the New York Stock Exchange Composite Transaction
Tape on that date.

As of March 28, 1997, there were 20,352,127 outstanding shares of the
Registrant's Class A Common Stock, par value $.01 per share (the "Class A Common
Stock") and 7,394,000 outstanding shares of the Registrant's Class B Common
Stock, par value $.01 per share (the "Class B Common Stock").

                      DOCUMENTS INCORPORATED BY REFERENCE

     None.
<PAGE>
 
                               TABLE OF CONTENTS

                                                                            Page
                                                                            ----
 
PART I.....................................................................   1
     ITEM 1.   BUSINESS....................................................   1
     ITEM 2.   PROPERTIES..................................................  10
     ITEM 3.   LEGAL PROCEEDINGS...........................................  10
     ITEM 4.   SUBMISSION OF MATTERS TO A
               VOTE OF SECURITY HOLDERS....................................  11
 
PART II....................................................................  11
     ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
               STOCKHOLDER MATTERS.........................................  11
     ITEM 6.   SELECTED FINANCIAL DATA.....................................  12
     ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
               CONDITION AND RESULTS OF OPERATIONS.........................  13
     ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.................  16
     ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
               ON ACCOUNTING AND FINANCIAL DISCLOSURE......................  16
 
PART III...................................................................  17
     ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF
               THE REGISTRANT..............................................  17
     ITEM 11.  EXECUTIVE COMPENSATION......................................  21
     ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
               OWNERS AND MANAGEMENT.......................................  24
     ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..............  25
 
PART IV....................................................................  31
     ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
               AND REPORTS ON FORM 8-K.....................................  31
 
SIGNATURES.................................................................  37
 
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL
STATEMENT SCHEDULE......................................................... F-1

                                      -i-

<PAGE>
 
                      CAUTIONARY STATEMENT FOR PURPOSES OF
                        THE "SAFE HARBOR" PROVISIONS OF
              THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995



     EXCEPT FOR HISTORICAL INFORMATION CONTAINED HEREIN, THE STATEMENTS IN THIS
REPORT REGARDING THE COMPANY'S PRODUCTS, LICENSING RELATIONSHIPS AND GROWTH
PLANS ARE FORWARD-LOOKING STATEMENTS THAT ARE DEPENDENT UPON CERTAIN RISKS AND
UNCERTAINTIES, INCLUDING THOSE RELATING TO DEVELOPMENTS IN THE MARVEL
ENTERTAINMENT GROUP, INC. BANKRUPTCY PROCEEDINGS, THE POPULARITY OF LICENSED
CHARACTERS AND TRADEMARKS, CONSUMER ACCEPTANCE OF NEW PRODUCT INTRODUCTIONS, THE
DEPENDENCE ON MANUFACTURERS IN CHINA, U.S. TRADE RELATIONS WITH CHINA, CHANGING
CONSUMER PREFERENCES, PRODUCTION DELAYS OR SHORTFALLS AND GENERAL ECONOMIC
CONDITIONS.  THOSE AND OTHER RISKS AND UNCERTAINTIES ARE DESCRIBED IN THE
COMPANY'S FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION.

                                     -ii-
<PAGE>
 
                                     PART I

ITEM 1.   BUSINESS

GENERAL

     Toy Biz, Inc. (the "Company") was incorporated in Delaware on March 18,
1993.  The Company designs, markets and distributes a diverse product line
comprised of boys', girls', infant/pre-school and activity toys in the United
States and internationally, based on popular entertainment properties, consumer
brand names and proprietary designs.  The Company's products are distributed to
a number of general and specialty merchandisers and distributors, principally in
the United States and around the world.

     For purposes of this Form 10-K Annual Report, the "Company" includes,
unless the context otherwise requires, the Company, its subsidiary and their
respective predecessors.  The "Predecessor Company" means Toy Biz, Inc., a
Delaware corporation incorporated in 1990 and subsequently renamed Zib Inc., and
its foreign sales affiliate, Toy Biz International Ltd., a Hong Kong
corporation.  The Company's principal executive offices are located at 333 East
38th Street, New York, New York  10016 and its telephone number is (212) 682-
4700.

     In connection with the Company's formation, the Company obtained an
exclusive, perpetual and royalty-free license (the "Marvel License") from Marvel
Entertainment Group, Inc. ("Marvel") which permits the Company to produce a
broad range of toys based on Marvel's more than 3,500 characters (the "Marvel
Characters"). The Company also has licenses to manufacture certain toy products
based on non-Marvel Characters depicted in television programs such as Hercules:
The Legendary Journeys(TM), Xena: Princess Warrior(TM) and Muppet Babies(TM),
all of which are broadcast on network, syndicated or cable television. A number
of motion pictures as to which the Company has obtained licenses to manufacture
certain products have been completed or are in the planning stages. These
include a made-for-television movie entitled Generation X(TM), which premiered
in prime time on the Fox Network, for which the Company has manufactured and
distributed mainly action figures, as well as a feature film entitled Muppet
Treasure Island(TM), a widely distributed first run motion picture, for which
the Company has manufactured and distributed certain plush items. Other motion
pictures (both related and unrelated to the Marvel Characters) for which the
Company has obtained licenses to manufacture certain products, are planned for
release by such licensors as The Walt Disney Company ("Disney") and Universal
City Studios, Inc. or its affiliates ("Universal"). See " - Licensing and
Related Rights - Marvel License Agreement."

     The Company believes that media events associated with the characters on
which it bases certain of its toy products increase overall consumer awareness
and popularity of these characters and the Company has in part followed a
strategy intended to capitalize on the popularity generated by such media
exposure.  The Company has used its success in marketing the Marvel line as a
means of attracting licenses for use of recognized trademarks and brand names
such as Gerber(R), Coleman(R), and NASCAR(R).

POSSIBLE CHANGE OF CONTROL
 
     Marvel owns approximately 26.6% of the outstanding common stock of the
Company and has 78.4% of the total voting power of the Company's outstanding
common stock.  On December 27, 1996, Marvel and its subsidiaries, other than
Panini S.p.A. ("Panini"), Marvel Restaurant Venture Corp., a general partner in
Marvel's Marvel Mania restaurant joint venture, and certain inactive
subsidiaries, filed voluntary petitions for reorganization under Chapter 11 of
the U.S. Bankruptcy Code in the United States Bankruptcy Court for the District
of Delaware (the "Petitions").  In a separate case, Marvel Holdings Inc.
("Marvel Holdings"), Marvel (Parent) Holdings Inc. ("Marvel (Parent)") and
Marvel III Holdings Inc. ("Marvel III" and collectively with Marvel Holdings and
Marvel (Parent), the "Marvel Holding Companies") also filed voluntary petitions
for reorganization under Chapter 11.  Under the proposed joint plan of
reorganization (the "Joint Plan of Reorganization"), Andrews Group Incorporated,
a Delaware corporation ("Andrews Group"), entered into a Stock Purchase
Agreement with Marvel dated as of December 27, 1996 (the "Stock Acquisition
Agreement") pursuant to which Andrews Group or an affiliate thereof
<PAGE>
 
would have acquired from Marvel a number of shares of common stock of Marvel
representing 80.8% of the outstanding shares of Marvel common stock, after
giving effect to such acquisition, in consideration for $365 million in cash or,
at the option of Andrews Group, shares of Class A Common Stock, par value $.01
per share (the "Class A Common Stock"), of the Company or a combination of the
foregoing.  Andrews Group has since terminated the Stock Acquisition Agreement.
Approximately 79% of the outstanding common stock of Marvel is owned (subject to
certain pledges thereof) by direct and indirect wholly owned subsidiaries of
Andrews Group.
 
     On February 26, 1997, upon consideration of a motion made by the Official
Bondholder's Committee in the Marvel Holdings, Marvel (Parent) and Marvel III
bankruptcy cases, the bankruptcy court granted relief from the automatic stay
which would allow the Official Bondholder's Committee to exercise certain
creditors' remedies.  Such remedies include the right to direct the indenture
trustee to vote the common stock of Marvel and the capital stock of Marvel
Holdings and Marvel (Parent) that is pledged under the indentures governing the
secured notes issued by Marvel Holdings, Marvel (Parent) and Marvel III to the
creditors represented by the Official Bondholder's Committee.  Marvel and the
Marvel Holding Companies have collectively pledged approximately 80% of the
outstanding common stock of Marvel.  On March 19, 1997, the Official
Bondholder's Committee notified Marvel that it intended to exercise its voting
rights to replace the board of directors of Marvel.  On March 24, 1997, the
bankruptcy court ruled that the Official Bondholder's Committee could exercise
the voting rights associated with the capital stock of Marvel Holdings and
Marvel (Parent), but could not exercise the voting rights associated with the
common stock of Marvel until authorized to do so by further order of the
bankruptcy court.  The incumbent board of directors of Marvel remains in office
as of April 14, 1997. See "Item 12. Security Ownership of Certain Beneficial
Owners and Management." Marvel is a party to a Stockholders' Agreement with the
Company, Avi Arad ("Arad") and Isaac Perlmutter ("Perlmutter") which provides
for Marvel's shares of Class B Common Stock to be converted into Class A Common
Stock upon a change of control of Marvel. See "Item 13. Certain Relationships
and Related Transactions - Stockholders' Agreement and Class B Voting Trusts."
 
     On December 27, 1996, following approval by an independent committee of the
Company's board of directors (the "Independent Committee"), the Company entered
into an Agreement and Plan of Merger (the "Merger Agreement") with Andrews Group
and Andrews Acquisition Corp. ("Acquisition"), an affiliate of Andrews Group,
pursuant to which Andrews Group would acquire the entire equity interest in the
Company not otherwise acquired from Isaac Perlmutter and Avi Arad, by means of a
merger (the "Merger") of the Company with and into Acquisition. On November 20,
1996, Andrews Group entered into stock purchase agreements (the "Stock Purchase
Agreements"), which were subsequently amended on January 29, 1997, with Arad and
with Perlmutter and certain of his affiliates (collectively, the "Perlmutter
Group"), pursuant to which Andrews Group would, immediately prior to the Merger,
purchase all of the Class A Common Stock of the Company held by Arad and the
Perlmutter Group. Marvel owns all but two shares (which two shares are held in
voting trusts) of the Class B common stock, par value $.01 per share (the "Class
B Common Stock" and, together with the Class A Common Stock, the "Common
Stock"), of the Company. See "Item 3. Legal Proceedings."

     Andrews Group's obligation to consummate the Merger is conditioned upon,
among other things, confirmation of the Joint Plan of Reorganization with
respect to Marvel and certain of its subsidiaries and the satisfaction or waiver
of all of the conditions to closing under the Stock Acquisition Agreement (as
defined below).

     The Company, Arad and Perlmutter have each received notice from Andrews
Group that Andrews Group has terminated its Stock Acquisition Agreement with
Marvel, and accordingly a condition to the obligations of Andrews Group and
Acquisition to consummate the Merger pursuant to the Merger Agreement will not
be satisfied.  Andrews Group further advised the Company, Arad and Perlmutter
that Andrews Group does not intend to waive such condition, and anticipates that
the Merger will not be consummated.  While the Merger Agreement has not been
formally terminated, the Merger will not be consummated if Andrews Group does
not waive such condition. Because such condition to consummation of the Merger
will not be satisfied, the conditions to the obligations of Andrews Group to
consummate the transactions contemplated by the Stock Purchase Agreements
will not be satisfied.

                                      -2-

<PAGE>
 
     The Merger Agreement, the Stock Purchase Agreements and the Stock
Acquisition Agreement are described more specifically herein under "Item 13.
Certain Relationships and Related Transactions."

DEVELOPMENTS WITH RESPECT TO THE COMPANY'S BUSINESS DURING FISCAL YEAR 1996

     During the past fiscal year, the Company continued to launch products based
on the various Marvel Character groups mentioned above.  These included, among
other things, new products and product line extensions in the Company's X-Men(R)
and Spider-Man(R) ranges.

     During 1996, the Company also continued its efforts to develop toys under
licenses for recognized consumer brand names and other popular characters.  The
Company continued to build on its line of dolls and infant and toddler learning
toys marketed under the Gerber(R) trademark.  The Company continues to develop a
line of children's toys with a camping and outdoor theme sold under the
Coleman(R) trademark.  The Company also licensed from NASCAR(R) and several
well-known stock car drivers the rights to manufacture various toy products
based upon such trademarks and personalities.

     During 1996, the Company also continued to manufacture and distribute
additional proprietary products in various categories including: Baby Tumbles
Surprise(TM), Baby Headstand Surprise(TM), Baby So Real(TM), Take Care of Me
Twins(TM) and multi-activity game tables.

     Since completing the acquisitions of the assets of Spectra Star, Inc.
("Spectra Star(R)") and Quest Aerospace Education, Inc. ("Quest") in 1995, the
Company's specialized activity toy business has continued to grow, with Spectra
Star(R) brand kites comprising a substantial share of United States domestic
kite business, and Quest(TM) brand rockets entering the growing mass merchandise
market and specialty store distribution channels.

INDUSTRY BACKGROUND

     The toy industry's highly competitive environment continues to place cost
pressures on manufacturers/distributors.  Discretionary spending among potential
toy consumers is limited and the toy industry competes for such dollars along
with the makers of computers and video games.  The Company believes that its
products are well made, attractively priced, and benefit from television
exposure arising from scheduled programming, media events, advertising and the
strength of recognized trademarks or brand names.

     Large mass market toy retailers dominate the toy industry and feature a
large selection of toys.  Continued consolidation among discount-oriented
retailers can be expected to require toy companies to keep prices low and to
implement and maintain production and inventory control methods permitting them
to respond quickly to changes in demand.

PRODUCTS

     The Company has historically marketed a variety of toy products designed
for children of different age groups.  The Company's current product strategy
seeks broad expansion and diversification of its product lines.

                                      -3-

<PAGE>                                              
 
     Boys' Products

     The Marvel License includes more than 3,500 Marvel Characters, all of which
are available to the Company for toy development.  The segment of the Marvel
universe which has been most successfully developed by the Company is the X-
Men(R), consisting of over 300 characters.  The popularity of the X-Men(R)
primarily resulted from that character group's long-standing success as a comic
book title, as well as the past success of the Fox Children's Network's animated
X-Men(R) television show.  The Company's sales of the X-Men(R) product line
decreased in 1996 as that product line matured.

     The Spider-Man(R) product line also capitalizes on an animated television
series which is broadcast on the Fox Children's Network.  The Spider-Man(R) toy
line includes action figures, vehicles and playsets.  The Company also markets
boys' toys based on characters portrayed in the Marvel-related Iron Man(R) and
Fantastic Four(TM) syndicated television programs, and is planning a launch of
Silver Surfer(TM) products based upon the Silver Surfer animated television
program (which is expected to begin broadcasting on the Fox Children's Network
in 1997).

     The Company's boys' business is also comprised of non-Marvel Character
genres supported by television advertising and broadcasts.  The Company
continues to market a line of action figures and playsets based on characters
portrayed in the Hercules: The Legendary Journey(TM) and Xena: Princess
Warrior(TM) syndicated television programs. The Company also markets playsets
and vehicles using well-known stock car drivers and NASCAR(R) licenses.

     Many of the action figure properties have proven to be highly popular with
the Company's international customers, especially those in Europe.

     Girls' Products

     The Company's girls' business has continued to thrive with new
introductions and product line extensions.  Baby Tumbles Surprise(TM) and Baby
Headstand Surprise(TM) continue as top-selling unit volume dolls. The Company
has also marketed Baby Looks So Real(TM), Take Care of Me Twins (TM), Bendy
Wendy(TM), and Pretty Sparkle Dancer(TM). The Company believes that it will
continue to be an important source of new girls' products for the retail toy
market.

     Preschool Products

     The Company continues to take advantage of the name recognition and the
goodwill associated with the Gerber(R) name with the production of its line of
dolls, as well as infant and toddler learning toys with the Gerber(R) trademark
and/or the famous trademarked Gerber(R) baby face.

     Activity Toys

     The Spectra Star(R) brand name accounts for a substantial share of the
United States domestic kite business, and thrives on license-driven products.
The Company's kite licenses have been granted by the licensing entities
associated with such well-known licensors as Disney, Universal and Warner Bros.
The Company's activity toy products also include the model rocketry products
associated with the business acquired from Quest and the Company's proprietary
multi-activity game tables.

FACTORS WHICH MAY AFFECT THE COMPANY'S PRODUCT STRATEGY

     The success of the Company's product strategy depends in part upon consumer
acceptance of its new toy products for which there can be no assurance.
Consumer acceptance of many of the Company's products is dependent on the
popularity generated by television programs and other media events, the strength
of recognized consumer trademarks and brand names, and consumer interest in the
Company's core product categories.  There

                                      -4-
<PAGE>
 
can be no assurance that any scheduled or anticipated television program or
other media event will occur at all or will continue to be broadcast or will
otherwise result in substantial marketing value to, or sales of the Company's
toy products.  Nor can there be any assurance that the goodwill associated with
recognized consumer trademarks or brand names will add marketing value to the
Company's toy products or that the Company's core products will maintain the
buying interest of consumers.  The Company's new and existing products are also
subject to changing consumer preferences.  Some products in the toy industry are
successfully marketed for a limited period, sometimes only one or two years.
There can be no assurance that any existing product lines will retain their
current popularity or that new products developed by the Company will meet with
the same success as the Company's current products.  While it is impossible to
predict future trends in a business as fad-oriented as the toy industry, the
Company's believes its product line is sufficiently diverse to benefit from such
trends.  No assurance can be given that the Company will accurately anticipate
future trends or will be able to successfully develop, produce and market
products to take advantage of market opportunities presented by such trends.

     The Company believes its sales and business have been adversely affected by
concerns among retailers as to the impact of the Marvel bankruptcy. While the
Company is attempting to address these concerns, to the extent they are not
alleviated, it can be expected that they will continue to adversely affect
demand for the Company's products.

LICENSING AND RELATED RIGHTS

     In carrying out its business strategy, the Company continuously monitors
existing licensed properties and pursues new licenses, where it believes such
licenses fit with the Company's core product lines, or where they may add to the
Company's core product mix.

     In 1996, the Company produced a majority of its products under licenses
which it has obtained from third parties.  Some of these licenses confer rights
to exploit original concepts developed by toy inventors and designers.
Character licenses, such as the Marvel License, permit the Company to
manufacture and market toys based on characters owned by others which have or
develop their own popular identity, often through exposure in various media such
as television programs, movies, cartoons and books.  Other licenses, referred to
as trademark or brand name licenses, permit the Company to produce toys bearing
the recognized consumer trademark or brand name owned by the licensor.  In
return for these rights (other than those under the Marvel License), the Company
pays royalties to its licensors.

     A determination to acquire a character license must frequently be made
before the commercial introduction of the property in which a licensed character
appears, and such license arrangements often require the payment of non-
refundable advances or guaranteed minimum royalties.  Accordingly, the success
of a character licensing program is dependent upon the ability of the Company to
accurately assess the future success and popularity of the character properties
which it is evaluating, to bid for such properties on a selective basis in
accordance with such evaluation and to capitalize on the properties for which it
has obtained licenses in an expeditious manner.  The success of the trademark
licensing program depends in part on whether the strength of the licensed
trademark will produce marketing value for the toy products.  There can be no
assurance that product produced under the licenses acquired by the Company will
obtain significant market acceptance.

     Royalties paid by the Company to licensors and inventors are typically
based on a percentage of net sales.  Most licenses have terms of one to three
years and some are renewable at the option of the Company upon payment of
minimum guaranteed payments or the attainment of certain sales levels during the
term of the license.  In the future, royalty rates and minimum guaranteed
payments may increase or decrease depending upon various competitive forces in
the toy industry.

                                      -5-

<PAGE>
 
     Marvel License Agreement

     In connection with the formation of the Company, Marvel granted the Company
the Marvel License, an exclusive, perpetual and royalty-free license, subject to
certain limitations, to manufacture and distribute a broad range of toys and
toy-related products based upon the Marvel Characters and properties in which it
owns copyrights, trademarks or trade names.  The Marvel License covers all
characters (including the associated copyrights and trademarks) owned by Marvel
and disseminated under the Marvel Comics(R) trademark during the perpetual term
of the Marvel License.  The Marvel License currently covers more than 3,500
different Marvel Characters, including: Marvel Super Heroes(TM), X-Men(R) and 
X-Force(TM) (including Wolverine(R), Nightcrawler(TM), Colossus(TM), Storm(TM),
Cyclops(TM), Bishop(R) and Gambit(TM)); Spider-Man(R); Captain America(R);
Fantastic Four(TM) (including Mr. Fantastic(TM), The Human Torch(TM), Invisible
Woman(TM) and The Thing(TM)); Hulk(R); Thor(TM); The Silver Surfer(TM);
Daredevil(TM); Iron Man(R); The Punisher(R); Dr. Strange(TM); Ghost Rider(TM);
Cable(TM) and the other Marvel Characters. The Marvel License covers specified
categories of toys and toy-related products. In connection with the Marvel
bankruptcy proceedings, representatives of the Official Bondholder's Committee
have publicly stated that they could seek to reject the Marvel License as an
executory contract. The Company would vigorously oppose any such action to
reject the Marvel License and would seek any and all damages resulting from any
such action.

     The Marvel License restricts Marvel, subject to the Company's prior
consent, from manufacturing, using, distributing or advertising the licensed
products and from granting other licenses to use the Marvel Characters in
connection with any licensed toy products.  If the Company fails to
substantially attain performance goals for sales of any category of licensed
products, Marvel has the right to require the Company to enter into one or more
sublicenses with respect to that category of licensed products on terms and
conditions that Marvel and the Company reasonably determine.  While Marvel has
never required the Company to enter into any such sublicenses, the Company
maintains an active sublicensing program, as to which it retains all revenues,
and has granted sublicenses under the Marvel License to a variety of companies
in the United States and around the world.

     Master License Agreement

     Mr. Arad and the Company are parties to a license agreement which amended
the licenses between Mr. Arad and the Predecessor Company outstanding at the
time of the Company's formation and which governs the licensing of new material
to the Company by Mr. Arad thereafter.  The license agreement provides that Mr.
Arad is entitled to receive royalty payments on net sales of Marvel Character-
based toys and on net sales of non-Marvel based toys of which Mr. Arad is the
inventor of record.  In no event, however, may the total royalties payable to
Mr. Arad during any calendar year exceed $7.5 million.

     Gerber License Agreement

     The Company is a party to a license agreement with the Gerber Products
Company (the "Gerber License") which grants the Company an exclusive license to
use the Gerber(R) trademark in connection with the manufacture and distribution
of dolls as well as infant and toddler learning toys.  The Gerber License, which
continues until December 31, 1997, provides for a royalty on net sales of the
licensed products and contains certain minimum sales guarantees and customary
quality control and indemnification provisions.  The Gerber License is
terminable immediately by Gerber if Avi Arad & Associates ceases to be involved
in the product development and marketing of the licensed products or upon a
change of ownership, control or management of the Company without Gerber's prior
approval.  A change in control of Marvel in the bankruptcy proceedings may give
rise to a change in control of the Company within the meaning of the Gerber
Agreement.  In such event, the Company will seek any necessary approval from
Gerber for which there can be no assurance.

     Other License Agreements

     The Company is a party to a license agreement (the "Coleman License") with
The Coleman Company, Inc., an affiliate of the Company and Marvel, which grants
the Company a license to utilize the Coleman(R) trademark in

                                      -6-
<PAGE>
 
connection with the manufacture, distribution and sale of certain children's
toys in the United States and Canada.  The Coleman License expires December 31,
1997, and is subject to a three year extension based upon certain conditions.

INTELLECTUAL PROPERTY RIGHTS

     The Company believes that intellectual property rights, including
trademarks, patented devices and designs, and copyrighted material, owned or
licensed by it represent valuable assets in the operation of its business.  The
Company generally seeks trademark, patent and copyright protection in the United
States and certain other countries for intellectual property rights used in its
business to the extent that such protection is available and meaningful.  The
Company believes that all material intellectual property rights necessary for
the operation of its business are adequately protected and available to it.

DESIGN AND DEVELOPMENT; MANUFACTURING

     The Company maintains a product development staff and also obtains new
product ideas from third-party inventors.  The time from concept to production
of a new toy can range from six to twenty-four months, depending on product
complexity.

     The Company relies on independent parties in the People's Republic of China
("China") to manufacture a substantial portion of its products.  The remainder
of its products are manufactured in Mexico or the United States.  As a matter of
policy, the Company uses several different manufacturers.  By concentrating its
manufacturing among certain manufacturers, the Company thereby pursues a
strategy of selecting manufacturers at which the Company's product volume
qualifies the Company as a significant customer.  The Company is not a party to
any long-term agreement with any manufacturer.

     The principal raw materials used in the production and sale of the
Company's products are plastics and paper products.  Raw materials are generally
purchased by the manufacturers who deliver completed products to the Company.
The Company believes that an adequate supply of raw materials used in the
manufacture of its products is readily available from existing and alternative
sources at reasonable prices.  However, there can be no assurance that, in the
event of a disruption in raw material supplies, alternative sources of supply
could be obtained in a timely manner.

     While the Company is not dependent on any single manufacturer in China to
supply it with products, the Company is subject to the risks of foreign
manufacturing, including currency exchange fluctuations, transportation delays
and interruptions, and political or economic disruptions affecting international
businesses generally.  The Company's ability to obtain products from its Chinese
manufacturers is dependent upon the United States' trade relationship with
China.  The "Most Favored Nation" status of China, which is reviewed annually by
the United States government, is a regular topic of political controversy.  The
loss of China's "Most Favored Nation Status" would increase the cost of
importing products from China significantly, which could have a material adverse
effect on the Company.  The imposition of further trade sanctions on China could
result in significant supply disruptions or higher merchandise costs to the
Company.  The Company believes that alternate sources of manufacturing are
available outside China, although there can be no assurance that these alternate
sources will be available on acceptable terms.

     Transactions in which the Company purchases goods from manufacturers are
mostly effected in Hong Kong dollars, and, accordingly, fluctuations in Hong
Kong monetary rates may have an impact on the cost of goods.  However, in recent
years, the value of the Hong Kong dollar has been tied to the value of the
United States dollar, eliminating fluctuations between the two currencies.
There can be no assurance that the Hong Kong dollar will continue to be tied to
the United States dollar.  Furthermore, appreciation of Chinese currency values
relative to the Hong Kong dollar could increase the cost to the Company of
products manufactured in China and thereby have a negative impact on the
Company.

                                      -7-
<PAGE>
 
     The Company's Spectra Star(R) products are manufactured mainly in Mexico.
Pursuant to an agreement with the former owner of Spectra Star's business, the
Company reimburses all of the operating costs incurred in the manufacture of
Spectra Star(R) products at the former owner's Mexican facility.  While it
expects to maintain a consistent level of manufacturing in Mexico, due to
capacity constraints of the Mexican facility, the Company does not currently
view manufacturing in that country as an alternative to manufacturing in China.
The Company is currently constructing a new manufacturing facility in Mexico in
order to expand manufacturing capacity for the Spectra Star(R) and possibly
other product lines.  See "Item 7.  Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital
Resources."

     The Company maintains a Hong Kong office from which it regularly monitors
the progress and performance of its manufacturers and subcontractors.  The
Company also uses Acts Testing Labs (H.K.) Ltd., a leading independent quality-
inspection firm, to maintain close contact with its manufacturers and
subcontractors in China and to monitor quality control of the Company's
products.  The Company uses an affiliate of Acts Testing Labs (H.K.) Ltd. to
provide testing services for a limited amount of product currently produced in
the United States.

CUSTOMERS, MARKETING AND DISTRIBUTION

     The Company markets and distributes its products throughout the world, with
sales to customers in the United States accounting for approximately 80% of the
Company's net sales in 1996.

     The following table sets forth information concerning the Company's net
sales in the United States and internationally:

<TABLE>
<CAPTION>
                       Year ended December 31,
                       ------------------------
                         1994         1995        1996
                       --------  --------------  ------
                                 (In Millions)
<S>                    <C>       <C>             <C>
Domestic Sales.......    $142.7         $175.8   $176.6
International Sales..      13.8           20.6     45.0
                         ------         ------   ------
      Total..........     156.5          196.4    221.6
                         ======         ======   ======
</TABLE>

     Domestic Sales

     Outlets for the Company's products in the United States include specialty
toy retailers, mass merchandisers, mail order companies and variety stores, as
well as independent distributors who purchase products directly from the Company
and ship them to retail outlets.  The Company's five largest customers include
Toys 'R' US, Inc., Wal-Mart Stores, Inc., Kmart Corporation, Target Stores,
Inc., a division of Dayton-Hudson Corp. and Kay-Bee Toys, a division of
Consolidated Stores, Inc. which customers accounted in the aggregate for
approximately 74.8% of the Company's domestic gross sales and 59.6% of the
Company's total sales in 1996.

     The Company maintains a sales and marketing staff and retains various
independent manufacturers' sales representative organizations in the United
States.  The Company's senior management, coordinates and supervises the efforts
of its salesmen and its other sales representatives.  The Company also directly
introduces and markets to customers new products and extensions to previously
marketed product lines by participating in the major trade shows in New York,
Hong Kong and Europe and through a showroom maintained by the Company in New
York.

     The Company utilizes an independent public warehouse in the Seattle,
Washington area, for storage of its products.  The Company believes that
adequate alternative storage facilities are available.  Disruptions in shipments

                                      -8-
<PAGE>
 
from China or from this facility could have a material adverse effect on the
Company.  The Company believes foreign markets continue to represent a
significant opportunity for future expansion.

     International Sales

     The Company's products are sold outside the United States through
independent distributors by its Hong Kong subsidiary, under supervision of the
Company's management.  The Company's international product line generally
includes products currently or previously offered in the United States, packaged
to meet local regulatory and marketing requirements.

ADVERTISING

     Although a portion of the Company's advertising budget is expended for
newspaper advertising, magazine advertising, catalogs and other promotional
materials, the Company allocates a majority of its advertising budget to
television promotion.  The Company advertises on national television and
purchases advertising spots on a local basis.  The Company believes that
television programs underlying various Company product lines increase exposure
and awareness.  The Company engages Tangible Media, Inc. ("Tangible Media"), an
affiliate of Mr. Perlmutter, to purchase all advertising for the Company.  The
Company believes that its transactions with Tangible Media are on terms which
are no less favorable to the Company than those that it could obtain from
independent third parties, and the Company may engage other companies to perform
similar services at any time.  The Company retains the services of a media
consulting agency for advice on matters of advertising creativity.

COMPETITION

     The toy industry is highly competitive and the Company competes with many
larger toy companies in the design and development of new toys, the procurement
of licenses and for adequate retail shelf space for its products.  The larger
toy companies include Hasbro, Inc., Mattel Inc., Tyco Toys, Inc., Playmates,
Inc. and Bandai, Co., Ltd., and the Company considers Just Toys, Inc., Lewis
Galoob Toys, Inc., Empire of Carolina, Inc. and Ohio Art Co. to be among its
competitors as well.  The Company believes that the Marvel License, other strong
character and product licenses, the industry reputation and ability of its
senior management, the quality of its products and its overhead and operational
controls have enabled the Company to compete successfully.

SEASONALITY

     The Company, like the toy industry in general, experiences a significant
seasonal pattern in sales and net income due to the heavy demand for toys during
the Christmas season. During 1994, 1995 and 1996, 70%, 69% and 64% respectively,
of the Company's domestic net sales were realized during the months of July
through December.  This seasonal pattern requires significant use of working
capital mainly to build inventory during the year, prior to the Christmas
selling season.  The Company expects that its business will continue to
experience a significant seasonal pattern for the foreseeable future.

GOVERNMENT REGULATIONS; INSURANCE

     The Company is subject to the provisions of, among other laws, the Federal
Hazardous Substances Act and the Federal Consumer Product Safety Act.  Those
laws empower the Consumer Product Safety Commission (the "CPSC") to protect
children from hazardous toys and other articles.  The CPSC has the authority to
exclude from the market articles which are found to be hazardous.  Similar laws
exist in some states and cities in the United States, in Canada and Europe.  The
Company maintains a quality control program (including the inspection of goods
at factories and the retention of an independent quality-inspection firm) to
ensure compliance with applicable laws.  The Company's business exposes it to
potential product liability risks which are inherent in the design, marketing
and sale of children's products.  The Company currently maintains product
liability insurance and an umbrella liability policy.  In the event of a
successful claim against the Company, a lack of sufficient insurance coverage

                                      -9-
<PAGE>
 
could have a material adverse effect on the Company's business and operations.
Moreover, though the Company maintains what it considers to be adequate
insurance, any successful claim could materially and adversely affect the
reputation and prospects of the Company.

EMPLOYEES

     As of March 28, 1997, the Company had 129 employees, of whom 63 were based
at the Company's New York office, 46 were based at the Company's Arizona offices
and 20 were based at the Company's Hong Kong office.  In total, 77 employees are
involved in the manufacturing or creative process, while the balance of
employees are involved in sales, marketing, finance or administrative functions.


ITEM 2.   PROPERTIES

     The Company's principal executive offices and showroom are located in New
York City where the Company occupies approximately 17,000 square feet of office
space pursuant to a lease that expires in April 1997.  The Company has entered
into a sublease that expires in June, 2000, pursuant to which it will occupy
approximately 30,000 square feet of new office space and expects to relocate its
executive and principal offices to such premises in June 1997.  Under a lease
that expires in 2004, the Company also maintains a showroom at the Toy Center
Building in New York City, where the Company leases approximately 5,200 square
feet of display and office space.  The Company also leases approximately 80,000
square feet of warehouse space in Yuma, Arizona, and leases additional property
in Arizona pursuant to a lease that expires in 2006, where it manufactures the
Quest product line.  The Company believes that additional office and warehouse
space is readily available and that such new space, together with the Company's
existing facilities, will be adequate and suitable for the operation of its
business for the foreseeable future.


ITEM 3.   LEGAL PROCEEDINGS

     On December 28, 1995 G.D.L. Management Incorporated ("GDL") commenced an
action against the Company, Mr. Perlmutter and the Predecessor Company in the
Supreme Court of the State of New York, County of New York.  The amended
complaint in that action, which was served on March 19, 1996, alleges that GDL
is entitled to receive ten percent of the capital stock of the Predecessor
Company pursuant to a 1990 agreement between GDL and Mr. Perlmutter and seeks
money damages based on the value of ten percent of the Company's Class A Common
Stock beneficially owned by Mr. Perlmutter and a variety of equitable remedies,
including an order rescinding the 1993 transfer of the assets of the Predecessor
Company to the Company pursuant to the Formation and Contribution Agreement.
Mr. Perlmutter has denied all of the material allegations made in support of
GDL's claims, and pursuant to the Formation and Contribution Agreement, agreed
to indemnify the Company in respect to any liability arising from GDL's claims.
The Company does not believe that any of the claims made against it will have a
material adverse effect on its financial position because it believes that all
of the claims against it are without merit and because of the indemnity provided
to it in the Formation and Contribution Agreement.

       On November 15, 1996, John A. Holl, an alleged stockholder of the
Company, filed a purported class action complaint against the Company, Marvel,
Andrews Group, Ronald O. Perelman, Joseph Ahearn, Arad and Perlmutter in the
Court of Chancery of the State of Delaware in and for New Castle County.  The
complaint alleges, inter alia, that in pursuing the Merger, pursuant to which
the shares held by the Company's public stockholders will be purchased, the
defendants have breached their fiduciary duties or aided and abetted such
breaches by allegedly engaging in unfair dealing, acting in their own interests
and failing to obtain the highest possible price for the Company's stockholders.
The complaint seeks, inter alia, (i) to have the consummation of the Merger
enjoined and a committee of class members appointed to provide input into the
procedures to be followed in connection with any such transaction and (ii)
certain other declaratory relief and damages.  Although plaintiff filed a motion
to expedite discovery, he has made no further attempt to have the proceedings
expedited.  The Company has received notice

                                      -10-
<PAGE>
 
from Andrews Group that Andrews Group has terminated its Stock Acquisition
Agreement with Marvel and, accordingly, a condition to the obligations of
Andrews Group and Acquisition to consummate the Merger pursuant to the Merger
Agreement will not be satisfied.  Andrews Group further advised the Company that
Andrews Group does not intend to waive such condition and anticipates that the
Merger will not be consummated.  The Company therefore believes that the basis
of this complaint has become moot.  See "Item 1. Business - Possible Change of
Control."

     The Company is involved in various legal proceedings arising in the normal
course of business.  The Company believes that the final outcome of these
proceedings will not have a material adverse effect on the Company's results of
operations or financial position.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matter was submitted to a vote of the Company's stockholders during the
fourth quarter of the fiscal year covered by this report.


                                    PART II

ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     The following table sets forth, for each fiscal quarter indicated, the high
and low prices for the Company's Class A Common Stock as reported in the New
York Stock Exchange Composite Transaction Tape.  Regular-Way trading in the
Class A Common Stock commenced on the New York Stock Exchange on February 23,
1995.

<TABLE>
<CAPTION>
FISCAL YEAR              HIGH      LOW
---------------------  --------  --------
<S>                    <C>       <C>
 
     1995
 
     First Quarter      $21 1/8   $18 5/8
     Second Quarter     $20 1/4   $16 3/8
     Third Quarter      $26 1/4   $18
     Fourth Quarter     $25 1/8   $20 1/4
 
 
     1996
 
     First Quarter      $24 3/4   $17 7/8
     Second Quarter     $22 3/8   $17 5/8
     Third Quarter      $20 1/4   $14
     Fourth Quarter     $19 7/8   $17
</TABLE>

     As of March 28, 1997, there were 85 holders of record of the Company's
Class A Common Stock.

     The Company has not declared any dividends.  For a description of certain
restrictions on payment of dividends, see Note 7 to the December 31, 1996
Consolidated Financial Statements included elsewhere in this Report.

                                      -11-
<PAGE>
 
ITEM 6.   SELECTED FINANCIAL DATA

     The following table presents selected combined or consolidated financial
data for the business of the Company and the Predecessor Company for the five
year period ended December 31, 1996 which were derived from audited financial
statements of the Company's business.

     The Company has not paid dividends on its capital stock during any of
the periods presented below.

<TABLE>
<CAPTION>
                                        Predecessor Company
                                        -------------------
                                                     Four      Eight 
                                          Year      Months    Months          Year Ended 
                                         Ended       Ended     Ended  ----------------------------
                                          Dec.        Apr.      Dec.      Dec.      Dec.      Dec.
                                           31,        30,       31,       31,       31,       31,
                                          1992       1993      1993      1994      1995      1996
                                        -------   --------   -------  --------  --------  --------
<S>                                     <C>       <C>        <C>      <C>       <C>       <C>
Statement of Operations
   Data: (1) (2)
Net Sales...........................    $57,934    $10,175   $79,569  $156,525  $196,395  $221,624
Operating income (loss).............      2,654    ( 1,611)    6,266    32,072    47,014    27,215
Net income (loss) (3)...............        888    ( 1,110)    3,488    18,014    28,402    16,687
Net income (loss) per               
   common share (3)(4)..............       0.03    (  0.04)     0.13      0.67      1.05      0.61
 
At December 31:
 
Balance Sheet Data:
Working capital.....................    (   844)              24,780    39,839    85,174   102,192
Total assets........................     28,852               56,877   104,723   152,218   171,732
Borrowings under credit             
   facility.........................         --                4,500    21,500        --        --
Due to stockholders and             
   affiliated companies.............     13,407               15,746    16,845        --        --
Redeemable preferred                
   stock............................         --                   --        --     3,016     1,681
Stockholders' equity................      2,384               16,283    38,416   111,332   137,455
</TABLE>

(1)  The year ended December 31, 1992 and the four month period ended April 30,
     1993 represent the combined results of the business of the Company, which
     was then wholly owned by Mr. Perlmutter, and Toy Biz International Ltd., a
     Hong Kong company indirectly controlled by the Predecessor Company.  These
     operations are referred to as the Predecessor Company results.  The eight
     month period ended December 31, 1993 and the years ended December 31, 1994,
     1995 and 1996 represent the consolidated results of the Company.  There was
     no change in the carrying value of the Company's assets or liabilities as a
     result of the April 30, 1993 transaction (see Note 1 of notes to audited
     financial statements).

(2)  The four month period ended April 30, 1993 includes the five months of
     results of Toy Biz International Ltd. as a result of changing Toy Biz
     International Ltd's fiscal year end from November 30 to December 31.  The
     sales and operating loss of Toy Biz International Ltd. for the month of
     December 1992 were not significant.

(3)  For the taxable periods from January 1, 1992 until April 30, 1993, the
     Predecessor Company was subject to taxation under Subchapter S of the
     Internal Revenue code of 1986, as amended.  As a result, the Predecessor
     Company was not subject to Federal and certain state income taxes as its
     sole stockholder included the results of its operations in his personal
     income for these tax purposes.  Provision for income taxes for the
     aforementioned periods reflects income

                                      -12-
<PAGE>
 
     tax (expense) benefit (at an assumed effective combined tax rate of 40%) on
     a pro forma basis as if the Predecessor Company had not been an S
     corporation.

(4)  Assumes 27,000 common and common equivalent shares outstanding for periods
     prior to 1995.


ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
          CONDITION AND RESULTS OF OPERATIONS

     The following discussion and analysis of the financial condition and
results of operations of the Company and its subsidiaries should be read in
conjunction with the Consolidated Financial Statements and the Notes thereto,
included elsewhere in this Report.

OVERVIEW

     The Company designs, markets and distributes in the United States and
internationally new and traditional toys in the boys', girls', preschool, and
activity toy categories featuring major entertainment and consumer brand name
properties.  The Company also designs, markets and distributes its own line of
proprietary toys.

RESULTS OF OPERATIONS

     YEARS ENDED DECEMBER 31, 1996 AND 1995

     The Company's net sales increased 12.8% to approximately $221.6 million
from approximately $196.4 million in 1995.

     Domestic net sales of boys' toys decreased 27% from approximately $105.5
million in 1995 to $76.5 million in 1996 due primarily to decreased sales of the
X-Men(R), Fantastic Four(TM) and Iron Man(R) product lines.  International net
sales of boys' toys more than doubled from approximately $16.4 million in 1995
to approximately $39.6 million in 1996.  Domestic net sales of girls' toys
increased 54% from approximately $37.7 million in 1995 to approximately $57.9
million in 1996 due mainly to the introduction of Take Care of Me Twins(TM)
doll, as well as the expansion of the Baby Tumbles Surprise(TM) category in
1996. Sales in the activity toy category increased 72% from approximately $15.5
million in domestic net sales in 1995 to approximately $26.6 million in 1996 due
to the introduction of the multi-activity game tables and the full-year effect
of kite sales from the Spectra Star(R) acquisition, which only had four months
of sales included in the 1995 year. The preschool category decreased 32% from
approximately $13.5 million in domestic net sales in 1995 to approximately $9.2
million in 1996. International net sales more than doubled from approximately
$20.6 million in 1995 to approximately $45.0 million in 1996, due to the
continued expansion of the Company's product offerings overseas. Distribution
agreement fees and sub-licensing revenues more than doubled from approximately
$5.7 million in 1995 to approximately $13.6 million in 1996.

     Gross profit decreased 3% to approximately $105.2 million in 1996 from
approximately $108.0 million in 1995.  Gross profit as percentage of net sales
("gross margin") decreased from approximately 55% in 1995 to approximately 47%
in 1996 due primarily to changes in the Company's product mix, additional sales
allowances and the effect of a higher percentage of international sales, which
typically have a lower gross margin than domestic sales.

     Selling, general and administrative expenses increased 28% to approximately
$61.9 million (approximately 28% of net sales) in 1996 from approximately $48.2
million (approximately 25% of net sales) in 1995.  The increase of approximately
$13.7 million was due to increased advertising and miscellaneous selling and
administrative expenses, which increased as a result of sales growth, and
additional salaries attributable to the Company's expanded product lines, as
well as the effect of a full year of the Spectra Star(R) operations in 1996.

                                      -13-
<PAGE>
 
     Depreciation and amortization expense increased to approximately $16.1
million in 1996 from approximately $12.8 million in 1995.  This increase was
primarily attributable to increased amortization of product tooling costs
resulting from increased investment in product and package design costs and
molds, tools and equipment to support the Company's expanded product line.
Depreciation and amortization expense as a percentage of net sales increased
from 6.5% in 1995 to 7.2% in 1996.  This increase in depreciation expense as a
percentage of net sales was primarily attributable to a changing product mix and
decreased unit sales of boys' toys assortments.

     Interest income, net of interest expense, increased 6.43% to $596,000 in
1996 from $560,000 in 1995.

     As a result of the above, net income decreased 41% to approximately $16.7
million in 1996 from approximately $28.4 million in 1995.

     The Company believes its sales and business were adversely affected in 1996
by concerns among retailers as to the impact of the Marvel bankruptcy. While the
Company is attempting to address these concerns, to the extent they are not
alleviated, it can be expected that they will continue to adversely affect
demand for the Company's products.

YEARS ENDED DECEMBER 31, 1995 AND 1994

     The Company's net sales increased 25% to approximately $196.4 million for
1995 from approximately $156.5 million in 1994.

     Domestic net sales of boys' toys decreased 4% from approximately $110.4
million in 1994 to approximately $105.5 million in 1995.  International net
sales of boys' toys increased 49% from approximately $11.0 million in 1994 to
approximately $16.4 million in 1995.  Domestic net sales of girls' toys nearly
tripled from approximately $12.7 million in 1994 to approximately $37.7 million
in 1995, due mainly to the introduction of Baby Tumbles Surprise(TM), Baby 
Looks So Real(TM) and Pooch the Good Puppy(TM) in 1995, offset by a decrease in
sales of Jumpsie(R) and Caboodles(R) products from 1994 to 1995. The
infant/preschool category increased 85% from approximately $7.3 million in
domestic net sales in 1994 to approximately $13.5 million in 1995, due to the
continued expansion of the Company's infant/preschool line. Sales in the
activity toy category more than doubled from approximately $6.1 million in
domestic net sales in 1994 to approximately $15.5 million in 1995 due to the
introduction of the Wild & Wacky Painter(TM) and, to a lesser extent, the
initial sales of interactive CD-ROM products and kites. International net sales
increased 49% from approximately $13.8 million in 1994 to approximately $20.6
million in 1995, due to the expansion of the Company's product offerings
overseas.

     Gross profit increased 30% to approximately $108.0 million in 1995 from
approximately $83.0 million in 1994.  Gross profit as a percentage of net sales
increased from approximately 53% in 1994 to approximately 55% in 1995 due
primarily to additional sub-licensing revenues in 1995.

     Selling, general and administrative expenses increased 26% to approximately
$48.2 million (approximately 25% of net sales) in 1995 from approximately $38.3
million (approximately 24% of net sales) in 1994.  The increase of approximately
$10.0 million was due to increased advertising, royalties and miscellaneous
selling and administrative expenses, which increased as a result of sales
growth, and additional salaries and consulting expense attributable to the
Company's expanded product lines.

     Depreciation and amortization expense increased to approximately $12.8
million in 1995 from approximately $8.6 million in 1994.  This increase was
primarily attributable to increased amortization of product tooling costs
resulting from increased investment in product tooling to support the Company's
expanded product line.

     The Company recognized approximately $4.1 million in 1994 as a non-
recurring non-cash compensation expense related to the vesting and exercise of a
compensatory stock option granted to Mr. Arad (the "Arad Stock Option") in
connection with the formation of the Company.

                                      -14-
<PAGE>
 
     Interest (income) expense, net was ($560,000) for 1995 and approximately
$1.8 million for 1994.  The net increase of ($2.4 million) was due primarily to
decreased borrowings and the temporary investment of cash raised in the
Company's initial public offering and generated from operating activities.

     As a result of the above, net income increased 58% to approximately $28.4
million in 1995 from approximately $18.0 million in 1994.

BACKLOG

     Customer open orders were approximately $6.5 million on December 31, 1995
and $7.8 million on December 31, 1996.  The Company believes that this increase
in open orders resulted from several causes, including the diversification of
the Company's product base.

LIQUIDITY AND CAPITAL RESOURCES

     The Company's operating activities (used) or provided net cash of
approximately ($1.5 million), $35.5 million, and ($1.2 million) in 1994, 1995
and 1996, respectively.  The decline in cash flow from operating activities is
due principally to a slow down in the collection of receivables.

     Cash used in investing activities in 1994, 1995 and 1996 was approximately
$17.2 million, $25.1 million, and $23.6 million, respectively and consisted of
capital expenditures for molds, tools and equipment for the production of new
products, as well as capitalized product and package design expenditures.  In
1995, approximately $9.0 million cash was used for the acquisition of Spectra
Star(R) and Quest.

     Cash provided by financing activities in 1994, 1995 and 1996 was
approximately $18.1 million, $8.0 million and $8.3 million, respectively.  In
1994, cash provided by financing activities comprised principally of net
borrowings under the Credit Facility (defined below).  In 1995, cash provided by
financing activities consisted principally of net proceeds from the initial
public offering of $44.1 million, offset by repayments of notes to the
stockholders, which totalled approximately $15.1 million, and by repayments of
funds previously borrowed under the Credit Facility with the balance used for
working capital and general corporate purposes.  In 1996, cash provided by
financing activities consisted principally of approximately $9.3 million in net
proceeds from an additional public offering Class A Common Stock completed in
August 1996, offset by the redemption of preferred stock issued in connection
with the Spectra Star(R) acquisition, with the balance used for working capital
and general corporate purposes.

     In March 1995, the Company entered into a three year $30 million revolving
line of credit (the "Credit Facility") with a syndicate of banks for which The
Chase Manhattan Bank (formerly named Chemical Bank) serves as administrative
agent.  Substantially all of the assets of the Company were pledged to secure
borrowings under the Credit Facility.  Borrowings under the Credit Facility bear
interest at either The Chase Manhattan Bank's alternate base rate or at the
Eurodollar rate plus the applicable margin.  The applicable margin is 3/4 of 1%
to 1% to be determined based upon the Company's financial performance.  The
Credit Facility requires the Company to pay a commitment fee of 3/8 of 1% per
annum on the average daily unused portion of the Credit Facility.  The Company
had no outstanding indebtedness under the line of credit as of March 3, 1997.

     The Credit Facility, as amended, contains various financial covenants, as
well as restrictions, on new indebtedness, prepaying or amending subordinated
debt, acquisitions and similar investments, the sale or transfer of assets,
capital expenditures, limitations on restricted payments, dividends, issuing
guarantees and creating liens.  The Credit Facility also requires an annual
reduction, commencing January 1, 1996, of outstanding borrowings to zero for a
period of 45 consecutive days commencing during the first six months of the
calendar year.  In addition, the Credit Facility also requires that (a) Marvel
continue to control the Company and (b) the toy license agreement between the
Company and Marvel remain in effect.  The Credit Facility is not guaranteed by
Marvel.  Proceedings in the Marvel bankruptcy could result in a change of
control in the Company which could cause the Credit Facility

                                      -15-
<PAGE>
 
to be terminated.  If such an event occurred, the Company could seek a waiver of
the foregoing provisions and believes it could obtain a replacement credit
facility if a termination of the Credit Facility were to occur.

     Certain indebtedness of Marvel and Marvel's direct and indirect parent
companies impose restrictions that limit the ability of Marvel and its
subsidiaries, including the Company, to incur debt, make restricted payments,
enter into transactions with affiliates and sell or transfer assets.

     For a description of the Spectra Star(R) acquisition in September 1995, see
"Note 12 to the December 31, 1996 Consolidated Financial Statements included
elsewhere in this Report."

     The approximately $9.1 million net proceeds to the Company from the August
1996 public offering was intended to fund the working capital of the Company and
a portion of the Company's capital commitment to Marvel Studios, the Company's
proposed joint venture with Marvel.  At this time, the Company has no plans to
invest a material amount of funds in Marvel Studios in the short term, and
before the Company makes any material investment in Marvel Studios, the Company
intends to assess the developments in Marvel's bankruptcy proceeding.

     The Company has commenced construction of a new manufacturing facility in
Mexico in order to expand manufacturing capacity for the Spectra Star(R) product
line, and expects that expenditures to complete such facility will amount to
approximately $3 million.

     The Company has authorized the repurchase of up to three million shares of
Class A Common Stock. The repurchase program requires the consent of Marvel
Characters, Inc. a subsidiary of Marvel, which has announced that it will seek
approval of the bankruptcy court for such consent and the consent of the lenders
under the Credit Facility. See "Item 1. Business--Possible Change of Control."

     The Company believes that it has sufficient funds available from cash and
cash equivalents operating activities and borrowings under the Credit Facility
to meet peak working capital needs and capital expenditure requirements.  During
1996, the maximum amount outstanding under the Credit Facility was $4,000,000.


ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The financial statements required by this item, the report of the
independent accountants thereon and the related financial statement schedule
required by Item 14(a)(2) appear on pages F-2 to F-20.  See the accompanying
Index to Financial Statements and Financial Statement Schedule on page F-1.  The
supplementary financial data required by Item 302 of Regulation S-K appears in
Note 10 to the December 31, 1996 Consolidated Financial Statements.


ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
          ON ACCOUNTING AND FINANCIAL DISCLOSURE

     Not applicable.

                                      -16-
<PAGE>
 
                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

EXECUTIVE OFFICERS AND DIRECTORS

     The executive officers and Directors of the Company, their ages as of March
28, 1997 and their positions with the Company are as follows:

<TABLE>
<CAPTION>
NAME                     AGE  POSITION
----                     ---  --------
<S>                      <C>  <C>
Joseph M. Ahearn.......   41  President, Chief Executive Officer and Director
Daniel J. Werther......   35  Executive Vice President, Senior Legal Officer and Secretary
Andrew R. Gatto........   48  Executive Vice President, Marketing
David J. Fremed........   36  Chief Financial Officer and Treasurer
Alan Fine..............   46  Chief Operating Officer
Avi Arad...............   48  Director
William C. Bevins......   49  Director
Donald G. Drapkin......   48  Director
James F. Halpin........   46  Director
Bobby G. Jenkins.......   35  Director
Ronald O. Perelman.....   53  Director
Isaac Perlmutter.......   53  Director
Alfred A. Piergallini     49  Director
Terry C. Stewart.......   50  Director
Paul R. Verkuil........   56  Director
</TABLE> 

DIRECTORS

     The name, principal occupation for the last five years, selected
biographical information and period of service as a director of the Company of
each director are set forth below.  Pursuant to a stockholders' agreement
discussed below, Messrs. Perelman, Bevins, Drapkin, Stewart, Jenkins, Halpin,
Piergallini and Verkuil are the designees of Marvel Characters, Messrs.
Perlmutter and Ahearn are the designees of Mr. Perlmutter and Mr. Arad is the
designee of Mr. Arad.  See "Item 13. Certain Relationships and Related
Transactions."

     Joseph M. Ahearn has served as Chief Executive Officer and a Director of
the Company since April 1993 and as President of the Company since November
1994.  From January 1990 to April 1993, Mr. Ahearn served initially as a
consultant to, and after April 1990, as an executive officer and director of the
Company's predecessor company.  During such period, he served as a consultant to
other businesses affiliated with Mr. Perlmutter.  From 1987 to August 1991, Mr.
Ahearn was a principal of GDL, a corporation that provides management advice and
assistance to financially distressed companies.  From August 1988 to August
1991, Mr. Ahearn, in his capacity as a principal of GDL, served as Chief
Operating Officer of Coleco Industries, Inc. and as a director or officer of
various other businesses that were the subject of bankruptcy proceedings.  From
1981 to 1987, Mr. Ahearn was employed by Touche Ross & Co., attaining the
position of senior manager.  From 1976 to 1980, Mr. Ahearn served in both the
audit and consulting departments of Arthur Andersen & Co.

     Avi Arad has served as a Director of and consultant to the Company since
April 1993. Mr. Arad has been the President and Chief Executive Officer of New
World Animation, a media production company under common control with Marvel,
since April 1993 where he has served as the Executive Producer of the X-Men(R)
and the Spider-Man(R) animated TV series currently carried on the Fox Children's
Network and the Fantastic Four(TM) and Iron

                                      -17-
<PAGE>
 
Man(R) animated syndicated programs. Mr. Arad has been a toy inventor and
designer for more than 20 years for major toy companies including Mattel Inc.,
Hasbro, Inc. and Tyco Toys, Inc.  During his career, Mr. Arad has designed or
co-designed more than 160 toys.  Mr. Arad is also the owner of Avi Arad &
Associates, a firm engaged in the design and development of toys and the
production and distribution of television programs and is a beneficial owner in
Classic Heroes, Inc.

     William C. Bevins has been a Director of the Company since April 1993. Mr.
Bevins has been a director of Marvel since 1989 and was Chief Executive Officer
of Marvel from 1991 until 1996. Mr. Bevins has been Chief Executive Officer of
Andrews Group since 1988 and Executive Vice President of MacAndrews Holdings
since 1988. Mr. Bevins also is a director of Andrews Group, Marvel Holdings,
Marvel Parent and Marvel III. Mr. Bevins was a director and Chief Financial &
Administrative Officer of Turner Broadcasting System, Inc. for more than five
years prior to 1988. On December 27, 1996, Marvel Holdings, Marvel Parent,
Marvel III, Marvel and several of its subsidiaries filed voluntary petitions for
reorganization under Chapter 11 of the U.S. Bankruptcy Code.

     Donald G. Drapkin has been a Director of the Company since April 1993. Mr.
Drapkin has been a director of Marvel since 1991. He has been Vice Chairman and
a director of MacAndrews & Forbes and Vice Chairman of various of its affiliates
since 1987. Mr. Drapkin also is a director of the following corporations which
file reports pursuant to the Exchange Act: Andrews Group, Coleman Company, Inc.
("Coleman"), Coleman Holdings Inc. ("Coleman Holdings"), Coleman Worldwide
Corporation ("Coleman Worldwide"), Consolidated Cigar Holdings, Inc.
("Consolidated Cigar"), Consolidated Cigar Corporation, Marvel, Marvel
Holdings, Marvel Parent, Marvel III, Revlon Inc. ("Revlon"), Revlon Consumer
Products Corporation ("Revlon Products"), Revlon Worldwide Corporation ("Revlon
Worldwide"), Algos Pharmaceutical Corporation and VIMRx Pharmaceuticals Inc. Mr.
Drapkin was a partner at the law firm of Skadden, Arps, Slate, Meagher & Flom
for more than five years prior to March 1987. On December 27, 1996, Marvel
Holdings, Marvel Parent, Marvel III, Marvel and several of its subsidiaries
filed voluntary petitions for reorganization under Chapter 11 of the U.S.
Bankruptcy Code.

     James F. Halpin has served as a Director of the Company since March 1995.
Mr. Halpin has been President, Chief Operating Officer and a director of CompUSA
Inc., a retailer of computer hardware, software, accessories and related
products, since May 1993 and Chief Executive Officer of CompUSA, Inc. since
December 1993.  From 1990 to November 1992, Mr. Halpin was President of
Homebase, a home center warehouse retailer.  From 1988 to 1990, Mr. Halpin was
President of BJ's Wholesale Club, a chain of club retail stores.  Mr. Halpin
also served as Executive Vice President of Waban Inc., the parent of Homebase
and BJ's Wholesale Club, from 1988 to May 1993.

     Bobby G. Jenkins has served as Director of the Company since March 1995.
Mr. Jenkins served as Chief Financial Officer and Treasurer of the Company from
March, 1995 through October, 1996. Mr. Jenkins has been Executive Vice President
and Chief Financial Officer of Marvel since December 1993. From 1992 until he
joined Marvel, Mr. Jenkins was Assistant Vice President-Finance of Turner
Broadcasting System, Inc., and, for more than five years prior thereto, he was
associated with Price Waterhouse, where he last served as Senior Audit Manager.
On December 27, 1996, Marvel and several of its subsidiaries filed voluntary
petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code.

     Ronald O. Perelman has been a Director of the Company since March 1995, and
he served as Chairman of the Board of Directors until March, 1997. Mr. Perelman
has been Chairman of the Board and Chief Executive Officer of MacAndrews &
Forbes and various affiliates since 1980. Mr. Perelman is Chairman of the Board
of Andrews Group, Consolidated Cigar, Mafco Consolidated Group Inc. ("Mafco
Consolidated"), Meridian Sports Incorporated ("Meridian"), and Power Control
Technologies Inc. ("PCT") and is Chairman of the Executive Committee of Coleman,
Revlon, Revlon Products and Marvel. Mr. Perelman is a director of the following
corporations which file reports pursuant to the Securities Exchange Act of 1934,
as amended (the "Exchange Act"): Andrews Group, Coleman, Coleman Holdings,
Coleman Worldwide, Consolidated Cigar,

                                      -18-

<PAGE>
 
Consolidated Cigar Corporation ("Cigar Corp."), California Federal Bank, A
Federal Savings Bank, First Nationwide Holdings Inc., First Nationwide (Parent)
Holdings Inc., Marvel, Marvel Holdings, Marvel Parent, Marvel III, Meridian,
PCT, Preumo Abex Corporation, Revlon, Revlon Products and Revlon Worldwide.  On
December 27, 1996, Marvel Holdings, Marvel Parent, Marvel III, Marvel and
several of its subsidiaries filed voluntary petitions for reorganization under
Chapter 11 of the U.S. Bankruptcy Code.

     Isaac Perlmutter has served as a Director of the Company since April 1993
and he served as Chairman of the Board of Directors until March 1995.  Mr.
Perlmutter purchased the Company's predecessor company from Charan Industries,
Inc. in January 1990.  Mr. Perlmutter is actively involved in the management of
the affairs of the Company and has been an independent financial investor for
more than the past five years.  As an independent investor Mr. Perlmutter
currently has, or has had within the past five years, controlling ownership
interests in Remington Products Company, Westwood Industries, Inc., a
manufacturer and distributor of table and floor lamps, Job Lot Incorporated (and
its predecessor Job Lot Associates L.P.) ("Job Lot"), a discount oriented retail
chain, Tangible Media, Inc. ("Tangible Media"), a media buying and barter
advertising agency, and REC Sound Incorporated, a distributor of licensed
novelty electronics, and is also the majority stockholder of Classic Heroes,
Inc., a distributor of apparel manufactured under licenses from Marvel and
others.

     Alfred A. Piergallini has served as a Director of the Company since March
1995.  Mr. Piergallini has been a director of Gerber since 1989, Chairman of the
Board and Chief Executive Officer of Gerber since January 1990 and President of
Gerber since January 1993.  Mr. Piergallini also served as President of Gerber
from January 1990 to May 1992.  Mr. Piergallini is also a director of Comerica,
Incorporated, a financial services holding company.  From February 1986 to April
1989, Mr. Piergallini was a Senior Vice President of The Carnation Company.

     Terry C. Stewart has been a Director of the Company since April 1993. Mr.
Stewart has been a Director of Marvel since 1991 and an Executive Vice President
of Marvel since March 1996.  Mr. Stewart joined Marvel in 1989 as Executive Vice
President, Development and served as President and Chief Operating Officer from
September 1990 to July 1994, Vice Chairman from March 1995 to December 1995 and
President and Chief Operating Officer, Marvel Comics from July 1994 until March
1996.  From 1984 to 1989, Mr. Stewart was Vice President-Business Development at
Combustion Engineering. On December 27, 1996, Marvel and several of its
subsidiaries filed voluntary petitions for reorganization under Chapter 11 of
the U.S. Bankruptcy Code.

     Paul R. Verkuil is an attorney-at-law and Dean of the Cardozo Law School,
Yeshiva University. Mr. Verkuil served as President of the College of William
and Mary from 1985 to 1992. He has been on the faculty of the Columbia Law
School as an Adjunct Professor and on the faculty of the University of
Pennsylvania as a Visiting Professor from January 1995 to December 1995. Mr.
Verkuil served as Dean of Tulane Law School from 1978 to 1985. Mr. Verkuil also
served as the President and Chief Executive officer of the American Automobile
Association from January 1992 to December 1994. Mr. Verkuil is a director of
Universal Health Services, Inc. and previously served as a director of
NationsBank of Florida from 1992 to 1995 and of Florida Progress Corporation
from 1993 to 1995.

EXECUTIVE OFFICERS

     The following sets forth the  positions held with the Company and selected
biographical information for the executive officers of the Company who are not
Directors.

     Daniel J. Werther (35) has served as Executive Vice President, Senior Legal
Officer and Secretary of the Company since April 1993.  Mr. Werther has also
served as Senior Vice President of Andrews Group since February 1993.  From
April 1991 to February 1993, Mr. Werther was a senior associate in the law firm
of Klehr, Harrison, Harvey, Branzburg & Ellers in Philadelphia, Pennsylvania.
Prior to that time, Mr. Werther was an associate in the law firm of Obermayer,
Rebmann, Maxwell & Hippel in Philadelphia, Pennsylvania.

                                      -19-
<PAGE>
 
     Andrew R. Gatto (49) has served as Executive Vice President - Marketing
since July 1995.  Prior to joining the Company, Mr. Gatto served as the
President of the Buddy-L Toys Division of SLM Inc. from December 1994 through
July 1995, having been hired as work out specialist while such firm was the
subject of bankruptcy proceedings.  From June 1990 through November 1994, he
served as a consultant to and later as President of Play-Tech, Inc., a
manufacturer of learning aid toys.  Prior thereto, Mr. Gatto served as Executive
Vice President of Universal Match Box Group, Ltd., a toy manufacturer.

     Alan Fine (46) has served as the Chief Operating Officer of the Company
since September 1996.  From June 1996 to September 1996, Mr. Fine was the
President and Chief Operating Officer of Toy Biz International Ltd.  From May
1995 to May 1996, Mr. Fine was the President and Chief Operating Officer of Kay-
Bee Toys, a national toy retailer, and from December 1989 to May 1995, he was
the Senior Vice President General Merchandise Manager of Kay-Bee Toys.

     David J. Fremed (36) has served as the Chief Financial Officer and
Treasurer of the Company since October 1996 and Vice President/Controller of the
Company since 1990.

                                      -20-
<PAGE>
 
ITEM 11.  EXECUTIVE COMPENSATION

     The following table sets forth information for the years indicated
concerning the compensation awarded to, earned by or paid to the Chief Executive
Officer of the Company and the four most highly paid executive officers earning
over $100,000, other than the Chief Executive Officer, who served as executive
officers of the Company as of December 31, 1996 (the "Named Executive
Officers"), for services rendered in all capacities to the Company and its
subsidiaries during such period.


                           SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
                                                                         LONG TERM
                                         ANNUAL COMPENSATION           COMPENSATION
------------------------------------------------------------------------------------------
                                                                   SECURITIES UNDERLYING
NAME AND PRINCIPAL POSITION           YEAR  SALARY($)  BONUS($)         OPTIONS(#)       
---------------------------           ----  ---------  --------    ---------------------
<S>                                   <C>   <C>        <C>        <C>
Joseph M. Ahearn                      1996  $350,000   $150,000                 --
     President and Chief Executive    1995   350,000         --            280,000(1)
     Officer                          1994   300,000         --                 --
                                                                       
Daniel J. Werther                     1996   300,000     25,000                 --
     Executive Vice President and     1995   252,000     25,000             75,000
     Senior Legal Officer             1994   220,830     25,000                 --
                                                                       
Andrew R. Gatto(2)                    1996   275,000     50,000                 --
     Executive Vice President -       1995   126,923     30,000             30,000
     Marketing                          --        --         --                 --
                                                                       
Alan Fine(3)                          1996   253,846    117,858             30,000
     Chief Operating Officer            --        --         --                 --
                                        --        --         --                 --

David J. Fremed                       1996   140,000     25,000                 --
     Chief Financial Officer            --        --         --                 --
                                        --        --         --                 --
</TABLE>
_____________________________

(1)  Includes options for 250,000 shares granted in March 1995 after
     consummation of the Company's IPO and options for 30,000 shares granted in
     December 1995 in lieu of $150,000 non-discretionary cash bonus payable
     pursuant to the terms of Mr. Ahearn's employment agreement with the
     Company.

(2)  Mr. Gatto commenced employment with the Company in July 1995.

(3)  Mr. Fine commenced employment with the Company in May 1996.

                                      -21-
<PAGE>
 
STOCK OPTION PLAN

     The following table sets forth stock options issued in 1996 to the
executive officers named in the Summary Compensation Table.  The table also sets
forth the hypothetical gains that would exist for the stock options at the end
of their ten year terms, assuming compound rates of appreciation of 5% and 10%.
The actual future value of the options will depend on the market value of the
Company's Class A Common Stock.
 
                     OPTION/SAR GRANTS IN LAST FISCAL YEAR

<TABLE> 
<CAPTION> 
                                                                      Potential Realizable Value at
                                                                        Assumed Annual Rates of
                                                                      Stock Price Appreciation for
                    Individual Grants                                        Option Term(2)
-------------------------------------------------------------------  ------------------------------
    (a)            (b)             (c)          (d)         (e)            (f)             (g)
             Number of                                  
             Securities                                                                        
             Underlying       % of Total                           
             Options/         Option/SARs    Exercise 
             SARs             Granted to     or Base               
             Granted          Employees in   Price      Expiration 
Name         (#)(1)           Fiscal Year    ($/Sh)     Date          5% ($)           10% ($) 
-----------  ----------      ------------    --------   ----------    --------         -------- 
<S>          <C>              <C>            <C>        <C>          <C>              <C>
Alan Fine        30,000          15.4%        15.00      8/16/06      $283,003         $717,184
</TABLE>

---------------
1/   Represents shares underlying stock options; none of the executive officers
     were granted SARs.  One-third of the options become exercisable on the date
     of grant and the balance becomes exercisable in equal increments on the
     first and second anniversaries of the date of grant.

2/   The amounts of potential realizable value, which are based on assumed
     appreciation rates of 5% and 10% prescribed by Securities and Exchange
     Commission ("SEC") rules, are not intended to forecast possible future
     appreciation, if any, of the Company's stock price.  The amounts of
     potential value with respect to the options do not account for expiration
     of the options upon termination of employment or the phased-in exercise
     schedule.  Future compensation resulting from the options is based solely
     on the actual performance of the Company's stock price in the trading
     market.

                                      -22-
<PAGE>
 
     The following chart shows the 1996 year-end value of the stock options held
by the Named Executive Officers.  None of the Named Executive Officers exercised
stock options during 1996.


                        YEAR END 1996 OPTION/SAR VALUES

<TABLE>
<CAPTION>
 
                        Number of Securities         Value of Unexercised
                       Underlying Unexercised              In-the-
                       Options/SARs at Year         Money Options/SARs at
                              End #(1)                   Year End (2)
                     --------------------------  ----------------------------
 
Name                 Exercisable  Unexercisable  Exercisable   Unexercisable
----                 -----------  -------------  ------------  --------------
<S>                  <C>          <C>            <C>           <C>
 
Joseph M. Ahearn         186,666         93,334      $249,999        $125,001
 
Daniel J. Werther         50,000         25,000        75,000          37,500
 
Andrew R. Gatto           20,000         10,000        20,000          10,000
 
Alan Fine                 10,000         20,000        45,000          90,000

David J. Fremed           20,000         10,000        30,000          15,000
</TABLE>

-------------
(1)  Represents shares underlying stock options; none of the executive officers
     hold SARs.

(2)  Amounts shown represent the market value of the underlying Class A Common
     Stock at year end calculated using the December 31, 1996, New York Stock
     Exchange (the "NYSE") closing price per share of Class A Common Stock of
     $19.50 minus the exercise price of the stock option.  The actual value, if
     any, an executive may realize is dependent upon the amount by which the
     market price of Common Stock exceeds the exercise price when the stock
     options are exercised.  The actual value realized may be greater or less
     than the value shown in the table.


EMPLOYMENT AGREEMENTS

     The Company is a party to an employment agreement with each of Joseph M.
Ahearn, Andrew R. Gatto and Alan Fine which govern, respectively, Mr. Ahearn's
employment as President and Chief Executive Officer, Mr. Gatto's employment as
Executive Vice President - Marketing and Mr. Fine's employment as Chief
Operating Officer.

     Pursuant to the employment agreements, Messrs. Ahearn and Gatto have agreed
to render their exclusive and full-time services to the Company for terms of
employment expiring on December 31, 1997 and Mr. Fine has agreed to render his
exclusive and full time services to the Company for a term of employment
expiring on December 31, 1999.  However, Mr. Ahearn may from time to time
participate in business activities not competitive with the Company, provided
such activities do not involve more than 60 hours in any twelve month period.
Under their agreements, Messrs. Ahearn, Gatto and Fine earn base salaries,
subject to discretionary increases, of $350,000, $275,000 and $400,000,
respectively.  Messrs Ahearn and Gatto are entitled to annual non-discretionary
bonuses of $150,000 and $50,000, respectively.  Mr. Fine is entitled to an
annual non-discretionary bonus based on a formula for FOB sales.  The employment
agreements further provide for the payment of discretionary bonuses and
participation in the Company's Stock Option Plan as determined by the Board of
Directors.  Messrs. Ahearn,

                                      -23-
<PAGE>
 
Gatto and Fine also receive $1,000 monthly automobile allowances and are
entitled to participate in employee benefit plans generally available to the
Company's employees.

     Each of the employment agreements provides that, in the event of
termination other than for cause, the employee is entitled to his salary and car
allowance earned through the date of termination and thereafter for a period up
to twelve months.  All three officers are also entitled to the pro rata portion
of their annual bonuses earned through the date of termination.

     Each of the employment agreements prohibits disclosure of proprietary and
confidential information regarding the Company and its business to anyone
outside the Company both during and subsequent to employment and otherwise
provides that all inventions made by the employees during their employment
belong to the Company.  In addition, the employees have agreed during their
employment, and for one year thereafter, not to engage in any competitive
business activity.



ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The following table sets forth certain information, as of March 28, 1997,
with respect to the shares of Common Stock beneficially owned by (a) each person
known by the Company to be the beneficial owner of 5% or more of the outstanding
Common Stock, (b) each Director of the Company and (c) all Directors and
executive officers of the Company as a group, and as adjusted at that date to
reflect the sale of the shares of Common Stock offered hereby:
<TABLE>
<CAPTION>
                                      Class A Common Stock                  Class B Common Stock
                                   -------------------------           --------------------------
                                        Number of Shares                      Number of Shares
                                       Beneficially Owned                    Beneficially Owned
Five Percent Stockholders,         -------------------------           --------------------------        Percent of
Directors and                                    Percent of                              Percent of     Total Voting
Executive Officers                     Number      Class               Number              Class           Power
----------------------------------   ----------  -----------      --------------         ----------      -----------
<S>                                  <C>         <C>             <C>                     <C>            <C>
Marvel Characters, Inc.(1).........   7,394,000        26.6%       7,394,000(2)             100%             78.4%
  c/o Marvel Entertainment
  Group, Inc.
  387 Park Avenue South
  New York, New York 10016
Avi Arad (3).......................   4,150,000        20.4%               1(4)                               4.4%
  1698 Post Road East
  Westport, Connecticut  06880
Isaac Perlmutter (5)...............   9,506,000        46.7%               1(6)                              10.1%
  P.O. Box 1028
  Lake Worth, Florida  33460-1028
Joseph M. Ahearn (7)...............     270,100            *                 0                                   *
David J. Fremed (8)................      30,000            *                 0                                   *
William C. Bevins..................      10,000            *                 0                                   *
Donald G. Drapkin (9)..............      12,000            *                 0                                   *
Terry C. Stewart...................       1,000            *                 0                                   *
Bobby G. Jenkins (8)...............      50,000            *                 0                                   *
James F. Halpin....................       5,000            *                 0                                   *
Alfred A. Piergallini..............       4,000            *                 0                                   *
Paul R. Verkuil....................       2,000            *                 0                                   *
Andrew R. Gatto (8)................      20,000            *                 0                                   *
Daniel J. Werther (8)..............      75,000            *                 0                                   *
</TABLE> 

                                      -24-
<PAGE>
 
<TABLE> 
<S>                                  <C>         <C>             <C>                     <C>            <C>
Alan Fine (8)......................      10,000            *                 0                                   *
All executive officers and           
  Directors as a group
  (15 persons)(10).................   21,539,100            *         7,394,000(8)                           93.0%*
</TABLE> 

--------------------------

*  Less than 1%.

(1)  Represents shares of Class A Common Stock issuable upon the conversion of
     Class B Common Stock owned by Marvel Characters, Inc., a wholly owned
     subsidiary of Marvel Entertainment Group, Inc.  Does not include 13,656,000
     shares which Andrews Group has the right to acquire pursuant to the Stock
     Purchase Agreements.  See "Item 13.  Certain Relationships and Related
     Transactions - the Stock Purchase Agreements."  At December 31, 1996,
     Marvel had 101,809,657 shares of common stock outstanding, of which
     82,628,392 shares were owned of record by Marvel Holdings and Marvel
     (Parent) and certain other indirect, wholly owned subsidiaries of Mafco
     Holdings, which is wholly owned of record by Ronald O. Perelman.  At
     December 31, 1996, 77,302,326 shares of common stock of Marvel held by
     Marvel Holdings and Marvel (Parent) were pledged to secure the debt
     obligations under the secured notes issued by Marvel Holdings, Marvel
     (Parent) and Marvel III and an additional approximately 2.9 million shares
     of Marvel common stock are subject to a negative pledge under the secured
     notes issued by Marvel Holdings. The capital stock of Marvel Holdings and
     Marvel (Parent) is also pledged to secure the debt obligations under the
     secured notes issued by Marvel Holdings, Marvel (Parent) and Marvel III.
     The right to vote the pledged shares of Marvel, Marvel Holdings and Marvel
     (Parent) is the subject of proceedings in bankruptcy actions relating
     to those entities. See "Item 1. Business -- Possible Change of Control."

(2)  Includes two shares of Class B Common Stock held in voting trusts.  Marvel
     is the sole beneficiary of each voting trust.

(3)  Mr. Arad is a Director and principal Stockholder of the Company.

(4)  Includes one share of Class B Common Stock held by a voting trust of which
     Mr. Arad is the sole trustee.

(5)  Represents Class A Common Stock owned by Zib, formerly Toy Biz, Inc., a
     Delaware corporation incorporated in 1990, which is owned entirely by the
     Isaac Perlmutter T.A., a revocable trust established by Mr. Perlmutter.
     Mr. Perlmutter is the sole beneficiary of the trust during his lifetime and
     may revoke the trust at any time.  Mr. Perlmutter and his wife serve as the
     trustees of such trust.

(6)  Includes one share of Class B Common Stock held by a voting trust of which
     Mr. Perlmutter is the sole trustee.

(7)  Includes 270,000 shares of Class A Common Stock subject to employee options
     granted pursuant to the Stock Option Plan which are immediately exercisable
     or exercisable within 60 days.

(8)  Represents shares of Class A Common Stock subject to employee options
     granted pursuant to the Stock Option Plan which are immediately exercisable
     or exercisable within 60 days.

(9)  Represents shares held in trusts for the benefit of Mr. Drapkin's children
     for which Mr. Drapkin disclaims beneficial ownership.

(10) Includes 455,000 shares of Class A Common Stock subject to employee options
     granted pursuant to the Stock Option Plan.


ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Because Marvel and various of its affiliates are the subject of actions for
reorganization under Chapter 11, agreements described below to which Marvel or 
those affiliates are parties which are determined by the bankruptcy court to be 
executory contracts may be subject to rejection in those actions.

THE MERGER AGREEMENT AND RELATED AGREEMENTS

     The Company, Arad and Perlmutter have each received notice from Andrews
Group that Andrews Group has terminated its Stock Acquisition Agreement with
Marvel, and accordingly a condition to the obligations of Andrews Group and
Acquisition to consummate the Merger pursuant to the Merger Agreement will not
be satisfied.  Andrews Group further advised the Company, Arad and Perlmutter
that Andrews Group does not intend to waive such condition, and anticipates that
the Merger will not be consummated. While the Merger Agreement has not been
formally terminated, the Merger will not be consummated if Andrews Group does
not waive such condition. Because Andrews Group does not intend to waive that
condition to consummation of the Merger, the conditions to the obligations of

                                      -25-
<PAGE>
 
Andrews Group to consummate the transactions contemplated by the Stock Purchase
Agreements discussed herein will not be satisfied.  In addition, certain
performance bonus agreements and the consulting agreements between the Company
and each of Arad and Perlmutter (or, in the case of Arad, the amendment and
restatement of his existing consulting agreement with the Company) discussed
herein will not become effective because the Merger will not be consummated.  
See "Item 1. Business - Possible Change of Control."

     The Merger Agreement

     On December 27, 1996, following approval by the Independent Committee, the
Company entered into the Merger Agreement.  The following is a summary of
certain provisions of the Merger Agreement and is qualified in its entirety by
reference to the Merger Agreement, a copy of which is filed (by means of
incorporation by reference) as an exhibit hereto.

     Pursuant to the Merger Agreement, Acquisition would have been merged with
and into the Company.  Following the Merger, the Company would have continued as
the surviving corporation and the separate existence of Acquisition would have
ceased.  In the Merger, each of the outstanding shares of Class A Common Stock
and each of the outstanding shares of Class B Common Stock would have been
converted into the right to receive $22.50 per share (the "Merger
Consideration"), and each of the outstanding shares of Preferred Stock of the
Company would have been converted into the right to receive an amount per share
equal to the then applicable redemption price, payable to the holder thereof,
without interest (the "Preferred Merger Consideration").  Holders of outstanding
options to purchase shares of Common Stock granted under the Company's 1995
Stock Option Plan would have received an amount in respect thereof equal to the
product of (A) the excess, if any, of the Merger Consideration over the exercise
price of such employee options and (B) the number of shares represented by such
employee options.

     The Merger Agreement provides that the obligations of Andrews Group to
consummate the Merger are conditioned upon, among other things, the confirmation
of the Joint Plan of Reorganization of Marvel (with such changes as Andrews
Group may have approved) (the "Plan Condition") and that all conditions to
closing under the Stock Acquisition Agreement (excluding the condition that all
conditions to the closing of the Merger Agreement be satisfied) shall have been
satisfied or waived.  As discussed above, the Company, Arad and Perlmutter have
each received notice from Andrews Group that Andrews Group has terminated its
Stock Acquisition Agreement with Marvel, and accordingly a condition to the
obligations of Andrews Group and Acquisition to consummate the Merger pursuant
to the Merger Agreement will not be satisfied.  Andrews Group further advised
the Company, Arad and Perlmutter that Andrews Group does not intend to waive
such condition and anticipates that the Merger will not be consummated.  While
the Merger Agreement has not been formally terminated, the Merger will not be
consummated if Andrews Group does not waive such condition.

     The Stock Purchase Agreements

     The Stock Purchase Agreements, each dated as of November 20, 1996 as
amended as of January 29, 1997, are, respectively, between Andrews Group and
Arad and between Andrews Group and the Perlmutter Group, and both contain
substantially similar provisions.  Each provides for the purchase by Andrews
Group of all the shares of the Company owned by Arad and the Perlmutter Group
upon the terms and the satisfaction or waiver of certain conditions contained
therein.  The Stock Purchase Agreements provide that the obligations of Andrews
Group to consummate such stock purchases are conditioned upon, among other
things, the consummation of the Merger.  While the Merger Agreement has not been
formally terminated, as discussed above, the Company, Arad and Perlmutter have
each received notice from Andrews Group indicating that the Merger will not be
consummated. Accordingly, the transactions contemplated by the Stock Purchase
Agreements will not be consummated.

                                      -26-
<PAGE>
 
     Pursuant to the Stock Purchase Agreements, the Perlmutter Group and Arad
would have sold 9,506,000 and 4,150,000 shares of Class A Common Stock,
respectively, to Andrews Group on the closing dates set forth in such agreements
(the "Stock Closings").  The aggregate purchase price for the shares sold by the
Perlmutter Group and Arad would have been $171,184,000 in cash and $20 million
in debt of Andrews Group.  In addition, the Perlmutter Group and Arad would have
been entitled to additional payments based upon the earnings of the Company for
the 12 month period ended December 31, 1997.  The Perlmutter Group and Arad also
would have been entitled to additional payments if Andrews Group and its
affiliates were to sell or otherwise transfer for value, including by way of
merger, substantially all of the stock or assets of the Company within one year
after the Stock Closings.

     Consulting and Bonus Agreements with Arad and Perlmutter

     Arad is a party to a consulting agreement with the Company that would have
been amended and restated, and Perlmutter has entered into a consulting
agreement with the Company (in both cases pursuant to the Stock Purchase
Agreements), each of which would have become effective upon the consummation of
the Merger.  While the Merger Agreement has not been formally terminated, as
discussed above, the Company, Arad and Perlmutter have each received notice from
Andrews Group indicating that the Merger is unlikely to be consummated.
Accordingly, it is unlikely that either the amendment and restatement of Arad's
consulting agreement, or the consulting agreement between Perlmutter and the
Company, will become effective.

     Arad's amended and restated consulting agreement would have provided for
Arad to be engaged exclusively in the business of the Company, except for
certain pre-existing commitments, work performed under an employment contract
with New World Animation Ltd. (which has been assigned to Marvel Studios) and
work performed under a letter agreement with Marvel for the Marvel Films
division of Marvel.  Arad currently receives, and would have received under his
amended and restated consulting agreement, $375,000 annually and reimbursement
of reasonable out-of-pocket expenses incurred in performance of his duties, in
addition to certain other benefits.  Arad currently receives under his contract
with New World Animation Ltd., and will receive under his contract with Marvel
Studios, $375,000 annually in addition to certain other employee benefits.  Arad
is also entitled to receive a fee ranging from $7,500 to $10,000 per episode for
television projects and from $100,000 to $250,000 for made-for-television movies
based on Marvel's characters.  Arad's consulting agreement has, and his amended
and restated consulting agreement would have had, provisions that restrict
Arad's ability to compete with the Company for one year after he ceases to be
engaged by the Company if the termination results from a breach by Arad of his
consulting, employment or other agreements with the Company.

     Perlmutter's consulting agreement would have provided for Perlmutter to
provide consulting services for the Company at the request of the current Chief
Executive Officer of the Company.

     Arad and Perlmutter are parties to performance bonus agreements with the
Company, and Joseph Ahearn, the President and Chief Executive Officer of the
Company, is a party to a performance bonus arrangement with the Company, each of
which would have become effective upon consummation of the Merger.  While the
Merger Agreement has not been formally terminated, as discussed above, the
Company, Arad and Perlmutter have each received notice from Andrews Group
indicating that the Merger is unlikely to be consummated.  Accordingly, it is
unlikely that either of the performance bonus agreements (or, in the case of
Joseph Ahearn, the performance bonus arrangement) will become effective.

          Pursuant to the performance bonus agreements (or, in the case of
Joseph Ahearn, the performance bonus arrangement), each of Arad, Perlmutter and
Joseph Ahearn would have been entitled to receive payments, subject to certain
conditions, based upon the increase in value of the Company over a fixed time
period.  In the case of Joseph Ahearn, his eligibility to receive such bonus
would have been subject to the approval by shareholders of Marvel of his
performance bonus arrangement.  If Arad's, Perlmutter's or Joseph Ahearn's
services to the Company ceased by reason of death or disability, then the
Company would have paid a prorated portion (based on the portion of the
performance period prior to cessation of service) of the performance bonus to
such individual (or his estate)

                                      -27-
<PAGE>
 
at the time the bonus would have otherwise have been payable.  In such
circumstances, the forfeited portion of the performance bonus would have been
used to augment the performance bonuses payable to the other individuals.

MARVEL LICENSE AGREEMENTS

     In connection with the formation of the Company, Marvel granted the Company
the Marvel License, an exclusive, perpetual and royalty-free license to
manufacture and distribute a broad range of toys based upon characters owned by
Marvel and properties in which it owns copyrights, trademarks or tradenames.
The Marvel License covers all characters (including the associated copyrights
and trademarks) owned by Marvel and disseminated under the Marvel Comics
trademark.

     The Marvel License restricts Marvel, subject to the Company's prior
consent, from manufacturing, using, distributing or advertising the licensed
products and from granting other licenses to use the Marvel Characters in
connection with the licensed products.

     The Company and Marvel have entered into an exclusive license agreement
pursuant to which Marvel may use the Toy Biz trademark on online services and
electronic networks, including the Internet.  The license is limited to Marvel-
related products of the Company.  Marvel paid the Company $500,000 for such
license.

     The Company also distributes certain products through a wholly owned
subsidiary of Marvel engaged in the distribution of products to certain comic
book retailers.  During the years ended December 31, 1995 and 1996, the
Company's sales to that subsidiary totalled $1,616,000 and $324,000,
respectively.

LICENSE WITH AVI ARAD

     Avi Arad & Associates ("Associates"), of which Avi Arad is the sole
proprietor, and the Company are parties to a license agreement which amended the
licenses between Associates and the Predecessor Company outstanding at the time
of the Company's formation and which governs the licensing of new material to
the Company by Associates thereafter.  The license agreement provides that
Associates is entitled to receive royalty payments on net sales of Marvel
character-based toys and on net sales of non-Marvel based toys of which Arad is
the inventor of record.  In no event, however, may the total royalties payable
to Associates during any calendar year exceed $7.5 million.  If the Stock
Purchase Agreement between the Company and Arad was consummated, the license
agreement between the Company and Associates would have been amended to reduce
the maximum royalties payable during any calendar year to $2.5 million.  Arad
has agreed that he is not entitled to receive royalties based on sales in 1996
of certain Marvel character-based toys which were developed independently of
Arad in 1996. Arad agreed to pay the Company approximately $500,000, for certain
advertising expenses related to the Company's Battle Builder product in 1996.

MARVEL SERVICES ARRANGEMENT

     In connection with the IPO in March 1995, the Company and Marvel entered
into a services agreement (the "Services Agreement") governing the provision by
Marvel of services to the Company.  Under the Services Agreement, upon request
by the Company and acceptance by Marvel, Marvel provides certain management,
consulting and administrative services and certain services purchased from third
party providers, including legal and accounting services.  The Company is
obligated to reimburse Marvel for the costs of such services.  The Services
Agreement has a term of one year and will be automatically renewed for
successive one-year terms unless terminated upon 120 days' notice.  Marvel is
under no obligation to provide services under the Services Agreement.  The
Company accrued or reimbursed to Marvel approximately $306,000 and $262,000 for
1995 and 1996, respectively.

STOCKHOLDERS' AGREEMENT AND CLASS B VOTING TRUSTS

                                      -28-

<PAGE>
 
     In connection with the initial public offering of the Company in March
1995, Marvel, the Perlmutter Group, Arad and the Company entered into a
stockholders' agreement (the "Stockholders' Agreement") which provides, among
other things, that Marvel and its permitted transferees (generally entities
which are affiliates of Marvel) ("Permitted Transferees"), if any, Perlmutter
and Arad will vote their respective shares of common stock of the Company to
elect as directors of the Company (i) eight persons designated by Marvel, (ii)
two persons designated by Perlmutter and (iii) one person designated by Arad.
The Stockholders' Agreement also permits certain pledges of Class B Common Stock
owned by Marvel and its Permitted Transferees.

     The Stockholders' Agreement provides that, upon a change of control of
Marvel, Marvel is obligated to convert its shares of Class B Common Stock into
Class A Common Stock, unless Perlmutter and Arad consent to such shares
remaining Class B Common Stock.  The Stockholders' Agreement terminates upon,
among other events, the mutual agreement of the parties thereto, upon the sale
of all or substantially all of the assets of the Company or upon the conversion
into Class A Common Stock of the Class B Common Stock held by Marvel and its
Permitted Transferees pursuant to a change in control of Marvel and also will
terminate as to any holder owning Class B Common Stock (other than pursuant to
the Voting Trusts (as defined below)) when such holder no longer beneficially
owns or holds such Class B Common Stock.  Arad and the Perlmutter Group have
agreed, in the Stock Purchase Agreements, that prior to closing of the Stock
Purchase Agreements they will not, without the consent of Andrews Group, grant
any consent that would prevent the shares of Class B Common Stock from being
converted into Class A Common Stock following a change of control of Marvel.
See "- Stock Purchase Agreements."

     Each of Arad and Perlmutter is the sole trustee of a Class B voting trust
in which Marvel deposited one share of Class B Common Stock (the "Voting
Trusts").  Marvel is the sole beneficiary of each of the Voting Trusts.  Each of
Messrs. Perlmutter and Arad has the right to vote the share of Class B Common
Stock held by his respective Voting Trust in his absolute discretion, subject to
certain exceptions, until the termination of such trust.

     The rights and obligations of the Perlmutter Group and Arad under the
Stockholders' Agreement cease, and the Voting Trusts of which Perlmutter and
Arad are the trustees will terminate and the shares of Class B Common Stock held
by the Voting Trusts will be distributed to Marvel, upon the occurrence of
certain events, including a reduction in the holdings of Class A Common Stock by
Perlmutter and Arad below specified amounts.  In addition, each Voting Trust
terminates if either Perlmutter or Arad attempts to transfer or dispose of his
respective right to vote the Class B Common Stock subject to the Voting Trust of
which he is trustee or any interest therein.  It is a condition to the closing
of the Stock Purchase Agreements that the respective Voting Trust agreements of
Arad and Perlmutter have terminated.

COMPANY REGISTRATION RIGHTS AGREEMENT

     The Company is a party to a registration rights agreement (the "Company
Registration Rights Agreement") with Marvel, Arad and Perlmutter, pursuant to
which they and certain of their transferees each have the right, subject to
certain conditions, to require the Company to register under the Securities Act,
all or any portion of the shares of Class A Common Stock held by them or, in the
case of Marvel, issuable upon conversion of its Class B Common Stock on two
occasions.  In addition, Marvel, Arad, Perlmutter and certain of their
transferees have certain rights to participate in such registrations and in
other registrations by the Company of its Class A Common Stock.  The Company is
obligated to pay any expenses incurred in connection with such registrations,
except for underwriting discounts and commissions attributable to the shares of
Class A Common Stock sold by stockholders pursuant to such registrations.

TANGIBLE MEDIA ADVERTISING SERVICES

     Tangible Media, a corporation which is wholly owned by Perlmutter, acts as
the Company's media consultant in placing the Company's advertising and, in
connection therewith, receives certain fees and commission based on the cost of
the placement of such advertising.  Tangible Media is compensated solely as a
consultant on an event-by-event basis with no written arrangements in place.  It
is expected that Tangible Media, upon request,

                                      -29-
<PAGE>
 
will continue to arrange for the placement for the Company's advertising.  The
Company retains the services of a non-affiliated media consulting agency on
matters of advertising creativity.  Tangible Media received payments of fees and
commissions totalling approximately $970,000 and $965,000 in 1995 and 1996,
respectively.

EMPLOYEE, OFFICE SPACE AND OVERHEAD COST SHARING ARRANGEMENTS

     Under expense sharing arrangements with Tangible Media, Classic Heroes, REC
Sound and Marvel Software, affiliated companies owned by Perlmutter in the case
of Tangible Media, Classic Heroes and REC Sound, or owned equally by Marvel and
the Company in the case of Marvel Software (collectively, the "Affiliates"), the
Company and the Affiliates have shared certain space at the Company's principal
executive offices and related overhead expenses.  Since 1994, Tangible Media and
the Company have been, and until the end of 1995 Classic Heroes and REC Sound
were, parties to an employee, office space and overhead cost sharing agreement
governing the Company's sharing of employees, office space and overhead expenses
(the "Cost Sharing Agreement").  Under the Cost Sharing Agreement, any party
thereto may through its employees provide services to another party, upon
request, whereupon the party receiving services shall be obligated to reimburse
the providing party for the cost of such employees' salaries and benefits
accrued for the time devoted by such employees to providing services.  Under
this agreement, Tangible Media is currently obligated to reimburse the Company
for 15% of the rent paid under the sublease for the space, which obligations
reflect the approximate percentage of floor space occupied by Tangible Media.
The agreement also requires Tangible Media to reimburse the Company for any
related overhead expenses comprised of commercial rent tax, repair and
maintenance costs and telephone and facsimile services, in proportion to its
percentage occupancy.  The Cost Sharing Agreement is coterminous with the term
of the Company's lease for its executive offices.  The Company received net
reimbursements from one of the Affiliates of approximately $245,000 for 1996 for
rent and other matters.

SHOWROOM SHARING ARRANGEMENT

     Under an expense sharing arrangement with Marvel, Classic Heroes and REC
Sound (the "Showroom Affiliates"), the Company and the Showroom Affiliates have
shared showroom space and related overhead expenses.  Since 1995, Marvel and the
Company have been, and until the end of 1995 Classic Heroes and REC Sound were,
parties to a showroom space sharing agreement (the "Showroom Sharing
Agreement").  Under the Showroom Sharing Agreement, Marvel is currently
obligated to reimburse the Company for 30% of the rent paid under the lease for
the showroom space, which obligations reflect the percentage of floor space
occupied by Marvel.  The agreement also requires Marvel to reimburse the Company
for any related overhead expenses comprised of commercial rent tax, repair and
maintenance costs and telephone and facsimile service, in proportion to their
percentage occupancy, except that overhead expenses which inure to the benefit
of a single party shall be reimbursed entirely by such party.  The agreement has
a term which is coterminous with the term of the Company's lease for the
showroom space.  The Company was reimbursed approximately $47,000 in 1996 under
the Showroom Sharing Agreement.

MARVEL STUDIOS

     The Company and Marvel formed Marvel Studios with the objective of
facilitating the release of live action and animated motion pictures and
television programming and other media based on the Marvel Characters in order
to create greater consumer interests in these characters and related
merchandise.  The Company believes that any feature film or television
programming, theatrical productions or other media and any advertising and
promotion associated with such media will create consumer interest in the Marvel
Characters and revenue opportunities for Marvel's businesses and the Company's
licensing and toy businesses. The Company believes that Marvel Studios will
facilitate the release of feature films, television programming and other media.
The Company and Marvel expect Marvel Studios to utilize the experience that the
Company and Marvel have developed in licensing the Marvel Characters for
television and film projects and capitalizing on related toy sales. Arad, an
executive producer of the X-Men(R) and Spider-Man(R) Saturday morning television
shows, is to be the President, Chief Executive Officer and creative head of
Marvel Studios for film projects and co-creative head for animated

                                      -30-

<PAGE>
 
projects and an executive producer of all film and television projects of Marvel
Studios.  The rights to produce certain feature films based on certain of the
Marvel Characters are currently licensed to third parties.  A portion of the
approximately $9.1 million net proceeds to the Company form the 1996 public
offering was intended to fund the Company's capital commitment to Marvel
Studios.  At this time, the Company has no plans to invest a material amount of
funds in Marvel Studios in the short term, and before the Company makes any
material investment in Marvel Studios, the Company intends to assess the
developments in Marvel's bankruptcy proceeding.

OTHER AGREEMENTS WITH AFFILIATES

     The Company is a party to a license agreement entered into in September
1994 with Coleman, an affiliate of the Company, pursuant to which the Company
licenses certain Coleman trademarks.

     The Company is a party to a license agreement entered into in July 1995
with Revlon Consumer Products Corporation, an affiliate of the Company, pursuant
to which the Company licenses certain Revlon Consumer Products Trademarks.

     The Company believes that the terms of the foregoing transactions are no
less favorable than could be obtained by the Company from unrelated parties on
an arm's-length basis.


                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
          AND REPORTS ON FORM 8-K

     (a)  Documents Filed with this Report

          1.   Financial Statements
               --------------------

               See the accompanying Index to Financial Statements and Financial
               Statement Schedule on page F-1.

          2.   Financial Statement Schedule
               ----------------------------

               See the accompanying Index to Financial Statements and Financial
               Statement Schedule on page F-1.

          3.   Exhibits
               --------

               See the accompanying Exhibit Index appearing on page 32.

     (b)  Reports on Form 8-K.

          1.   The Registrant filed a Current Report on Form 8-K, dated as of
               December 27, 1996 and filed on January 2, 1997.

                                      -31-

<PAGE>
 
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT NO.
-----------
<C>          <S>
        2.1  Agreement and Plan of Merger, dated as of December 27, 1996, by and among
             Andrews Group Incorporated ("Andrews Group"), Andrews Acquisition Corp.
             ("Acquisition") and the Company (Incorporated by reference to Exhibit (c)(1) to the
             Transaction Statement on Schedule 13E-3 filed by Andrews Group and Acquisition on
             January 30, 1997.
 
        2.2  Amended and Restated Asset Purchase Agreement, dated August 17, 1995, between
             the Company and Spectra Star, Inc., as amended by the First, Second, Third, Fourth
             and Fifth Amendments thereto.  (Incorporated by reference to Exhibits 2.1, 2.2, 2.3
             2.4 and 2.5 to the Company's Current Report on Form 8-K, filed with the
             Commission on September 26, 1995.)
 
        3.1  Restated Certificate of Incorporation. (Incorporated by reference to Exhibit 3.1 to the
             Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1995.)
 
        3.2  Certificate of Designation of Series A Preferred Stock of Toy Biz, Inc. (Incorporated
             by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K, filed with
             the Commission on September 26, 1995.)
 
        3.3  Bylaws (as restated and amended). (Incorporated by reference to Exhibit 3.2 to the
             Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1995.)
 
        4.1  Specimen Copy of Stock Certificate for shares of Class A Common Stock.
             (Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on
             Form S-1, File No. 33-87268.)
 
        9.1  Voting Trust Agreement, dated as of March 2, 1995, by and among Marvel
             Entertainment Group, Inc., Avi Arad and the Company.  (Incorporated by reference
             to Exhibit 9.1 to the Company's Registration Statement on Form S-1, File No. 33-
             87268.)
 
        9.2  Voting Trust Agreement, dated as of March 2, 1995, by and among Marvel
             Entertainment Group, Inc., Isaac Perlmutter and the Company.  (Incorporated by
             reference to Exhibit 9.2 to the Company's Registration Statement on Form S-1, File
             No. 33-87268.)
 
       10.1  Stockholders Agreement, dated as of March 2, 1995, by and among the Company,
             Isaac Perlmutter T.A., Marvel Entertainment Group, Inc., Avi Arad and Zib Inc.
             (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on
             Form 10-Q for the quarter ended March 31, 1995.)
 
       10.2  Registration Rights Agreement, dated as of March 2, 1995, by and among the
             Company, Marvel Entertainment Group, Inc., and Isaac Perlmutter and Avi Arad.
             (Incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on
             Form 10-Q for the quarter ended March 31, 1995.)
</TABLE> 
 

                                      -32-
<PAGE>
 
<TABLE>
<CAPTION>
EXHIBIT NO.
-----------
<C>          <S>
       10.3  Assignment and Assumption of Sublease by and between Job Lot of West 45th St.,
             Inc. and the Company, as amended by First Amendment of Sublease, dated May 26,
             1994, by and between Kallir, Philips, Ross, Inc. and the Company; Agreement of
             Sublease, dated May 6, 1991, by and between Kallir, Philips, Ross, Inc. and Job Lot
             of West 45th St., Inc.; Agreement of Sublease, dated January 1989, by and between
             673 First Realty Company and Kallir, Philips, Ross, Inc.  (Incorporated by reference
             to Exhibit 10.3 to the Company's Registration Statement on Form S-1, File No. 
             33-87268.)
 
       10.4  Lease, dated December 3, 1993, by and between 200 Fifth Avenue Associates and the
             Company.  (Incorporated by reference to Exhibit 10.4 to the Company's Registration
             Statement on Form S-1, File No. 33-87268.)
 
       10.5  Sublease, dated December 19, 1996, by and between Gruner & Jahr USA Publishing
             and the Company.
 
       10.6  Letter Agreement, effective March 1, 1994, by and between Regal West Warehouse
             Trucking and the Company.  (Incorporated by reference to Exhibit 10.5 to the
             Company's Registration Statement on Form S-1, File No. 33-87268.)
 
       10.7  Credit Agreement, dated as of February 22, 1995 among the Company, the Banks (as
             defined therein) and Chemical Bank as administrative agent for the Banks, as
             amended by First Amendment and Consent Number 1, dated as of August 29, 1995.
             (Incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on
             Form 10-Q for the quarter ended March 31, 1995 and Exhibit 10.7 to the Company's
             Current Report on Form 8-K filed on September 26, 1995.)
 
       10.8  License Agreement, dated April 30, 1993, by and between the Company and Marvel
             Entertainment Group, Inc., as amended by Amendments thereto, dated December 1,
             1994, and February 22, 1995.  (Incorporated by reference to Exhibits 10.9 and 10-
             9(b) to the Company's Registration Statement on Form S-1, File No. 33-87268 and to
             Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the Quarter ended
             March 31, 1995).
 
       10.9  License Agreement, dated July 1, 1994, between Marvel Entertainment Group, Inc.
             and the Company.  (Incorporated by reference to Exhibit 10.12 to the Company's
             Registration Statement on Form S-1, File No. 33-87268.)
 
      10.10  License Agreement, dated March 1, 1993, by and between the Company and Gerber
             Products Company as amended by Amendment thereto, dated April 5, 1995.
             (Incorporated by reference to Exhibit 10.13 to the Company's Registration Statement
             on Form S-1, File No. 33-87268 and Exhibit 10.6 to the Company's Quarterly Report
             on Form 10-Q for the quarter ended June 30, 1995.), (Confidential treatment has
             been requested for a portion of this exhibit).
 
      10.11  Distribution Agreement, dated July 29, 1993, by and between the Company and Tyco
             Industries, Inc.  (Incorporated by reference to Exhibit 10.17 to the Company's
             Registration Statement on Form S-1, File No. 33-87268).
 
      10.12  Services Agreement, dated as of March 2, 1995, by and between the Company
             and Marvel Entertainment Group, Inc.  (Incorporated by reference to Exhibit 10.18 to
             the Company's Registration Statement on Form S-1, File No. 33-87268.)
</TABLE> 
 

                                      -33-
<PAGE>
 
<TABLE>
<CAPTION>
EXHIBIT NO.
-----------
<C>          <S>
      10.13  Showroom Sharing Agreement, dated as of March 2, 1995, by and among the
             Company, Marvel Entertainment Group, Inc., Classic Heroes, Inc. and REC Sound
             Incorporated.  (Incorporated by reference to Exhibit 10.20 to the Company's
             Registration Statement on Form S-1, File No. 33-87268.)
 
      10.14  Master License Agreement, dated as of April 30, 1993, between Avi Arad &
             Associates and the Company.  (Incorporated by reference to Exhibit 10.21 to the
             Company's Registration Statement on Form S-1, File No. 33-87268.)
 
      10.15  Amended and Restated Consulting Agreement by and between the Company and Avi
             Arad, as amended and restated as of March 2, 1995.  (Incorporated by reference to
             Exhibit 10.22 to the Company's Registration Statement on Form S-1, File No. 33-
             87268.)*
 
      10.16  Amended and Restated Employment Agreement between New World Animation, Ltd.
             and Avi Arad.  (Incorporated by reference to Exhibit 10.23 to the Company's
             Registration Statement on Form S-1, File No. 33-87268.)
 
      10.17  Stock Option Agreement, dated as of April 30, 1993, between the Company and Avi
             Arad as amended.  (Incorporated by reference to Exhibits 10.25, 10.26 and 10.26(b)
             to the Company's Registration Statement on Form S-1, File No. 33-87268.)
 
      10.18  Employment Agreement, by and between Joseph M. Ahearn and the Company.
             (Incorporated by reference to Exhibit 10.27 to the Company's Registration Statement
             on Form S-1, File No. 33-87268.)*
 
      10.19  Employment Agreement, by and between Andrew R. Gatto and the Company.
             (Incorporated by reference to Exhibit 10.18 to the Company's Annual Report on Form
             10-K, filed on April 1, 1995.)*
 
      10.20  Employment Agreement, by and between Alan Fine and the Company.*
 
      10.21  1995 Stock Option Plan.  (Incorporated by reference to Exhibit 10.30 to the
             Company's Registration Statement on Form S-1, File No. 33-87268.)*
 
      10.22  Registration Rights Agreement, dated September 11, 1995, by and between the
             Company and Spectra Star, Inc.  (Incorporated by reference to Exhibit 10.8 to the
             Company's Current Report on Form 8-K, filed on September 26, 1995.)
 
      10.23  Option Agreement, dated September 11, 1995, by and between the Company and
             Spectra Star, Inc.  (Incorporated by reference to Exhibit 10.9 to the Company's
             Current Report on Form 8-K, filed on September 26, 1995.)
 
      10.24  Purchase and Option Agreement, dated September 11, 1995, by and between the
             Company, Frank Alonso, Jr. and Estrella Maquiladoras, S.A. DE C.V.
             (Incorporated by reference to Exhibit 10.10 to the Company's Current Report on
             Form 8-K, filed on September 26, 1995.)
 
      10.25  Maquila and Technical Assistance Agreement, dated September 11, 1995, by and
             between the Company and Estrella Maquiladoras, S.A. DE C.V.  (Incorporated by
             reference to Exhibit 10.11 to the Company's Current Report on Form 8-K, filed on
             September 26, 1995.)
</TABLE> 
 

                                      -34-
<PAGE>
 
<TABLE>
<CAPTION>
EXHIBIT NO.
-----------
<C>          <S>
      10.26  Stock Purchase Agreement, dated as of November 20, 1996, between Andrews and
             Avi Arad (Incorporated by reference to Exhibit A to Amendment No. 1 to the
             Schedule 13D filed by Andrews Group and Mafco Holdings, Inc. with respect to the
             Company), as amended by the Amendment to the Stock Purchase Agreement, dated
             as of January 29, 1997 (Incorporated by reference to Exhibit (c)(10) to the
             Transaction Statement on Schedule 13E-3 filed by Andrews Group and Acquisition on
             January 30, 1997).
 
      10.27  Stock Purchase Agreement, dated as of November 20, 1996, between Andrews Group
             and Isaac Perlmutter, Isaac Perlmutter, T.A. and Zib, Inc. (Incorporated by reference
             to Exhibit B to Amendment No. 1 to the Schedule 13D filed by Andrews Group and
             Mafco Holdings, Inc. with respect to the Company), as amended by the Amendment
             to the Stock Purchase Agreement, dated as of January 29, 1997 (Incorporated by
             reference to Exhibit (c)(11) to the Transaction Statement on Schedule 13E-3 filed by
             Andrews Group and Acquisition on January 30, 1997).
 
      10.28  Stock Purchase Agreement, dated as of December 27, 1996, by and between Andrews
             Group and Marvel Entertainment Group, Inc. (Incorporated by reference to Exhibit C
             to Amendment No. 3 to the Schedule 13D filed by Andrews Group and Mafco
             Holdings, Inc. with respect to the Company).
 
      10.29  Letter Agreement, February 14, 1997, between the Company and Avi Arad amending
             the Master License Agreement, dated as of April 20, 1993, between Avi Arad
             Associates and the Company.
 
       21.1  Subsidiaries of the Company.
 
         23  Consent of Accountants.

         24  Power of Attorney.

         27  Financial Data Schedule.

</TABLE>

* Management contract or compensatory plan or arrangement.

                                      -35-

<PAGE>
 
                                   SIGNATURES

    Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                              TOY BIZ, INC.

                              By:  /s/ Joseph M. Ahearn
                                 ---------------------------------------
                                      Joseph M. Ahearn
                                      President and Chief Executive Officer

                              Date: April 7, 1997


    Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
Signature                   Title                                Date
---------                   -----                                ----        
<S>                         <C>                                  <C>
 
            *               Director                             April 7, 1997 
-------------------------
Ronald O. Perelman

 

/s/ Joseph M. Ahearn        President, Chief Executive Officer   April 7, 1997  
-------------------------   and Director (principal executive                   
Joseph M. Ahearn            officer)                             
                         
                         
 
/s/ David J. Fremed         Chief Financial Officer and          April 7, 1997 
-------------------------   Treasurer (principal financial and                 
David J. Fremed             accounting officer)                                 
                         
 
 
/s/ Avi Arad                Director                             April 7, 1997 
-------------------------
Avi Arad


 
/s/ William C. Bevins       Director                             April 7, 1997 
------------------------- 
William C. Bevins


 
/s/ Donald G. Drapkin       Director                             April 7, 1997 
-------------------------
Donald G. Drapkin


 
/s/ Bobby G. Jenkins        Director                             April 7, 1997 
-------------------------
Bobby G. Jenkins
</TABLE> 

                                      -36-

<PAGE>
 
<TABLE>
<CAPTION>
Signature                   Title                             Date
---------                   -----                             ----        
<S>                         <C>                               <C>
 
/s/ James F. Halpin         Director                          April 7, 1997 
-------------------------
James F. Halpin
 
/s/ Isaac Perlmutter        Director                          April 7, 1997 
-------------------------   
Isaac Perlmutter
 
/s/ Alfred A. Piergallini   Director                          April 7, 1997 
-------------------------   
Alfred A. Piergallini
 
/s/ Paul R. Verkuil         Director                          April 7, 1997 
-------------------------
Paul R. Verkuil
 
/s/ Terry C. Stewart        Director                          April 7, 1997 
-------------------------
Terry C. Stewart


*By: /s/ Daniel J. Werther
     -------------------------
     Daniel J. Werther
     Attorney-in-Fact
</TABLE>



                                      -37-

<PAGE>
 
                         INDEX TO FINANCIAL STATEMENTS
                        AND FINANCIAL STATEMENT SCHEDULE
<TABLE>
<CAPTION>
                                                                       PAGE
                                                                       ----
<S>                                                                    <C>
 
Report of Independent Auditors.......................................   F-2
 
Consolidated Balance Sheets as of December 31, 1995
 and December 31, 1996...............................................   F-3
 
Consolidated Statements of Income for the Years Ended
 December 31, 1994, 1995 and 1996....................................   F-4
 
Consolidated Statements of Stockholders' Equity for the Years Ended
 December 31, 1994, 1995 and 1996....................................   F-5
 
Consolidated Statements of Cash Flows for the Years Ended
 December 31, 1994, 1995 and 1996....................................   F-6
 
Notes to Consolidated Financial Statements...........................   F-7
 
FINANCIAL STATEMENT SCHEDULES
 Schedule II - Valuation of Qualifying Accounts......................  F-22
 
</TABLE>


     All other schedules prescribed by the accounting regulations of the
     Commission are not required or are inapplicable and therefore have been
     omitted.

                                      F-1
<PAGE>
 
                         REPORT OF INDEPENDENT AUDITORS



THE STOCKHOLDERS OF TOY BIZ, INC.

We have audited the accompanying consolidated balance sheets of Toy Biz, Inc.
and subsidiary as of December 31, 1995 and 1996 and the related consolidated
statements of income, stockholders' equity and cash flows for each of the three
years in the period ended December 31, 1996.  Our audits also included the
financial statement schedule listed in the index at item 14(a).  The financial
statements and schedule are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements.  An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Toy Biz, Inc., and
subsidiary at December 31, 1995 and 1996 and the consolidated results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1996 in conformity with generally accepted accounting principles.
Also, in our opinion, based upon our audits, the financial statement schedule
referred to above, when considered in relation to the basic financial statements
taken as a whole, presents fairly in all material respects the information set
forth therein.

                                                               ERNST & YOUNG LLP



New York, New York
March 25, 1997

                                      F-2
<PAGE>
 
                                 TOY BIZ, INC.
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                     DECEMBER 31,      DECEMBER 31,
                                                                         1995              1996
                                                                     -------------    --------------
                                                                (In thousands, except per share data)
<S>                                                             <C>                  <C>
 
ASSETS
Current Assets:
  Cash and cash equivalents....................................           $ 22,484          $  6,022
  Accounts receivable, net (Note 3)............................             74,748            95,591
  Inventories, net (Note 3)....................................             17,195            20,935
  Deferred income taxes (Notes 1 and 6)........................              4,141             6,173
  Prepaid expenses and other...................................              4,476             6,067
                                                                       -----------       ----------- 
 
     Total current assets......................................            123,044           134,788
 
Molds, tools and equipment, net (Note 3).......................             12,102            17,680
Product and package design costs, net (Note 3).................              6,971             9,283
Goodwill and other intangibles, net (Note 3)...................             10,101             9,981
                                                                       -----------       ----------- 
 
     Total assets..............................................           $152,218          $171,732
                                                                       ===========       =========== 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable.............................................           $  8,830          $ 10,237
  Accrued expenses and other (Note 3)..........................             29,040            22,359
                                                                       -----------       ----------- 
     Total current liabilities.................................             37,870            32,596
                                                                       -----------       ----------- 
Redeemable preferred stock.....................................              3,016             1,681
                                                                       -----------       ----------- 
 
 
Stockholders' equity (Note 8, 9 and 10)
 
  Preferred Stock, $.01 par value, 25,000,000 shares
   authorized, none issued)....................................                --                --
  Class A common stock, $.01 par value, 100,000,000 shares
     authorized, 17,126,130 issued and outstanding at 12/31/95                                       
     and 20,348,794 issued and outstanding at 12/31/96.........                171               203 
  Class B common stock, $.01 par value, 20,000,000 shares
     authorized, 9,894,000 issued and outstanding at 12/31/95                                         
     and 7,394,000 issued and outstanding at 12/31/96..........                 99                74 
  Additional paid-in capital...................................             61,158            70,587 
  Retained earnings............................................             49,904            66,591 
                                                                       -----------       ----------- 

            Total stockholders' equity.........................            111,332           137,455
                                                                       -----------       ----------- 
 
            Total liabilities and stockholders' equity.........           $152,218          $171,732
                                                                       ===========       ===========
</TABLE>
                See Notes to Consolidated Financial Statements.

                                      F-3
<PAGE>
 
                                 TOY BIZ, INC.
                       CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
 
 
                                                       YEARS ENDED DECEMBER 31,
 
                                                   1994          1995          1996
                                               ---------------------------------------
                                                (In thousands, except per share data)
<S>                                            <C>           <C>           <C>
 
Net sales....................................     $156,525      $196,395      $221,624
Cost of sales................................       73,490        88,397       116,455
                                                  --------      --------      --------
 
     Gross profit............................       83,035       107,998       105,169
 
 
Operating expenses:
  Selling, general and administrative........       38,263        48,234        61,876
  Depreciation and amortization..............        8,609        12,750        16,078
  Compensatory stock option..................        4,091             -             -
                                                  --------      --------      --------
     Total expenses..........................       50,963        60,984        77,954
                                                  --------      --------      --------
 
Operating income.............................       32,072        47,014        27,215
 
Interest expense.............................       (1,862)         (490)         (112)
Other income, net............................           65         1,050           708
                                                  --------      --------      --------
  Income before income taxes.................       30,275        47,574        27,811
 
  Income taxes (Note 6)......................       12,261        19,172        11,124
                                                  --------      --------      --------
 
     Net income..............................     $ 18,014      $ 28,402      $ 16,687
                                                  ========      ========      ========
 
Net income per share.........................        $0.67         $1.05         $0.61
 
Weighted average number of common and
   common equivalent shares outstanding (in
   thousands) (assumes 27,000 shares
   outstanding for periods prior to 1995)....       27,000        27,115        27,366
</TABLE>

                See Notes to Consolidated Financial Statements.

                                      F-4
<PAGE>
 
                                 TOY BIZ, INC.
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
 
 
 
                                                   ADDITIONAL
                                           COMMON    PAID-IN    RETAINED
                                           STOCK     CAPITAL    EARNINGS    TOTAL
                                           ------  -----------  --------  ---------
                                                       (In thousands)
<S>                                        <C>     <C>          <C>       <C>
 
Balance at December 31, 1993.............      --     $12,795    $ 3,488  $ 16,283
 
Compensatory stock option................      --       4,091         --     4,091
 
Exercise of stock option (Note 10).......      --          28         --        28
 
Net income for 1994......................      --          --     18,014    18,014
                                           ------     -------    -------  --------
 
Balance at December 31, 1994.............      --      16,914     21,502    38,416
 
Proceeds from initial public offering....    $270      43,875         --    44,145
 
Exercise of stock option.................      --         411         --       411
 
Accretion of redeemable preferred stock..      --         (42)        --       (42)
 
Net income for 1995......................      --          --     28,402    28,402
                                           ------     -------    -------  --------
 
Balance at December 31, 1995.............     270      61,158     49,904   111,332
 
Proceeds from secondary offering.........       7       9,096         --     9,103
 
Exercise of stock option.................      --         438         --       438
 
Accretion of redeemable preferred stock..      --        (105)        --      (105)
 
Net income for 1996......................      --          --     16,687    16,687
                                           ------     -------    -------  --------
Balance at December 31, 1996.............    $277     $70,587    $66,591  $137,455
                                           ======     =======    =======  ========
</TABLE>
                See Notes to Consolidated Financial Statements.

                                      F-5
<PAGE>
 
                                 TOY BIZ, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                                          1994       1995       1996
                                                      --------------------------------
                                                                (In thousands)
<S>                                                     <C>        <C>        <C>
Net income............................................  $ 18,014   $ 28,402   $ 16,687

  Adjustments to reconcile net income to net cash
    provided by operating activities:
 
    Depreciation and amortization.....................     8,609     12,750     16,078
 
    Provision for deferred income taxes...............     2,811        696     (2,032)
 
    Compensatory stock option.........................     4,091         --         --
 
    Changes in operating assets and liabilities:
 
      Accounts receivable.............................   (34,571)   (11,260)   (20,843)
 
      Inventories.....................................    (9,913)     1,130     (3,740)
 
      Prepaid expenses and other......................     1,431     (2,378)    (1,591)
 
      Other assets....................................       449        (17)      (283)
 
      Accounts payable................................     2,399      3,656      1,407
 
      Accrued expenses and other......................     5,215      2,028     (6,838)
 
      Due to affiliates...............................        --        517         --
                                                        --------   --------   --------
 
Net cash (used in) provided by operating activities...    (1,465)    35,524     (1,155)
                                                        --------   --------   --------
 
 
 
Cash flow from investing activities:
 
  Purchases of molds, tools and equipment.............   (10,862)    (9,591)   (15,352)
 
  Expenditures for product and package                    
    design costs......................................    (6,369)    (6,545)    (8,213)
 
  Acquisition of Spectra Star & Quest.................        --     (9,004)        --
                                                        --------   --------   --------
 
  Net cash used in investing activities...............   (17,231)   (25,140)   (23,565)
                                                        --------   --------   --------
 
 
Cash flow from financing activities:
 
  Payment of notes to stockholder.....................        --    (15,119)        --
 
  Exercise of stock option............................        28        411        438
 
  Net borrowings under credit agreement...............    17,000    (21,500)        --
 
  Borrowings from stockholder and affiliates..........     1,099         --         --
 
  Redemption of Preferred Stock.......................        --         --     (1,440)
 
  Proceeds from initial public offering...............        --     44,166         --
 
  Proceeds from additional public offering............        --         --      9,260
                                                        --------   --------   --------
 
Net cash provided by financing activities.............    18,127      7,958      8,258
                                                        --------   --------   --------
 
Net (decrease) increase in cash and cash equivalents..      (569)    18,342    (16,462)
 
Cash and cash equivalents at beginning of year........     4,711      4,142     22,484
                                                        --------   --------   --------
 
Cash and cash equivalents at end of year..............  $  4,142   $ 22,484   $  6,022
                                                        ========   ========   ========
 
Supplemental disclosure of cash flow information:
 
  Interest paid during the period.....................  $    624   $  2,335   $    149
 
  Income taxes paid during the period.................     5,878     16,410     16,156
 
Other non-cash transactions:
  Issuance of preferred stock for Spectra Star,
  including accretion of preferred dividend of $42
  for 1995 and $105 for 1996 (See Note 12)............        --      3,016         --
</TABLE>
                See Notes to Consolidated Financial Statements.

                                      F-6
<PAGE>
 
                                 TOY BIZ, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                               DECEMBER 31, 1996


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

     Toy Biz, Inc. ("Toy Biz" or the "Company") was formed on April 30, 1993
pursuant to a Formation and Contribution Agreement ("Formation Agreement"),
entered into by the Predecessor Company, Mr. Isaac Perlmutter (the sole
stockholder of the Predecessor Company), Marvel Entertainment Group, Inc.
("Marvel") and Avi Arad ("Mr. Arad").  The Predecessor Company had been Marvel's
largest toy licensee.  Toy Biz designs, markets and distributes boys', girls',
infant/preschool and activity toys based on popular entertainment properties and
consumer brand names.  The Company also designs, markets and distributes its own
line of proprietary toys.  The Predecessor Company was incorporated in 1990,
pursuant to an asset purchase agreement with Charan Industries, Inc.

     In accordance with the Formation Agreement, the Predecessor Company
contributed all of its and an affiliate's assets ($23,335,000) and certain
specified liabilities ($21,949,000) to the Company for 44% of Toy Biz's capital
stock.  Such specified liabilities included approximately $15,363,000 due to Mr.
Perlmutter and other affiliated companies of the Predecessor Company.  A portion
of the assumed liabilities due to Mr. Perlmutter was paid in cash ($8,752,000)
and the remainder of the assumed liabilities due to Mr. Perlmutter was converted
into a promissory note ($6,611,000).  Marvel made a capital contribution of
$500,000 for 46% of the Company's capital stock and a loan, in the form of a
note, of $8,507,000.  In addition, Marvel granted the Company an exclusive,
perpetual and royalty-free license to design and distribute toys based on Marvel
characters.  Pursuant to the Formation Agreement, in exchange for the
contribution to the Company of his interests in certain license agreements with
the Company and cash, Mr. Arad received 10% of the Company's capital stock.  In
addition, the Company granted Mr. Arad the Arad Stock Option (the "Option") to
acquire an additional 10% of the Company's capital stock (see Note 10 regarding
the Option and its subsequent exercise).  Mr. Arad also agreed to enter into the
Arad Consulting Agreement and the Master License Agreement.

Basis of Presentation

     The consolidated financial statements include the accounts of the Company
and its subsidiary in Hong Kong.  Upon consolidation, all significant
intercompany accounts and transactions are eliminated.

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 reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  The principal areas of judgement relate to provisions for
returns and other sales allowances, and doubtful accounts, and the realizability
of inventories, molds, tools and equipment, and product and package design
costs.  Actual results could differ from those estimates.

                                      F-7
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)

Cash Equivalents

     The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents.

Inventories

     Inventories are valued at the lower of cost (first-in, first-out method) or
market.

Molds, Tools, and Equipment

     Molds, tools and equipment are stated at cost less accumulated depreciation
and amortization.  The Company owns the molds and tools used in production of
the Company's products by third-party manufacturers.  At December 31, 1996,
certain of these costs related to products that were not yet in production or
were not yet being sold by the Company.  For financial reporting purposes,
depreciation and amortization is computed by the straight-line method over a
three year period (the estimated life) for molds and tooling costs and over the
useful life for furniture and fixtures and office equipment.  On an ongoing
basis the Company reviews the lives and carrying value of molds and tools based
on the sales and operating results of the related products.  If the facts and
circumstances suggest a change in useful lives or an impairment in the carrying
value, the useful lives are adjusted and unamortized costs are written off
accordingly.  Write-offs, in excess of normal amortization, which are included
in depreciation and amortization on the accompanying Consolidated Statements of
Income for the years ended December 31, 1994, 1995 and 1996 were approximately
$461,000, $636,000 and $364,000, respectively.

Product and Package Design Costs

     The Company capitalizes costs related to product and package design when
such products are determined to be commercially acceptable.  Product design
costs include costs relating to the preparation of precise detailed mechanical
drawings and the production of sculptings and other handcrafted models from
which molds and dies are made.  Package design costs include costs relating to
art work, modeling and printing separations used in the production of packaging.
At December 31, 1996, certain of these costs related to products that were not
yet in production or were not yet being sold by the Company.  For financial
reporting purposes, depreciation and amortization of product and package design
is computed by the straight-line method over a three year period (the estimated
life).  On an ongoing basis the Company reviews the useful lives and carrying
value of product and package design costs based on the sales and operating
results of the related products.  If the facts and circumstances suggest a
change in useful lives or an impairment in the carrying value, the useful lives
are adjusted and unamortized costs are written off accordingly.  Write-offs, in
excess of normal amortization, which are included in depreciation and
amortization on the accompanying Consolidated Statements of Income, for the
years ended December 31, 1994, 1995 and 1996 were approximately $807,000,
$1,276,000 and $1,164,000, respectively.

Goodwill and Other Intangibles

     Goodwill is amortized over 40 years and other intangibles are amortized
over 3 years.  For the years ended December 31, 1994, 1995 and 1996,
amortization of goodwill was $0, $68,000 and $245,000, respectively.

                                      F-8
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)

Research and Development

     Research and development ("R&D") costs are charged to operations as
incurred.  For the years ended December 31, 1994, 1995 and 1996, R&D expenses
were $2,829,000, $4,980,000 and $5,298,000, respectively.

Revenue Recognition

     Sales are recorded upon shipment of merchandise and a provision for future
returns and other sales allowances is established based upon historical
experience and management estimates.  Income from distribution fees and sub-
licensing of characters owned by the Company are recorded in accordance with the
distribution agreement and at the time characters are available to the licensee
and collection is reasonably assured.  For the years ended December 31, 1994,
1995 and 1996, distribution fees and sub-licensing revenues were $782,000, 
$5,730,000 and $13,637,000, respectively.

Advertising Costs

     Advertising production costs are expensed when the advertisement is first
run.  Media advertising costs are expensed on the projected unit of sales method
during interim periods.  For the years ended December 31, 1994, 1995 and 1996,
advertising expenses were $15,667,000, $18,864,000 and $25,471,000,
respectively.  At December 31, 1995 and 1996, the Company had incurred $474,000,
and $433,000, respectively, of prepaid advertising costs, principally related to
production of advertisement that will arise in fiscal 1996 and 1997,
respectively.

Royalties

     Minimum guaranteed royalties, as well as royalties in excess of minimum
guarantees, are expensed based on sales of related products.  The realizability
of minimum guarantees paid is evaluated by the Company based on the projected
sales of the related products.

Income Taxes

     The Company uses the liability method of accounting for income taxes as
required by Statement of Financial Accounting Standards No. 109, "Accounting for
Income Taxes".  Under this method, deferred tax assets and liabilities are
determined based on differences between financial reporting and the tax bases of
assets and liabilities and are measured using tax rates and laws that are
scheduled to be in effect when the differences are scheduled to reverse.

     Income tax expense includes U.S. and foreign income taxes, including U.S.
Federal taxes on undistributed earnings of foreign subsidiaries to the extent
that such earnings are planned to be remitted.

                                      F-9
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)

Foreign Currency Translation

     The financial position and results of operations of the Company's Hong Kong
subsidiary are measured using the U.S. dollar as the functional currency.
Assets and liabilities are translated at the exchange rate in effect at year-
end.  Income statement accounts and cash flows are translated at the average
rate of exchange prevailing during the period.  Translations adjustments, which
were not material, arising from the use of differing exchange rates are included
in the results of operations.

Income Per Share

     Net income per common share is computed by dividing net income, less the
amount applicable to preferred dividends, by the weighted average common and
common equivalent shares outstanding during the year.  When diluted, common
stock equivalents are included as stock equivalents using the treasury method.

Long-Lived Assets

     In accordance with Financial Accounting Standards Board ("FASB") Statement
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of", the Company records impairment losses on long-lived
assets used in operations, including intangible assets, when events and
circumstances indicate that the assets might be impaired and the undiscounted
cash flows estimated to be generated by those assets are less than the carrying
amounts of those assets.

2. SALES TO MAJOR CUSTOMERS AND INTERNATIONAL OPERATIONS

     The Company primarily sells its merchandise to major retailers, principally
throughout the United States.  Credit is extended based on an evaluation of the
customer's financial condition, and, generally, collateral is not required.
Credit losses are provided for in the financial statements and consistently have
been within management's expectation.

     During the year ended December 31, 1994, three customers accounted for
approximately 31%, 18% and 13% of total net sales.  During the year ended
December 31, 1995, three customers accounted for approximately 29%, 19% and 12%
of total net sales.  During the year ended December 31, 1996, two customers
accounted for approximately 23% and 18% of total net sales.

          The Company's Hong Kong subsidiary supervises the manufacturing of the
Company's products in China and sells such products internationally.  All sales
are made F.O.B. Hong Kong against letters of credit.  During the years ended
December 31, 1994, 1995 and 1996, international sales were approximately 9%,
11% and 20%, respectively, of total net sales.  During those periods, the Hong
Kong operations reported operating income of approximately $3,009,000,
$6,642,000, and $18,880,000 and income before income taxes of $3,003,000,
$6,721,000 and $19,079,000, respectively.  At December 31, 1995 and 1996 the
Company had assets in Hong Kong of approximately $13,915,000 and $29,342,000,
respectively, and the Hong Kong subsidiary represents $9,277,000 and
$24,785,000, respectively, of the Company's consolidated retained earnings.

                                      F-10
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996
<TABLE>
<CAPTION>
 
3. DETAILS OF CERTAIN BALANCE SHEET ACCOUNTS
    (IN THOUSANDS)
                                                                          DECEMBER 31
                                                                        1995       1996
                                                                   ------------ --------
<S>                                                                <C>          <C>
Accounts receivable, net, consists of the following:
 
  Accounts receivable..............................................   $86,019   $110,932

  Less allowances for:
 
    Doubtful accounts..............................................      (516)      (485)
 
    Advertising, markdowns, returns, volume discounts
      and other....................................................   (10,755)   (14,856)
                                                                     --------   -------- 
 
      Total........................................................   $74,748    $95,591
                                                                     =========  ======== 
 
Inventories, net, consist of the following:
 
  Finished goods...................................................   $13,504    $16,918
 
  Component parts, raw materials and
    work-in-process................................................     3,691      4,017
                                                                     --------   -------- 
 
      Total........................................................   $17,195    $20,935
                                                                     ========   ========
 
Molds, tools and equipment, net, consists of the following:
 
  Molds, tools and equipment.......................................   $20,921    $23,055
 
  Office equipment and other.......................................     1,628      4,092
 
  Less accumulated depreciation and amortization...................   (10,447)    (9,467)
                                                                   -----------  --------
 
      Total........................................................   $12,102    $17,680
                                                                   =====================
 
 
Product and package design costs, net, consists of the following:
 
  Product design costs.............................................    $9,854    $10,047
 
  Package design costs.............................................     3,675      3,612
 
  Less accumulated amortization....................................    (6,558)    (4,376)
                                                                     --------   -------- 
 
      Total........................................................    $6,971     $9,283
                                                                     ========   ======== 
 
 
Goodwill and other intangibles, net, consists of the following:
 
 
  Goodwill.........................................................    $9,815     $9,815
 
  Patents and other intangibles....................................       409        692
 
  Less accumulated amortization....................................      (123)      (526)
                                                                     --------   -------- 
 
      Total........................................................   $10,101     $9,981
                                                                     ========   ========
 
 
Accrued expenses and other consists of the following:
 
 
  Accrued advertising costs........................................    $9,459     $7,330
 
  Accrued royalties................................................     3,956        180
 
  Income taxes payable.............................................     7,374      4,343
 
  Deferred income..................................................       179        134
 
  Other accrued expenses...........................................     8,072     10,372
                                                                     --------   -------- 
      Total........................................................   $29,040    $22,359
                                                                     ========   ========
</TABLE>

                                      F-11
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


4. RELATED PARTY TRANSACTIONS

     The notes payable--stockholders were paid with proceeds from the Initial
Public Offering (as defined below) in March, 1995.  Interest accrued at the
prime rate, as defined, and was payable at maturity.  Interest expense on the
notes amounted to approximately $1,099,000 and $235,000 for the years ended
December 31, 1994 and 1995, respectively, and was added to the notes.

     Marvel provides significant support to the Company relating to licensing
agreements,  promotion, legal and financial matters.  The cost for these support
services has been included in selling, general and administrative expenses, and
amounted to $498,000, $306,000 and $262,000 for the years ended December 31,
1994, 1995 and 1996, respectively.  At December 31, 1996, the Company had a
receivable from Marvel of $165,000.

     The Company and Marvel have entered into an exclusive license agreement
pursuant to which Marvel may use the Toy Biz trademark on online services and
electronic networks, including the Internet.  The license is limited to Marvel-
related products of the Company.  Marvel paid the Company $500,000 for such
license.

     An affiliate of the Company, which is wholly-owned by Mr. Perlmutter, acts
as the Company's media consultant in placing the Company's advertising and, in
connection therewith, receives certain fees and commissions based on the cost of
the placement of such advertising.  During the years ended December 31, 1994,
1995 and 1996 the Company paid fees and commissions to the affiliate totalling
approximately $859,000, $970,000 and $965,000, respectively, relating to such
advertisements.

     The Company sold merchandise to a subsidiary of Marvel totalling $429,000,
$1,616,000 and $324,000 for the years ended December 31 1994, 1995 and 1996,
respectively.  Related receivables were $945,000 and $207,000 as of December 31,
1995 and 1996, respectively.  These amounts were subsequently collected.

     During the years ended December 31, 1994, 1995 and 1996, the Company
accrued royalties to Mr. Arad for toys he invented or designed of $6,541,000,
$5,734,000 and $1,848,000, respectively.  At December 31, 1996 the Company had a
receivable from Mr. Arad for $505,000 related to reimbursement of expenses.

     The Company shares office space and certain general and administrative
costs with affiliated entities.  The Company paid rent to the affiliated entity;
however, this was not subject to a formal sublease agreement.  In 1994, the
lease was amended and the Company become the lessee.  Rent paid to the
affiliated entity amounted to approximately $128,000 for the year ended December
31, 1994.  Rent received from affiliates was $155,000, $172,000 and $109,000 for
the years ended December 31, 1994, 1995 and 1996.  While certain costs are not
allocated among the entities, the Company believes that it bears its
proportionate share of these costs.

                                      F-12
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996

5. COMMITMENTS AND CONTINGENCIES

     Leases:  The Company is a party to various noncancelable operating leases
involving office and warehouse space expiring on various dates from February 28,
1997 through March 31, 2006.  The leases are subject to escalations based on
cost of living adjustments and tax allocations.  Minimum future obligations on
these leases are as follows:

<TABLE>
<S>           <C>
 
1997           $  347,000
 
1998              156,000
 
1999              172,000
 
2000              172,000
 
2001              172,000
 
Thereafter        440,000
               ----------
               $1,459,000
               ==========
</TABLE>
     Rent expense amounted to approximately $406,000, $522,000 and $788,000 for
the years ended December 31, 1994, 1995 and 1996, respectively. See Note 4
regarding sublease income.

     The Company is a party to various royalty agreements with future guaranteed
payments through 1999.  Minimum future obligations are as follows:

<TABLE>
<S>     <C>
1997     $1,757,000
 
1998      1,569,000
 
1999        325,000
         ----------
         $3,651,000
         ==========
</TABLE>

     Legal Matters:  On December 28, 1995 G.D.L. Management Incorporated ("GDL")
commenced an action against the Company, Mr. Perlmutter and the Predecessor
Company in the Supreme Court of the State of New York, County of New York.  The
amended complaint in that action, which was served on March 19, 1996, alleges
that GDL is entitled to receive ten percent of the capital stock of the
Predecessor Company pursuant to a 1990 agreement between GDL and Mr. Perlmutter
and seeks money damages based on the value of ten percent of the Company's Class
A Common Stock beneficially owned by Mr. Perlmutter and a variety of equitable
remedies, including an order rescinding the 1993 transfer of the assets of the
Predecessor Company to the Company pursuant to the Formation and Contribution
Agreement.  Mr. Perlmutter has denied all of the material allegations made in
support of GDL's claims, and pursuant to the Formation and Contribution
Agreement, agreed to indemnify the Company in respect to any liability arising
from GDL's claims.  The Company does not believe that any of the claims made
against it will have a material adverse effect on its financial position because
it believes that all of the claims against it are without merit and because of
the indemnity provided to it in the Formation and Contribution Agreement.

          The Company is also involved in various legal proceedings arising in
the normal course of business.  Management believes that the final outcome of
these proceedings will not have a significant adverse effect on the Company's
results of operations or financial position.

                                      F-13
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996

6. INCOME TAXES

     The provision (benefit) for income taxes for the years ended December 31,
1994, 1995 and 1996 is summarized as follows:

<TABLE>
<CAPTION>
                                1994         1995           1996
                             -----------  -----------  --------------
<S>                          <C>          <C>          <C>
CURRENT:
 
  Federal                    $ 7,222,000  $15,429,000  $   8,474,000
 
  State                        2,225,000    1,923,000      1,943,000
 
  Foreign                          3,000    1,124,000      2,739,000
                             -----------  -----------  -------------
 
                             $ 9,450,000  $18,476,000  $  13,156,000
 
DEFERRED:
 
  Federal                    $ 2,192,000  $   543,000   ($ 1,586,000)
 
  State                          619,000      153,000       (446,000)
                             -----------  -----------  -------------
 
                               2,811,000      696,000     (2,032,000)
                             -----------  -----------  -------------
 
 
PROVISION FOR INCOME TAXES:  $12,261,000  $19,172,000  $  11,124,000
                             ===========  ===========  =============
</TABLE>

     The differences between statutory Federal income tax rate and the effective
tax rate for the years ended December 31, 1994, 1995 and 1996 are attributable
to the following:

<TABLE>
<CAPTION>
                                      1994   1995   1996
                                      -----  -----  -----
<S>                                   <C>    <C>    <C>
 
Federal income tax provision
  computed at the statutory rate      35.0%  35.0%  35.0%
 
State taxes, net of Federal income
  tax effect                           5.5%   5.3%   5.0%
                                      -----  -----  -----
                                      40.5%  40.3%  40.0%
                                      =====  =====  =====
</TABLE>

     Deferred income taxes 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.  Significant components
of the Company's deferred tax assets at December 31, 1995 and 1996 are as
follows:

<TABLE>
<CAPTION>
                                                1995         1996
                                             -----------  -----------
<S>                                          <C>          <C>
 
Allowance for future returns, other sales
  allowances and doubtful accounts and
  other allowances                           $1,377,000   $1,620,000
 
Inventory valuation                           1,842,000    2,861,000
 
Depreciation                                    983,000    1,762,000
 
Amortization                                    (61,000)     (70,000)
                                           ------------   ----------
                                             $4,141,000   $6,173,000
                                           ============   ==========
</TABLE>

                                      F-14
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996

7.  CREDIT FACILITY

     The Company has a $30,000,000 revolving credit facility (the "Credit
Facility") with a syndicate of banks with The Chase Manhattan Bank (formerly
named Chemical Bank) as administrative agent.  The Credit Facility matures on
February 21, 1998; however, the Company may voluntarily reduce the commitment
from time to time with appropriate notice to the administrative agent for the
syndicate of banks.  Borrowings under the Credit Facility are collateralized by
substantially all Company assets. Borrowings under the Credit Facility bear
interest at either The Chase Manhattan Bank's alternate base rate or at the
Eurodollar rate plus the applicable margin (as defined).

     The Credit Facility contains various financial covenants, as well as
restrictions, on new indebtedness, prepaying or amending subordinated debt,
acquisitions and similar investments, the sale or transfer of assets, capital
expenditures, limitations on restricted payments, dividends, issuing guarantees
and creating liens.  The Credit Facility also requires an annual reduction,
commencing January 1, 1996, of outstanding borrowings to zero for a period of 45
consecutive days, commencing during the first six months of each calendar year.
In addition, the Credit Facility also requires that (a) Marvel continue to
control the Company and (b) the toy license agreement between the Company and
Marvel remain in effect.  The Credit Facility is not guaranteed by Marvel.

     Certain indebtedness of Marvel and Marvel's direct and indirect parent
companies impose restrictions that limit the ability of Marvel and its
subsidiaries, including the Company, to incur debt, make restricted payments,
enter into transactions with affiliates and sell or transfer assets.

     The interest rate for borrowing as of December 31, 1995 and 1996 was 8.5%
and 8.25%, respectively and the weighted average interest rate for 1995 and 1996
was 8.8% and 8.27%, respectively.  The maximum amounts outstanding during 1995
and 1996 were $21,500,000 and $4,000,000, respectively.  The amount available
under the Credit Facility at December 31, 1996 was $30,000,000.  The Credit
Facility requires the Company to pay a commitment fee of 3/8 of 1% per annum on
the unused portion.

8. CAPITAL STOCK STRUCTURE

     In addition to Class A and Class B  common stock shown on the accompanying
balance sheet, the Company has authorized 2,500 shares of preferred stock, par
value $.01.

     Two shares of Class B Common Stock are owned of record by voting trusts of
which Messrs. Perlmutter and Arad are trustees and Marvel is the sole
beneficiary.  Each of Messrs. Perlmutter and Arad will have the right to vote
the share of Class B Common Stock held by voting trust in his absolute
discretion until the termination of such trust.  Certain fundamental
transactions will require the unanimous consent of the holders of Class B Common
Stock voting as a class.

     The Class B Common Stock has ten votes for each share outstanding for most
matters brought to a vote of the stockholders; whereas, the Class A Common Stock
has only one vote per share on such matters.

          On March 2, 1995, the Company completed an initial public offering
(the "Offering") by issuing 2,750,000 new shares of its Class A Common Stock at
$18.00 per share.  The net proceeds of the Offering to the Company ($44,145,000)
were used to repay notes payable to the principal shareholders and to increase
working capital.  As part of the Offering, Mr. Arad sold 700,000 shares of Class
A Common Stock owned by him to pay taxes due in connection with the exercise of
a stock option.  See Note 10.

                                      F-15
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


8. CAPITAL STOCK STRUCTURE--(CONTINUED)

     On August 13, 1996, the Company completed an additional public offering by
issuing 700,000 new shares of Class A Common Stock at $15.00 per share.  As part
of such offering, Marvel Entertainment Group, Inc. ("Marvel"), a principal
stockholder, also sold 2,500,000 shares of Class A Common Stock.  The Company
intends to use the net proceeds from the sale of the new shares of Class A
Common Stock, of approximately $9.1 million, after deducting estimated fees and
expenses, to fund a portion of its capital commitment to Marvel Studios ("Marvel
Studios"), an entity to be formed with Marvel to facilitate the development of
television programming, feature films and other media and theatrical productions
based on Marvel characters.  It is anticipated that the structure of Marvel
Studios may change.  Pending such use, the net proceeds are being used for
working capital and general corporate purposes.

9. STOCK OPTIONS

     The Company's 1995 Stock Option Plan (the "Plan") provides for the issuance
of Stock Options ("Options") and Stock Appreciation Rights ("SAR's") for up to
1,350,000 shares of the Company's Class A Common Stock at fair market value at
the time of grant.  One-third of the Options become exercisable at the date of
the grant (the "Grant Date"), and the balance of the Options become exercisable
in equal increments on the first and second anniversaries of the Grant Date.  No
SAR's have been granted and Options with respect to 186,321 shares are available
for future grants.

     The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123 "Accounting for Stock Based Compensation"
(FAS 123).  Accordingly, no compensation expense has been recognized for the
stock option plans.  For purposes of FAS 123 pro forma disclosures, the
estimated fair value of the options is amortized to expense over the options'
vesting period.  The Company's pro forma information follows:

<TABLE>
<CAPTION>
                                   1995     1996
                                  -------  -------
<S>                               <C>      <C>
 
Pro forma net income............  $25,433  $15,195
Pro forma net income per share..  $  0.94  $  0.55
==================================================
</TABLE>

     The fair value for each option grant was estimated at the date of grant
using a Black Scholes option pricing model with the following weighted-average
assumptions for the various grants made during 1995 and 1996: risk free interest
rates from 5.26% to 7.19%; no dividend yield; expected volatility of .354 and
expected lives of three to five years.

                                      F-16
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


9. STOCK OPTIONS --(CONTINUED)

     The Black Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable.  In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility.  Because the Company's employee stock options have characteristics
significantly different from those traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
<TABLE>
<CAPTION>
 
 
                                             1995                       1996
                                 ---------------------------  -------------------------
 
                                              WEIGHTED-AVG.              WEIGHTED-AVG.
                                    OPTIONS   EXERCISE PRICE   OPTIONS   EXERCISE PRICE
                                   ---------  --------------  ---------  --------------
 
 
<S>                                <C>        <C>             <C>        <C>
 
Outstanding at
beginning of year................          0                    995,602          18.183
 
Granted..........................  1,049,000          18.173    195,250          17.111
 
Exercised........................     20,130          18.000     22,664          18.000
 
Forfeited........................     33,268          18.000     47,303          18.119
 
Outstanding at end of year.......    995,602          18.183  1,120,885          18.002
 
Exercisable at end of year.......    329,187          18.184    691,211          18.089

Weighted-average fair value of
options granted during the year..                       6.85                       6.15
---------------------------------------------------------------------------------------
</TABLE>

Exercise prices for options outstanding as of December 31, 1996 ranged from
$15.00 to $22.625.


10. ARAD OPTION AGREEMENT

     Pursuant to the Formation Agreement executed by the Company, Mr. Arad
received the Option to acquire an additional 278 shares of the Company's Class C
common stock at $100 per share, subsequently converted to 2,696,600 shares of
Class A common stock.  The Option, which expires April 30, 1998, was exercisable
contingent upon the Company achieving certain operating results, as defined.  At
the end of 1993, it became evident that the operating results necessary for the
Option to become exercisable would, in all likelihood, be achieved sometime in
1994.  Therefore, the Company amended the Option so that it became exercisable
March 31, 1994.  Based on an independent appraisal of the value of the Option,
the Company charged operations for the last quarter of 1993 $10,909,000 for this
compensatory stock option and operations for the three month period ended March
31, 1994 with the remainder of the value of the Option ($4,091,000).  The
appraisal of the value of the Option, performed in April, 1994, determined the
value of the shares issuable on exercise of the Option to be $6.19 per share.
The appraisal applied market multiples of 1994 earnings estimates of publicly
traded companies considered to be comparable to the Company to the Company's
1994 projected earnings and considered the Company dependence on Mr. Arad and
the illiquid nature of the shares subject to the Option.

                                      F-17
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


10. ARAD OPTION AGREEMENT--(CONTINUED)

     On June 30, 1994, Mr. Arad exercised the stock option described above.  In
connection with that exercise, the Company agreed to loan Mr. Arad (the "Option
Loan") an amount necessary to allow Mr. Arad to pay the incremental Federal,
state and local income tax liability that he incurred as a result of the vesting
and exercise of the Option.  The Company advanced Mr. Arad $10,000 in 1994 under
the Option Loan.  Mr. Arad repaid the $10,000 advance under the Option Loan upon
the consummation of the initial public offering and the pledge was released at
that time.  See Note 8.

                                      F-18
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


11. QUARTERLY FINANCIAL DATA (UNAUDITED)

Summarized quarterly financial information for the years ended December 31, 1995
and 1996 is as follows (dollars in thousands, except per share data):

<TABLE>
<CAPTION>
                                                   1995                                                    1996
                             ----------------------------------------------- --------------------------------------------
QUARTER ENDED                  MARCH 31  JUNE 30  SEPTEMBER 30  DECEMBER 31  MARCH 31  JUNE 30  SEPTEMBER 30  DECEMBER 31
                             ----------------------------------------------- --------------------------------------------
<S>                            <C>       <C>      <C>           <C>          <C>       <C>      <C>           <C>
Net Sales                       $27,888  $30,435       $58,687      $79,385   $38,369  $45,814       $83,437      $54,004
 
Gross Profit                     14,490   18,420        32,227       42,861    18,636   22,875        42,988       20,670
 
Operating income (loss)           5,078    6,981        15,789       19,166     5,123    7,472        18,884       (4,264)
 
Net income (loss)                 2,859    4,323         9,480       11,740     3,173    4,594        11,417       (2,497)
 
Net income (loss) per share       $0.11  $  0.16       $  0.35      $  0.43     $0.12  $  0.17       $  0.42       ($0.09)

Weighted average number
  of common and common
  equivalent shares out-
  standing (in thousands)        27,000   27,000        27,193       27,199    27,201   27,134        27,398       27,761 
</TABLE>

The income (loss) per common share computation for each quarter and the year are
separate calculations. Accordingly, the sum of the quarterly income (loss) per
common share amounts may not equal the income per common share for the year. The
fourth quarter includes pretax adjustments of $1,600,000 related to prior
quarter matters.

                                      F-19
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


12. ACQUISITION

     On September 11, 1995, pursuant to an Asset Purchase Agreement dated as of
August 17, 1995, as amended, between the Company and Spectra Star, Inc.
("Spectra Star"), the Company acquired certain assets and assumed certain
liabilities of Spectra Star (the "Acquisition").  Spectra Star is the leading
U.S. manufacturer and marketer of children's and performance kites.  They also
manufacture other toy and recreation products, many of which feature popular
children's entertainment characters.  The purchase price, including estimated
fees related to the Acquisition, totaled approximately $13.6 million, consisting
of approximately $10.6 million of cash and assumed liabilities and a maximum of
130,303 shares of Series A Preferred Stock (the "Preferred Stock") with a
maximum redemption value of $4.3 million.  The Preferred Stock is convertible at
any time after March 10, 1996 at the option of the holders into 130,303 shares
of Class A Common Stock or cash at the then present value of the Preferred
Stock.  During the year ended December 31, 1996, 53,030 shares of the Preferred
Stock were redeemed for cash at an aggregate present value of approximately $1.4
million.  The present value of the Preferred Stock issued was approximately $1.7
million as of December 31, 1996.  The Company utilized available cash to finance
the Acquisition and to redeem the Preferred Stock.

The Acquisition was accounted for using the purchase method of accounting.  The
fair value of the assets acquired is summarized below.
<TABLE>
<CAPTION>
 
<S>                   <C>
 
Current assets......   $ 3,470
 
Non-current assets..   $   521
 
Intangibles.........   $ 9,566
                       -------
                       $13,557
                       =======
</TABLE>

The following unaudited pro forma consolidated financial information gives
effect to the Acquisition as if it occurred at the beginning of the periods
presented.  These pro forma results include certain adjustments, such as
increased amortization, decreased interest expense and the elimination of a
discontinued product line, and are not necessarily indicative of what results
would have been had the Acquisition occurred at the beginning of the respective
periods.
<TABLE>
<CAPTION>
 
 
                       FOR THE YEAR    
                          ENDED        FOR THE YEAR ENDED
                      DECEMBER, 1994     DECEMBER, 1995  
                     ----------------  ------------------ 
 
<S>                  <C>               <C>
 
Net Sales..........          $173,548            $210,762
 
Net Income.........          $ 16,500            $ 27,680

Earning Per Share..          $    .60            $   1.01
</TABLE>

                                      F-20
<PAGE>
 
                                 TOY BIZ, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

                               DECEMBER 31, 1996


13. OFFER TO ACQUIRE THE COMPANY

     On October 17, 1996, Andrews Group Incorporated ("Andrews Group"), an
indirect parent of Marvel, announced that it had reached agreement with each of
Isaac Perlmutter and Avi Arad to purchase approximately 67% of the outstanding
Class A Common Stock for debt of Andrews Group and cash. Andrews Acquisition
Corp. ("Acquisition"), an affiliate of Andrews Group, made a subsequent proposal
to the Company's board of directors to acquire all remaining shares of Class A
Common Stock and, as part of such transaction, the Company would become a
wholly owned subsidiary of Marvel. On December 27, 1996, following approval by
an independent committee of the Company's board of directors (the "Independent
Committee"), the Company entered into an Agreement and Plan of Merger (the
"Merger Agreement") with Andrews Group and Acquisition, pursuant to which
Andrews Group would acquire the entire equity interest in the Company not
otherwise acquired from Isaac Perlmutter and Avi Arad, by means of a merger (the
"Merger") of the Company with and into Acquisition. The Andrews Group agreements
with each of Messrs. Perlmutter and Arad are subject to a number of significant
conditions, including the consummation of Andrews Group's investment in Marvel
pursuant to a Stock Purchase Agreement between Andrews Group and Marvel dated as
of December 27, 1996 (the "Stock Acquisition Agreement").

     Andrews Group has since terminated the Stock Acquisition Agreement.
Accordingly, a condition to the obligations of Andrews Group and Acquisition to
consummate the Merger pursuant to the Merger Agreement will not be satisfied.
Andrews Group has further advised that Andrews Group does not intend to waive
such condition, and anticipates that the Merger will not be consummated. Because
such condition to consummation of the Merger will not be satisfied, the
conditions to the obligations of Andrews Group to consummate the transactions
contemplated by the agreements with Messrs. Perlmutter and Arad will not be
satisfied.

     On December 27, 1996, Marvel and its subsidiaries filed a voluntary
position for reorganization under Chapter 11 of the U.S. Bankruptcy Code. All of
the Company Class B Common Stock (7,394,000 shares) is owned by Marvel. The
Class B Common Stock has ten votes for each share outstanding while such shares
are owned by Marvel, which effectively gives Marvel voting control for most
matters brought to a vote of the stockholders. See Note 8. While the Company was
not a participant of Marvel's bankruptcy filing, the final resolution of
Marvel's bankruptcy filing could result in change in control of the Company.
This could cause the Company's Credit Facility to be terminated. See Note 7. The
Company believes it could obtain a replacement credit facility if a termination
of the Credit Facility were to occur.


14. SUBSEQUENT EVENT

     On March 25, 1997, the Company acquired Colorforms, Inc., a manufacturer of
vinyl stick-ons and other toy products. The purchase price was approximately
$5.0 million, excluding fees and expenses, consisting of approximately $2.9
million in cash paid at the closing and the assumption of approximately $2.1
million of the acquired company's accounts payable and accrued liabilities at
the closing date. The transaction will be accounted for as a purchase.

                                      F-21
<PAGE>
 
                                 TOY BIZ, INC.

                                  SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
 
                                          BALANCE     CHARGED TO SALES   CHARGED TO                 BALANCE
                                        AT BEGINNING    OR COSTS AND       OTHER                    AT END
DESCRIPTION                              OF PERIOD        EXPENSES        ACCOUNTS   DEDUCTIONS    OF PERIOD
-----------                             ------------  -----------------  ----------  -----------  -----------
<S>                                     <C>           <C>                <C>         <C>          <C>
Year Ended December 31, 1994,
Allowances included in Accounts
Receivable, Net:
 
   Doubtful accounts                     $   991,000    $    30,000 (1)          --  $   505,000  $   516,000
 
   Advertising, markdowns,                 8,530,000     15,493,000 (2)          --   14,270,000    9,753,000
   returns, volume discounts,
   and other
 
Year Ended December 31, 1995,
Allowances included in Accounts
Receivable, Net:
 
   Doubtful accounts                         516,000        443,000 (1)          --      443,000      516,000
 
   Advertising, markdowns,                 9,753,000     21,682,000 (2)          --   20,680,000   10,755,000
   returns, volume discounts,
   and other
 
Year Ended December 31, 1996,
Allowances included in Accounts
Receivable, Net:
 
   Doubtful accounts                         516,000                --           --       31,000      485,000
 
   Advertising, markdowns,                10,755,000     39,317,000 (2)          --   35,216,000   14,856,000
   returns, volume discounts,
   and other
</TABLE> 
 
--------------------------------------
 
  (1) Charged to costs and expenses.

  (2) Charged to sales.

                                      F-22