FORM 10-K

                     U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                     For fiscal year ended December 31, 1997

                         Commission file number: 0-22340
                                [OBJECT OMITTED]

                        PALOMAR MEDICAL TECHNOLOGIES, INC.
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             (Exact name of registrant as specified in its charter)

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<S>             <C>                                              <C>

                Delaware                                                     04-3128178
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(State or other jurisdiction of incorporation or organization)    (I.R.S. Employer Identification No.)
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               45 Hartwell Avenue, Lexington, Massachusetts 02173
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                    (Address of principal executive offices)
                                 (781) 676-7300
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                (Issuer's telephone number, including area code)

Securities registered pursuant to Section 12 (b) of the Act:
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                                                       Name of each exchange on
         Title of each class                                which registered
         -------------------                           ------------------------
         Not Applicable                                     Not Applicable  

          Securities registered pursuant to Section 12 (g) of the Act:
          -----------------------------------------------------------
                          Common Stock, $.01 par value

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

     Check if there is no disclosure  of  delinquent  filers in response to Item
405 of  Regulation  S-K  contained  in  this  form,  and no  disclosure  will be
contained,  to the  best of  registrant's  knowledge,  in  definitive  proxy  or
information  statements  incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [ ]

     As of March 20, 1998,  59,553,243  shares of Common Stock were outstanding.
The  aggregate  market value of the voting  shares (based upon the closing price
reported by Nasdaq on March 20,  1998) of Palomar  Medical  Technologies,  Inc.,
held by nonaffiliates was $66,009,188.  For purposes of this disclosure,  shares
of Common  Stock held by entities who own 5% or more of the  outstanding  Common
Stock, as reported in Amendment No. 3 to a Schedule 13G filed on March 10, 1998,
and shares of Common Stock held by each officer and director  have been excluded
in that such  persons may be deemed to be  "affiliates"  as that term is defined
under the Rules and  Regulations  of the Securities  Exchange Act of 1934.  This
determination of affiliate status is not necessarily conclusive.

                       DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the definitive  proxy  statement to be filed prior to April 30,
1998,  pursuant to  Regulation  14A of the  Securities  Exchange Act of 1934 are
incorporated by reference into Part III of this Form 10-K

Transitional Small Business Disclosure Format:       Yes      X    No
                                                 ---         ---

<PAGE>

                                     PART I

ITEM 1.  BUSINESS.

(a)      INTRODUCTION

         Palomar Medical  Technologies,  Inc. (the "Company" or "Palomar" or the
"Registrant")  was organized in 1987 to design,  manufacture  and market lasers,
delivery systems and related disposable  products for use in medical procedures.
In December 1992 the Company went public.  Subsequently,  the Company pursued an
aggressive  acquisition program,  acquiring companies in its core laser business
as well as others,  principally in the electronics  industry, in order to spread
risk and bolster  operating  assets,  among other  reasons.  By the beginning of
1997, the Company had more than a dozen  subsidiaries.  At the same time, having
obtained FDA  clearance to market its  EpiLaser(R)  hair removal laser system in
March 1997, the Company was well  positioned to focus on what it believes is the
most promising product in its core laser business. Hence, under the direction of
a new Board and management,  the Company  undertook an ambitious program in 1997
of exiting all non-core  businesses and  investments  and focusing only on those
businesses   which  it  believes  hold  the  greatest   promise  for  maximizing
stockholder value. Currently,  the Company has four subsidiaries,  one of which,
Dynaco Corp. ("Dynaco"),  the only remaining electronics subsidiary, the Company
anticipates exiting in 1998. (See Report on Form 8-K filed December 23, 1997 and
incorporated  herein by reference.) The remaining three subsidiaries are Palomar
Medical Products, Inc. ("PMP"), in Lexington, Massachusetts, where the Company's
ruby hair removal laser system is manufactured,  Star Medical Technologies, Inc.
("Star") in Pleasanton,  California, where the Company's diode hair and leg vein
removal  laser is  manufactured,  and Cosmetic  Technology  International,  Inc.
("CTI"), also headquartered in Lexington, Massachusetts, which provides cosmetic
laser services.

(b)      FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS

         The Company conducts business in one industry segment, medical products
and  services.  In 1997,  the Company  began a program of  divesting  all of its
noncore electronics  subsidiaries.  The Company expects to complete this program
in 1998.  (See  Item 7.  "Management's  Discussion  and  Analysis  of  Financial
Condition  and  Results  of  Operations  -  Overview"  and  Note 2 to  Financial
Statements.)

(c)      DESCRIPTION OF BUSINESS

         (i)      PRINCIPAL PRODUCTS AND SERVICES

                  Lasers for Hair Removal

         The word "laser" is the acronym for "light  amplification by stimulated
emission of  radiation."  The  emitted  radiation  oscillates  within an optical
resonator  and is amplified by an active  medium,  resulting in a  monochromatic
beam of light,  which is narrow,  highly  coherent  and thus can be focused to a
small spot with a high degree of  precision.  In recent  years,  scientists  and
clinicians  have  developed a concept  called  tissue optics to describe how the
unique properties of the laser can be used to treat human tissue selectively and
more precisely.  By careful  selection of laser  parameters,  such as wavelength
(color),   energy  and  pulse  width  (exposure   time),  and  with  a  detailed
understanding of the physical and optical  properties of the target tissue,  the
clinician  can  selectively   treat  the  target  tissue  while   minimizing  or
eliminating  damage to surrounding  tissue. The concept of color selectivity has
been useful in  developing a number of successful  dermatological  applications.
The patented hair removal technology  utilized by Palomar targets the pigment in
a hair  follicle  and was  developed  by Dr. R. Rox  Anderson  at  Massachusetts
General Hospital ("MGH").  Pigment,  called melanin, is found in the upper layer
of the skin and in the hair shaft and hair follicle  deeper below the surface of
the skin. With the appropriate selection of wavelength (color), energy and pulse
width to allow for the  preferential  absorption  of laser energy by the melanin
present in the hair, there is negligible  absorption by the surrounding  tissue.
Energy from ruby lasers is particularly  well absorbed by melanin and absorption
by other  cells and tissue is  particularly  low.  Palomar  uses a patented  and
proprietary  contact  cooling  technology to protect the upper layer of the skin
while the ruby or diode laser light is  targeting  and  destroying  the follicle
deeper within the skin tissue. In addition,  Palomar's  patented contact cooling
handpiece enables the laser light to penetrate to the correct depth while at the
same time limiting the amount of discomfort associated with the procedure.  This
method  of hair  removal  using  the  cooling  handpiece  allows  for  selective
destruction  of the target  follicle  

                                       1
<PAGE>

without harming the surrounding  skin or surface of the skin. The laser light is
pulsed at a rapid rate  covering  approximately  one-eighth  square inch at each
pulse.  This  treatment  method  allows  for a large  area of  treatment  over a
relatively short period of time.

         Using its core ruby laser technology,  originally  developed for tattoo
removal and pigmented  lesions,  Palomar  developed a long pulse ruby laser, the
EpiLaser(R)  laser  system,  that  is  specifically   configured  to  allow  the
appropriate  wavelength,   energy  level  and  pulse  duration  to  be  absorbed
effectively  by the hair  follicle  without  being  absorbed by the  surrounding
tissue. That, combined with the patented ChillTip(TM) cooling handpiece,  allows
for safe and effective hair removal.

         In an effort to find a way to allow the laser light to pass through top
skin layers and be deeply absorbed in the hair follicle below, a contact cooling
handpiece  was  developed  by  MGH  and  licensed  to  Palomar  on an  exclusive
world-wide  perpetual basis. This unique cooling handpiece is key to the success
and  safety of  Palomar's  laser  hair  removal  systems,  as it  permits  laser
applications of higher power with better targeting and greater safety.  The cold
sapphire  tip  protects  the  epidermis   while  allowing  the  laser  light  to
efficiently  destroy  the target  follicles.  The  Company  believes  its unique
delivery  system  enables the user to address a  potentially  larger market than
electrolysis currently does by offering to treat large areas of the body such as
back,  chest,   abdomen,   legs,  arms  and  other  areas.  (See  "Research  and
Development.")

         In March 1997,  Palomar was the first  company to receive FDA clearance
to sell and market a ruby laser in the U.S. for hair  removal.  In December 1997
and January 1998 respectively, Palomar was also the first company to receive FDA
clearance  for a diode laser for hair  removal and for leg vein  treatment,  the
Company's LightSheer(TM) diode laser system.

         During  1998,  Palomar may  upgrade its ruby laser  system to include a
fiber delivery  system,  a higher energy head and a new handpiece.  Palomar will
continue to make  improvements to the ruby laser systems including higher energy
(for even more effective  hair  reduction),  colder cooling and user  selectable
pulse  widths (for more comfort and safety with darker  skin),  and faster pulse
rate (for faster hair removal).

         Throughout  1997, the Company's Star  subsidiary  continued work on the
Company's  latest hair removal  system,  the  LightSheer(TM)  diode laser.  This
revolutionary device incorporates state-of-the-art laser diode technology into a
2,000 watt  system that the Company  feels will be the ideal  complement  to the
current ruby laser technology for hair removal.  The LightSheer(TM)  diode laser
weighs approximately  one-eighth the weight of the EpiLaser(R) laser system, can
complete a treatment  more rapidly than the ruby laser,  and plugs into any wall
outlet.  Clinical results after 18 months of testing show comparable  results to
the EpiLaser(R)  laser system for most hair and skin types.  The new system uses
Palomar's  exclusive  patented  contact  cooling  technology to provide  greater
efficacy while maintaining epidermal safety.

                  The Hair Removal Market

         The market for  laser-based  hair removal is in its early stages and is
rapidly  growing.  The  final  size of that  market  cannot  yet be  determined;
however,  the Company  believes that the current  electrolysis  market is a good
model.  Last year,  more than one million women in the United  States  underwent
treatment  using  electrolysis,  spending  on  average  more than  $1,000  each,
representing a market of approximately $1 billion annually. In addition, surveys
indicate  as  many  as 15% of men  would  also  like  to  remove  unwanted  hair
especially from back and chest areas. Electrolysis is a commonly used method for
the  long-term  removal of body hair.  Other  methods  of hair  removal  include
waxing, depilatories,  tweezing, depilatory creams and shaving, all resulting in
only  short-term  hair  removal.  (See Item 7.  "Risk  Factors -  Dependence  on
Developing Market; Product Concentration.")

         Electrolysis  is a process in which an  electrologist  inserts a needle
directly into a hair  follicle and activates an electric  current in the needle,
which disables the hair  follicle.  The tiny blood vessels in each hair follicle
are heated and coagulated,  presumably  cutting off the blood supply to the hair
matrix,  or are destroyed by chemical  action  depending upon modality used. The
success  rate for  electrolysis  is  variable  depending  upon the  skill of the
electrologist  and  always  requires  a series of  treatments.  Electrolysis  is
time-consuming, expensive and sometimes painful. There is also some risk of skin
blemishes and a rising concern relating to needle infection.  Since electrolysis
only  treats  one  hair  follicle  at a time  and can only  treat  visible  hair
follicles,  the  treatment  of an area as  small  as an  upper  lip may  require
numerous  visits  at an  aggregate  cost of up to  $1,000.  Although  70% of all
electrolysis  treatments are for facial hair, the neck,  breasts and bikini line
are  also  

                                       2
<PAGE>

treated.  Because hair  follicles  are disabled one at a time,  electrolysis  is
rarely used to remove hair from large areas such as the back, chest, abdomen and
legs.

         Market  surveys report that more than 70% of women in the United States
employ one or more  techniques  for temporary hair removal from various parts of
the body.  Pulling hair from the follicle  produces the  longest-term  temporary
results,  but is painful and may cause skin  irritation.  A number of techniques
are used to pull hair  from the  follicle  including  waxing,  depilatories  and
tweezing. In the waxing process, a lotion, generally beeswax-based, is spread on
the area to be treated and allowed to harden,  thereby  trapping the hairs.  The
hardened  film is then  rapidly  peeled off,  pulling out the  entrapped  hairs.
Depilatories  employ  rotating  spring coils or slotted rubber rolls to trap and
pull out the hairs.  Tweezing involves removing  individual hairs with a pair of
tweezers.  Depilatory creams,  which contain chemicals to separate hair from the
follicle, frequently leave a temporary,  unpleasant odor and may also cause skin
irritation.  Shaving is the most widely used method of hair removal,  especially
for legs and underarms, but produces the shortest-term results. Hair bleaches do
not  remove  hair,  but  instead  lighten  the  color of hair so that it is less
visible.  A  principle  drawback  of all of these  methods is that they  require
frequent treatment.

         Studies  using  Palomar's  laser  hair  removal  process   demonstrated
significant permanent reduction of hair following treatment with the EpiLaser(R)
laser system.  The first  treatment  causes a portion of the hair (typically the
hair in the growth mode) to be reduced in size,  color and/or quantity (based on
studies  followed  for up to three  years) and causes  significant  growth delay
(three  to six  months)  of most of the  rest of the  hair.  Since  the  partial
re-growth  tends to occur in synchrony,  the  follow-up  treatment is often more
effective than the first treatment.  An FDA submission  seeking to allow Palomar
to claim permanent  reduction of hair from treatments with its EpiLaser(R) laser
system was filed in January of 1998.  Benefits of  Palomar's  laser hair removal
process include: significant long term cosmetic improvement, treatment of larger
areas in each treatment session, relatively painless procedure,  reduced risk of
scarring,  non-invasive procedure,  no risk of  cross-contamination,  and higher
success rates than with previous methods.

                  Marketing, Distribution and Service

         Pursuant to an  agreement  executed in November  1997,  Coherent,  Inc.
("Coherent") is the exclusive  distributor for Palomar's hair removal lasers. If
Coherent fails to meet certain  minimums sales quotas specified in its agreement
with  Palomar,  it loses its  exclusive  distribution  rights.  Coherent  is the
largest  medical  laser  company  in the  world,  with  over 200  sales  persons
worldwide.  Under its agreement with Palomar, Coherent is responsible for sales,
marketing,  service,  training  and  education.  Coherent  has  over 50  service
representatives in the US, and over 100 worldwide.  (See Item 7. "Risk Factors -
Dependence  on New  Relationship  with  Coherent"  and Note  12(e) to  Financial
Statements.)

                  Laser for Tattoo and Pigmented Lesion Removal

         The Company also sells a Q-switched  ruby laser for tattoo  removal and
treating  pigmented  lesions,  the  RD-1200(TM).   In  1997,  RD-1200(TM)  sales
constituted  approximately  10% of  the  Company's  sales,  and  were  primarily
overseas,  in Japan,  Korea  and other  parts of the  world.  Palomar  sells and
services the RD-1200(TM)  through  distributors  internationally.  In the United
States,  Palomar has provided service through its own service organization,  but
expects to arrange for third party service beginning in the middle of 1998.

         The RD-1200(TM) Q-switched ruby laser has been on the market for nearly
nine years. Competition in the medical device industry is intense and technology
developments  have  continued  at a rapid pace over the past  decade.  While the
RD-1200(TM) Q-switched ruby laser is still recognized as the "gold standard" for
performance in this market,  there are less expensive products now available for
this purpose. Palomar expects sales of this product to continue in 1998 at a low
volume to foreign  countries where the advantages of ruby laser for treatment of
pigmented lesions is especially important.

                  Cosmetic Laser Services

         An  additional  avenue  that the  Company  has  explored  for its laser
technology is the service business  conducted through its CTI subsidiary,  which
was incorporated in 1996 for that purpose. During 1997, CTI established a number
of test sites to explore business models.

                                       3
<PAGE>

         In early  1997,  CTI  entered  into a binding  letter  of  intent  with
Columbia/HCA,  one of the  world's  largest  owners  and  operators  of  medical
facilities,  to  establish  revenue-sharing  cosmetic  laser  service  sites  in
existing  Columbia/HCA   facilities.   To  date,  three  such  sites  have  been
established.  CTI provides each of its sites with a turnkey package of laser and
medical  device  technology,   equipment,   training  and  service,   operations
personnel,  strategic  advertising  and marketing  programs,  patient  financial
credit  programs and management  assistance.  To date,  ten CTI  revenue-sharing
sites in  addition  to the  Columbia/HCA  sites are open and under  development.
During 1997,  CTI generated  revenues of  approximately  $1,000,000 and incurred
operating expenses of approximately $4,500,000.

         (ii)     PRODUCTS UNDER DEVELOPMENT

                  Burn Diagnosis Laser System

         In 1994,  the Company's  Star  subsidiary was awarded a $60,000 Phase I
Small Business  Innovation  Research Grant ("SBIR")  entitled "High Energy Diode
Laser for Burn Diagnosis" by the U.S. Air Force,  Phillips Laboratory.  In 1994,
Star  obtained  an  exclusive,  worldwide  license to a patent  relating  to the
measurement of burn depth in skin from the Office of Technology  Affairs at MGH.
In 1995,  Star was  granted  a  $743,000  follow-on  Phase II SBIR  contract  by
Phillips  Laboratory  for the research and  development  of the burn  diagnostic
system.  During the fiscal years ended  December 31, 1997,  1996 and 1995,  Star
recognized  $149,251,  $281,991 and  $307,000 of  government  contract  revenue,
respectively. In 1996, Star began initial clinical testing of the burn diagnosis
system at the Shriner  Burn Center in Boston,  Massachusetts  and at the Augusta
Medical  Center in Augusta,  Georgia.  The system is designed to illuminate  the
wound site with near  infrared  light from a diode  laser and to image the blood
flow using a fluorescence  dye as an aid to the doctor in determining the extent
of blood flow within the dermis to more accurately diagnose the degree of a burn
and to enable  physicians  to improve  treatment of burn  patients.  To date the
system has been tested on a small number of burn  patients and has  demonstrated
the  ability to detect the absence or presence of blood flow deep in the dermis.
The system has also been used  clinically  to determine  blood flow  surrounding
skin ulcers and in surgical flaps,  again, on a very limited number of patients.
Clinical  testing  continues at the Augusta Medical Center.  The Company expects
that it may take several years before a commercial blood flow diagnostic product
is available.

                  Laser Tonsillectomy

         In June 1994, the Company  signed an agreement with the  Otolaryngology
Research  Center for Advanced  Endoscopic  Applications  at New England  Medical
Center,  Boston,  Massachusetts  (the "NEMC  Agreement"),  to provide a research
grant and to  sponsor  investigations  and  development  of laser  applications,
advanced  delivery systems and disposable  products in the area of dye and diode
laser  applications in otolaryngology  and related  specialties.  Under the NEMC
Agreement,  the  Company  provided a total of $150,000 in funding and $50,000 in
the form of laser hardware.  The parties have reached an understanding  that the
Company will obtain  ownership rights or the right of first refusal to exclusive
worldwide  licenses to sell and market any  inventions  developed with the grant
funding.  In August  1994,  the NEMC  Agreement  was  amended to support  animal
testing with one of the  Company's  diode lasers in connection  with  performing
tonsillectomies.  In the year ended  December  31,  1997,  the Company  provided
$54,000 in funding. The animal studies were completed  successfully in 1997. The
Company intends to fund human clinical studies in this area over the next twelve
month  period.  The Company  expects  that it may take  several  years  before a
commercial product for tonsillectomy is available.

                  Dye Laser

         During  1995,  the Company  entered into a two year cost plus fixed fee
contract  with  the U.S.  Army  for the  investigation  of  compact,  wavelength
diverse,  high efficiency  solid-state dye lasers.  In 1997, the Company,  which
does not anticipate this research will result in a commercial product within the
next few years,  concluded with the U.S. Army a Novation Agreement which novates
this  contract  to Physical  Sciences,  Inc.  ("PSI").  Upon  completion  of the
contract,  PSI has agreed to offer the  Company a right of first  refusal  for a
commercial license to sell,  manufacture or otherwise dispose of solid-state dye
laser  technology  as  developed  by PSI under the  contract  for use in medical
products.

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<PAGE>

                  Laser Thrombolysis

         In 1993,  the Company  entered into an  agreement  with the Edwards LIS
Division of Baxter (the  "Baxter  Agreement")  regarding  an  integrated  system
utilizing lasers and catheters for the removal of blood clots.  Under the Baxter
Agreement,  Baxter licensed its proprietary  technology to the Company,  and the
Company cross-licensed its laser thrombolysis  technology to Baxter. The Company
also granted to Baxter a license to sell and market products  incorporating such
technology.  Baxter agreed to transfer its interest in the agreement to Advanced
Cardiovascular  Systems,  Inc.  ("ACS"),  a division of Eli Lilly,  as part of a
purchase by Eli Lilly of the Baxter LIS division.  Eli Lilly  subsequently  sold
ACS to Guidant Corp.

         In January 1997, Palomar became an equity partner in the formation of a
new company, LaTIS, Inc., created to use Palomar's laser thrombolysis technology
to develop a pulsed-dye laser system for treating strokes. All licenses relating
to this  technology have been  transferred to LaTIS.  With the formation of this
new venture, laser thrombolysis is no longer part of Palomar's strategic agenda,
although the Company can still derive some benefits from its research due to its
equity participation.

         (iii)    PRODUCTION AND SOURCES AND AVAILABILITY OF MATERIALS

         Palomar's  manufacturing  and research and  development  operations are
located in two locations, Lexington,  Massachusetts and Pleasanton,  California.
The ruby laser  system is  manufactured  in  Massachusetts  and the diode  laser
system is manufactured in California. Manufacturing consists of the assembly and
testing  of   components   purchased   from  outside   suppliers   and  contract
manufacturers.  Palomar  maintains  control of and  manufactures  key components
in-house.  The entire fully  assembled  system is subjected to a rigorous set of
tests prior to shipment to the customer or distributors.

         Palomar depends and will depend upon a number of outside  suppliers for
components used in its manufacturing  process.  Most of Palomar's components and
raw materials are available from a number of qualified  suppliers.  Two critical
components that are available through only one qualified  supplier each are ruby
rods for the ruby  lasers  and diode  bars for the diode  lasers.  To date,  the
Company has not experienced,  nor does it expect to experience,  any significant
delays in obtaining  component parts or raw materials.  Palomar has expanded its
manufacturing capabilities to satisfy projected demand. Palomar has the approval
for the CE  Mark  for the  EpiLaser(R)  laser  system,  and is  working  towards
completion of ISO 9001  registrations for both facilities.  (See "Risk Factors -
Dependence on Suppliers.")

         (iv)     PATENTS AND LICENSES

         Certain  processes by which the Company is able to produce its products
are largely  proprietary.  The Company  believes  that patent  protection of its
technology and products that result from the Company's  research and development
efforts  is  important  to  the  possible  commercialization  of  the  Company's
technology.   The  Company  continually  attempts  to  protect  its  proprietary
technology  by  obtaining  patent  application  protection  and relying on trade
secret laws and non-disclosure and confidentiality agreements with its employees
and persons that have access to its proprietary technology.

         To date,  the Company and its  subsidiaries  have filed  eleven  patent
applications  related to its laser  products  with the United  States Patent and
Trademark Office in order to protect its current  technology.  This includes two
applications  that are continuations of previous  applications.  To date, two of
these patents have been issued.  Additionally,  the Company  extends many of its
domestic filings into foreign  applications.  To date, four foreign applications
have been filed, and no foreign patents have been issued. The Company intends to
aggressively  pursue any person or company that offers products that the Company
believes  infringe  on one  or  more  of  its  patents  or on  patents  licensed
exclusively to the Company.

         The  Company  believes  it owns,  or has the  right to use,  the  basic
patents covering its products.  However, each year there are hundreds of patents
granted  worldwide  related to lasers and their  applications.  In the past, the
Company  has been able to obtain  patent  licenses  for  patents  related to its
products on commercially  reasonable  terms.  The failure to obtain a key patent
license  from a third party could  cause the  Company to incur  liabilities  for
patent  infringement  and, in the extreme case, to discontinue the manufacturing
of products that infringe upon the patent.  Management believes that none of the
Company's  current products  infringe upon a valid claim of any patents owned by
third parties, where the failure to license the patent would have a material and
adverse effect on the Company's financial position or results of operations.

                                       5
<PAGE>

         In March 1997, one of Palomar's competitors,  Selvac Acquisitions Corp.
("Selvac"), filed a complaint alleging, among other things, that the EpiLaser(R)
laser system infringes a patent held by Selvac.

         Another  company  has  recently   informally   notified  the  Company's
distributor  that it believes that the Company's  contact cooling method as used
in connection  with the Company's diode laser for vascular  lesions  infringes a
patent owned by that company.  The Company is evaluating this contention.  Based
upon the Company's review to date, it does not appear that this patent should be
successfully assertable against the Company.

         Other than the two matters  described  above,  the Company has not been
notified  that it is  currently  infringing  on any  patents nor has it been the
subject of any patent infringement action. Defense of a claim of infringement is
costly and could have a material adverse effect on the Company's business,  even
if the Company  were to prevail.  (See Item 3. "Legal  Proceedings"  and Item 7.
"Risk Factors - Patents/Possible Patent Infringements.")

         The Company also entered  into a four year  agreement  with MGH whereby
MGH  agreed  to  conduct   clinical   trials  on  a  laser  treatment  for  hair
removal/reduction  invented  by Dr. R. Rox  Anderson,  Wellman  Laboratories  of
Photomedicine,  MGH. As part of the  agreement,  MGH  provided  the Company with
prior data  already  generated  by Dr.  Anderson  with respect to the ruby laser
device at MGH.  This  information  was the basis for the  Company's  application
filed with the FDA for approval of the  Company's  EpiLaser(R)  laser system for
treating  unwanted hair. The Company is obligated to fund the clinical  research
in the aggregate amount of approximately  $917,000 over the term of its contract
with MGH.  Effective  February 14, 1997, the Company  amended the 1995 agreement
with MGH. Under the terms of this  amendment,  the Company agreed to provide MGH
with a grant of $203,757 to perform research and evaluation in the field of hair
removal.  During 1997, the Company incurred  approximately  $1,100,000 under its
clinical research agreement with MGH and other clinical studies.

         In  August  1995,  the  Company  entered  into  a  worldwide  exclusive
agreement  with MGH to license (with the right to  sublicense)  U.S.  Patent No.
5,595,568  ("Permanent  Hair Removal Using Optical Pulses") as well as any other
patents arising out of the Palomar-funded  clinical trials. As consideration for
this  license,  the  Company  is  obligated  to pay MGH  royalties  of 5% of net
revenues  on  products   covered  by  valid  patents  licensed  to  the  Company
exclusively;  2.5% of net revenues on products covered by valid patents licensed
to the Company  non-exclusively;  no less than 2.5% of net revenues for products
sold for hair removal as well as other uses,  and a royalty to be  negotiated on
services  or  commercial  dispositions  (other than  sales)  involving  products
covered by valid patents licensed to the Company.

         On February 24, 1993, the  principals of the Company's Star  subsidiary
applied for a patent.  This application was subsequently  transferred to Star in
connection with the technology  underlying the use of a high-powered diode laser
for the treatment of psoriasis and other derma vascular malformation. The patent
was issued on June 18, 1996. Star has applied for additional  patents  regarding
the design and use of  high-powered  diode  lasers.  On June 22,  1995,  the New
England Medical Center ("NEMC") filed a patent application for Coagulation Laser
Tonsillectomy;  which  application  was issued as a patent on May 28, 1996.  The
Company  has  exclusive  rights  to the NEMC  patent.  MGH has filed a number of
patents surrounding  technology  involving laser hair removal.  The first patent
was issued on January 21, 1997,  and a  continuation-in-part  of this patent was
issued on April 7, 1998.  The  Company  has  licensed  this  laser hair  removal
technology from MGH in accordance with a certain license and research  agreement
as previously discussed.

         (v)      SEASONAL INFLUENCES

         There is no significant seasonal influence on the Company's sales.

         (vi)     FINANCING OF OPERATIONS AND INCREASE IN OUTSTANDING SHARES

         The Company has financed  current  operations and past expansion of its
core business with short-term  financial  borrowings and investments through the
private sale of debt and equity securities of the Company.  The Company raised a
total of $31,197,709 and  $53,534,990 in such financings  during the years ended
December 31, 1997, and December 31, 1996, respectively.  The Company anticipates
that it will require  substantial  additional  financing  during the next twelve
month period.  The Company may from time to time be required to raise additional
funds  through  additional  private  sales  of  the  Company's  debt  or  equity
securities.  Sales of  securities  to  private  investors  have  been  sold at a
discount to the current 

                                       6
<PAGE>

or future  public  market  for  similar  securities.  It has been the  Company's
experience that private  investors require that the Company make its best effort
to register their securities for resale to the public at some future time. There
can be no assurance  that the Company will be successful  in raising  additional
capital on favorable terms.  (See Notes 1, 6, 7 and 13 to Financial  Statements,
Item 5. "Market for Common Equity and Related Stockholder  Matters," and Item 7.
"Risk Factors - Substantial  Continuing Losses;  Doubt About Ability to Continue
as a Going Concern.")

         As a result of financing activities, business developments, mergers and
acquisitions,  issuance of  incentive  stock  options  and  warrants to purchase
common  stock to attract  and retain key  employees,  the  Company's  issued and
outstanding  shares of common stock have increased to 45,792,585 at December 31,
1997.  The Company also had  additional  reserved but unissued  shares of common
stock of  31,149,432  shares at December  31,  1997.  The  Company's  issued and
outstanding shares of common stock increased  subsequent to December 31, 1997 to
59,553,243  shares with additional  reserved but unissued shares of common stock
of 28,180,020 shares as of March 20, 1998. A substantial number of the Company's
reserved shares are registered and could be resold into the public market.  (See
Item 7. "Risk  Factors -  Issuance  of  Reserved  Shares;  Registration  Rights;
Issuance  of  Preferred  Stock  and  Debenture  Could  Affect  Rights  of Common
Stockholders;  and Significant  Outstanding  Indebtedness;  -  Subordination  of
Debentures.")

         There are no special inventory requirements or credit terms extended to
customers  that would have a material  adverse  effect on the Company's  working
capital.

         (vii)     DEPENDENCY ON A SINGLE CUSTOMER

         Sales pursuant to the Company's  Sales Agency,  Development and License
Agreement with Coherent  accounted for  approximately 11% of the Company's total
revenues in fiscal 1997.  (See -  Marketing,  Distribution  and  Service,  "Risk
Factors - Dependence on New Relationship with Coherent" and Notes 3(i) and 12(e)
to Financial Statements.)

         (viii)   BACKLOG

         The Company's  backlog of firm orders for its continuing  operations at
December 31, 1997,  and December 31, 1996,  was  approximately  $2.5 million and
$2.2 million,  respectively.  The backlog as of year-end has already been filled
in 1998. As of March 31, 1998,  the Company's  backlog of firm orders related to
its laser hair removal systems was approximately $7,000,000.

         (ix)     GOVERNMENT CONTRACTS

         Not applicable.

         (x)      COMPETITION

         The  markets  in which the  Company  is  engaged  are  subject  to keen
competition and rapid  technological  change.  Four other companies,  ThermoLase
Corporation,  Laser Industries,  Ltd., MEHL/Biophile International and Cynosure,
Inc.  have  received  market  clearance  from the FDA for laser hair removal and
another  company,  ESC Medical  Systems  Limited,  has received FDA clearance to
market a laser-like  system using  filtered  intense  light to remove hair.  The
Company  expects  that other  hair  removal  devices  will be  developed  and/or
introduced in 1998,  making laser hair removal the most competitive  application
within the cosmetic laser marketplace.  The Company also expects that there will
be further consolidation of companies within the laser hair removal industry via
acquisitions,  partnering  arrangements or joint  ventures;  ESC Medical Systems
Limited recently  completed the acquisition of Laser  Industries.  The Company's
products  will also compete with other hair  removal  products and methods.  The
Company  competes  primarily on the basis of  technology,  product  performance,
price, quality,  reliability,  distribution and customer service and support. To
remain  competitive,  the  Company  will be  required to continue to develop new
products,  periodically enhance its existing products and compete effectively in
the areas  described  above.  (See Item 7.  "Risk  Factors -  Dependence  on New
Products; Highly Competitive Industries.")

         In the cosmetic laser services  industry,  the Company's CTI subsidiary
competes  not only with other laser  companies  which also either  revenue-share
with  physicians  and/or  operate  their own centers,  but also with  healthcare
providers.  CTI's  services will also compete for business with other  aesthetic
service providers such as electrologists, beauty

                                       7
<PAGE>

salons,  spas, and  aestheticians,  among others.  Product  efficacy,  location,
marketing,  a wide offering of laser procedures,  price and customer service are
all important competitive factors. (See Item 7. "Risk Factors - New Ventures.")

         (xi)     RESEARCH AND DEVELOPMENT

         During fiscal 1997,  fiscal 1996, and fiscal 1995, the Company incurred
approximately   $11,990,332,   $6,297,477  and  $3,964,920,   respectively,   of
internally  sponsored  research  and  development  programs.  Due to the intense
competition and rapid technological  changes in the laser industry,  the Company
believes that it must  continue to improve and refine its existing  products and
services, and develop new applications for its technology.

         Wellman  Laboratories  ("Wellman Labs"), the world's largest biomedical
laser  research  facility  and part of the MGH Laser  Center  located in Boston,
Massachusetts,  was  created to oversee and speed the flow of  biomedical  laser
research from the laboratory to patient care. Funded in part by a grant from the
Department of Energy, the MGH Laser Center brings together two strengths of MGH:
its  clinical  departments  and the Wellman  Labs.  The MGH Laser  Center  works
together with industry,  academia and the Department of Energy  Laboratories  to
access  information and technology  across a broad spectrum of laser and medical
capabilities. The principals at Wellman Labs study the fundamental photophysical
and   photochemical   properties  and  processes  of  biomolecules   excited  by
ultraviolet,  visible and near infrared radiation.  Engineers,  laser physicists
and physicians  familiar with all aspects of  biomolecules,  cells and tissue in
vitro staff the labs.  The  scientists  work side by side with the clinicians to
understand the basic  principles  involved in the complex  interactions of light
and tissue.  In 1994, the Company began a number of studies for the treatment of
certain  dermatological  conditions  using its diode laser at Wellman  Labs.  In
1995,  those  studies  were  expanded to include the  Company's  ruby lasers for
cosmetic  procedures.  In 1997, those studies were again expanded to include the
Company's diode lasers for cosmetic  purposes.  Wellman Labs and the Company are
currently  evaluating the data  associated  with these  treatments.  The Company
works closely with Dr. R. Rox Anderson,  the Research  Director of the MGH Laser
Center and Associate  Professor of Dermatology at Harvard Medical School, who is
a recognized expert in laser tissue  interaction and the inventor of a number of
laser  procedures  in use today.  Dr.  Anderson has  authored  over 60 papers in
peer-reviewed publications relating to the use of lasers in dermatology,  is the
recipient  of  numerous  awards in the field of laser  medicine  and serves as a
member of the Blue  Ribbon Government  Liaison Committee of the American Society
for Laser  Medicine and Surgery.  Dr.  Anderson  holds ten U.S.  patents and has
pending  applications  for an  additional  eleven.  The Company feels that these
types of  relationships  are  critical  in  developing  effective  products  for
widespread  use in the  market  on a timely  basis,  and  that  this  method  of
conducting  research and  development  provides a higher level of technical  and
clinical expertise than it could provide on its own and in a more cost-efficient
manner.

         PMP's Vice President of Research and Development, Gregory Altshuler, is
the former Director of the Laser Center of the St. Petersburg (Russia) Institute
of Fine Mechanics and Optics (the "St. Petersburg Laser Center)" and the Company
continues to work closely with the St. Petersburg Laser Center,  contracting out
research  and  development  tasks to them on a project  basis.  Palomar owns all
inventions, developments and patents which result from the work performed at the
St. Petersburg Laser Institute and funded by Palomar. In 1997, the Company spent
approximately  $100,000  on  research  and  development  conducted  at  the  St.
Petersburg  Laser  Institute.  Dr.  Altshuler holds  approximately 50 patents in
Russia in the field of lasers and the application of lasers in medicine, and has
authored  approximately  130 papers  relating to laser physics,  engineering and
medicine.

         While MGH focuses on the biological aspects of laser hair removal,  Dr.
Altshuler's  in-house  research  and  development  team  focuses on the physical
aspects.  Approximately  40 employees of the Company and its  subsidiaries  were
engaged full time in research and development activities at December 31, 1997.

         Pursuant to the Sales Agency,  Development  and License  Agreement that
the  Company  entered  into with  Coherent  in  November  1997,  the Company has
committed to spend the following  amounts on research and  development  over the
next three years:  at least  $5,000,000  in 1998, at least 10% of its 1998 gross
revenues (minus  commissions to Coherent) from cosmetic laser products ("Product
Revenues") in 1999, and at least 10% of its 1999 Product Revenues in 2000.

         (See Item 7. "Risk Factors - Dependence on Third Party Researchers" and
Note 8 to Financial Statements.)

                                        8
<PAGE>

         (xii)    ENVIRONMENTAL PROTECTION REGULATIONS

         The Company  believes that  compliance  with  federal,  state and local
environmental regulations will not have a material adverse effect on its capital
expenditures, earnings or competitive position.

         (xiii)   IMPACT OF MEDICAL DEVICE REGULATIONS

     The Company's  products are subject to regulation and control by the Center
for  Devices  and   Radiological   Health,   a  branch  of  the  Food  and  Drug
Administration (FDA) within the Department of Health and Human Services. The FDA
medical device regulations  require either an Investigational  Device Exemption,
Pre-Market  Approval or 510(K) clearance before new products can be marketed to,
or utilized by, the  physician.  The  Company's  products are subject to similar
regulations in its major international markets. Complying with these regulations
is necessary for the  Company's  strategy of expanding the markets for and sales
of its products into these countries.  These approvals may necessitate  clinical
testing,  limitations  on the number of sales and controls of end user  purchase
price,  among other things.  In certain  instances,  these constraints can delay
planned shipment  schedules as design and engineering  modifications are made in
response to regulatory  concerns and requests.  The  Company's  competitors  are
subject  to the same  regulations.  (See  Item 7.  "Risk  Factors  -  Government
Regulation.")

         (xiv)    NUMBER OF EMPLOYEES

         As of  December  31,  1997,  the  Company  and its  PMP,  CTI and  Star
subsidiaries  employed  165  people,  two  independent   contractors  and  three
temporary employees.  In addition, as of December 31, 1997, the Company's Dynaco
subsidiary employed 187 people.

         The Company's  ability to develop,  manufacture and market its products
and to  establish  and  maintain a  competitive  position in the  industry  will
depend,  in large  part,  upon its  ability  to  attract  and  retain  qualified
technical,  marketing and managerial  personnel.  The Company  believes that its
relations  with its  employees  are good.  None of the  Company's  employees are
represented  by a union.  (See  Item 7.  "Risk  Factors  - Need  for  Additional
Qualified Personnel.")

(d)      FINANCIAL INFORMATION ABOUT EXPORTS BY DOMESTIC OPERATIONS

         Aggregate  export sales for the Company's  continuing  operations  were
approximately  $2,468,000 for 1995, $3,935,000 for 1996 and $4,978,000 for 1997.
The 1995 export sales  consisted  primarily of the  RD-1200(TM)  tattoo  removal
laser,  the 1996 export sales of a combination of both the  RD-1200(TM)  and the
EpiLaser(R) laser system, and the 1997 export sales primarily of the EpiLaser(R)
laser system. (See Note 3(h) to Financial Statements.)

ITEM 2.  PROPERTIES.

         The  Company  and its PMP and  CTI  subsidiaries  occupy  approximately
25,000  square feet of office,  manufacturing  and research  space in Lexington,
Massachusetts under a lease expiring in May 2000. The Company's Star subsidiary
occupies approximately 15,000 square feet of office,  manufacturing and research
space  under a lease  expiring  in April  1999 in  Pleasanton,  California.  The
Company  believes that these  facilities  are in good condition and are suitable
and  adequate  for  its  current  operations.   (See  Note  12(a)  to  Financial
Statements.)

ITEM 3.  LEGAL PROCEEDINGS.

         On October 7, 1996 the Company filed a declaratory  judgment  action in
the United  States  District  Court for the  District of  Massachusetts  against
MEHL/Biophile  ("MEHL")  seeking (i) a declaration that MEHL is without right or
authority to threaten or maintain  suit against the Company or its customers for
alleged infringement of the patent held by MEHL's subsidiary Selvac Acquisitions
Corp.  (the  "Selvac  Patent"),  that the  Selvac  Patent is  invalid,  void and
unenforceable,  and that the Company does not infringe the Selvac patent; (ii) a
preliminary and permanent injunction enjoining MEHL from threatening the Company
or its customers  with  infringement  litigation or  infringement;  and (iii) an
award to the Company of damages  suffered in connection with MEHL's conduct.  On
March 7, 1997,  Selvac filed a complaint for  injunctive  relief and damages for
patent  infringement  and for unfair  competition in the United States  District
Court for the District of New Jersey against the Company, two of its

                                       9
<PAGE>

subsidiaries and a New Jersey dermatologist. Selvac's complaint alleges that the
Company's  EpiLaser(R)  laser system  infringes  the Selvac  Patent and that the
Company  unfairly  competed by promoting the  EpiLaser(R)  laser system for hair
removal before it had received FDA approval for that specific  application.  The
Company  and  Selvac  agreed to dismiss  the  Massachusetts  litigation  without
prejudice.  The Company has brought in the New Jersey action its claims that the
Selvac patent is invalid,  that the Company has not infringed the Selvac patent,
that  MEHL  should  be  enjoined  from  making  further  assertions   concerning
infringement  and unfair  competition,  and that the  Company  should be awarded
attorney fees and other appropriate  relief.  Thus both the Company's and MEHL's
claims will be presented on the merits in New Jersey.  The court has granted the
Company's motion to dismiss Selvac's federal unfair  competition claim so far as
it depends on the Company's supposed violations of FDA rules. The court has also
granted the  Company's  motion to amend its  complaint  to allege that  Selvac's
patent was obtained by  inequitable  conduct.  The Company has moved for summary
judgment on the grounds  that the Selvac  patent is invalid and was  obtained by
inequitable  conduct.  Discovery  in the  case has been  stayed  by court  order
pending a ruling on the Company's  dispositive motion. The Company believes that
MEHL's claims are without merit.

         On October 16, 1997, the Company brought a declaratory  judgment action
in United States  District Court for the District of  Massachusetts  against the
holders and the indenture trustee of the Company's 4.5% Subordinated Convertible
Debentures due 2003, denominated in Swiss francs (the "Swiss Franc Debentures").
The  defendants  in this  action are  Banque SCS  Alliance  SA,  Arbuthnot  Fund
Managers,  Ltd.,  Banca  Commerciale  Lugano,  Privatinvest  Bank AG (these four
defendants  being  referred to  collectively  as the "Asserting  Holders"),  CUF
Finance S.A., Fibi Bank (Schweiz) AG, Teawood Nominees, Ltd., JS Gadd & CIE, SA,
Swedbank  (Luxembourg)  SA,  Christiana Bank Luxembourg SA, (now known as Credit
Agricole Indosuez),  Landatina Financiera SA and American Stock Transfer & Trust
Co., as trustee ("Trustee").  Just prior to this suit, the Asserting Holders had
alleged that the Company is in breach of certain protective  covenants under the
indenture.  The Company  believes that it is not in default under any protective
covenants,  and the Company's  action seeks a declaration from the Court to that
effect.  All payments on the Swiss Franc  Debentures were current to the time of
suit. On October 22, 1997, the Asserting Holders sued the Company and all of its
principal  subsidiaries  in the same court;  the October  16th and October  22nd
cases  have  been  assigned  to the same  judge,  and the  dispute  between  the
Asserting Holders and the Company is proceeding under the October 22nd case. The
Asserting  Holders  claim  that the  Company  has  breached  certain  protective
indenture  covenants  and that the  Asserting  Holders are entitled to immediate
payment of their indebtedness under the Swiss Franc Debentures (which amounts to
approximately  US$5,087,000 at current  exchange rates).  The Asserting  Holders
sought a temporary  restraining  order  attaching  bank accounts and barring the
Company from  transferring any interest in securities of its  subsidiaries.  The
Court denied this  motion,  and the  Asserting  Holders  withdrew a  preliminary
injunction  motion  concerning  essentially the same issues.  As of November 13,
1997, acting under applicable provisions of the indenture,  the Company notified
the holders of the Swiss Franc  Debentures  that it is causing the conversion of
all of the Swiss Franc  Debentures  into an aggregate  of 914,028  shares of the
Company's  common  stock.  The court  thereafter  denied  without  prejudice the
Company's  motion to dismiss the complaint on the ground the  Asserting  Holders
had failed to proceed  through the  Trustee,  as  required,  and denied  without
prejudice the Company's  motion for summary  judgment as to its conversion.  The
Asserting Holders' summary judgment motion, arguing that an event of default has
occurred  as a matter of law,  is under  advisement.  The court has  schedule  a
time-limited  evidentiary  hearing,  further  to clarify  the legal and  factual
issues.  If there remain  disputed  issues after that hearing,  the case will be
tried  before a  factfinder.  The Company  believes  that its  position in these
matters is correct and intends to contest  the claims of the  Asserting  Holders
vigorously. (See Note 6(a) to Financial Statements.)

         On August 27, 1997,  Pamela Siegman,  as Trustee for the Pamela Siegman
Trust,  filed an action in the Court of Chancery of the State of Delaware in and
for New Castle County against the Company and each of its current  directors and
two former  directors.  Siegman,  purportedly  on behalf of  similarly  situated
shareholders,  claimed  disclosure  errors and omissions in the Company's annual
meeting proxy statement,  and sought a declaration that the Company's  preferred
stock is void because of a purported deficiency in the Company's  Certificate of
Incorporation.  On March 9, 1998, the Court of Chancery ruled against Siegman on
all of her claims  (she had  abandoned  some of her claims  prior to the Court's
ruling).  The Company does not know whether  Siegman will appeal the ruling,  as
the court's final order has not of this date been entered.

        (See "Risk Factors - Risks Associated with Pending  Litigation" and Note
12(d) to Financial Statements.)

                                       10
<PAGE>

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

         Not applicable.

                                       11
<PAGE>

                                     PART II

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

         The  Company's  common  stock  is  currently  traded  on  the  National
Association of Securities Dealers Automated  Quotation System (NASDAQ) under the
symbol PMTI.  The following  table sets forth the high and low bid prices quoted
on NASDAQ  for the  Common  Stock for the  periods  indicated.  Such  quotations
reflect inter-dealer prices,  without retail markup,  markdown or commission and
do not necessarily represent actual transactions.


                                                        Fiscal Year Ended
                                                        December 31, 1996
                                                        -----------------
                                                        High          Low
                                                        -----------------

           Quarter Ended March 31, 1996                 13 1/8      5
           Quarter Ended June 30, 1996                  16 3/8      8 7/8
           Quarter Ended September 30, 1996             14 5/8      7 7/8
           Quarter Ended December 31, 1996               9 1/8      5 7/8


                                                        Fiscal Year Ended
                                                        December 31, 1997
                                                        -----------------
                                                        High          Low
                                                        -----------------

           Quarter Ended March 31, 1997                  9 1/4     5 7/16
           Quarter Ended June 30, 1997                   5 3/4     2 3/8
           Quarter Ended September 30, 1997              4 7/16   1 15/16
           Quarter Ended December 31, 1997              2 31/32     25/32


         As of March 20,  1998,  the Company had 751 holders of record of common
stock. This does not include holdings in street or nominee names.

         The Company has not paid dividends to its common stockholders since its
inception and does not plan to pay dividends to its common  stockholders  in the
foreseeable  future.  The Company  intends to retain any earnings to finance the
operations of the Company.

         PRIVATE PLACEMENTS OF COMMON STOCK

         Pursuant to Section 4(2) of the Act, on December 29, 1997,  the Company
sold  700,000  shares of Nexar  Technologies,  Inc.  ("Nexar")  common stock and
300,000  shares of the Company's  common stock for an aggregate of $1,750,000 to
Clearwater Fund IV, LLC.

         Pursuant to Section  4(2) of the Act, on February  20, 1998 the Company
sold 2,000,000  shares,  1,500,000 shares,  1,100,000 shares,  1,000,000 shares,
250,000  shares  and  1,350,000  shares  of the  Company's  common  stock to the
Travelers Insurance Company, AIM Overseas Ltd., TJJ Corporation,  PAR Investment
Partners  L.P.,  Pequot  Scout  Fund  L.P.,  and  other  individual   investors,
respectively,  for an aggregate  of  $7,200,000.  In  addition,  for every share
purchased the investor received a warrant to purchase the Company's common stock
for $3 per share. These warrants expire five years from the closing date and are
exercisable beginning six months after the closing date.

         CONVERTIBLE DEBENTURES

         Pursuant  to  Section  4(2) of the  Act,  the  Company  sold a total of
$1,000,000  5%  Convertible   Debentures  on  January  13,  1997  to  High  Risk
Opportunities  Hub  Fund  Ltd.  The  debentures,   due  January  13,  2002,  are
convertible  into shares of 

                                       12
<PAGE>

common stock at a conversion price equal to 85% of the average closing bid price
of the  Company's  common stock price during the ten trading days  preceding the
date of  conversion,  provided that in any thirty day period the holder of these
debentures  may  convert no more than 33% (or 34% in the last  thirty day period
available for conversion) of the debentures.

         Pursuant  to  Section  4(2) of the  Act,  the  Company  sold a total of
$5,500,000  5%  Convertible  Debentures  on March 10,  1997 to 16  domestic  and
overseas  entities and  individuals.  The  debentures,  due March 10, 2002,  are
convertible  into shares of common stock at a conversion  price equal to 100% of
the Average  Stock Price through June 7, 1997 and 90% of the Average Stock Price
thereafter,  provided  that between June 8, 1997 and October 5, 1997 the holders
of these  debentures may convert no more than one-third of the  debentures.  The
Average  Stock Price for the  debentures  is the lesser of i) the average of the
closing bid of the Company's common stock during the five trading days preceding
each  conversion;  or ii) the average of the closing bid of the Company's common
stock during the ten trading days preceding each conversion.

         Pursuant  to  Section  4(2) of the  Act,  the  Company  sold a total of
$500,000 6%  Convertible  Debentures  on March 13, 1997 to Soginvest  Bank.  The
debentures, due March 13, 2002, are convertible into shares of common stock at a
conversion  price of $11.00,  provided  that in any thirty day period after June
11, 1997 the holder of these  debentures may convert no more than 33% (or 34% in
the last thirty day period available for conversion) of the debentures.

         Pursuant  to  Section  4(2) of the  Act,  the  Company  sold a total of
$7,000,000  6%, 7% and 8%  Convertible  Debentures  on September 30, 1997 to JNC
Opportunity  Fund  Ltd.,   Diversified  Strategies  Fund,  L.P.  and  Southbrook
International  Investment  Ltd. The coupon is payable in kind upon conversion at
6% from September 30, 1997 through March 28, 1998, 7% from March 29 through June
26,  1998 and 8%  thereafter.  The  debentures,  due  September  30,  2002,  are
convertible  into  shares of common  stock at a  conversion  price  equal to the
average of the closing bid price of the  Company's  common  stock during the ten
trading days preceding each  conversion,  provided that in any thirty day period
from the  closing  date to April 27,  1998 the  holder of these  debentures  may
convert no more than 33% (or 34% in the last  thirty day  period  available  for
conversion) of the  debentures.  In addition,  the holder of the debentures were
issued 413,109 shares of the Company's common stock in lieu of a discount.  (See
Note 6 to Financial Statements.)

         Pursuant  to Section  4(2) of the Act,  the Company  sold a  $2,000,000
convertible  debenture on March 27, 1998 to an individual.  The debenture is due
the earlier of May 26, 1998 or one day following the sale of Dynaco or any other
Palomar  assets  outside the normal  course of  business or any other  financing
where the use of proceeds to pay back debt is not  prohibited.  If the debenture
is not repaid by the maturity date, the debenture becomes  convertible at market
value at the option of the debentureholder,  as defined. If the note is not paid
by the maturity  date and/or June 23, 1998,  penalties of $100,000 and $125,000,
payable in the Company's common stock, will be owed on May 26, 1998 and June 23,
1998, respectively,  if the note has not been repaid by those dates. Interest on
this debenture is in the form of a warrant to purchase  125,000 shares of common
stock for $.01 per share exercisable over five years.

         PREFERRED STOCK

         Pursuant to Section 4(2) of the Act, the Company sold 16,000  shares of
Series H  Convertible  Preferred  Stock  to RGC  International  Investors,  LDC,
Proprietary  Convertible  Investment  Group, Inc. (an affiliate of Credit Suisse
First  Boston  Corp.),   CC  Investments,   LDC  and  Southbrook   International
Investments,  Ltd. in three separate  tranches for an aggregate of  $16,000,000.
The first tranche  consisted of 6,000 shares sold on March 31, 1997,  the second
tranche  of 7,000  shares  sold on May 5,  1997 and the third  tranche  of 3,000
shares sold on May 23, 1997.  The premium for all tranches is payable at 6% from
March 31, 1997 through  September 26, 1997,  7% from  September 27, 1997 through
December 25, 1997 and 8% thereafter. The Series H Preferred Stock is convertible
at a  conversion  price equal to 100% of the Average  Stock Price from March 31,
1997 through  September 26, 1997,  90% of the Average Stock Price from September
27,  1997  through  December  25,  1997,  and  85% of the  Average  Stock  Price
thereafter.  The Average  Stock  Price is the  average  closing bid price of the
Company's  common stock price during the ten trading days  preceding the date of
conversion,  provided  that in any thirty day period  from the  closing  date to
October  26,  1997 the  holders may convert no more than 33% (or 34% in the last
thirty day period  available for conversion) of the Preferred  Stock.  (See Note
7(b) to Financial Statements.)

                                       13
<PAGE>

ITEM 6.  SELECTED FINANCIAL DATA.

         The  following  table sets forth  selected  consolidated  financial and
other  information  (in  thousands  except  per  share  data) on a  consolidated
historical  basis for the Company and its subsidiaries as of and for each of the
fiscal  years in the five year  period  ended  December  31,  1997.  Pursuant to
Accounting  Principles  Board Opinion  ("APB") No. 30,  Reporting the Results of
Operations - Reporting  the Effects of Disposal of a Segment of a Business,  and
Extraordinary,  Unusual and Infrequently Occurring Events and Transactions,  the
consolidated  financial  statements  of the Company  have been  reclassified  to
reflect the  dispositions  of its  subsidiaries  that  comprise the  electronics
segment. (See Note 2 to Consolidated  Financial  Statements.) (Note that in 1994
the Company  changed  its fiscal  year end from March 31 to  December  31.) This
table should be read in conjunction with the Consolidated  Financial  Statements
of the Company and the Notes thereto included elsewhere in this Annual Report on
Form 10-K.

                                       14
<PAGE>

<TABLE>
<S>                              <C>                        <C>                   <C>           <C>             <C>

                                        Year ended           Nine months ended                   Year ended
                                        March 31,              December 31,                     December 31,
                                 ------------------------    ------------------   ---------------------------------------------
Income Statement Data                      1994                    1994             1995           1996             1997
                                 ------------------------    ------------------   ------------  -------------  ----------------

Revenues                                             $10               $40          $5,610        $17,607           $20,995
Cost of Revenues                                      --                18           3,464         14,169            20,056
                                  -----------------------    ------------------   ------------  -------------  ----------------
     Gross profit                                     10                22           2,146          3,438               939
                                  -----------------------    ------------------   ------------  -------------  ----------------

Operating Expenses

     Research and development                      1,911             2,939           3,965          6,297            11,990
     Sales and marketing                              --                --           2,769          5,077             6,960
     General and administrative                    1,630             1,561           2,142          9,753            15,332
     Business development                             --             1,240           1,409          2,880             2,061
     Restructuring and Asset                          --                --              --          1,661             3,325
     Write-off
     Settlement and Litigation                        --                --             700            880             3,199
     Costs
                                  -----------------------    ------------------   ------------  -------------  ----------------
        Total operating expenses                   3,541             5,740          10,985         26,548            42,867
                                  -----------------------    ------------------   ------------  -------------  ----------------

        Loss from operations                      (3,531)           (5,718)         (8,839)       (23,110)          (41,928)

Interest Expense                                     (33)              (76)           (766)          (271)           (6,994)
Interest Income                                       53                38             912          1,355               456
Net Gain on Trading Securities                        --                --             201          2,033               (52)
Asset Write-off                                       --                --              --         (1,397)           (9,658)
Other Income (Expense)                                82                67             102            592              (193)
                                  -----------------------    ------------------   ------------  -------------  ----------------
     Net Loss from Continuing     
     Operations                                   (3,429)           (5,689)         (8,390)       (20,798)          (58,369)
                                  -----------------------    ------------------   ------------  -------------  ----------------

Loss from Discontinued Operations:

     Loss from Operations                           (634)               (3)         (4,231)       (20,896)          (29,509)
     Gain on Dispositions, net                        --                --              --          3,830             2,074
                                  -----------------------    ------------------   ------------  -------------  ----------------
     Net Loss from Discontinued   
     Operations                                     (634)               (3)         (4,231)       (17,066)          (27,435)
                                  -----------------------    ------------------   ------------  -------------  ----------------

        Net Loss                                 $(4,063)          $(5,692)       $(12,621)      $(37,864)         $(85,804)
                                  =======================    ==================   ============  =============  ================

Basic and Diluted Net Loss
     Per Common Share:

     Continuing Operations                        $(0.85)           $(0.84)         $(0.60)        $(0.84)           $(1.79)
     Discontinued Operations                       (0.15)             0.00           (0.30)         (0.65)            (0.78)
                                  -----------------------   -------------------   ------------  -------------  ----------------

     Total Loss Per Common Share                  $(1.00)           $(0.84)         $(0.90)        $(1.49)           $(2.57)
                                  =======================   ===================   ============  =============  ================

Weighted Average Number of
    Common Shares Outstanding                      4,053             6,759          14,165         26,167            35,105
                                  =======================   ===================   ============  =============  ================

Balance Sheet Data:

Working Capital                                      279             2,491          12,998         15,203            (9,139)
Total Assets                                       2,581             6,551          33,656         67,533            28,968
Long-term obligations                                 37             2,322           1,765         14,665            12,446
Stockholders' Equity (Deficit)                     1,466             2,794          25,289         38,077            (6,184)

</TABLE>

                                       15
<PAGE>

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

(a)      OVERVIEW

         In the  third  and  fourth  quarter  of 1997,  the  Board of  Directors
authorized  management  to focus the  Company  on its core  laser  products  and
services  business  principally  related to cosmetic hair removal and to proceed
with a  restructuring  plan to reorganize  the Company and divest its electronic
subsidiaries,  Dynaco,  Dynamem,  Inc.  ("Dynamem"),  Comtel  Electronics,  Inc.
("Comtel")  and  Nexar  (the  "Electronic  Subsidiaries"),   and  other  noncore
businesses.

         Pursuant to Accounting  Principles  Board Opinion No. 30, Reporting the
Results  of  Operations-Reporting  the  Effects  of  Disposal  of a Segment of a
Business,  and  Extraordinary,  Unusual and  Infrequently  Occurring  Events and
Transactions,  the  consolidated  financial  statements of the Company have been
reclassified  to  reflect  the  dispositions  of  the  Electronic  Subsidiaries.
Accordingly,  the revenues,  cost and expenses,  assets and liabilities and cash
flows  of the  Electronics  Subsidiaries  have  been  reported  as  discontinued
operations in these consolidated financial statements.  (See Note 2 to Financial
Statements.)

         As part of the Company's overall  restructuring  efforts implemented in
the fourth quarter of 1997, the Company made the strategic decision to focus its
operations principally on its cosmetic hair removal products.  Accordingly,  the
Company also divested its  wholly-owned  subsidiary  Tissue  Technologies,  Inc.
("Tissue  Technologies")  due in part to a  significant  decline in revenues for
Tissue  Technologies'  Tru-Pulse(R)  CO2 skin  resurfacing  laser  caused  by an
overall  decline  in the  worldwide  CO2 skin  resurfacing  laser  market.  This
restructuring  also included a reduction in the Company's work force and closing
of the Company's  manufacturing  facility in Hull,  England due to underutilized
plant  capacity.  The Company has simplified its  organization  and now conducts
business  in  only  two  locations,  Lexington,  Massachusetts  and  Pleasanton,
California. Prior to this restructuring,  the Company conducted business in over
a dozen different locations. (See Item 1. "Introduction.")

(b)      RESULTS

         (i)      YEAR ENDED DECEMBER 31, 1997,  COMPARED TO 
                  YEAR ENDED DECEMBER 31, 1996

         Revenues from  continuing  operations  for the year ended  December 31,
1997,  were  $20,994,546 as compared to $17,606,871  for the year ended December
31,  1996.  The 19.2%  increase  mainly was due to  additional  sales  volume of
approximately  $11.3 million  associated with the  EpiLaser(R)  laser system and
service revenue and  RD-1200(TM)  ruby laser  manufactured  by the Company.  The
Company  obtained FDA clearance to market and sell the EpiLaser(R)  laser system
for hair removal in the United  States in March 1997.  This increase in revenues
was offset by a decline of  approximately  $7.9  million in sales volume for the
Company's  Tru-Pulse(R)  CO2 laser  product.  The Company  believes that overall
revenues  from its medical  products  will  increase in 1998 due to its improved
manufacturing  process,  growing market demand for its EpiLaser(R)  laser system
and   recently  FDA  cleared   LightSheer(TM)   laser  system  and  an  improved
distribution  network  as a  result  of  the  Company's  exclusive  distribution
arrangement  with Coherent.  (See "Risk Factors - Dependence on New Relationship
With Coherent.")

         Gross margin for the year ended December 31, 1997 was $938,583 (4.5% of
revenues) versus  $3,437,400 (19.5% of revenues) for the year ended December 31,
1996. The decline in gross margin  percentage was caused mainly by lower margins
attained on the  Company's  EpiLaser(R)  laser system due to  manufacturing  and
production  inefficiencies in the initial manufacturing stage of this product as
well as underabsorbed  overhead costs incurred during the fourth quarter of 1997
as the Company  transitioned  to its  exclusive  distribution  arrangement  with
Coherent. The decline in gross margin dollars was due principally to a reduction
in  revenues  related  to the  Company's  Tru-Pulse(R)  CO2 laser  product.  The
Company's  overall  strategy  was to first  demonstrate  and prove  the  overall
efficacy of its proprietary  cosmetic hair removal technology  licensed from MGH
and gain early entrance to the market.  This resulted in higher than anticipated
costs of materials and manufacturing  techniques.  As a result of this strategy,
the Company  believes that during 1997 it demonstrated to the medical  community
the efficacy of its  technology and its long term benefits and  advantages.  The
Company  believes  that its gross  margins will improve  throughout  1998 as the
Company  introduces  its successor  hair removal laser products in the first and
second quarter.  The Company expects to obtain  manufacturing  efficiencies  and
volume production  related to these successor laser products.  In addition,  the
Company anticipates an increase in revenues

                                       16
<PAGE>

due  to an  improved  distribution  network  related  to  its  arrangement  with
Coherent.  (See "Risk Factors - Dependence  on New  Products;  Dependence on New
Relationship with Coherent.")

         Research  and  development  costs  increased to  $11,990,332  (57.1% of
revenues)  for the year ended  December  31,  1997,  from  $6,297,477  (35.8% of
revenues) for the year ended December 31, 1996.  This 90.4% increase in research
and  development  reflects the Company's  strategic  decision to accelerate  its
research and development efforts during 1997 to develop and obtain FDA clearance
for its successor hair removal and other  cosmetic  products using the Company's
proprietary  cooling technology licensed from MGH. The Company also continued to
concentrate on the  development  of additional  products for other medical laser
applications.  Although as part of its agreement with Coherent,  the Company has
committed  to  certain  minimum   research  and  development   spending  levels,
management believes that research and development  expenditures in the aggregate
and as a percentage of revenues will  substantially  decrease over the next year
as the Company  introduces  to the market its successor  hair removal  products.
(See Item 1. "Description of Business - Research and Development.")

         Selling  and  marketing  expenses  increased  to  $6,959,750  (33.2% of
revenues)  for the year ended  December  31,  1997,  from  $5,076,941  (28.8% of
revenues) for the year ended December 31, 1996.  This 37.1%  increase  reflected
the Company's  effort to expand its marketing and distribution for the Company's
EpiLaser(R) laser system. The Company anticipates that its aggregate selling and
marketing  expenses  will  increase  as  revenues  increase  due  to  the  costs
associated with its distribution  agreement with Coherent.  (See "Risk Factors -
Dependence on New Relationship With Coherent.")

         General and administrative  expenses increased to $15,332,241 (73.0% of
revenues)  for the year ended  December  31,  1997,  from  $9,752,922  (55.4% of
revenues)  for the year ended  December  31, 1996.  This 57.2%  increase was the
result of  additional  administrative  resources  required at the  Company's now
closed corporate offices and subsidiaries to oversee the growth of the Company's
medical products and service  businesses,  the initial public offering of common
stock of Nexar,  and divestiture  efforts  substantially  completed during 1997,
combined with the  transformation  of the Company from the development  stage to
product  commercialization  stage.  The  Company  anticipates  that  general and
administrative  expenses  will  decrease  in  the  aggregate  amount  and  as  a
percentage  of revenues in 1998 as a result of the third  quarter  restructuring
effort.

         Business  development and financing costs decreased to $2,060,852 (9.8%
of revenues) for the year ended  December 31, 1997,  from  $2,879,603  (16.4% of
revenues)  for the  year  ended  December  31,  1996.  This  28.4%  decrease  is
attributable to the Company's restructuring efforts to focus on its core medical
product  and  service   businesses.   The  Company   anticipates  that  business
development  expense  will  decrease  substantially  in 1998 as a result  of the
restructuring.

         Restructuring  and asset  write-off  costs  totaling  $12,983,000  were
incurred  for  the  year  ended  December  31,  1997.   These  charges   reflect
restructuring  and asset write-off costs for certain  operating and nonoperating
assets  that  the  Company  believes  were  not  fully  realizable  for both the
Company's  medical business and other nonmedical  investments.  Included in this
charge  is  a  $2.7  million  charge  for  severance   costs   associated   with
consolidating the selling, general and administrative  functions,  including the
closing of certain facilities.

         Settlement and litigation  costs totaled  $3,199,000 for the year ended
December 31, 1997,  an increase  from  $880,000 for the year ended  December 31,
1996.  These costs are  attributable  to a lawsuit brought by an investment bank
and other claims made against the Company.  In this suit,  the  investment  bank
alleged  that the  Company  breached a contract in which the bank was to provide
certain  investment  banking services in return for certain  compensation.  This
case was settled on August 18, 1997 for $1.875 million.

         Interest expense from continuing operations increased to $6,993,898 for
the year ended December 31, 1997,  from $271,619 for the year ended December 31,
1996.  This amount for 1997  includes $5.4 million of noncash  interest  expense
related  to the value  ascribed  to the  discount  features  of the  convertible
debentures issued by the Company.

         Interest  income  decreased to $456,945 for the year ended December 31,
1997,  from  $1,355,488 for the year ended  December 31, 1996.  This decrease is
primarily  the result of a reduction  in interest  received due to a decrease in
other  loans and  investments  and a  decrease  in the  Company's  average  cash
position during 1997.

                                       17
<PAGE>

         Loss from  discontinued  operations was  $29,508,755 for the year ended
December  31, 1997 as  compared  with a loss of  $20,895,534  for the year ended
December  31,  1996.  The  Company  also  reported a gain of  $2,073,943  on the
disposition  of its  discontinued  operations.  This  amount  includes a gain of
$6,221,689  related to the disposition of 1,960,736 shares of Nexar common stock
which was offset by losses incurred and accrued of $4,148,000 on the disposition
of  Dynaco  and  its  wholly  owned  subsidiaries.  The  Company  completed  the
disposition of Comtel and Dynamem on December 9, 1997.  The Company  anticipates
that the  disposition  of Dynaco and the  remainder  of its Nexar  stock will be
completed by the fourth quarter of 1998.

         (ii)     YEAR ENDED DECEMBER 31, 1996, COMPARED TO 
                  YEAR ENDED DECEMBER 31, 1995

         For the year ended  December  31, 1996,  the Company had revenues  from
continuing  operations of  $17,606,871  as compared to  $5,610,280  for the year
ended  December 31,  1995.  The 214%  increase in revenues  from 1995 to 1996 is
principally  attributable  to $10.1 million of revenues  generated from sales of
Tissue Technologies' Tru-Pulse(R) CO2 skin resurfacing laser in 1996 as compared
to only $114,000 of revenues  generated from the Tru-Pulse(R) laser for the year
ended  December  31,  1995.  The  Company  began  commercial   shipment  of  the
Tru-Pulse(R)  laser  in  the  fourth  quarter  of  1995.  Furthermore,  revenues
increased  approximately  $2.3 million for the year ended December 31, 1996 as a
result of the Company's  introduction  and initial  shipments of its EpiLaser(R)
laser system during the third and fourth quarters of 1996.

         Gross margin for the year ended December 31, 1996 was $3,437,400 (19.5%
of revenues) versus  $2,145,808  (38.2% of revenues) for the year ended December
31, 1995. This decrease in gross profit was due to the novation of the Company's
research and  development  contract  with the U.S. Army in  anticipation  of the
commercialization of its medical products. (See Item 1. "Description of Business
- Products  Under  Development;  Dye  Laser.")  The gross  profit  percent  also
decreased  due  to   underutilization   of  increased   production  capacity  in
preparation  for the anticipated  increase in demand for the  EpiLaser(R)  laser
system in fiscal 1997. A portion of this decrease in gross margins was offset by
an increase in gross margins  attributed to the introduction of the Tru-Pulse(R)
laser to the commercial marketplace in the first quarter of 1996.

         Research  and  development  costs  increased  to  $6,297,477  (35.8% of
revenues)  for the year ended  December  31,  1996,  from  $3,964,920  (70.7% of
revenues) for the year ended December 31, 1995.  This 58.8% increase in research
and development reflects the Company's focused efforts during 1996 to obtain FDA
clearance  for hair removal  using the  EpiLaser(R)  laser  system.  The Company
received FDA clearance to market its  EpiLaser(R)  laser system for hair removal
in March 1997. The Company also  continued to concentrate on the  development of
additional  products for medical and cosmetic laser  applications.  (See Item 1.
"Description of Business - Research and Development.")

         Selling  and  marketing  expenses  increased  to  $5,076,941  (28.8% of
revenues)  for the year ended  December  31,  1996,  from  $2,768,541  (49.3% of
revenues) for the year ended December 31, 1995. This 83.4% increase reflects the
Company's  effort to expand its  marketing and  distribution  to support its new
internally developed EpiLaser(R) and Tru-Pulse(R) laser product lines.

         General and  administrative  expenses increased to $9,752,922 (55.4% of
revenues)  for the year ended  December  31,  1996,  from  $2,141,798  (38.2% of
revenues)  for the year  ended  December  31,  1995.  This  355.4%  increase  is
primarily due to acquisition  efforts during 1996 and the  transformation of the
Company  from the  development  stage  to  commercialization  combined  with the
increased   administrative  resources  required  at  the  Company's  now  closed
corporate  offices  and  subsidiaries  to oversee  the  growth of the  Company's
business.  The Company expanded its general and administrative  support staff to
accommodate the forecasted growth in the fourth quarter of 1996 and in 1997

         Business development and financing costs increased to $2,879,603 (16.4%
of revenues) for the year ended  December 31, 1996,  from  $1,409,303  (25.1% of
revenues)  for the year ended  December  31,  1995.  This  104.3%  increase  was
attributable to the Company's continuing acquisitions and financing activities.

         Restructuring  and asset write-off costs of $3.06 million were incurred
for the year ended December 31, 1996.  These charges reflect  restructuring  and
asset write-off  costs for certain  operating and  nonoperating  assets that the
Company  believes  were not  fully  realizable  for both the  Company's  medical
business and other nonmedical investments.

                                       18
<PAGE>

         Settlement  and  litigation  costs totaled  $880,000 for the year ended
December  31, 1996 up from  $700,000 for the year ended  December 31, 1995.  The
$700,000 of settlement and litigation  costs incurred  during 1995 resulted from
the pledge of 2,860,000 shares of the Company's common stock as collateral for a
$5,000,000  debt  financing  that was canceled  before it was  consummated;  the
Company  was  required  to pay  $700,000 to a third party in order to secure the
return of these common shares.  The $880,000 of settlement and litigation  costs
incurred  during 1996 was  associated  with the lawsuit filed by the  investment
bank.  In this suit,  the  investment  bank alleged that the Company  breached a
contract  with it in which the bank was to provide  certain  investment  banking
services in return for certain compensation. The Company settled this lawsuit on
August 18, 1997 for $1.875 million.

         Interest expense from continuing  operations  decreased to $271,619 for
the year ended December 31, 1996,  from $766,079 for the year ended December 31,
1995. This decrease was principally  attributable to the Company's increased use
of preferred stock financing in 1996.

         Interest income increased to $1,355,488 for the year ended December 31,
1996,  from  $912,019 for the year ended  December 31,  1995.  This  increase is
primarily the result of interest  received  from  subscriptions  receivable  and
other loans and  investments  made as a result of the  Company's  improved  cash
position as of December 31, 1996.

         Net gain on  trading  securities  represents  realized  and  unrealized
trading  gains and losses of  $2,033,371  for the year ended  December 31, 1996.
Included in this amount is an unrealized gain totaling approximately  $1,547,000
related to the Company's  investment in a publicly traded company and a realized
gain totaling  approximately  $827,000  related to the  Company's  investment in
another publicly traded company offset by various  unrealized losses aggregating
approximately  $340,000. The Company had a net realized trading gain of $201,067
for the year ended December 31, 1995.

         Other income  totaled  $591,853 for the year ended December 31, 1996 as
compared to $102,305 for the year ended  December  31,  1995.  Included in other
income for the year ended December 31, 1996 is a foreign currency  exchange gain
of $446,596.

         Loss from  discontinued  operations was  $20,895,534 for the year ended
December  31,  1996 as  compared  with a loss of  $4,231,326  for the year ended
December 31, 1995. The Company also reported a gain on disposition of $3,380,000
on the  disposition of 400,000 shares of Nexar common stock that was consummated
during the fourth quarter of 1996.

(c)      LIQUIDITY AND CAPITAL RESOURCES

         As of December  31,  1997,  the Company  had  approximately  $4,453,000
million in cash, cash equivalents and trading securities.  During the year ended
December 31, 1997, the Company  generated $16.7 million,  $15.0 million and $5.6
million in net proceeds from the issuance of convertible debentures, the sale of
its preferred  stock, and the private  placement of  Palomar-owned  Nexar common
stock, respectively.

         The  Company's  net loss for the year ended  December 31, 1997 included
the following  noncash  items:  $2.2 million of  depreciation  and  amortization
expense;   $5.4  million  of  additional   interest   expense  relating  to  the
amortization of the discounts on the convertible debentures and $13.0 million in
restructuring and asset write-off costs.

         The Company anticipates that capital  expenditures in the normal course
of manufacturing operations and administrative  requirements related thereto for
1998 will total  approximately  $2  million.  The  Company  will  finance  these
expenditures  with cash on hand and equipment  leasing lines or the Company will
seek to raise  additional  funds.  If  necessary,  the Company can reduce  these
expenditures.  There can be no assurance  that the Company will be able to raise
the necessary funds.

         The Company has entered into a Loan Agreement  with Coherent,  pursuant
to which  Coherent  has agreed to loan the  Company  money to help  finance  the
Company's working capital  requirements,  which loans are  collateralized by the
Company's  accounts  receivable  where Coherent has acted as the Company's sales
agent. (See "Risk Factors - Dependence on New Relationship With Coherent.")

                                       19
<PAGE>

         The Company has  marketable  securities  for two of its  investments in
publicly  traded  companies  whose market value was $17.2 million as of December
31,  1997.  The  sale of some of  these  securities  may be  subject  to  volume
limitations.  As part of the Company's  ongoing  strategic  financing  plan, the
Company is evaluating  sale of these  securities in an effort to raise funds for
ongoing operations.

         During 1997, the Company funded its CTI service  business in the amount
of  $5,097,000.  The  Company is in the  process  of  evaluating  its  strategic
business  plan related to the cosmetic  laser  service  business in an effort to
ascertain  the risks and  benefits of  investing  additional  resources  in this
business. If the Company believes that additional  investments in CTI contribute
toward its overall goal of maximizing  shareholder  value,  then the Company may
continue to make substantial additional investments in CTI.

         Dynaco has a three year revolving credit and security  agreement with a
financial  institution.  The  agreement  provides  for  the  revolving  sale  of
acceptable accounts  receivable,  as defined in the agreement,  with recourse at
85% of face value, up to a maximum commitment of $3 million.  As of December 31,
1997, the amount of accounts  receivable sold that remained  uncollected totaled
$2.1 million net of related reserves and fees, as defined in the agreement. This
amount  is  included  in  the  net  assets  of  discontinued  operations  in the
accompanying  balance  sheet as of December 31, 1997.  The interest rate on such
outstanding  amounts is the bank's prime rate plus 1.5%, and interest is payable
monthly in arrears.  The financing is collateralized  by the purchased  accounts
receivable and  substantially  all of Dynaco's  assets.  The Company  guarantees
borrowings under this loan agreement.

         In connection  with the  disposition of Comtel,  the Company  assumed a
note issued by Comtel to a loan  association that totals  $3,233,000.  This note
bears interest at the loan association's prime rate plus 2.25% and is payable in
24  monthly  installments  of  principal  and  interest  totaling  approximately
$150,000, beginning in March 1998. This note is secured by a pledge of 3,250,000
shares  of the  Company's  common  stock.  In  addition,  the  Company  has also
guaranteed up to an  additional  maximum  amount of  $2,500,000  under a line of
credit extended by this loan association to Biometric  Technologies Corp. (BTC),
the buyer of Comtel.  The stockholders of BTC have personally  guaranteed to the
Company payment for any amounts  borrowed under this line of credit in excess of
approximately  $1,500,000  in the event that the Company is  obligated  to honor
this guarantee.  The stockholders of BTC have  collateralized  this guarantee by
the Company with certain assets personally owned by the stockholders.

         The  Company's  strategic  plan is to  continue  to fund  research  and
development  for its medical  products.  This  research and  development  effort
entails  extensive  clinical  trials  leading  up  to  FDA  submissions.   These
activities  are an important  part of the Company's  business  plan.  Due to the
nature of clinical  trials and research and  development  activities,  it is not
possible to predict with any certainty  the  timetable  for  completion of these
research  activities  or the total amount of funding  required to  commercialize
products  developed as a result of such  research and  development.  The rate of
research  and the number of research  projects  underway  are  dependent to some
extent upon external funding. While the Company is regularly reviewing potential
funding  sources in relation to these  ongoing and proposed  research  projects,
there can be no  assurance  that the  current  levels of funding  or  additional
funding  will be  available,  or, if  available,  on terms  satisfactory  to the
Company. (See Item 1. "Description of Business - Research and Development.")

         The Company has had significant losses to date and expects these losses
to  continue  through  1998.  Therefore,  the  Company  must  continue to secure
additional  financing  to continue  to complete  its  research  and  development
activities,   commercialize  its  current  and  proposed  medical  products  and
services,  and fund ongoing operations for the next twelve months.  There can be
no  assurance  that  events in the future  will not  require the Company to seek
additional  financing  sooner.  The Company  continues  to  investigate  several
financing  alternatives,  including  strategic  partnerships,   additional  bank
financing,  private debt and equity  financing,  sale of assets,  including  the
Company's marketable securities consisting of Nexar and The American Materials &
Technology  Corporation  ("AMTK"),  and other  sources.  Based on its historical
ability to raise funds as necessary  and ongoing  preliminary  discussions  with
potential financing sources,  the Company believes that it will be successful in
obtaining  additional  financing in order to fund current operations in the near
future.  Although the Company  believes  that it will be successful in obtaining
additional financing,  there can be no assurance that any such financing will be
available on terms satisfactory to the Company.  (See "Risk Factors  Substantial
Continuing Losses; Doubt About Ability to Continue as a Going Concern.")

                                       20
<PAGE>

         Subsequent to December 31, 1997,  the Company  entered into a financing
agreement with a Series G Preferred  shareholder  to sell this investor  500,000
shares of Nexar common stock for $2,000,000.  Under the terms of this agreement,
the Company has guaranteed a $2,000,000  aggregate  value to be realized by this
entity. To the extent this amount is not realized by this investor,  the Company
will repay any deficiency two years from the date of closing. In connection with
this  financing,  the Company also agreed to certain  amendments of the Series G
Preferred Stock, as defined in the agreement.

         In February 1998, the Company sold 7,200,000 shares of its common stock
to a group of investors  for  $7,200,000.  In addition,  the Company also issued
warrants to the  investors  to purchase  7,200,000  shares of common stock at an
exercise price of $3.00 per share.

         On March 27, 1998, the Company borrowed $2,000,000. This bridge loan is
payable the earlier of May 26, 1998 or (i) one day  following the sale of Dynaco
(ii) the sale of any other Palomar  assets in a  transaction  outside the normal
course of business or (iii) any financing  where the use of proceeds to pay back
debt is not  prohibited.  The Company issued  125,000  warrants to the lender to
purchase  125,000  shares of common stock at an exercise price of $.01 per share
in lieu of interest.

(d)      RECENTLY ISSUED ACCOUNTING STANDARDS

         In February 1997,  Financial Accounting Standards Board ("FASB") issued
Statement of Financial  Accounting  Standards  ("SFAS") No. 129,  Disclosure  of
Information  about Capital  Structure.  In June 1997,  FASB issued SFAS No. 130,
Reporting  Comprehensive  Income and SFAS No. 131, Disclosures about Segments of
an Enterprise and Related  Information.  SFAS No. 129, 130 and 131 are effective
for fiscal years  beginning  after December 15, 1997. The Company  believes that
the adoption of these new accounting  standards will not have a material  impact
on the Company's financial statements.

          STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT

         In addition to the other information in this Annual Report on Form 10-K
the following cautionary statements should be considered carefully in evaluating
the Company and its  business.  Statements  contained in this Form 10-K that are
not historical  facts  (including,  without  limitation,  statements  concerning
anticipated  operational  and capital  expense  levels and such  expense  levels
relative to the Company's total revenues) and other information  provided by the
Company and its employees from time to time may contain certain  forward-looking
information,  as defined by (i) the Private Securities  Litigation Reform Act of
1995 (the "Reform Act") and (ii) releases by the SEC. The factors  identified in
the cautionary statements below, among other factors, could cause actual results
to differ  materially from those suggested in such  forward-looking  statements.
Readers  are  cautioned  not to place undue  reliance  on these  forward-looking
statements,  which speak only as of the date hereof.  The Company  undertakes no
obligation   to  release   publicly  the  results  of  any  revisions  to  these
forward-looking  statements that may be made to reflect events or  circumstances
after the date hereof or to reflect the occurrence of unanticipated  events. The
cautionary  statements  below are being made  pursuant to the  provisions of the
Reform Act and with the  intention  of  obtaining  the  benefits  of safe harbor
provisions of the Reform Act.

                                  RISK FACTORS

         SUBSTANTIAL  CONTINUING  LOSSES;  DOUBT ABOUT  ABILITY TO CONTINUE AS A
GOING CONCERN.  The Company  incurred a net loss from  continuing  operations of
$58,369,079  for the year ended December 31, 1997. The Company  expects to incur
losses for the near term and through the third quarter of 1998.  However,  there
can be no assurance that the Company will achieve profitable  operations or that
profitable  operations will be sustained if achieved.  At December 31, 1997, the
Company's  accumulated  deficit and working  capital  deficit was $6,183,687 and
$9,138,915, respectively. The Company's Star, PMP and CTI subsidiaries each have
had a history of losses.  There can be no assurance  that these  companies  will
achieve profitable operations or that profitable operations will be sustained if
achieved.   As  a  result,  the  report  of  the  Company's  independent  public
accountants  in connection  with the Company's  Consolidated  Balance  Sheets at
December  31,  1997  and  1996,  and  the  related  consolidated  statements  of
operations,  stockholders'  equity  (deficit) and cash flows for the three years
ended  December  31, 1997  includes an  explanatory  paragraph  stating that the
Company's recurring losses, working capital deficiency and stockholders' deficit
raises  substantial  doubts about the  Company's  ability to continue as a going
concern.  The Company must continue to secure  additional  financing to complete
its research and development activities,  commercialize its current and proposed
cosmetic laser products,  and fund ongoing  operations.  The Company anticipates
that  it  will  require  substantial   additional   financing  during  the  next
twelve-month  period.  The Company believes that the cash generated to date from
its financing activities,  continued sale of assets and the Company's ability to
raise cash in future  financing  activities  will be  sufficient  to satisfy its
working capital  requirements  through the next twelve-month period. The Company
bases its belief that it has the ability to raise cash in future  financings  on
its demonstrated  historical ability to raise money and its ongoing  preliminary
discussions with financing sources. However, there can be no assurance that this
assumption  will prove to be  accurate  or that  events in the  future  will not
require  the  Company  to obtain  additional  financing  sooner  than  presently
anticipated.  The Company may also determine,  depending upon the  opportunities
available to it, to seek additional  debt or equity  financing to fund the costs
of  acquisitions  or  expansion.  To the extent  that the  Company  finances  an
acquisition with a combination of cash and equity securities,  any such issuance
of equity  securities 

                                       21
<PAGE>

could  result  in  dilution  to the  interests  of the  Company's  shareholders.
Additionally,  to the  extent  that  the  Company  incurs  indebtedness  to fund
increased levels of accounts receivable or to finance the acquisition of capital
equipment or issues debt  securities in  connection  with any  acquisition,  the
Company  will  be  subject  to  risks  associated  with  incurring   substantial
additional  indebtedness,  including the risks that interest rates may fluctuate
and cash flow may be  insufficient  to pay  principal  and  interest on any such
indebtedness.   The  Company   continues  to   investigate   several   financing
alternatives,  including  strategic  partnerships,  additional  bank  financing,
private, debt and equity financing and other sources,  including the liquidation
of its  marketable  securities  (Nexar and AMTK).  While the  Company  regularly
reviews  potential  funding  sources in relation  to its  ongoing  and  proposed
projects,  there can be no  assurance  that the  current  levels of  funding  or
additional  funding  will  be  available,  or if  available  will  be  on  terms
satisfactory to the Company. Failure to obtain additional financing could have a
material adverse effect on the Company,  including requiring it to significantly
curtail its operations.  (See "Management's Discussion and Analysis of Financial
Condition  and  Results  of  Operations,"  Item 1.  "Description  of  Business -
Financing of Operations and Increase in Outstanding  Shares," and Notes 1, 6 and
7 to Financial Statements.)

         DEPENDENCE ON NEW RELATIONSHIP  WITH COHERENT.  The Company has entered
into a Sales  Agency,  Development  and License  Agreement  with  Coherent  (the
"Agreement")  pursuant to which Coherent serves as exclusive distributor for the
Company's laser based hair removal systems.  As a result,  the Company no longer
has its own sales force.  Coherent  receives a marketing  and sales  commission,
based on the end-user  price,  for each Palomar laser it sells.  There can be no
assurance  that Coherent will be successful in  distributing  the Company's hair
removal  lasers  or that it will  give  sufficient  priority  to  marketing  the
Company's products.  In addition,  Coherent may develop,  market and manufacture
its own lasers that incorporate the Company's proprietary technology and compete
with the  Company's  lasers,  in which case it must pay the Company a royalty on
such sales.  If Coherent  proves unable to sell Palomar's hair removal lasers in
the volume anticipated, it could have a material adverse effect on the Company's
business,  financial  condition  and  results  of  operations.  Pursuant  to the
Agreement,  if Palomar is unable (as defined) or unwilling  to  manufacture  the
cosmetic laser products to be distributed by Coherent, then Palomar will license
to Coherent the technology necessary to make such products.  The initial term of
the Agreement is for three years, commencing on November 17, 1997. At the end of
each year, the Agreement  automatically  renews for another year,  unless either
party  provides  written  notice of its  nonrenewal 30 days prior to the renewal
date. In the  Agreement,  the Company has agreed to upgrade all its  EpiLaser(R)
laser systems sold prior to the date of the Agreement. The unanticipated loss of
Coherent as a distributor,  any  significant  reduction in orders from Coherent,
the introduction by Coherent of competitive  products,  and unanticipated costly
product upgrades would have a material adverse effect on the Company's business,
financial  condition  and  results of  operations.  (See Notes 3(i) and 12(e) to
Financial Statements.)

         DEPENDENCE  ON NEW  PRODUCTS.  The Company  expects that a  significant
portion  of future  revenue  will  continue  to be  derived  from sales of newly
introduced products.  The Company must continue to make significant  investments
in research  and  development  in order to  continue  to develop  new  products,
enhance  existing  products and achieve  market  acceptance  for such  products.
However,  there can be no assurance  that  development  stage  products  will be
successfully  completed  or, if  developed,  will achieve  significant  customer
acceptance.  If the Company  were  unable to  successfully  define,  develop and
introduce  competitive  new  products,  and enhance its existing  products,  its
future  results of  operations  would be  adversely  affected.  Development  and
manufacturing  schedules for technology  products are difficult to predict,  and
there can be no assurance that the Company will achieve timely initial  customer
shipments of new products.  The timely  availability of these products in volume
and their  acceptance by customers  are  important to the future  success of the
Company. Delays, whether due to manufacturing delays, lack of market acceptance,
delays in  regulatory  approval,  or  otherwise,  could have a material  adverse
effect on the company's results of operations. From time to time, the Company or
its  competitors may announce new products,  capabilities  or technologies  that
have the potential to replace or shorten life cycles of the  Company's  existing
products.  No assurance can be given that  announcements of currently planned or
other new products will not cause customers to defer purchasing existing Company
products.  To the extent that new products are not developed in a timely manner,
do not achieve  customer  acceptance or do not generate  higher sales prices and
margins than existing products, the Company's business,  financial condition and
results of operations could be materially adversely affected.

         DEPENDENCE ON DEVELOPING MARKET; PRODUCT CONCENTRATION.  The market for
laser hair removal is new and rapidly  evolving.  The Company  currently derives
substantially  all of its  revenues  from its laser hair  removal  products  and
expects  that  revenues  from  these  products  will  continue  to  account  for
substantially  all of its  revenues  in the  foreseeable  

                                       22
<PAGE>

future.  Broad market  acceptance of laser hair removal and, in particular,  the
Company's  EpiLaser(R) and LightSheer(TM) laser hair removal systems is critical
to the Company's future success.

         NEXAR. As of March 20, 1998, the Company owned approximately 31% of the
voting  capital stock of Nexar.  In order to  successfully  execute its business
plan, the Company is to a certain  degree  dependent on the success of Nexar and
Nexar's  ability to fund its  operations and achieve  profitability  in the near
term.  The  Company  intends to reduce its  ownership  of Nexar over time as the
Company  continues to focus on its core cosmetic laser business.  (See Note 2 to
Financial Statements.)

         HOLDING COMPANY  STRUCTURE.  The Company has no significant  operations
other  than  those  incidental  to its  ownership  of the  capital  stock of its
subsidiaries.  As a holding  company,  the Company is  dependent on dividends or
other  intercompany  transfers  of  funds  from  its  subsidiaries  to meet  the
Company's  debt  service  and  other  obligations.  Claims of  creditors  of the
Company's subsidiaries,  including trade creditors, will generally have priority
as to the assets of such  subsidiaries  over the claims of the  Company  and the
holders of the Company's indebtedness.

         LIMITED  OPERATING  HISTORY.  The Company's  subsidiaries  have limited
operating histories and are in the development stage, and the Company is subject
to all of the risks inherent in the establishment of a new business  enterprise.
The  likelihood  of success of the Company  must be  considered  in light of the
problems,   expenses,   difficulties,   complications   and  delays   frequently
encountered  in  connection  with  the  establishment  of  a  new  business  and
development of new technologies in the cosmetic laser products  industry.  These
include, but are not limited to, government regulation, competition, the need to
expand  manufacturing   capabilities  and  market  expertise,  and  setbacks  in
production, product development, market acceptance and sales and marketing. (See
Item 1. "Description of Business.")

         NEW VENTURES.  The Company's CTI subsidiary has entered into agreements
with healthcare  providers to provide cosmetic laser services at laser treatment
centers and plans to enter into more such  agreements  in the future.  While the
Company believes these new partnerships are strategically  important,  there are
substantial  uncertainties  associated  with the  development  of new  products,
technologies  and services for evolving  markets.  The success of these ventures
will be determined not only by the Company's  efforts,  but also by those of its
partners.  Initial  timetables  for  the  development  and  introduction  of new
technologies,  products or services may not be achieved,  and  price/performance
targets may not prove  feasible.  External  factors,  such as the development of
competitive  alternatives  or  government  regulation,  may cause new markets to
evolve in unanticipated directions.  (See "- Highly Competitive Industries," and
Item 1. "Description of Business -  Cosmetic Laser Services.")

         INVESTMENTS  IN UNRELATED  BUSINESSES.  The Company has  investments in
marketable securities  (consisting  principally of Nexar and AMTK common stock).
The  Company's  basis  for  financial  reporting  in  these  investments  totals
approximately  $5.1  million.  The  Company's  current  market  value  of  these
investments totals  approximately $14.0 million. The amount that the Company may
ultimately realize from these investments could differ materially from the value
of these investments  recorded in the Company's  financial  statements,  and the
ultimate disposition of these investments could result in a loss to the Company.
(See "Management's Discussion and Analysis of Financial Condition and Results of
Operations," and Notes 2 and 3(b) and (c) to Financial Statements.)

         HIGHLY  COMPETITIVE  INDUSTRIES.  The cosmetic laser industry is highly
competitive and is characterized  by the frequent  introduction of new products.
The Company competes in the development, manufacture, marketing and servicing of
cosmetic  laser products with numerous  other  companies,  certain of which have
substantially greater financial, marketing and other resources than the Company.
In addition,  the  Company's  cosmetic  laser  products  face  competition  from
alternative  medical  products and procedures,  such as electrolysis and waxing,
among  others.  There  can be no  assurance  that  the  Company  will be able to
differentiate  its  products  from the products of its  competitors  or that the
marketplace  will  consider the  Company's  products to be superior to competing
products or medical procedures.  There can be no assurance that competitors will
not develop products or that new technologies  will not be developed that render
the  Company's  products  obsolete or less  competitive.  (See "-  Technological
Obsolescence.")  In  addition,  in  entering  areas of  business in which it has
little or no experience,  such as the opening of laser  treatment  centers,  the
Company may not be able to compete  successfully  with competitors that are more
established in such areas.  (See "- New Ventures," and Item 1.  "Description  of
Business - Cosmetic Laser Services.")

                                       23
<PAGE>

         FLUCTUATIONS  IN  QUARTERLY  PERFORMANCE.   The  Company's  results  of
operations have fluctuated substantially and can be expected to continue to vary
significantly.  The Company's  quarterly operating results depend on a number of
factors,  including the timing of the introduction or acceptance of new products
offered by the Company or its  competitors,  changes in the mix of products sold
by the Company,  changes in  regulations  affecting the cosmetic  laser products
industry,  changes in the Company's  operating  expenses,  personnel changes and
general economic conditions.

         VOLATILITY   OF  SHARE  PRICE.   Factors  such  as   announcements   of
developments  related to the Company's  business,  announcements by competitors,
quarterly fluctuations in the Company's financial results and other factors have
caused  the  price  of  the  Company's   stock  to  fluctuate,   in  some  cases
substantially,  and  could  continue  to do so in the  future.  If  revenues  or
earnings in any quarter fail to meet the  investment  community's  expectations,
there could be an immediate  impact on the price of the Company's  common stock.
In  addition,  the  stock  market  has  experienced  extreme  price  and  volume
fluctuations  that  have  particularly   affected  the  market  price  for  many
technology  companies  and that  have  often  been  unrelated  to the  operating
performance of these  companies.  These broad market  fluctuations may adversely
affect the market price of the Company's common stock.

         GOVERNMENT REGULATION.  The Company's laser product business segment is
subject to regulation  in the United  States and abroad.  Failure to comply with
applicable regulatory  requirements can result in fines, denial or suspension of
approvals,  seizures or recall of products,  operating restrictions and criminal
prosecutions,  any or all of which could have a material  adverse  effect on the
Company.  Furthermore,  changes  in  existing  regulations  or  adoption  of new
regulations could prevent the Company from obtaining, or could affect the timing
of, future regulatory approvals.  (See Item 1. "Description of Business - Impact
of Medical Device Regulations.")

         All laser medical  devices,  including  those sold by the Company,  are
subject to  regulation  by the FDA under the Medical  Device  Amendments  of the
United States Food,  Drug and Cosmetics Act of 1976, as amended (the "FDA Act"),
pursuant to which the FDA regulates the clinical testing, manufacture, labeling,
sale,  distribution and promotion of medical devices. Before a new device can be
introduced  into the  market,  the  manufacturer  must obtain  market  clearance
through  either  the 510(k)  premarket  notification  process  or the  lengthier
premarket approval ("PMA") application process.  Compliance with this process is
expensive  and  time-consuming.  Three of the  Company's  lasers  have  received
clearance  from the FDA  through the 510(k)  process for certain  dermatological
applications:  the Q-switched  RD-1200(TM)  ruby laser for tattoo  removal,  the
StarLight(TM) diode laser for hair and leg vein removal and the EpiLaser(R) hair
removal  laser.  The  Company  is  also  investigating   other  applications  in
dermatology  for its laser systems.  It will be required to obtain FDA clearance
before commercially  marketing any other application.  The Company believes that
it will be able to seek such  clearance  under the 510(k)  application  process;
however,  no assurance can be given that the FDA will not require the Company to
follow the more extensive and time-consuming PMA process. FDA review of a 510(k)
application currently averages about seven to twelve months and requires limited
clinical data based on substantial  equivalence  to a product  marketed prior to
1976,  while a PMA review can last for several  years and require  substantially
more clinical data.  There can be no assurance that the  appropriate  clearances
from the FDA will be granted,  that the process to obtain such  clearances  will
not be excessively expensive or lengthy or that the Company will have sufficient
funds to pursue such clearances. The Company's business, financial condition and
operations  are,  and will  continue  to be,  critically  dependent  upon timely
receipt of FDA clearance for its current and proposed  cosmetic laser  products.
Delays or failure to obtain such approval  would have a material  adverse effect
on the Company.

         The FDA also imposes various  requirements on manufacturers and sellers
of  products  under  its  jurisdiction,  such as  labeling,  good  manufacturing
practices,  record  keeping  and  reporting  requirements.  The FDA may  require
postmarket testing and surveillance programs to monitor a product's effects. The
Company is  subject to the laser  radiation  safety  regulations  of the FDA Act
administered by the National Center for Devices and Radiological Health ("CDRH")
of the FDA. These regulations  require a laser  manufacturer to file new product
and annual  reports,  to maintain  quality  control,  product  testing and sales
records,  to distribute  appropriate  operation manuals,  to incorporate certain
design and  operating  features in lasers sold to  end-users  and to certify and
label each laser sold to end-users  as one of four  classes of lasers  (based on
the level of radiation from the laser). In addition, various warning labels must
be affixed on the product  and  certain  protective  devices  must be  installed
depending upon the class of product. Under the Act, the Company is also required
to  register  with the FDA as a medical  device  manufacturer  and is subject to
inspection on a routine  basis by the FDA for  compliance  with Quality  Systems
Regulations   ("QSR").   QSR  impose  certain   procedural   and   documentation
requirements upon the Company relevant to its manufacturing, testing and quality
control  activities.  Noncompliance  with applicable 

                                       24
<PAGE>

FDA  regulations,  including  QSR,  can result in,  among other  things,  fines,
injunctions,  civil penalties,  recall or seizure of products,  total or partial
suspension of production, failure of the government to grant premarket clearance
or premarket  approval  for  devices,  withdrawal  of  marketing  approvals  and
criminal  prosecution.  The  FDA  also  has the  authority  to  request  repair,
replacement  or  refund  of the  cost  of any  medical  device  manufactured  or
distributed  by the  Company.  The  Company  believes  that it is  currently  in
compliance with these regulations.

         In order to be sold outside the United States,  the Company's  products
are subject to FDA permit  requirements  that are conditioned  upon clearance by
the importing country's appropriate regulatory authorities.  Many countries also
require that imported products comply with their own or international electrical
and safety standards.  Additional  approvals may be required in other countries.
The Company's  EpiLaser(R) laser system has received the CE Mark pursuant to the
European  Medical  Device  Directive  which  allows that laser to be sold in all
countries that recognize the CE Mark,  including the countries that comprise the
European Community.  The Company has not yet sought  international  approval for
its diode laser for use in cosmetic surgery and dermatology,  because it has not
yet begun to ship this laser overseas.

         UNCERTAINTY OF MARKET ACCEPTANCE.  The Company continually develops new
products  intended  for  use in the  cosmetic  laser  market.  As  with  any new
products,  there is substantial  risk that the  marketplace may not accept or be
receptive to the potential  benefits of such products.  Market acceptance of the
Company's  current and proposed  products will depend,  in large part,  upon the
ability  of  the  Company  or  any  marketing  partners  to  demonstrate  to the
marketplace  the  advantages  of the  Company's  products  over  other  types of
products.   There  can  be  no  assurance  that  the  marketplace   will  accept
applications or uses for the Company's current and proposed products or that any
of  the  Company's  current  or  proposed  products  will  be  able  to  compete
effectively. (See Item 1. "Description of Business - Competition.")

         UNCERTAINTY  OF HEALTHCARE  REIMBURSEMENT  AND REFORM.  The  healthcare
industry is subject to changing  political,  economic and regulatory  influences
that may affect the procurement  practices and operations of healthcare industry
participants.  During  the past  several  years,  state and  federal  government
regulation of reimbursement rates and capital  expenditures in the United States
healthcare  industry has increased.  Lawmakers  continue to propose  programs to
reform the United  States  healthcare  system,  which may  contain  programs  to
increase  governmental  involvement in  healthcare,  lower Medicare and Medicaid
reimbursement  rates or  otherwise  change  the  operating  environment  for the
Company's  customers.  Healthcare  industry  participants  may  react  to  these
proposals by curtailing or deferring  investments,  including investments in the
Company's products.

         DEPENDENCE  ON THIRD PARTY  RESEARCHERS.  The Company is  substantially
dependent upon third party  researchers and others,  over which the Company will
not have absolute control,  to  satisfactorily  conduct and complete research on
behalf of the Company and to grant to the Company favorable  licensing terms for
products  which  may  be  developed.  The  Company  has  entered  into  research
agreements  with recognized  research  hospitals and clinical  laboratories.  At
present,  the Company's  principal  research partner is the Wellman Labs at MGH.
The Company provides research  funding,  laser technology and optics know-how in
return for licensing  agreements with respect to specific  medical  applications
and patents.  Management  believes that this method of  conducting  research and
development  provides a higher level of technical and clinical expertise than it
could  provide on its own and in a more cost  efficient  manner.  The  Company's
success will be highly dependent upon the results of the research, and there can
be no  assurance  that such  research  agreements  will provide the Company with
marketable  products in the future or that any of the products  developed  under
these agreements will be profitable for the Company.  (See Item 1.  "Description
of Business - Research and Development" and Note 8 to Financial Statements.)

         TECHNOLOGICAL OBSOLESCENCE.  The markets for the Company's products are
characterized by rapid and significant  technological change,  evolving industry
standards and frequent new product  introductions and enhancements.  Many of the
Company's   products  and  products  under   development   are   technologically
innovative, and require significant planning, design, development and testing at
the technological,  product and manufacturing  process levels.  These activities
require  significant  capital  commitments  and  investment by the Company.  The
Company's  failure to develop products in a timely manner in response to changes
in the industry,  whether for financial,  technological  or other reasons,  will
have a material adverse effect on the Company's  business,  financial  condition
and results of operations. (See Item 1. "Description of Business.")

                                       25
<PAGE>

         PATENTS/POSSIBLE  PATENT  INFRINGEMENTS.  The Company  currently  holds
several patents and intends to pursue various  additional  avenues that it deems
appropriate to protect its technology. There can be no assurance,  however, that
the Company  will file any  additional  patent  applications  or that any patent
applications that have been, or may be, filed will result in issued patents,  or
that any patent,  patent  application,  know-how,  license or cross-license will
afford any protection or benefit to the Company.  (See Item 1.  "Description  of
Business - Patents and Licenses.")

         The laser industry is  characterized by frequent  litigation  regarding
patent and other intellectual  property rights.  Because patent applications are
maintained in secrecy in the United States until such patents are issued and are
maintained  in  secrecy  for a period of time  outside  the United  States,  the
Company can conduct only limited  searches to determine  whether its  technology
infringes any patents or patent applications. Any claims for patent infringement
could be time-consuming, result in costly litigation, diversion of technical and
management  personnel,  cause  shipment  delays,  require the Company to develop
noninfringing  technology  or to enter  into  royalty or  licensing  agreements.
Although patent and  intellectual  property  disputes in the laser industry have
often been settled through licensing or similar  arrangements,  costs associated
with such  arrangements  may be  substantial  and often  require  the payment of
ongoing  royalties,  which could have a negative impact on gross margins.  There
can be no assurance that necessary licenses would be available to the Company on
satisfactory terms, or that the Company could redesign its products or processes
to avoid infringement, if necessary.  Accordingly, an adverse determination in a
judicial or  administrative  proceeding or failure to obtain necessary  licenses
could prevent the Company from  manufacturing  and selling some of its products.
This could have a material adverse effect on the Company's business,  results of
operations  and  financial  condition.  Conversely,  costly  and time  consuming
litigation may be necessary to enforce patents issued to the Company, to protect
trade   secrets  or  know-how   owned  by  the  Company  or  to  determine   the
enforceability, scope and validity of the proprietary rights of others.

         The Company is aware of patents relating to laser  technologies used in
certain  applications.  The Company intends to pursue such laser technologies in
the future;  hence, if the patents relating to those  technologies are valid and
enforceable, they may be infringed by the Company. After consulting with outside
counsel to the Company, the Company believes that it is not infringing currently
on patents held by others; however, were the issue ever to be litigated, a court
could reach a different  opinion.  If the Company's current or proposed products
are, in the opinion of patent counsel,  infringing on any of these patents,  the
Company intends to seek nonexclusive,  royalty-bearing  licenses to such patents
but  there can be no  assurance  that any such  license  would be  available  on
favorable  terms,  if at all. One of the  Company's  competitors  has filed suit
against  the Company  alleging  patent  infringement,  among  other  things.  No
assurance can be given that other  infringement  claims will not be made or that
the Company would prevail in any legal action with respect thereto. Defense of a
claim of infringement  would be costly and could have a material  adverse effect
on the  Company's  business,  even if the Company were to prevail.  (See Item 3.
"Legal Proceedings.")

         DEPENDENCE ON PROPRIETARY  RIGHTS.  The Company relies on trade secrets
and proprietary  know-how which it seeks to protect, in part, by confidentiality
agreements with its  collaborators,  employees and consultants.  There can be no
assurance  that these  agreements  will not be breached,  that the Company would
have adequate  remedies for any breach, or that the Company's trade secrets will
not otherwise become known or be independently developed by competitors.

         RISKS  ASSOCIATED  WITH  PENDING   LITIGATION.   The  Company  and  its
subsidiaries  are involved in disputes  with third  parties.  Such disputes have
resulted  in  litigation  with such  parties  and,  although  the  Company  is a
plaintiff in several matters, the Company is subject to claims and counterclaims
for damages and has incurred,  and likely will continue to incur, legal expenses
in connection with such matters.  There can be no assurance that such litigation
will result in favorable  outcomes for the Company.  An adverse result in either
the MEHL patent  litigation or the action relating to the Swiss Franc Debentures
(both described in detail in Item 3) could have a material adverse effect on the
Company's business,  financial condition and results of operations.  The Company
is unable to determine  the total  expense or possible  loss,  if any,  that may
ultimately be incurred in the resolution of these proceedings. These matters may
result in diversion of  management  time and effort from the  operations  of the
business.  (See  Item  3.  "Legal  Proceedings"  and  Note  12(d)  to  Financial
Statements.)

         NEED FOR  ADDITIONAL  QUALIFIED  PERSONNEL.  The  Company's  ability to
develop, manufacture and market all of its products, and to attain a competitive
position within the laser products industry,  will depend, in large part, on its
ability to attract and retain  qualified  personnel.  Competition  for qualified
personnel  in these  industries  is intense and the Company  will be required to
compete for such personnel with companies  which may have greater  financial and
other  resources.  

                                       26
<PAGE>

There can be no assurance  that the Company will be  successful  in  attracting,
assimilating  and  retaining  the  personnel  it  requires  to grow and  operate
profitably.  The Company's  inability to attract and retain such personnel could
have a material adverse effect upon its business.

         ISSUANCE OF  PREFERRED  STOCK AND  DEBENTURES  COULD  AFFECT  RIGHTS OF
COMMON  SHAREHOLDERS.  The  Company is  authorized  to issue up to five  million
shares of Preferred Stock,  $.01 par value. The Preferred Stock may be issued in
one or more series, the terms of which may be determined at the time of issuance
by the Board of  Directors,  without  further  action by  shareholders,  and may
include  voting  rights  (including  the right to vote as a series on particular
matters), preferences as to dividends and liquidation, conversion and redemption
rights and sinking fund provisions. In July 1996, the Company issued 9,675 units
in a  convertible  debenture  financing.  Each unit  consisted of a  convertible
debenture  denominated in 1,000 Swiss francs and a warrant to purchase 24 shares
of the Company's common stock at $16.50 per share. In February 1997, the Company
redeemed 300 units for an aggregate  price of $195,044.  In November  1997,  the
remaining  9,375 units were converted into 914,028 shares of common stock.  (See
Item 3. "Legal  Proceedings.") In October 1996, the Company issued $5,000,000 in
4.5% Convertible Subordinated Promissory Notes. As of March 20, 1998, $5,000,000
principal  amount  was  converted  into  1,442,073  shares of common  stock.  In
December 1996 and January 1997,  the Company  issued a total of $6,000,000 in 5%
Convertible  Debentures.  As of March 20, 1998,  $5,533,356 principal amount was
converted  into  3,707,292  shares of common stock.  In March 1997,  the Company
issued $5,500,000 in 5% Convertible Debentures. As of March 20, 1998, $5,500,000
principal  amount was converted into 4,355,735  shares of common stock. In March
1997, the Company issued  $500,000 in 6%  Convertible  Debentures.  In September
1997, the Company issued $7,000,000 in 6%, 7% and 8% Convertible Debentures. The
holders  were  issued  413,109  shares upon  issuance in lieu of a discount.  In
addition,  as of March 20, 1998,  $160,000  principal  amount was converted into
103,021 shares of common stock. The Company also redeemed  $2,000,000  principal
amount for $2,196,667. In July 1996, the Company issued 6,000 shares of Series F
Convertible  Preferred  Stock at a price of $1,000 per share. In September 1996,
the Company  issued 10,000 shares of Series G Convertible  Preferred  Stock at a
price of $1,000 per share.  As of March 20,  1998,  7,316 shares of the Series G
Convertible  Preferred Stock were converted into 602,824 shares of common stock,
956,388 shares of common stock of Nexar and $47,731 in cash dividends.  In March
1997, the Company issued 6,000 shares of Series H Convertible Preferred Stock at
a price of $1,000 per share.  In May 1997,  the Company  issued 10,000 shares of
Series H Convertible Preferred Stock at a price of $1,000 per share. As of March
20,  1998,  11,100  shares of the  Series H  Convertible  Preferred  Stock  were
converted into 8,289,013  shares of common stock.  In addition,  2,950 shares of
the Series H  Convertible  Preferred  Stock were  redeemed for  $3,588,715.  The
issuance of any such additional  Preferred Stock or Debentures  could affect the
rights of the holders of common shares, and could reduce the market price of the
common  shares.  In  particular,  specific  rights  granted to future holders of
Preferred Stock or Debentures could be used to restrict the Company's ability to
merge with or sell its assets to a third party,  thereby  preserving  control of
the  Company  by the  existing  control  group.  (See  Item 1.  "Description  of
Business," Item 5. "Market for Common Equity and Related  Stockholder  Matters,"
and Notes 6, 7 and 13 to Financial Statements.)

         ISSUANCE OF RESERVED SHARES; REGISTRATION RIGHTS. As of March 20, 1998,
the Company had 59,553,243 shares of common stock  outstanding.  The Company has
reserved an additional  28,180,020 shares for issuance as follows: (1) 3,707,655
shares for  issuance to key  employees,  officers,  directors,  consultants  and
advisors  pursuant to the Company's  Stock Option Plans;  (2) 166,674 shares for
issuance to employees,  officers and directors  pursuant to the Company's 401(k)
Plan; (3) 966,014 shares for issuance  pursuant to the Company's  Employee Stock
Purchase Plan; (4) 9,998,030 shares for issuance upon exercise of three-, four-,
five- and seven year warrants issued to certain lenders, investors, consultants,
directors  and officers (a portion of which are subject to certain  antidilutive
adjustments);  (5)  530,217  shares for  issuance  upon  conversion  of $466,644
principal amount of a 5% Convertible Debentures;  (6) 45,455 shares for issuance
upon conversion of $500,000 principal amount of 6% Convertible  Debentures;  (7)
6,396,979 shares for issuance upon conversion of $4,840,000  principal amount of
a 6%, 7% and 8%  Convertible  Debenture;  (8) 600,000  shares for issuance  upon
conversion  of the 6,000 shares of Series F  Convertible  Preferred  Stock;  (9)
3,611,659  shares for issuance  upon  conversion of the 2,684 shares of Series G
Convertible  Preferred  Stock;  and (10)  2,157,337  shares  for  issuance  upon
conversion of the 1,950 shares of Series H Convertible  Preferred  Stock. All of
the foregoing  reserved  shares are, or the Company  intends for them shortly to
be, registered with the Securities and Exchange  Commission and therefore freely
salable on Nasdaq or elsewhere.

         PRODUCT  LIABILITY  EXPOSURE.  Cosmetic laser product companies face an
inherent business risk of financial  exposure to product liability claims in the
event that the use of their products results in personal  injury.  The Company's
products are 

                                       27
<PAGE>

and will  continue to be  designed  with  numerous  safety  features,  but it is
possible  that  patients  could  be  adversely  affected  by  use  of one of the
Company's  products.  Further,  in the event that any of the Company's  products
prove to be  defective,  the Company may be required to recall and redesign such
products.  Although the Company has not  experienced  any material losses due to
product  liability  claims to date,  there can be no assurance  that it will not
experience such losses in the future.  The Company  maintains  general liability
insurance in the amount of  $1,000,000  per  occurrence  and  $2,000,000  in the
aggregate  and  maintains   umbrella   coverage  in  the  aggregate   amount  of
$25,000,000; however, there can be no assurance that such coverage will continue
to be available on terms acceptable to the Company or that such coverage will be
adequate for liabilities  actually  incurred.  In the event the Company is found
liable for damages in excess of the limits of its insurance coverage,  or if any
claim or product  recall results in significant  adverse  publicity  against the
Company,  the Company's business,  financial condition and results of operations
could be materially and adversely affected. In addition,  although the Company's
products have been and will continue to be designed to operate in a safe manner,
and although the Company  attempts to educate medical  personnel with respect to
the proper use of its  products,  misuse of the  Company's  products  by medical
personnel over whom the Company cannot exert control may result in the filing of
product liability claims or significant adverse publicity against the Company.

         INTERNATIONAL OPERATIONS. Because the Company has minimal experience in
marketing and distributing its products internationally,  it engaged Coherent, a
company with particular  experience in  international  markets,  to serve as its
distributor in  international  markets.  (See "- Dependence on New  Relationship
with Coherent" and Item 1.  "Description  of Business - Marketing,  Distribution
and Service.") Accordingly,  the Company's success in international markets will
be substantially dependent upon the skill and expertise of Coherent in marketing
the Company's products.  There can be no assurance that Coherent will be able to
successfully  market,  sell and deliver the Company's products in these markets.
In addition, there are certain risks inherent in doing business in international
markets,  such  as  unexpected  changes  in  regulatory   requirements,   export
restrictions,  tariffs and other trade  barriers,  difficulties  in staffing and
managing  foreign  operations,  management's  lack of  international  expertise,
political   instability  and   fluctuations  in  currency   exchange  rates  and
potentially  adverse tax consequences,  which could adversely impact the success
of the Company's international operations. There can be no assurance that one or
more of such factors will not have a material  adverse  effect on the  Company's
future international  operations and,  consequently,  on the Company's business,
financial  condition or operating results.  (See Item 1. "Financial  Information
About Exports by Domestic Operations.")

         NEED FOR CONTINUED PRODUCT  DEVELOPMENT.  Although the Company received
FDA clearance in March and December 1997,  respectively,  to commercially market
its  EpiLaser(R)  and diode  laser  systems  for hair  removal,  the  Company is
continuing its development of both products.  The Company is continuing to study
both laser systems to optimize performance and treatment  parameters.  (See Item
1. "Description of Business.")

         DEPENDENCE ON SUPPLIERS.  The Company  relies on outside  suppliers for
substantially all of its manufacturing supplies,  parts and components.  Several
component  parts of the  Company's  cosmetic  laser  products  are  manufactured
exclusively by one supplier.  There can be no assurance that the Company will be
able to obtain a sufficient supply of such components at commercially reasonable
prices or at all. A shortage of necessary  parts and components or the inability
of the Company to obtain such parts and components would have a material adverse
effect on the Company's business, financial condition and results of operations.
(See Item 1.  "Description of Business - Production and Sources and Availability
of Materials.")

         SIGNIFICANT OUTSTANDING INDEBTEDNESS;  SUBORDINATION OF DEBENTURES. The
Company has incurred substantial  indebtedness in relation to its equity capital
and will be subject to all of the risks  associated with  substantial  leverage,
including  the risk that  available  cash may not be adequate  to make  required
payments to the holders of the Company's  debentures.  The Company's  ability to
satisfy its  obligations  under the debentures  from cash flow will be dependent
upon the Company's future performance and will be subject to financial, business
and other factors  affecting the operation of the Company,  many of which may be
beyond the Company's control.  In the event the Company does not have sufficient
cash resources to satisfy quarterly  interest or other repayment  obligations to
the  holders  of the  debentures,  the  Company  will be in  default  under  the
debentures,  which would have a material  adverse effect on the Company.  To the
extent that the Company is required to use cash  resources  to satisfy  interest
payments  to the  holders  of the  debentures,  it  will  have  fewer  resources
available for other  purposes.  Inability of the Company to repay the debentures
upon maturity would have a material  adverse effect on the Company,  which could
result in a reduction of the price of the Company's shares.  The debentures will
be unsecured and  subordinate in right of payment to all senior  indebtedness of
the Company.  The  

                                       28
<PAGE>

debentures  do not restrict the  Company's  ability to incur  additional  senior
indebtedness and most other  indebtedness.  The terms of senior indebtedness now
existing or incurred in the future  could affect the  Company's  ability to make
payments of principal and/or interest to the holders of debentures. (See Item 5.
"Market for Registrant's Common Equity and Related Shareholder Matters" and Note
6 to Financial Statements.)

         POTENTIAL EFFECT OF ANTI-TAKEOVER PROVISIONS. The Company is subject to
the anti-takeover  provisions of Section 203 of the Delaware General Corporation
Law, which prohibit the Company from engaging in a business  combination with an
interested  stockholder  for a  period  of  three  years  after  the date of the
transaction  in which the person becomes an interested  stockholder,  unless the
business  combination  is approved in a prescribed  manner.  The  application of
Section 203 could have the effect of delaying or  preventing a change of control
of the Company.  The  Company's  stock option  grants  generally  provide for an
exercise of some or all of the optioned stock,  including nonvested shares, upon
a change of control or similar  event.  The Board of Directors  has authority to
issue  up to  5,000,000  shares  of  Preferred  Stock  and  to fix  the  rights,
preference,  privileges and  restrictions,  including  voting  rights,  of these
shares without any further vote or action by the stockholders. The rights of the
holders of the common  stock will be subject to, and may be  adversely  affected
by, the rights of the holders of any  Preferred  Stock that may be issued in the
future. The issuance of Preferred Stock, while providing  desirable  flexibility
in connection with possible  acquisitions  and other corporate  purposes,  could
have the  effect of  making it more  difficult  for a third  party to  acquire a
majority of the  outstanding  voting  stock of the  Company,  thereby  delaying,
deferring or  preventing a change in control of the Company.  Furthermore,  such
Preferred Stock may have other rights,  including  economic rights senior to the
common stock, and, as a result,  the issuance of such Preferred Stock could have
a material  adverse  effect on the market  value of the  common  stock.  (See "-
Issuance  of  Preferred  Stock  and  Debentures  Could  Affect  Rights of Common
Shareholders.")

         YEAR  2000.  The  Company is aware of the  issues  associated  with the
programming  code in existing  computer  systems as the  millennium  (year 2000)
approaches. The "year 2000" problem is pervasive and complex, as virtually every
computer  operation  will be affected in the same way by the rollover of the two
digit  year value to 00. The issue is whether  computer  systems  will  properly
recognize date sensitive information when the year changes to 2000. Systems that
do not properly  recognize such  information  could  generate  erroneous data or
cause a system to fail. The Company is at this time utilizing internal resources
to  identify,  correct  or  reprogram,  and  test  the  systems  for  year  2000
compliance.  However,  there  can be no  assurance  that  the  systems  of other
companies on which the Company's systems rely will also be converted in a timely
manner or that any such failure to convert by another  company would not have an
adverse  effect  on the  Company's  systems.  Management  is in the  process  of
assessing the year 2000 compliance costs; however,  based on information to date
(excluding the possible impact of vendor  systems),  management does not believe
that it will have a material effect on the Company's  earnings.  (See Note 12(c)
to Financial Statements.)

                                       29
<PAGE>

ITEM 8.   FINANCIAL STATEMENTS.


                       PALOMAR MEDICAL TECHNOLOGIES, INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



Report of Independent Public Accountants                                     F-2

Consolidated Balance Sheets as of December 31, 1996 and 1997                 F-3

Consolidated Statements of Operations for 
     the years ended December 31, 1995, 1996 and 1997                        F-4

Consolidated Statements of Stockholders' Equity (deficit) 
     for the years ended December 31, 1995, 1996 and 1997                    F-5

Consolidated Statements of Cash Flows for 
     the years ended December 31, 1995, 1996 and 1997                        F-8

Notes to Consolidated Financial Statements                                  F-10

                                       F-1
<PAGE>

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To Palomar Medical Technologies, Inc. and Subsidiaries:

         We have audited the accompanying consolidated balance sheets of Palomar
Medical  Technologies,  Inc. (a Delaware  corporation)  and  subsidiaries  as of
December  31,  1996  and  1997,  and  the  related  consolidated  statements  of
operations,  stockholders' equity (deficit) and cash flows for each of the three
years in the period ended December 31, 1997. These financial  statements are the
responsibility of the Company's management.  Our responsibility is to express an
opinion  on these  financial  statements  based on our  audits.  The  summarized
financial data for Nexar Technologies, Inc. contained in Note 2 are based on the
financial  statements of Nexar  Technologies,  Inc.  which were audited by other
auditors.  Their report has been furnished to us and our opinion,  insofar as it
relates  to the data in Note 2, is  based  solely  on the  report  of the  other
auditors.

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

         In our  opinion,  based on our audit and the report of other  auditors,
the  financial  statements  referred to above  present  fairly,  in all material
respects,  the  financial  position of Palomar  Medical  Technologies,  Inc. and
subsidiaries  as of  December  31,  1996  and  1997,  and the  results  of their
operations  and their cash flows for each of the three years in the period ended
December 31, 1997 in conformity with generally accepted accounting principles.

         The accompanying  consolidated  financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
1, the Company has suffered  recurring  losses from operations and has a working
capital  deficiency and a stockholders'  deficit that raises  substantial  doubt
about the Company's ability to continue as a going concern.  Management's  plans
in  regard  to these  matters  are also  described  in Note 1. The  accompanying
consolidated  financial  statements  do not include any  adjustments  that might
result from the outcome of this uncertainty.






                                                             ARTHUR ANDERSEN LLP



Boston, Massachusetts 
February 6, 1998 (except for the 
matters discussed in Note 13, 
as to which the date is 
March 31, 1998)

                                       F-2
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS
<TABLE>
<S>                                                                                      <C>                      <C>

                                                                                          December 31,             December 31,
                                                                                              1996                     1997
                                                                                         ----------------         ----------------
ASSETS

Current Assets:
       Cash and cash equivalents                                                             $12,292,406               $3,003,300
       Marketable securities                                                                   2,893,792                1,449,326
       Accounts receivable, net of allowance for doubtful accounts of
            approximately $1,129,000 and $746,000, respectively                                2,171,086                2,248,680
       Inventories                                                                             5,205,954                4,711,474
       Loans to former officers                                                                  948,198                  478,343
       Notes receivable from related parties for sale of Dynaco subsidiary                           ---                  855,379
       Subscription receivable                                                                 3,500,000                      ---
       Other current assets                                                                    2,983,209                  820,219
                                                                                         ----------------         ----------------
            Total current assets                                                              29,994,645               13,566,721
                                                                                         ----------------         ----------------

Net Assets of Discontinued Operations (Note 2)                                                22,971,380                5,825,602
                                                                                         ----------------         ----------------

Property and Equipment, at Cost, Net                                                           3,827,990                6,455,586
                                                                                         ----------------         ----------------

Other Assets:
       Cost in excess of net assets acquired, net of accumulated amortization of
            approximately $725,000 and $1,280,000, respectively                                2,856,616                2,302,348
       Deferred financing costs                                                                1,943,420                  591,609
       Other noncurrent assets                                                                 5,938,826                  225,706
                                                                                         ----------------         ----------------
            Total other assets                                                                10,738,862                3,119,663
                                                                                         ----------------         ----------------

                                                                                             $67,532,877              $28,967,572
                                                                                         ================         ================

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

Current Liabilities:

       Current portion of long-term debt                                                        $497,377               $1,640,465
       Accounts payable                                                                        3,318,460                4,150,982
       Accrued liabilities                                                                    10,975,309               16,914,249
                                                                                         ----------------         ----------------
            Total current liabilities                                                         14,791,146               22,705,696
                                                                                         ----------------         ----------------

Long-Term Debt, Net of Current Portion                                                        14,665,140               12,445,563
                                                                                         ----------------         ----------------

Commitments and Contingencies (Notes 2, 6 and 10)

Stockholders' Equity (Deficit):
       Preferred stock, $.01 par value-
            Authorized - 5,000,000 shares
            Issued and outstanding -
            18,151 shares and 16,397 shares
            at December 31, 1996 and December 31, 1997, respectively
            (Liquidation preference of $17,714,474 as of December 31, 1997)                          182                      164
       Common stock, $.01 par value-
            Authorized - 100,000,000 shares
            Issued - 30,596,812 shares and 45,792,585 shares
            at December 31, 1996 and December 31, 1997, respectively                             305,968                  457,926
       Additional paid-in capital                                                            104,900,551              147,356,579
       Accumulated deficit                                                                   (64,971,200)            (152,359,497)
       Unrealized loss on marketable securities                                                 (342,500)                     ---
       Subscriptions receivable from related party                                              (604,653)                     ---
       Less: Treasury stock - (200,000 shares and 345,000 shares at cost, respectively)       (1,211,757)              (1,638,859)
                                                                                         ----------------         ----------------
            Total stockholders' equity (deficit)                                              38,076,591               (6,183,687)
                                                                                         ----------------         ----------------
                                                                                             $67,532,877              $28,967,572
                                                                                         ================         ================
</TABLE>
                  The accompanying notes are an integral part
                  of these consolidated financial statements.


                                       F-3
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<S>                                                       <C>                <C>              <C>

                                                                      Years Ended December 31,
                                                                 1995             1996             1997
                                                          ----------------   --------------   --------------

Revenues                                                       $5,610,280      $17,606,871      $20,994,546

Cost of Revenues                                                3,464,472       14,169,471       20,055,963
                                                          ----------------   --------------   --------------

        Gross profit                                            2,145,808        3,437,400          938,583
                                                          ----------------   --------------   --------------

Operating Expenses

        Research and development                                3,964,920        6,297,477       11,990,332
        Sales and marketing                                     2,768,541        5,076,941        6,959,750
        General and administrative                              2,141,798        9,752,922       15,332,241
        Business development                                    1,409,303        2,879,603        2,060,852
        Restructuring and asset write-off (Note 4)                     --        1,660,808        3,325,000
        Settlement and litigation costs                           700,000          880,000        3,199,000
                                                          ----------------   --------------   --------------

               Total operating expenses                        10,984,562       26,547,751       42,867,175
                                                          ----------------   --------------   --------------

               Loss from operations                            (8,838,754)     (23,110,351)     (41,928,592)

Interest Expense                                                 (766,079)        (271,619)      (6,993,898)

Interest Income                                                   912,019        1,355,488          456,945

Net Gain (Loss) on Trading Securities                             201,067        2,033,371          (52,272)

Asset Write-off (Note 4)                                               --       (1,397,000)      (9,658,000)

Other Income (Expense)                                            102,305          591,853         (193,262)
                                                          ----------------   --------------   --------------

        Net Loss from Continuing Operations                    (8,389,442)     (20,798,258)     (58,369,079)
                                                          ----------------   --------------   --------------

Loss from Discontinued Operations (Note 2):

        Loss from operations                                   (4,231,326)     (20,895,534)     (29,508,755)
        Gain on dispositions, net                                      --        3,830,000        2,073,943
                                                          ----------------   --------------   --------------

        Net Loss from Discontinued Operations                  (4,231,326)     (17,065,534)     (27,434,812)
                                                          ----------------   --------------   --------------

               Net Loss                                      $(12,620,768)    $(37,863,792)    $(85,803,891)
                                                          ================   ==============   ==============

Basic and Diluted Net Loss Per Common Share:

        Continuing operations                                      $(0.60)          $(0.84)          $(1.79)
        Discontinued operations                                     (0.30)           (0.65)           (0.78)
                                                          ----------------   --------------   --------------

        Total Loss Per Common Share                                $(0.90)          $(1.49)          $(2.57)
                                                          ================   ==============   ==============

Weighted Average Number of
    Common Shares Outstanding                                  14,164,901       26,166,538       35,105,272
                                                          ================   ==============   ==============

</TABLE>

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


                                       F-4
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)

<TABLE>
<S>                                                             <C>          <C>       <C>         <C>        <C>       <C>

                                                                   Preferred Stock          Common Stock           Treasury Stock
                                                                -------------------------------------------------------------------
                                                                  Number      0.01       Number       0.01      Number
                                                                of Shares   Par Value  of Shares   Par Value   of Shares     Cost
                                                                -------------------------------------------------------------------
Balance, December 31, 1994                                           --        $--     9,464,963    94,649         --          $--
                                                                                                           

     Sale of common stock pursuant to warrants and options           --         --     2,925,093    29,251         --           --
                                                                                                          
     Sale of common stock                                            --         --     1,622,245    16,223         --           --
                                                                                                           
     Payments received on subscriptions receivable                   --         --            --        --         --           --
     Issuance of preferred stock, including common stock 
          issued as a placement fee, net of issuance costs       21,295        213       300,000     3,000         --           --
     Purchase of treasury stock                                      --         --            --        --   (200,000)  (1,211,757)
     Issuance of common stock in lieu of payment of notes            --         --            --        --         --           --
          payable                                                    --         --       632,144     6,321         --           --
     Repayment of convertible debentures                             --         --            --        --         --           --
     Conversion of convertible debentures                            --         --     1,943,870    19,438         --           --
     Value ascribed to convertible debentures                        --         --            --        --         --           --
     Value ascribed to warrant in exchange for license
          technology                                                 --         --            --        --         --           --
     Issuance of common stock for technology                         --         --       739,546     7,395         --           --
     Conversion of preferred stock                               (7,435)       (74)    1,775,691    17,757         --           --
     Exercise of underwriter's warrants                              --         --       200,000     2,000         --           --
     Issuance of common stock for Spectrum Medical Tech., Inc.       --         --       364,178     3,642         --           --
     Issuance of common stock for investment banking and merger
          and acquisition consulting services                        --         --       167,676     1,677         --           --
     Amortization of deferred financing costs                        --         --            --        --         --           --
     Compensation expense related to warrants issued to
          consultants and investment bankers                         --         --            --        --         --           --
     Preferred stock dividends                                       --         --            --        --         --           --
     Net loss                                                        --         --            --        --         --           --
                                                                -------------------------------------------------------------------
Balance, December 31, 1995                                      $13,860       $139   $20,135,406  $201,353  $(200,000) $(1,211,757)
                                                                ===================================================================
</TABLE>

<TABLE>
<S>                                                              <C>           <C>           <C>         <C>           <C>

                                                                                             Unrealized                    Total
                                                                  Additional                   Loss on                 Stockholders'
                                                                   Paid-in     Accumulated   Marketable  Subscriptions    Equity 
                                                                   Capital       Deficit     Securities   Receivable     (Deficit)
                                                                  ------------------------------------------------------------------
Balance, December 31, 1994                                       $15,773,109   (13,119,279)         $--           $--     2,748,479

     Sale of common stock pursuant to warrants and options         7,588,888            --           --    (4,633,975)    2,984,164
     Sale of common stock                                          2,935,921            --           --            --     2,952,144
     Payments received on subscriptions receivable                        --            --           --     3,694,840     3,694,840
     Issuance of preferred stock, including common stock 
          issued as as a placement fee, net of issuance costs     19,382,750            --           --            --    19,385,963
     Purchase of treasury stock                                           --            --           --            --    (1,211,757)
     Issuance of common stock in lieu of payment of notes payable  1,873,611            --           --            --     1,879,932
     Repayment of convertible debentures                            (321,533)           --           --            --      (321,533)
     Conversion of convertible debentures                          3,071,302            --           --            --     3,090,740
     Value ascribed to convertible debentures                        899,813            --           --            --       899,813
     Value ascribed to warrant in exchange for license technology    100,000            --           --            --       100,000
     Issuance of common stock for technology                         292,605            --           --            --       300,000
     Conversion of preferred stock                                    68,377            --           --            --        86,060
     Exercise of underwriter's warrants                            1,049,574            --           --    (1,049,574)        2,000
     Issuance of common stock for Spectrum Medical Tech., Inc.       996,358            --           --            --     1,000,000
     Issuance of common stock for investment banking and merger
          and acquisition consulting services                        416,823            --           --            --       418,500
     Amortization of deferred financing costs                        (70,583)           --           --            --       (70,583)
     Compensation expense related to warrants issued to
          consultants and investment bankers                          95,370            --           --            --        95,370
     Preferred stock dividends                                            --      (124,610)          --            --      (124,610)
     Net loss                                                             --   (12,620,768)          --            --   (12,620,768)
                                                                 -------------------------------------------------------------------
Balance, December 31, 1995                                       $54,152,385  $(25,864,657)         $--   $(1,988,709)  $25,288,754
                                                                 ===================================================================
</TABLE>

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

                                       F-5
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                                  (Continued)

<TABLE>
<S>                                                              <C>        <C>       <C>          <C>       <C>        <C>

                                                                    Preferred Stock          Common Stock            Treasury Stock
                                                                 -------------------------------------------------------------------
                                                                   Number      0.01       Number       0.01      Number
                                                                 of Shares  Par Value   of Shares   Par Value  of Shares      Cost
                                                                 -------------------------------------------------------------------
Balance, December 31, 1995                                       $13,860       $139   $20,135,406  $201,353  ($200,000) ($1,211,757)

    Sale of common stock pursuant to warrants and options             --         --     2,967,996    29,681         --           --
    Sale of common stock                                              --         --     1,176,205    11,762         --           --
    Payments received on subscriptions receivable                     --         --            --        --         --           --
    Issuance of preferred stock, including common stock
        issued as a placement fee, net of issuance costs          32,000        320       115,000     1,150         --           --
    Issuance of common stock for 1995 employer 401(k) 
        matching contribution                                         --         --        45,885       459         --           --
    Conversion of preferred stock, including accrued 
        dividends and interest of $782,602                       (25,209)      (252)    4,481,518    44,815         --           --
    Conversion of convertible debentures                              --         --        34,615       346         --           --
    Redemption of convertible debentures                              --         --            --        --         --           --
    Value ascribed to convertible debentures                          --         --            --        --         --           --
    Redemption of preferred stock                                 (2,500)       (25)           --        --         --           --
    Exercise of underwriter's warrants                                --         --       500,000     5,000         --           --
    Exercise of stock options in majority controlled subsidiary       --         --            --        --         --           --
    Issuance of common stock for conversion of debentures at
        Tissue Technologies, Inc.                                     --         --       813,431     8,134         --           --
    Issuance of common stock for minority interest in 
        Star Medical subsidiary                                       --         --       224,054     2,241         --           --
    Issuance of common stock in exchange for license rights           --         --        56,900       569         --           --
    Issuance of common stock for acquisition of Dermascan, Inc.       --         --        35,000       350         --           --
    Issuance of common stock for investment banking and merger
        and acquisition consulting services                           --         --        56,802       568         --           --
    Compensation expense related to warrants issued to
        non-employees under SFAS No. 123                              --         --            --        --         --           --
    Return of escrowed shares                                         --         --       (46,000)     (460)        --           --
    Amortization of deferred financing costs                          --         --            --        --         --           --
    Unrealized loss on marketable securities                          --         --            --        --         --           --
    Preferred stock dividends                                         --         --            --        --         --           --
    Net loss                                                          --         --            --        --         --           --
                                                                 -------------------------------------------------------------------
Balance, December 31, 1996                                       $18,151       $182   $30,596,812  $305,968  ($200,000) ($1,211,757)
                                                                 ===================================================================
</TABLE>

<TABLE>
<S>                                                            <C>           <C>          <C>         <C>              <C>

                                                                                                                          Total
                                                               Additional                 Unrealized  Subscriptions    Stockholders'
                                                                 Paid-in    Accumulated     Loss on     Receivable        Equity
                                                                 Capital     Deficit      Marketable    Securities       (Deficit)
                                                               ---------------------------------------------------------------------

Balance, December 31, 1995                                     $54,152,385   ($25,864,657)      $--     ($1,988,709)    $25,288,754

     Sale of common stock pursuant to warrants and options       7,569,226             --        --              --       7,598,907
     Sale of common stock                                        6,049,618             --        --              --       6,061,380
     Payments received on subscriptions receivable                      --             --        --       2,441,556       2,441,556
     Issuance of preferred stock, including common stock 
          issued as a placement fee, net of issuance costs      30,821,677             --        --              --      30,823,147
     Issuance of common stock for 1995 employer 401(k) 
          matching contribution                                    160,139             --        --              --         160,598
     Conversion of preferred stock, including accrued 
          dividends and interest of $782,602                       744,124             --        --              --         788,687
          Conversion of convertible debentures                     145,260             --        --              --         145,606
     Redemption of convertible debentures                          (41,530)            --        --              --         (41,530)
     Value ascribed to convertible debentures                    2,757,860             --        --              --       2,757,860
     Redemption of preferred stock                              (3,123,127)            --        --              --      (3,123,152)
     Exercise of underwriter's warrants                          1,057,500             --        --      (1,057,500)          5,000
     Exercise of stock options in majority controlled subsidiary    50,000             --        --              --          50,000
     Issuance of common stock for conversion of debentures at
          Tissue Technologies, Inc.                              1,019,022             --        --              --       1,027,156
     Issuance of common stock for minority interest in 
          Star Medical subsidiary                                1,747,482             --        --              --       1,749,723
     Issuance of common stock in exchange for license rights       369,574             --        --              --         370,143
     Issuance of common stock for acquisition of Dermascan, Inc.   489,650             --        --              --         490,000
     Issuance of common stock for investment banking and merger
          and acquisition consulting services                      476,156             --        --              --         476,724
     Compensation expense related to warrants issued to
           non-employees under SFAS No. 123                        532,758             --        --              --         532,758
     Return of escrowed shares                                         460             --        --              --              --
     Amortization of deferred financing costs                      (77,683)            --        --              --         (77,683)
     Unrealized loss on marketable securities                           --             --  (342,500)             --        (342,500)
     Preferred stock dividends                                          --     (1,242,751)       --              --      (1,242,751)
     Net loss                                                           --    (37,863,792)       --              --     (37,863,792)
                                                              ----------------------------------------------------------------------
Balance, December 31, 1996                                    $104,900,551   ($64,971,200)($342,500)      ($604,653)    $38,076,591
                                                              ======================================================================
</TABLE>

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


                                       F-6
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                                  (Continued)

<TABLE>
<S>                                                    <C>         <C>          <C>          <C>          <C>             <C>

                                                           Preferred Stock          Common Stock              Treasury Stock
                                                       -----------------------------------------------------------------------------
                                                         Number      0.01        Number         0.01        Number
                                                       of Shares   Par Value    of Shares    Par Value    of Shares       Cost
                                                       -----------------------------------------------------------------------------

Balance, December 31, 1996                               18,151          182   30,596,812     $305,968     (200,000)    (1,211,757)

     Sale of common stock pursuant to warrants, 
          options and Employee Stock Purchase Plan           --           --      815,101        8,151           --             --
     Reduction in subscriptions receivable                   --           --           --           --           --             --
     Sale of preferred stock, net of issuance cost 
          of approximately $1,000,000                    16,000          160           --           --           --             --
     Issuance of common stock for 1996 employer 401(k) 
          matching contribution                              --           --       87,441          874           --             --
     Conversion and redemption of preferred stock       (17,754)        (178)   6,139,841       61,399           --             --
      Conversion of convertible debentures and issuance
          of common stock to an investor                     --           --    7,464,961       74,650           --             --
     Issuance of common stock for investment banking, 
          merger and acquisition and consulting services     --           --       20,000          200           --             --
     Value ascribed to the discount feature of
          convertible debentures issued                      --           --      413,109        4,131           --             --
     Unrealized gain on marketable securities                --           --           --           --           --             --
     Preferred stock dividends                               --           --           --           --           --             --
     Guaranteed value of common stock associated 
          with Dermascan Acquisition                         --           --           --           --           --             --
     Issuance of common stock for technology                 --           --      255,320        2,553           --             --
     Purchase of stock for treasury                          --           --           --           --     (145,000)      (427,102)
     Gain related to the issuance of common 
          stock by Nexar Technologies, Inc.                  --           --           --           --           --             --
     Value ascribed to warrant to purchase 
          common stock issued to Coherent, Inc.              --           --           --           --           --             --
     Net loss                                                --           --           --           --           --             --
                                                       ----------------------------------------------------------------------------

Balance, December 31, 1997                               16,397         $164   45,792,585     $457,926     (345,000)    (1,638,859)
                                                       ============================================================================
</TABLE>

<TABLE>
<S>                                                    <C>           <C>            <C>               <C>              <C>
                                                                                    Unrealized                            Total
                                                       Additional                  (Loss) Gain                         Stockholders'
                                                        Paid-in      Accumulated    on Marketable     Subscriptions       Equity
                                                        Capital        Deficit       Securities        Receivable        (Deficit)
                                                       ----------------------------------------------------------------------------

Balance, December 31, 1996                             104,900,551  $(64,971,200)      (342,500)        $(604,653)     $38,076,591
                                                                                                                              
      Sale of common stock pursuant to warrants, 
          options and Employee Stock Purchase Plan       1,606,083            --             --                --        1,614,234
      Reduction in subscriptions receivable                     --            --             --           604,653          604,653
      Sale of preferred stock, net of issuance 
          cost of approximately $1,000,000              14,999,840            --             --                --       15,000,000
      Issuance of common stock for 1996 employer 
          401(k) matching contribution                     317,280            --             --                --          318,154
      Conversion and redemption of preferred stock      (3,926,317)           --             --                --       (3,865,096)
      Conversion of convertible debentures and 
          issuance of common stock to an investor       16,935,713            --             --                --       17,010,363
      Issuance of common stock for investment 
          banking, merger and acquisition
          and consulting services                           52,925            --             --                --           53,125
      Value ascribed to the discount feature of 
          convertible debentures issued                  3,750,812            --             --                --        3,754,943
      Unrealized gain on marketable securities                  --            --        342,500                --          342,500
      Preferred stock dividends                                 --    (1,584,406)            --                --       (1,584,406)
      Guaranteed value of common stock associated 
          with Dermascan Acquisition                      (216,562)           --             --                --         (216,562)
      Issuance of common stock for technology            1,146,388            --             --                --        1,148,941
      Purchase of stock for treasury                            --            --             --                --         (427,102)
      Gain related to the issuance of common stock 
          by Nexar Technologies, Inc.                    7,409,866            --             --                --        7,409,866
      Value ascribed to warrant to purchase common 
          stock issued to Coherent, Inc.                   380,000            --             --                --          380,000
      Net loss                                                  --   (85,803,891)            --                --      (85,803,891)
                                                       -----------------------------------------------------------------------------
Balance, December 31, 1997                             147,356,579 $(152,359,497)           $--               $--      $(6,183,687)
                                                       =============================================================================
</TABLE>

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


                                       F-7
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<S>                                                        <C>             <C>            <C>

                                                                    Years Ended December 31,
                                                                1995           1996          1997
                                                           --------------  -------------  ------------
Cash Flows from Operating Activities
    Net loss                                               $(12,620,768)  $(37,863,792)  $(85,803,891)
       Less: Net Loss from Discontinued Operations           (4,231,326)   (17,065,534)   (27,434,812)
                                                            -------------  -------------  ------------
    Net Loss from Continuing Operations                      (8,389,442)   (20,798,258)   (58,369,079)
                                                            -------------  -------------  ------------

    Adjustments to reconcile net loss from continuing 
     operations to net cash
     used in operating activities-
       Depreciation and amortization                          1,006,055      2,343,013      2,246,412
       Restructuring and asset write-off costs                       --      3,057,808     12,983,000
       Write-off of in-process research and development              --         57,212             --
       Write-off of intangible assets                                --        631,702             --
       Loss on sale of wholly owned subsidiary                       --             --        165,845
       Write-off of deferred financing costs associated with
          redemption of convertible debentures                       --        201,500         27,554
       Valuation allowances for notes and investments                --             --      1,035,912
       Accrued interest receivable on note
           and subscription receivable                               --       (568,917)            --
       Foreign currency exchange gain                                --       (446,596)      (651,970)
       Noncash interest expense related to debt                 220,280        163,680      5,473,077
       Noncash compensation related to common stock 
           and warrants                                          95,370        836,982        205,238
       Realized gain on marketable securities                        --       (835,197)      (577,969)
       Unrealized (gain) loss on marketable securities         (133,568)    (1,198,174)       669,293
       Changes in assets and liabilities, net of effects
          from business combinations
                Purchases of marketable trading securities     (615,842)   (10,355,055)      (152,938)
                Sale of marketable trading securities and
                interest received on marketable trading 
                securities                                       50,000     10,244,044      2,234,436
          Accounts receivable                                  (734,080)       (82,025)    (1,809,371)
          Inventories                                          (614,364)    (4,661,443)    (3,390,396)
          Other current assets and loans to officers           (407,575)    (1,514,858)    (1,005,781)
          Accounts payable                                    1,046,192      1,243,161      1,378,637
          Accrued liabilites                                  2,141,429      4,762,781      6,494,790
                                                            -------------  ------------- -------------
                Net cash used in operating activities        (6,335,545)   (16,918,640)   (33,043,310)
                                                            -------------  ------------- -------------

Cash Flows from Investing Activities
    Cash acquired from purchase of Spectrum Medical              75,087             --              --
    Technologies, Inc.
    Purchases of property and equipment                        (649,642)    (3,180,112)     (5,777,446)
    Increase in other assets                                   (828,569)    (1,176,527)        (95,830)
    Loans to related parties                                 (3,861,375)    (7,338,625)     (1,250,000)
    Loans to nonrelated parties                                      --     (2,236,531)             --
    Payments received on loans to related parties                    --      9,322,284         941,288
    Guaranteed value associated with --rmascan Acquisition           --             --        (216,562)
    Investment in nonmarketable securities                     (500,000)    (2,077,054)     (1,057,631)
    Increase in organizational costs                           (500,000)            --              --
                                                            -------------  -------------  -------------
                Net cash used in investing activities        (6,264,499)    (6,686,565)     (7,456,181)
                                                            -------------  -------------  -------------

</TABLE>

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


                                       F-8
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<S>                                                       <C>          <C>            <C>

                                                                 Years Ended December 31,
                                                             1995         1996          1997
Cash Flows from Financing Activities                      ----------   ----------     ----------
    Proceeds from issuance of convertible debentures       4,150,000   14,169,441     16,715,169
    Proceeds from notes payable                            1,280,000           --      3,500,000
    Deferred financing costs incurred related to
          convertible debentures                            (182,000)  (1,365,217)            --
    Redemption of convertible debentures                  (1,048,967)    (930,000)      (196,000)
    Payments of notes payable and capital lease 
          obligations                                     (1,291,350)    (260,224)    (4,856,479)
    Proceeds from issuance of common stock                 9,631,148   13,715,287      1,462,121
    Issuance of preferred stock                           19,385,963   30,823,147     15,000,000
    Purchase of treasury stock                            (1,211,757)          --       (427,102)
    Payment of contingent note payable                            --     (500,000)            --
    Redemption of preferred stock, including accrued 
          dividends of $71,223                                    --   (3,194,375)            --
    Payments received on subscriptions receivable                 --    2,009,592             --
    Deferred costs                                                --     (932,661)            --
                                                         ------------ ------------   ------------
                Net cash provided by financing
                activities                                30,713,037   53,534,990     31,197,709
                                                         ------------ ------------   ------------
Net increase (decrease) in cash and cash equivalents      18,112,993   29,929,785     (9,301,782)
Net cash (used in) provided by discontinued operations    (8,677,687) (30,073,633)        12,676
Cash and cash equivalents, beginning of year               3,000,948   12,436,254     12,292,406
                                                         ------------ ------------   ------------
Cash and cash equivalents, end of year                   $12,436,254  $12,292,406     $3,003,300
                                                         ============ ============   ============

Supplemental Disclosure of Cash Flow Information
    Cash paid for interest                                  $125,702     $280,659       $534,037
                                                          ===========  ===========   ============

Supplemental Disclosure of Noncash Financing 
          and Investing Activities
     Conversion of convertible debentures and 
          related accrued interest, net of 
          financing fees                                  $3,190,740   $1,172,762    $17,010,363
                                                          ===========  ===========   ============

    Subscriptions received in connection with warrant
       exercises                                          
          notes payable                                   $1,988,709   $1,057,500            $--
                                                          ===========  ===========   ============

    Issuance of common stock in lieu of payment of
          notes payable                                   $1,879,932          $--            $--
                                                          ===========  ===========   ============

    Conversion of preferred stock                            $86,060     $788,687       $414,904
                                                          ===========  ===========   ============

    Exchange of preferred stock for investment in a
    discontinued      operation                                  $--          $--    ($4,280,000)
                                                          ===========  ===========   ============

    Issuance of common stock for purchase of technology
       related to a discontinued operation                       $--          $--     $1,148,941
                                                          ===========  ===========   ============

    Investment banking and consulting fees for services
       related to the issuance of common stock and
       convertible debentures                               $120,000     $709,224        $53,125
                                                          ===========  ===========   ============

    Issuance of common stock for 1995 and 1996 employer 401(k)
       matching contribution                                     $--     $160,598       $318,154
                                                          ===========  ===========   ============

    Issuance of common stock for minority interest
       in Star Medical subsidiary                                $--   $1,749,723            $--
                                                          ===========  ===========   ============

Acquisition of Spectrum Medical Technologies, Inc.
    Liabilities assumed                                  $(1,128,139)         $--            $--
    Fair value of assets acquired                          1,456,920           --             --
    Fair value of 364,178 shares of common stock issued   (1,000,000)          --             --
    Promissory note issued                                  (700,000)          --             --
    Cash paid                                               (300,000)          --             --
    Acquisition costs incurred                              (161,138)
                                                         ------------  -----------   ------------
Cost in Excess of Net Assets Acquired                    $(1,832,357)         $--            $--
                                                         ============  ===========   ============

</TABLE>

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

                                       F-9
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1)      ORGANIZATION AND OPERATIONS

          Palomar Medical Technologies,  Inc. and subsidiaries ("Palomar" or the
"Company")  are engaged in the commercial  sale and  development of cosmetic and
medical laser systems and services. During the year ended December 31, 1997, the
Company  formed and began  execution  of a plan to  dispose  of its  electronics
segment (see Note 2).

         Some of the Company's  medical laser  products are in various stages of
development,  and as such,  the  success  of future  operations  is subject to a
number  of risks  similar  to those of other  companies  in  similar  stages  of
development.  Principal  among these risks are the  successful  development  and
marketing of the Company's  products,  proper regulatory  approval,  the need to
achieve profitable  operations,  competition from substitute products and larger
companies,  the need to obtain adequate  financing to fund future operations and
dependence on key individuals.

         The  Company has  incurred  significant  losses  since  inception.  The
Company  continues to seek  additional  financing from issuances of common stock
and/or other  potential  sources in order to fund its  operations  over the next
twelve months.  The Company has financed  current  operations,  expansion of its
core business and outside short-term financial investments primarily through the
private sale of debt and equity securities of the Company.  The Company raised a
total  of  approximately  $30,713,000,   $53,535,000  and  $31,198,000  in  such
financings   during  the  years  ended   December  31,  1995,   1996  and  1997,
respectively.  The Company  believes that it will require  additional  financing
during the next  twelve-month  period to continue to fund operations and growth.
The Company may raise  additional  funds through  private sales of the Company's
debt or equity  securities  and sales of its  investment in Nexar  Technologies,
Inc.  ("Nexar")  (see  below).  Sales of  securities  to private  investors  are
generally sold at a discount to the public market for similar securities. It has
been the Company's  experience that private  investors  require that the Company
make its best effort to register  these  securities  for resale to the public at
some future time.

(2)      DISCONTINUED OPERATIONS

         During the fourth  quarter of 1997,  the  Company's  Board of Directors
approved a plan to dispose of the electronics  business segment. The electronics
segment consists of the manufacture and sale of personal computers, high-density
flexible electronics circuitry and memory modules.

         Included  in the  electronics  business  segment is Nexar.  Nexar is an
early-stage company that manufactures, markets and sells personal computers with
a unique  circuit  board that  enables  end users to  upgrade  and  replace  the
microprocessor,  memory  and hard drive  components.  On April 14,  1997,  Nexar
completed an initial public offering of 2,500,000 shares at $9.00 per share, for
net proceeds of approximately  $19,593,000.  The Company recorded an increase in
stockholders' equity of $7,409,866, in accordance with Staff Accounting Bulletin
("SAB") No. 51 as a result of Nexar's  initial  public  offering.  The Company's
accounting policy for gains arising under SAB No. 51 is to recognize these gains
in its statement of  operations to the extent that such gains are  realizable at
the date of each transaction.

        As of the effective date of Nexar's initial public offering, the Company
beneficially owned 6,100,000 shares of Nexar's common stock and 45,684 shares of
Nexar's  convertible  preferred  stock.  In April 1997,  the  Company  purchased
300,000  shares of Nexar's  newly issued  publicly  registered  common stock for
approximately  $2,777,000  from  Nexar's  underwriter  in  a  private  placement
transaction.  The convertible preferred stock is convertible into 406,080 shares
of Nexar's common stock. Pursuant to an agreement between the Company and Nexar,
1,200,000  common shares (the Contingent  Shares) of the total 6,506,080  common
and common equivalent shares of Nexar owned by the Company were placed in escrow
and are subject to a mandatory  repurchase,  in whole or part, by Nexar at $0.01
per share (or  $12,000)  after the 48 month  anniversary  of the initial  public
offering of Nexar's  common stock unless these shares are released  from escrow.
The Contingent  Shares are subject to release to the Company in  installments of
400,000 shares each upon the  achievement of any three of the four milestones as
specified in the agreement  between the Company and Nexar.  The  

                                       F-10
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

milestones are based on Nexar achieving certain revenue and net income levels as
defined  in the  agreement.  On  December  10,  1997,  the  Company  sold  these
contingent shares for $5,000 to an investor.  However, if the investor sells the
escrow  shares for a price in excess of  $240,000,  the  excess  will be paid to
Palomar.

         During the fourth quarter of 1997, the Company reduced its ownership in
Nexar  through the sale of common  stock to private  investors.  At December 31,
1997, the Company  beneficially  owned 3,746,343 shares of Nexar's common stock,
representing approximately a 36% ownership.  Subsequent to year-end, the Company
further  reduced its ownership  through the sale of 500,000  shares to a private
investor for $2,000,000; 400,000 of these shares will be held by a custodian and
released  for sale by the  investor  over the next two years.  The  Company  has
guaranteed  the investor a minimum  selling price of $5.00 a share.  The Company
has  deferred  the  gain on the sale of Nexar  stock  to the  investor  and will
recognize  gains related to these shares as the investor sells them. The Company
plans to liquidate  its  remaining  position in Nexar within the next year.  The
Company has accounted for its  investment in Nexar as a  Discontinued  Operation
using the equity method.  During the years ended December 31, 1996 and 1997, the
Company has  recognized  gains on the  disposition  of Nexar of  $3,830,000  and
$6,221,689,  respectively.  These amounts are included in "Gain on Dispositions"
in the Consolidated Statements of Operations.

         The other entities  included in the  electronics  business  segment are
Dynaco  Corp.   ("Dynaco")  and  Dynaco's  wholly  owned   subsidiaries   Comtel
Electronics, Inc. ("Comtel") and Dynamem, Inc. ("Dynamem"). On December 9, 1997,
the Company  entered into a two-phase  stock  purchase  agreement with Biometric
Technologies  Corporation  ("BTC"). BTC was formed jointly by Dynaco's President
and its Chairman of the Board.  The first phase was  consummated  on December 9,
1997 and consisted of the sale of all of the issued and outstanding common stock
of Comtel and Dynamem in exchange for  $3,654,000  payable in two  installments.
The first  installment  is an $850,000  promissory  note due  February  15, 1998
bearing interest at a rate of prime plus two percent and secured by a Pledge and
Security Agreement. The second installment is a $2.8 million promissory note due
in forty-eight monthly installments,  beginning February 1, 1999. The note bears
interest  at the prime  rate.  This  promissory  note was fully  reserved by the
Company during 1997, as its ultimate collectability is uncertain.

         As part of phase I, the Company  entered  into a Loan and  Subscription
Agreement  with a  creditor  of Comtel  for  $3,233,000.  This  promissory  note
represents  the settlement of amounts owed the creditor by Comtel and guaranteed
by Palomar. Principal and interest payments will be made over twenty-four months
and interest  will accrue at the bank's prime rate plus 2.25%.  This  promissory
note has been  collateralized by 3,250,000 shares of the Company's common stock.
The Company also guarantees $2,500,000 of Comtel's borrowings from this creditor
until October 31, 1998. The  stockholders of BTC have  personally  guaranteed to
the Company payment for any amounts borrowed under this line of credit in excess
of approximately  $1,500,000 in the event that the Company is obligated to honor
this guarantee. The Company also restructured all assets and investments related
to a  significant  customer of Comtel into a $4,000,000  note  receivable.  This
receivable  was fully  reserved  by the Company  during  1997,  as its  ultimate
collectability is uncertain.

         In phase II, which shall occur upon the earlier of BTC's initial public
offering  of stock or June 30,  1998,  BTC will  purchase  all of the issued and
outstanding stock of Dynaco. The phase II purchase price is $5,346,000, of which
$2,673,000  will be paid in cash and $2,673,000 will be paid in BTC common stock
of equal value. Alternatively, the Company may elect to have the entire phase II
purchase paid in cash at a value of $3,500,000.  If phase II is not completed by
June 30, 1998,  the Company will exercise  alternative  options for disposing of
and /or  liquidating  Dynaco.  BTC also has the option to sell Dynaco to a third
party in which case any proceeds  greater than  $3,500,000  will be split evenly
between  BTC  and  Palomar.  The  Company  recognized  a loss  of  approximately
$4,148,000  related to the phase I and phase II  dispositions.  The  Company has
estimated Dynaco's 1998 operating loss through June 30, 1998 to be approximately
$850,000.  These  charges  have  been  netted  in "Gain on  Disposition"  in the
accompanying  Consolidated  Statement  of  Operations.  The  Company  guarantees
$3,000,000 of amounts borrowed by Dynaco to a creditor.  This guarantee  expires
in May 1999.

         Pursuant  to  Accounting  Principles  Board  ("APB")  Opinion  No.  30,
"Reporting  the Results of  Operations - Reporting  the Effects of Disposal of a
Segment of a Business,  and  Extraordinary,  Unusual and Infrequently  Occurring
Events and Transactions," the consolidated  financial  statements of the Company
have  been  reclassified  to  reflect  the  

                                       F-11
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

dispositions of the  aforementioned  subsidiaries  that comprise the electronics
segment.  Accordingly,  the assets and liabilities,  revenues and expenses,  and
cash flows of the  electronics  segment have been excluded  from the  respective
captions  in  the  Consolidated  Balance  Sheets,   Consolidated  Statements  of
Operations and  Consolidated  Statements of Cash Flows.  The net assets of these
entities have been reported as "Net Assets of  Discontinued  Operations"  in the
accompanying  Consolidated  Balance  Sheets;  the net operating  losses of these
entities have been reported as "Net Loss from  Discontinued  Operations"  in the
accompanying Consolidated Statements of Operations;  the net cash flows of these
entities  have been  reported as "Net Cash (Used in)  Provided  by  Discontinued
Operations" in the accompanying Consolidated Statements of Cash Flows.

         Summarized financial  information for the discontinued  operations were
as follows:


<TABLE>
<S>     <C>                                              <C>                 <C>
                                                                   December 31,
                                                             1996                1997
                                                         --------------      --------------
        Current Assets                                     $36,153,021          $5,683,694
        Total Assets                                        46,195,699          11,506,145

        Current Liabilities                                 21,524,767           5,375,353
        Total Liabilities                                   23,224,319           5,680,543

                                                         --------------      --------------
        Net Assets of Discontinued Operations              $22,971,380          $5,825,602
                                                         ==============      ==============
</TABLE>

<TABLE>
<S>          <C>                                       <C>             <C>               <C>

                                                                    Year Ended December 31,
                                                            1995            1996              1997
                                                       --------------- ----------------  ----------------
             Revenues                                     $16,296,224      $52,491,572       $57,663,080

             Net Loss from Discontinued Operations        ($4,231,326)    ($17,065,534)     ($27,434,812)
</TABLE>

         The following is the summarized financial information for Nexar:
<TABLE>
<S>            <C>                            <C>                          <C>    

                                                                  December 31,
                                                        1996                        1997
                                              -------------------------    ------------------------

               Current Assets                              $16,966,851                 $17,810,564
               Non-Current Assets                            2,622,270                   2,098,495
               Current Liabilities                           6,542,296                   7,886,594
               Non-Current Liabilities                      22,817,998                     883,613
</TABLE>

<TABLE>
<S>            <C>                        <C>                    <C>                   <C>

                                                            Period Ended December 31,
                                                1995                  1996                   1997
                                          -----------------      ----------------      -----------------

               Net Revenues                       $619,629           $18,695,364            $33,608,063
               Gross Profit                         45,018             2,302,881                740,151
               Net Loss                         (2,261,434)           (7,510,139)           (13,346,380)
</TABLE>


                                       F-12
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

(3)      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         The  accompanying   consolidated   financial   statements  reflect  the
application of certain accounting  policies described below and elsewhere in the
Notes to Consolidated Financial Statements.

(a)      PRINCIPLES OF CONSOLIDATION

         The  accompanying   consolidated   financial   statements  reflect  the
consolidated  financial  position,  results of operations  and cash flows of the
Company  and  all  wholly  owned  and  majority-owned  subsidiaries.   Nexar,  a
discontinued  entity,  has been accounted for in consolidation  under the equity
method  in  accordance  with  APB No.  30 as  described  in Note  2.  All  other
investments  are  accounted  for using the cost method as the Company  owns less
than 20% of the common stock outstanding for these investments. All intercompany
transactions have been eliminated in consolidation.

(b)      MANAGEMENT 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.  Actual  results  could  differ from those  estimates.  As of
December 31, 1997, the Company has investments in marketable securities totaling
approximately $5,054,000, including amounts totaling $3,604,880 in net assets of
discontinued  operations.  Included in the amount of $3,604,880 is the Company's
financial  reporting  basis for 3,746,343  shares of Nexar common stock that the
Company  beneficially  owns. The amount that the Company may ultimately  realize
from  these  investments  could  differ  materially  from  the  value  of  these
investments recorded in the accompanying consolidated financial statements as of
December 31, 1997.

(c)       INVESTMENTS

         The Company  accounts for  marketable  securities  in  accordance  with
Statement of Financial  Accounting  Standards  ("SFAS") No. 115,  Accounting for
Certain  Investments  in  Debt  and  Equity  Securities.  Under  SFAS  No.  115,
securities  that the  Company  has the  positive  intent and  ability to hold to
maturity are  reported at amortized  cost and  classified  as  held-to-maturity.
There were no  held-to-maturity  securities  as of  December  31, 1996 and 1997.
Securities  purchased to be held for indefinite periods of time and not intended
at the time of purchase to be held until  maturity  are  reported at fair market
value and  classified as  available-for-sale  securities.  Unrealized  gains and
losses  related to  available-for-sale  securities  are  included  as a separate
component  of  stockholders'  equity.   Securities  that  are  bought  and  held
principally  for the  purpose of selling  them in the near term are  reported at
fair market value and classified as trading securities.  Realized and unrealized
gains and losses related to trading  securities are included in the Consolidated
Statements of Operations.  The Company's  investment  portfolios at December 31,
1996 and 1997 consist of the following:


                                       F-13
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


<TABLE>
<S>                                                       <C>           <C>           <C>            <C>

                                                                           December 31, 1996
                                                          --------------------------------------------------------

                                                                           Gross         Gross
                                                           Amortized    Unrealized     Unrealized        Fair
                                                             Cost          Gains         Losses         Value
                                                          ------------  ------------  -------------  -------------
     Trading Securities:
            Equity investments in  publicly
            traded companies                               $1,695,618    $1,537,614      $339,440       $2,893,792

              Available-for-Sale (long-term):
            Equity investments in  publicly
            traded companies                                1,000,000           ---       342,500          657,500

                                                          ------------  ------------  -------------  -------------
                                                           $2,695,618    $1,537,614      $681,940       $3,551,292
                                                          ============  ============  =============  =============




                                                                           December 31, 1997
                                                          --------------------------------------------------------

     Trading Securities:
            Equity investments in  publicly
            traded companies                               $1,050,649      $479,177       $80,500       $1,449,326
                                                          ============  ============  =============  =============
</TABLE>

(d)       INVENTORIES

         Inventories  are stated at the lower of cost  (first-in,  first-out) or
market.  Work-in-process  and finished  goods  inventories  consist of material,
labor and  manufacturing  overhead.  At December 31, 1996 and 1997,  inventories
consist of the following:


                                                        December 31,
                                                  1996                 1997
                                            ----------------    ----------------
         Raw materials                            $4,076,381          $2,928,350
         Work-in-process and finished goods        1,129,573           1,783,124
                                            ----------------    ----------------
                                                  $5,205,954          $4,711,474
                                            ================    ================

(e)      DEPRECIATION AND AMORTIZATION

         The Company  provides for depreciation and amortization on property and
equipment using the straight-line  method by charging to operations amounts that
allocate the cost of assets over their estimated useful lives as follows:

                                                              Estimated
                   Asset Classification                      Useful Life
            ------------------------------------        ----------------------
            Machinery and equipment                           5-8 Years
            Furniture and fixtures                             5 Years
            Leasehold improvements                          Term of Lease


                                       F-14
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

At December 31, 1996 and 1997, property and equipment consist of the following:

<TABLE>
<S>                         <C>                                     <C>                <C>

                                                                                 December 31,
                                                                           1996                1997
                                                                    ----------------   -----------------
                            Machinery and equipment                      $3,177,828          $6,328,442
                            Furniture and fixtures                        1,047,942           1,018,931
                            Leasehold improvements                          407,334             480,453
                                                                    ----------------   -----------------
                                                                          4,633,104           7,827,826
                            Less:  Accumulated depreciation
                                       and amortization                     805,114           1,372,240
                                                                    ----------------   -----------------
                                                                         $3,827,990          $6,455,586
                                                                    ================   =================
</TABLE>

         Included in machinery and equipment as of December 31, 1996 and 1997 is
approximately $884,000 and $3,470,000,  respectively,  of equipment manufactured
by the Company and used in its service business.

(f)      COST IN EXCESS OF NET ASSETS ACQUIRED

         The costs in excess of net assets  for  acquired  businesses  are being
amortized on a straight-line basis over 5 to 7 years.  Amortization  expense for
the years ended  December  31,  1995,  1996 and 1997  amounted to  approximately
$189,000,  $536,000 and $554,000,  respectively,  and is included in general and
administrative expenses in the Consolidated Statements of Operations.

         The Company accounts for long-lived  assets in accordance with SFAS No.
121,  "Accounting  for the  Impairment of Long-Lived  Assets and for  Long-Lived
Assets To Be Disposed Of." Under SFAS No. 121, the Company is required to assess
the valuation of its long-lived  assets,  including cost in excess of net assets
acquired,  based on the  estimated  future  cash flows to be  generated  by such
assets  (see  Note  4).  The  Company  has  assessed  the  realizability  of its
long-lived assets as of December 31, 1997 and believes them to be realizable.

(g)       DEFERRED FINANCING COSTS

         During the years ended December 31, 1996 and 1997, the Company incurred
financing costs related to several issuances of convertible debentures. Deferred
financing  costs are  amortized by a charge to interest  expense over the period
that the debt is outstanding (see Note 6).

(h)      REVENUE RECOGNITION

         The Company  recognizes  product revenue upon shipment.  Provisions are
made at the  time of  revenue  recognition  for any  applicable  warranty  costs
expected to be incurred. Revenues from services, which have not been significant
to date,  are recognized as the services are provided.  International  sales for
the years ended December 31, 1995, 1996 and 1997 were approximately 44%, 22% and
24%, respectively, of total revenue.

(i)      SIGNIFICANT CUSTOMERS

         For the year ended December 31, 1997, one customer accounted for 11% of
revenues  and  51% of  accounts  receivable.  This  customer  is  the  Company's
worldwide distributor of laser systems (see Note 12(e)).

(j)      RESEARCH AND DEVELOPMENT EXPENSES

         The Company charges research and development  expenses to operations as
incurred.

                                       F-15
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

(k)       NET LOSS PER COMMON SHARE

         In March 1997, the FASB issued SFAS No. 128,  Earnings per Share.  This
statement  establishes standards for computing and presenting earnings per share
and applies to entities  with publicly  traded common stock or potential  common
stock.  This  statement is effective for fiscal years ending after  December 15,
1997.  Basic net loss per share was  determined  by  dividing  net income by the
weighted average shares of common stock outstanding during the year. Diluted net
loss per share is the same as basic  earnings  per share  because the  Company's
potentially dilutive securities,  primarily stock options, warrants,  redeemable
preferred stock and convertible debentures are antidilutive.  The calculation of
the Company's net loss per common share from continuing operations for the years
ended December 31, 1995, 1996 and 1997 are as follows:

<TABLE>
<S>                                                <C>                 <C>                <C>

                                                                        December 31,
                                                        1995                1996               1997
                                                   ---------------     ---------------    ----------------
   Net loss from continuing operations               $(8,389,442)       $(20,798,258)       $(58,369,079)
   Preferred stock dividends                            (124,610)         (1,242,751)         (1,584,406)
   Amortization of value ascribed to preferred
   stock conversion discount                                 ---                 ---          (2,823,529)
                                                   ---------------     ---------------    ----------------
   Adjusted net loss from continuing  operations     $(8,514,052)       $(22,041,009)       $(62,777,014)
                                                   ===============     ===============    ================

   Basic net loss per common share from
   continuing operations                                  $(0.60)             $(0.84)             $(1.79)
                                                   ===============     ===============    ================

   Weighted average number of
         common shares outstanding                    14,164,901          26,166,538          35,105,272
                                                   ===============     ===============    ================
</TABLE>


         Net loss from  discontinued  operations per common share is computed by
dividing  the net loss from  discontinued  operations  by the  weighted  average
number of common shares outstanding for the period.

         In 1995, 1996 and 1997, 11,275,200,  17,636,423 and 29,271,031 weighted
average common equivalent shares, respectively, were not included in the diluted
weighted average shares outstanding as they were antidilutive.

(l)      CONCENTRATION OF CREDIT RISK

         SFAS No. 105,  Disclosure of Information  about  Financial  Instruments
with  Off-Balance-Sheet  Risk and Financial  Instruments with  Concentrations of
Credit Risk, requires disclosure of any significant off-balance-sheet and credit
risk  concentrations.  Financial  instruments that subject the company to credit
risk consist primarily of cash and trade accounts receivable. The Company places
its cash in highly rated financial institutions.  The Company has no significant
off-balance-sheet   concentration  of  credit  risk  such  as  foreign  exchange
contracts,  options contracts or other foreign hedging  arrangements.  To reduce
its accounts receivable risk, the Company relies on its worldwide distributor to
assess the  financial  strength  of its end  customers  and,  as a  consequence,
believes  that its  accounts  receivable  credit risk  exposure is limited.  The
Company  maintains an allowance  for  potential  credit  losses.  The  Company's
accounts  receivable  credit risk is not concentrated  within any one geographic
area.

(m)      DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

         SFAS No. 107,  Disclosure  about Fair Value of  Financial  Instruments,
requires  disclosure  of an  estimate  of the fair  value of  certain  financial
instruments.  At December 31, 1996 and 1997, financial  instruments consisted of
principally  convertible  debentures and preferred  stock  financings.  The fair
value of  financial  instruments  pursuant  to SFAS No. 107  

                                       F-16
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

approximated  their carrying  values at December 31, 1996 and 1997.  Fair values
have been  determined  through  information  obtained  from  market  sources and
management estimates.

(n)      RECLASSIFICATIONS

         Certain   reclassifications  have  been  made  to  the  1995  and  1996
consolidated   financial   statements   to  conform  with  the  current   year's
presentation.

(o)      RECENTLY ISSUED ACCOUNTING STANDARDS

         In  February  1997,  the  FASB  issued  SFAS  No.  129,  Disclosure  of
Information about Capital Structure. In June 1997, the FASB issued SFAS No. 130,
Reporting  Comprehensive Income, and SFAS No. 131, Disclosures about Segments of
an Enterprise and Related  Information.  SFAS No. 129, 130 and 131 are effective
for fiscal years  beginning  after December 15, 1997. The Company  believes that
the adoption of these new accounting  standards will not have a material  impact
on the Company's financial statements.

(4)      ASSET WRITE-OFF AND RESTRUCTURING

         In  accordance  with SFAS No. 121,  the Company  determined  during the
third  quarter of 1997 that certain  investments'  carrying  values for both its
continuing  and  discontinued  operations  will  not  be  realizable  due to the
Company's  change in  strategy.  The  Company  has fully  reserved  for all such
investments  from continuing  operations  resulting in a charge of approximately
$10,283,000.

         In the third quarter of 1997,  the Company  recognized a  restructuring
charge of  $2,700,000  based on the  decision  to  discontinue  certain  medical
product and service business units and consolidate others. The majority of these
amounts   relate  to  severance   benefits.   All  expenses   accounted  for  as
restructuring charges were in accordance with the criteria set forth in Emerging
Task Force Issue 94-3,  Liability  Recognition for Certain Employee  Termination
Benefits and Other Costs to Exit an Activity  (Including  Certain Costs Incurred
in a  Restructuring),  and are exclusive of the charges  related to discontinued
operations,  as disclosed in Note 2. During the three months ended  December 31,
1997, the Company paid out  approximately  $718,000 of severance  resulting in a
restructuring  liability  balance of  approximately  $1,982,000  at December 31,
1997.  This  restructuring  liability  will  be paid  in  1998.  As part of this
restructuring, the Company disposed of the following medical businesses:

(a)      TISSUE TECHNOLOGIES, INC.

         On December 16, 1997,  the Company sold assets and certain  liabilities
of Tissue  Technologies,  Inc.  ("Tissue  Technologies"),  a  manufacturer  of a
dermatological  laser  product for the  treatment  of wrinkles to a newly formed
medical laser manufacturer. This medical laser manufacturer was formed by former
executives  of Tissue  Technologies  Inc. In  exchange,  the Company  received a
$500,000  note  receivable  due in  monthly  installments  over the  next  year,
royalties  ranging from 2% to 5% on product  revenue over the next ten years,  a
15% equity position in the newly formed company and a warrant to purchase 10% of
the common stock of the newly formed company at $.50 per share. This transaction
did not have a material  effect on the Company's  operations  for the year ended
December 31, 1997.

(b)      DERMASCAN, INC.

         Subsequent  to year end, the Company  sold  Dermascan,  an  electrology
marketing subsidiary,  back to a Dermascan shareholder for $167,000. This amount
was offset against amounts owed to the Dermascan  shareholder under an agreement
terminated in connection with the Company's sale of Dermascan.  This transaction
did not have a material  effect on the Company's  operations  for the year ended
December 31, 1997.

                                       F-17
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

(c)      PALOMAR TECHNOLOGIES, LTD.

         On January 1, 1998 the Company sold  substantially  all of the business
assets and liabilities of Palomar Technologies, Ltd., a foreign manufacturer, to
a publicly traded company.  The Company received cash of approximately  $200,000
and was relieved of obligations related to the building lease and all employment
agreements.  This  transaction  did not have a material  effect on the Company's
operations for the year ended December 31, 1997.

(5)      INCOME TAXES

         The Company  provides  for income taxes under the  liability  method in
accordance with the provisions of SFAS No. 109,  Accounting for Income Taxes. At
December 31,  1997,  the Company had  available,  subject to review and possible
adjustment  by the  Internal  Revenue  Service,  a federal  net  operating  loss
carryforward  of  approximately  $85,000,000 to be used to offset future taxable
income,  if any. This net operating  loss  carryforward  will begin to expire in
2003. The Internal Revenue Code contains provisions that limit the net operating
loss  carryforwards  due to changes  in  ownership,  as defined by the  Internal
Revenue Code.  The Company  believes that its net operating  loss  carryforwards
will  be  limited  due  to its  reorganization  in  1991  and  subsequent  stock
offerings.  The  Company  has not  recorded  a  deferred  tax  asset for the net
operating  losses,  due to  uncertainty  relating  to the  Company's  ability to
utilize such carryovers.

(6)      LONG-TERM DEBT

         At  December  31,  1996  and  1997,  long-term  debt  consisted  of the
following:


                                                            December 31,
                                                       1996             1997
                                                --------------   ---------------
Dollar denominated convertible debentures           $7,288,063      $10,683,440
Swiss franc denominated convertible debentures       7,222,846               --
Note payable in connection with guarantee on 
    behalf of discontinued subsidiary (See Note 2)          --        3,233,000
Other notes payable                                    651,608          169,588
                                                --------------   ---------------
                                                    15,162,517       14,086,028
Less - current maturities                             (497,377)      (1,640,465)
                                                --------------   ---------------
                                                   $14,665,140      $12,445,563
                                                ==============   ===============

                                       F-18
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

(a)       CONVERTIBLE DEBENTURES

         The  following  table  summarizes  the issuance and  conversion  of the
convertible debentures for the years ended December 31, 1996 and 1997.

<TABLE>
<S>                                                      <C>                <C>             <C>           <C>
                                                                                                             Common
                                                                                                             Shares
                                                                                   Outstanding at            Issued
                                                             Face                   December 31,              Upon
                                                                            -----------------------------
   Series                                                    Value              1996            1997       Conversion
   ----------------------------------------------------  --------------     --------------  ------------- -------------
   3% Series due September 30, 1996                       $    750,000      $          --      $      --        370,189
   6% Series due November 21, 1997                           2,000,000                 --             --      1,172,132
   7% Series due March 31, 2000                              1,100,000                 --             --             --
   7% Series due July 1, 2000                                1,200,000                 --             --        401,549
   8% Series due October 26, 1997                            1,000,000                 --             --         34,615
   4.5% Series due October 21, 1999, 2000, 2001              5,000,000          3,761,038        100,000      1,381,264
   5% Series due December 31, 2001                           5,000,000          3,527,025        923,439      2,074,992
   5% Series due January 13, 2002                            1,000,000                 --      1,000,000             --
   5% Series due March 10, 2002                              5,500,000                 --      1,160,001      3,094,677
   6% Series due March 13, 2002                                500,000                 --        500,000             --
   6%, 7% and 8% Series due September 30, 2002               7,000,000                 --      7,000,000             --
   4.5% Series denominated in Swiss francs
        due July 3, 2003                                     7,669,442          7,222,846             --        914,028
                                                         --------------     --------------  ------------- -------------

                                                           $37,719,442        $14,510,909    $10,683,440     9,443,446
                                                         ==============     ==============  ============= =============
</TABLE>

         On January 13, 1997,  the Company  issued  $1,000,000 of 5% convertible
debentures due January 13, 2002. The  convertible  debentures  have a conversion
price equal to 85% of the  average  closing  bid price of the  Company's  common
stock price as defined,  provided that in any thirty-day  period,  the holder of
these  debentures  may  convert no more than 33% (or 34% in the last  thirty-day
period  available for conversion) of the debentures.  The Company has ascribed a
value of $176,471 for the discount conversion feature.

         On March 10, 1997,  the Company  issued  $5,500,000  of 5%  convertible
debentures  due March 10, 2002.  The  convertible  debentures  have a conversion
price of 100% of the Company's average stock price, as defined, within the first
90 days and 90% of the average stock price, as defined,  thereafter. The Company
has ascribed a value of $611,111 for the 10% conversion discount.

         It is the Company's policy to discount convertible  debentures based on
the discount  conversion  price and amortize the discount to operations over the
expected life of the  convertible  debentures,  which in most cases is less than
the term of the debentures.  Accordingly,  the Company has credited the ascribed
value for the discount features described above to additional paid-in capital.

         On March 13,  1997,  the  Company  issued  $500,000  of 6%  convertible
debentures  due March 13, 2002.  The  convertible  debentures  have a conversion
price of $11.00. In addition,  after 90 days, the debentureholder may convert no
more than one-third of the debenture in any thirty-day  period.  The Company has
accounted for these debentures at face value.

         On September 30, 1997,  the Company  issued  $7,000,000 of  convertible
debentures due September 30, 2002. The debentures  bear interest at a rate of 6%
for  the  first  179  days,  7%  for  days  180-269  and  8%   thereafter.   The
debentureholders were also issued 413,109 shares of common stock related to this
financing.  The fair market  value of the 

                                       F-19
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

common stock was  $1,050,000  and this amount is being  treated as debt discount
and amortized to interest expense. The convertible  debentures have a conversion
price of 100% of the Company's average stock price as defined. In addition,  the
debentureholder may convert no more than 33% in any thirty-day period (or 34% of
the  debentures in the last thirty day period).  The Company also has redemption
rights related to this financing.  (See Note 13.) The Company incurred  deferred
financing costs of $350,000 relating to the issuance of these debentures.

         On July 3, 1996, the Company raised  approximately  $7,669,000  through
the issuance of 9,675 units in a convertible  debenture  financing.  These units
are traded on the Luxembourg Stock Exchange. Each unit consists of a convertible
debenture  denominated in 1,000 Swiss francs and a warrant to purchase 24 shares
of the Company's  common stock at $16.50 per share and is due July 3, 2003.  The
warrants are  non-detachable and may be exercised only if the related debentures
are simultaneously converted, redeemed or purchased. Interest on the convertible
debentures accrues at a rate of 4.5% per annum and is payable quarterly in Swiss
francs. The convertible  debentures are convertible by the holder or the Company
commencing  October 1, 1996 at a conversion price equal to from 100% to 77.5% of
the applicable  conversion price,  calculated as defined. The Company ascribed a
value of  $1,917,360  to the  discount  conversion  feature  of the  convertible
debenture.  This amount was being amortized to interest expense over the life of
the Swiss franc  convertible  debenture.  During 1997, the Company  redeemed 300
units of this convertible debenture financing for $195,044.

         On October 16, 1997, the Company brought a declaratory  judgment action
in  the  United  States  District  Court  against  certain  of the  Swiss  franc
debentureholders.  Prior to this suit, those  debentureholders  had alleged that
the Company  was in breach of certain  protective  covenants  and on October 22,
1997, they brought suit based on these claims. On November 13, 1997, the Company
exercised its right to convert  9,375 units into 914,028  shares of common stock
and  cash  of  approximately   $36,000.   The  unamortized   discount   totaling
approximately $1,784,000 was amortized to interest expense upon conversion.  The
Company has  accounted  for these  debentures  as converted in the  accompanying
financial  statements.  The ongoing  litigation will be accounted for under SFAS
No. 5, Accounting for Contingencies (see Note 12(d)).

         The  Company  incurred   deferred   financing  costs  of  approximately
$2,038,000  and  $769,000  relating to the  issuance of  convertible  debentures
during the years ended  December  31, 1996 and 1997,  respectively.  These costs
have been reflected as deferred financing costs in the accompanying consolidated
balance sheets and are being amortized to interest  expense over the term of the
related convertible  debentures.  During the years ended December 31, 1995, 1996
and 1997, the Company amortized  approximately $71,000,  $78,000 and $276,000 to
interest expense,  respectively.  Any remaining  unamortized  deferred financing
costs are recorded to additional  paid-in  capital upon  conversion.  During the
years ended  December  31, 1996 and 1997,  the Company  amortized  approximately
$41,000 and $1,820,000, respectively, of unamortized deferred financing costs to
additional paid-in-capital.

         During the years ended  December 31, 1995,  1996 and 1997,  the Company
recorded  approximately  $168,000,  $77,000  and  $5,444,000,  respectively,  of
interest  expense  related to the  amortization  of the discount of  convertible
debentures.

(b)       FUTURE MATURITIES OF LONG-TERM DEBT

         Future  maturities  of notes  payable,  capital lease  obligations  and
convertible  debentures  reflected  at face value as of December 31, 1997 are as
follows:

                   1998                     $ 1,640,465
                   1999                       1,699,740
                   2000                          65,237
                   2001                       1,988,679
                   2002                       8,691,907
                                            =============
                                             $14,086,028
                                            =============

                                       F-20
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

(7)      STOCKHOLDERS' EQUITY

(a)      COMMON STOCK

         On February 28, 1997,  the Company  entered into an Asset  Purchase and
Settlement  Agreement  with a former  officer of Nexar.  Under the terms of this
agreement,  Palomar paid  approximately  $1,601,000  in cash and issued  255,320
shares of its common stock in exchange for rights to technology. The total value
of  this  purchased  technology  of  $2,750,000  was  transferred  to  Nexar,  a
discontinued  entity,  in  accordance  with the Asset  Purchase  and  Settlement
Agreement between the Company and Nexar.

         During the year ended  December 31,  1997,  the Company  issued  20,000
shares of common stock in connection with advisory services.

         On  December  31,  1997,  in  connection  with the  discontinuation  of
Dynaco's operations,  the Company entered a Security Agreement-Stock Pledge with
a bank. Pursuant to this agreement,  the Company pledged 3,250,000 shares of its
common  stock to the bank as security  for a guaranty  by the Company  (Note 2).
These shares are held in escrow, are not entitled to vote and are not considered
outstanding as of December 31, 1997.

(b)      PREFERRED STOCK

         The Company is authorized to issue up to 5 million  shares of preferred
stock,  $.01 par  value.  As of  December  31,  1996 and 1997,  preferred  stock
authorized, issued and outstanding consists of the following:

<TABLE>
<S>    <C>                                                                                        <C>              <C>

                                                                                                  1996             1997
                                                                                                  ----             ----

       Redeemable  convertible  preferred  stock,  Series  E, $.01 par value per
         share Authorized - 10,000 shares
         Issued and outstanding - 2,151 shares in 1996, liquidation preference of $2,235,615      $ 22            $  --
       Redeemable convertible preferred stock, Series F, $.01 par value per share
         Authorized - 6,000 shares
         Issued and outstanding - 6,000 shares in 1997, liquidation preference of $6,748,500
                                 at December 31, 1997                                               60               60
       Redeemable  convertible  preferred  stock,  Series  G, $.01 par value per
         share  Authorized - 10,000 shares Issued and outstanding - 2,684 shares
         in 1997, liquidation preference of $2,934,742
                                 at December 31, 1997                                              100               27
       Redeemable  convertible  preferred  stock,  Series  H, $.01 par value per
         share  Authorized - 16,000 shares Issued and outstanding - 7,690 shares
         in 1997, liquidation preference of $8,031,232
                                 at December 31, 1997                                               --               77

                                                                                                   ----            ----
           Total preferred stock                                                                   $182            $164
                                                                                                   ====            ====
</TABLE>


         The  Series  F  redeemable   convertible  preferred  stock  ("Series  F
Preferred"),  together with any accrued but unpaid  dividends,  may be converted
into common  stock at 80% of the  average  closing bid price for the ten trading
days preceding the conversion date, but in no event less than $3.00 or more than
$16.00.  This conversion floor was decreased by the two parties from an original
price of $7.00.  The Series F Preferred may be redeemed at the Company's  option
as defined,  with no less than 10 days' and no more than 30 days' notice or when
the stock price exceeds $16.80 per share for sixty consecutive  trading days, at
an amount equal to the amount of  liquidation  preference  determined  as of the
applicable  

                                       F-21
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

redemption date.  Dividends are payable  quarterly at 8% per annum in arrears on
March 31, June 30,  September  30 and  December  31.  Dividends  not paid on the
payment  date,  whether  or not such  dividends  have been  declared,  will bear
interest at the rate of 10% per annum until paid.

         The  Series  G  redeemable   convertible  preferred  stock  ("Series  G
Preferred"),  together with any accrued but unpaid  dividends,  may be converted
into common  stock at 85% of the average  closing bid price for the five trading
days preceding the conversion  date, but in no event less than $.01. On December
31, 1997,  the Company and the holder of the remaining  2,684 shares of Series G
Preferred entered into an Exchange Agreement. The conversion floor was decreased
by the two parties from an original  floor of $6.00.  In addition,  beginning on
March 1, 1998,  for any  thirty-day  period,  the holder may  exchange a limited
amount of the Series G Preferred  ("exchangeability amount") and any accrued but
unpaid  dividends  for common stock at 85% of the average  closing bid price for
the five trading days  preceding the  conversion  date  ("exchange  date").  The
exchangeability   amount   increases  as  the  exchange  rate   increases.   The
exchangeability amount ranges from 268 shares of preferred stock for an exchange
rate below $2.00 to 1,072  shares of  preferred  stock for an  exchange  rate in
excess of $4.00.  The Series G Preferred may be redeemed at the Company's option
at any time, with no less than 15 days' and no more than 20 days' notice,  at an
amount equal to the sum of (a) the amount of liquidation  preference  determined
as of the  applicable  redemption  date plus (b) $176.50.  Dividends are payable
quarterly  at 7% per annum in arrears on January 1, April 1, July 1 and  October
1.  Dividends not paid on the payment date,  whether or not such  dividends have
been declared, will bear interest at the rate of 12% per annum until paid.

         The conversion price for the Series F and G Preferred is adjustable for
certain  dilutive  events,  as  defined.  The  Series F and G  Preferred  have a
liquidation  preference  equal to  $1,000  per share of  redeemable  convertible
preferred  stock,  plus  accrued  but unpaid  dividends  and  accrued but unpaid
interest.  The  Series F and G  Preferred  stockholders  do not have any  voting
rights except on matters affecting the Series F and G Preferred.

         During the first and second quarters of 1997, the Company issued 16,000
shares of Series H redeemable convertible preferred stock ("Series H Preferred")
for  $16,000,000  with attendant  financing  costs of  $1,000,000.  The Series H
Preferred  accrues  dividends  at  rates  varying  from 6% to 8% per  annum,  as
defined. The Series H Preferred, including any accrued but unpaid dividends, may
be converted  into common stock at 100% of the average stock price,  as defined,
for the first 179 days from the closing date, 90% of the average stock price, as
defined,  for the  following  90 days and 85% of the  average  stock  price,  as
defined,  thereafter.  The conversion  price is adjustable for certain  dilutive
events, as defined.  The holders are restricted for the first 209 days following
the closing date to converting no more than 33% of the Series H Preferred in any
thirty-day  period  (or  34% in  the  last  thirty-day  period).  Under  certain
conditions,  the  Company  has the right to redeem the Series H  Preferred.  The
Company has ascribed a value of $2,823,529 to the discount conversion feature of
the Series H Preferred,  which is being  amortized as an  adjustment to earnings
available  to common  shareholders  over the most  favorable  conversion  period
attainable to the holders (270 days from the date of issuance).

         During  the year ended  December  31,  1997,  the  following  shares of
preferred stock,  accrued premium,  dividends,  interest and other related costs
were converted into shares of common stock as follows:

<TABLE>
<S>          <C>             <C>                   <C>                               <C>                   <C>

               Number of                               Additional Dollar Amount
 Preferred     Preferred       Dollar Amount of      Converted, Including Accrued                           Number of Common
   Stock         Shares        Preferred Stock       Premium, Dividends, Interest        Total Dollar       Shares Converted
  Series       Converted          Converted            and Other Related Costs         Amount Converted           Into
------------ --------------- --------------------- --------------------------------- --------------------- -------------------

     E            2,128            $2,128,000                   $126,366                   $2,254,366            332,859
     G            7,316             7,316,000                    438,234                    7,754,234            602,824
     H            8,310             8,310,000                    228,411                    8,538,411          5,204,158
             --------------- --------------------- --------------------------------- --------------------- -------------------

                 17,754           $17,754,000                   $793,011                  $18,547,011          6,139,841
</TABLE>

                                       F-22
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

         In addition to the 602,824 shares of common stock issued related to the
Series G  Preferred  conversion,  the  Company  issued to the Series G Preferred
stockholder  $47,731 in cash  dividends and 956,388 shares of Nexar common stock
valued at $4,671,597.

(c)      STOCK OPTION PLANS AND WARRANTS

         (i)      STOCK OPTIONS

         The Company has several  Stock Option Plans (the  "Plans") that provide
for the issuance of a maximum of 4,350,000 shares of common stock,  which may be
issued as incentive stock options  ("ISOs") or nonqualified  options.  Under the
terms of the Plans,  ISOs may not be granted at less than the fair market  value
on the date of grant (and in no event less than par  value);  in  addition,  ISO
grants to holders of 10% of the combined  voting power of all classes of Company
stock  must be granted  at an  exercise  price of not less than 110% of the fair
market  value  at the  date  of  grant.  Pursuant  to  the  Plans,  options  are
exercisable at varying dates, as determined by the Board of Directors,  and have
terms not to exceed 10 years (five years for 10% or greater  stockholders).  The
Board of  Directors,  at the request of the  optionee,  may, at its  discretion,
convert the optionee's ISOs into  nonqualified  options at any time prior to the
expiration of such ISOs.

         During the year ended December 31, 1997, the Company granted options to
certain Tissue Technologies  employees to purchase an aggregate of 60,845 shares
of common stock at an exercise  price of $.01 per share in settlement of a stock
option dispute. The employees  simultaneously  exercised these options. The fair
market value of the common stock issued totals approximately $152,000, which has
been  reflected  as a charge  in the  accompanying  Consolidated  Statements  of
Operations.

         The Company's  Star  subsidiary,  manufacturer  of the Company's  diode
laser,  also has  established a stock option plan that provides for the issuance
of both nonqualified options and ISOs. In the year ended December 31, 1996, Star
granted a total of 140,000  options to purchase  Star's common stock to officers
and employees at exercise  prices ranging from $2.50 to $9.50 per share.  In the
year ended December 31, 1996, an individual exercised 20,000 shares at $2.50 per
share; in addition,  12,000 shares at $6.00 per share were canceled. In the year
ended December 31, 1997,  Star granted a total of 50,500 options to purchase its
common stock to employees at an exercise  price of $19.00 per share.  During the
year ended  December 31,  1997,  no options  were  exercised or canceled.  As of
December 31, 1997,  options to purchase  255,500  shares of Star common stock at
prices ranging from $2.50 to $19.00 per share are outstanding.

                                       F-23
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

         The following table summarizes all stock option activity of the Company
for the years ended December 31, 1995, 1996 and 1997:

<TABLE>
<S>                                                             <C>              <C>                 <C>
                                                                 Number of          Exercise              Weighted Average
                                                                   Shares             Price             Exercise Price
                                                                -------------    ----------------    ----------------------
Outstanding, December 31, 1994                                     1,047,500         $1.00-$3.50             $2.25
            Granted                                                  820,235           0.40-3.00              1.75
            Exercised                                               (285,000)          1.00-3.50              1.76
            Canceled                                                 (75,000)               2.375             2.375
                                                                -------------    ----------------    ----------------------
Outstanding, December 31, 1995                                     1,507,735         $0.40-$3.50             $2.06
            Granted                                                1,520,000          6.00-10.50              7.08
            Exercised                                               (366,735)          0.40-3.50              1.28
            Canceled                                                  (5,000)               3.00              3.00
                                                                -------------    ----------------    ----------------------
Outstanding, December 31, 1996                                     2,656,000        $2.00-$10.50             $5.03
            Granted                                                1,747,345           0.01-6.50              2.53
            Exercised                                               (214,845)          0.01-3.00              1.62
            Canceled                                              (1,206,100)        2.375-10.50              6.23
                                                                -------------    ----------------    ----------------------
Outstanding, December 31, 1997                                     2,982,400         $1.50-$8.00             $3.33
                                                                =============    ================    ======================
Exercisable, December 31, 1997                                     1,657,565         $2.00-$8.00             $3.48
                                                                =============    ================    ======================
Available for future issuances under the Plans
            as of December 31, 1997                                  725,255
                                                                =============
</TABLE>

         The range of  exercise  prices  for  options  outstanding  and  options
exercisable at December 31, 1997 is as follows:
<TABLE>
<S>                  <C>              <C>                    <C>                        <C>            <C>

                                Options Outstanding                                              Options Exercisable
------------------------------------------------------------------------------------    --------------------------------------

                                        Weighted Average
     Range of            Options            Remaining           Weighted Average           Options        Weighted Average
  Exercise Prices      Outstanding      Contractual Life         Exercise Price          Exercisable       Exercise Price
-------------------- ---------------- ---------------------- -----------------------    -------------- -----------------------
   $1.50 - $2.50           2,415,900       3.39 years                $2.36                  1,257,733          $2.30
   $3.00 - $3.50              66,500       1.65 years                 3.23                     66,500           3.23
       $8.00                 500,000       3.65 years                 8.00                    333,332           8.00
-------------------- ---------------- ---------------------- -----------------------    -------------- -----------------------
                           2,982,400       3.40 years                $3.33                  1,657,565          $3.48
                     ================ ====================== =======================    ============== =======================
</TABLE>

         The Company accounts for its stock-based  compensation  plans under APB
Opinion No. 25,  Accounting for Stock Issued to Employees.  In October 1995, the
FASB issued SFAS No. 123,  Accounting  for  Stock-Based  Compensation,  which is
effective  for fiscal years  beginning  after  December  15, 1995.  SFAS No. 123
established a fair-value-based method of accounting for stock-based compensation
plans. The Company has adopted the  disclosure-only  alternative  under SFAS No.
123 which requires  disclosure of the pro forma effects on earnings per share as
if SFAS No. 123 had been adopted, as well as certain other information.

         The Company has computed the pro forma disclosures  required under SFAS
No. 123 for all stock  options  granted to employees of the Company in the years
ended  December 31, 1996 and 1997 using the  Black-Scholes  option pricing model
prescribed by SFAS No. 123. The pro forma  disclosure for the Company's  results
of  operations  related  to  stock  option  plans at its  Star  subsidiary  were
immaterial for the years ended December 31, 1996 and 1997.

                                       F-24
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

         The assumptions used to calculate the SFAS No. 123 pro forma disclosure
and the weighted average information for the years ended December 31, 1995, 1996
and 1997 for the Company are as follows:
<TABLE>
<S>                                                 <C>                   <C>                   <C>

                                                                             December 31,
                                                            1995                1996                   1997
                                                    -------------------   -----------------     -------------------

Risk-free interest rate                                    6.08%               6.37%                  6.09%
Expected dividend yield                                      -                   -                      -
Expected lives                                           3.2 years           4.4 years              3.69 years
Expected volatility                                         55%                 79%                    79%
Weighted-average grant date fair value of
     Options granted during the period                     $3.92               $4.57                  $2.06

</TABLE>

         The weighted fair market value and weighted  exercise  price of options
granted for the Company in the years ended December 31, 1995,  1996 and 1997 are
as follows:

<TABLE>
<S>                                                       <C>                <C>                  <C>

                                                                                December 31,
                                                              1995                 1996                 1997
                                                          --------------     -----------------    -----------------

Weighted average exercise price for options:
     Whose  exercise price exceeded fair market value at
      the date of grant                                       $3.00              $10.00               $2.53
     Whose  exercise  price  was  equal  to fair  market
      value at the date of grant                              $1.614              $6.875                  $-
Weighted Average Fair Market Value for options:
     Whose  exercise price exceeded fair market value at
      the date of grant                                       $2.125              $8.875               $1.87
     Whose  exercise  price  was  equal  to fair  market
      value at the date of grant                              $5.265              $6.875                  $-

</TABLE>

         (ii)     WARRANTS

         The following table  summarizes all warrant activity of the Company for
the years ended December 31, 1995, 1996 and 1997:

<TABLE>
<S>                                                      <C>               <C>               <C>

                                                                                                 Weighted
                                                           Number of          Exercise            Average
                                                             Shares             Price         Exercise Price
                                                         ----------------  ----------------  ------------------
Outstanding, December 31, 1994                                 4,554,862      $0.60-$15.00         $5.39
              Granted                                          4,835,155         0.01-7.50          2.36
              Exercised                                       (2,840,093)        0.60-5.00          3.86
                                                         ----------------  ----------------  ------------------
Outstanding, December 31, 1995                                 6,549,924      $0.01-$15.00         $3.82
              Granted                                          6,527,576        4.88-16.50          8.16
              Exercised                                       (3,101,261)        0.01-7.69          2.66
                                                         ----------------  ----------------  ------------------
Outstanding, December 31, 1996                                 9,976,239      $0.60-$16.50         $7.02
              Granted                                          2,793,187        2.50-8.875          4.29
              Exercised                                         (584,879)        0.60-7.50          2.10
              Canceled                                        (2,186,517)       1.00-16.50          6.65
                                                         ----------------  ----------------  ------------------
Outstanding, December 31, 1997                                 9,998,030      $2.00-$15.00         $6.65
                                                         ================  ================  ==================
Exercisable, December 31, 1997                                 8,233,020      $2.00-$15.00         $7.01
                                                         ================  ================  ==================
</TABLE>
                                       F-25
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

         The range of exercise  prices for warrants  outstanding and exercisable
at December 31, 1997 is as follows:
<TABLE>
<S>                  <C>              <C>                    <C>                        <C>            <C>

                               Warrants Outstanding                                             Warrants Exercisable
------------------------------------------------------------------------------------    --------------------------------------

                                        Weighted Average
     Range of           Warrants            Remaining           Weighted Average          Warrants       Weighted Average
  Exercise Prices      Outstanding      Contractual Life         Exercise Price          Exercisable      Exercise Price
-------------------- ---------------- ---------------------- -----------------------    -------------- ----------------------

      $2.00 - $3.50        2,535,452       3.29 years                  $2.68                1,970,452          $2.52
      $4.00 - $5.25        1,802,420       2.85 years                   4.89                1,402,412           4.99
      $6.00 - $7.50        3,000,000       3.25 years                   6.83                2,399,999           7.03
     $7.69 - $15.00        2,660,158       3.25 years                   6.83                2,460,157           7.03
                     ---------------- ---------------------- -----------------------    -------------- ----------------------
                           9,998,030       3.19 years                  $6.65                8,233,020          $7.01
                     ================ ====================== =======================    ============== ======================
</TABLE>

         The Company has computed the pro forma disclosures  required under SFAS
No. 123 for all warrants  granted in the years ended  December 31, 1996 and 1997
using the Black-Scholes option pricing model prescribed by SFAS No. 123.

         The assumptions used to calculate the SFAS No. 123 pro forma disclosure
and the weighted average information for the years ended December 31, 1995, 1996
and 1997 for the Company are as follows:
<TABLE>
<S>                                                   <C>                  <C>                   <C>

                                                                              December 31,
                                                           1995                  1996                  1997
                                                      ----------------     ------------------    ------------------
Risk-free interest rate                                    6.01%                  5.93%                6.13%
Expected dividend yield                                      -                     -                     -
Expected lives                                           4.8 years             5.9 years            4.44 years
Expected volatility                                         56%                    79%                   79%
Weighted-average grant date fair value of
     warrants granted during the period                    $1.81                 $5.39                 $2.17
Weighted-average exercise price of  warrants
     granted during the period                             $2.36                 $8.16                 $4.29

</TABLE>

         The weighted average  fair-value and weighted average exercise price of
warrants  granted by the Company for the years ended December 31, 1995, 1996 and
1997 are as follows:
<TABLE>
<S>                                                           <C>                 <C>                <C>

                                                                                   December 31,
                                                                   1995                1996                1997
                                                              ----------------    ---------------    -----------------

Weighted average exercise price for warrants:
     Whose  exercise  price  exceeded  fair market  value at
       date of grant                                               $2.72              $11.76              $4.30
     Whose  exercise  price was less than fair market  value
       at date of grant                                            $3.17               $7.07              $7.50
     Whose  exercise price was equal to fair market value at
       date of grant                                               $1.98               $6.67              $3.25
Weighted average fair market value for warrants:
     Whose  exercise  price  exceeded  fair market  value at
       date of grant                                               $2.18               $9.34              $2.09
     Whose  exercise  price was less than fair market  value
       at date of grant                                            $4.96               $8.82              $8.13
     Whose  exercise price was equal to fair market value at
       date of grant                                               $2.86               $6.67              $3.25
</TABLE>

                                       F-26
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

         (iii)    PRO FORMA DISCLOSURE

         The pro forma  effect on the Company of  applying  SFAS No. 123 for all
options and warrants to purchase common stock would be as follows:
<TABLE>
<S>                                                     <C>                       <C>                       <C>

                                                                                      December 31,
                                                               1995                       1996                   1997
                                                        --------------------      ----------------------    ----------------

Pro forma net loss from continuing operations              $(18,499,644)              $(48,292,780)          $(62,020,782)
Pro forma basic and dilutive net loss per share from
    continuing operations                                     $(1.31)                    $(1.89)                $(1.89)
</TABLE>

(d)      RESERVED SHARES

         At December  31, 1997,  the Company has  reserved  shares of its common
stock for the following:


             Warrants                                       9,998,030
             Stock option plans                             3,709,504
             Convertible debentures                         8,212,815
             Preferred stock                                8,077,786
             Employee Stock Purchase Plan                     984,623
             Employee 401(k) Plan                             166,674
                                                      ---------------
                                   Total                   31,149,432
                                                      ===============

         From  January 1, 1998  through  February 6, 1998,  5,473,265  shares of
common stock were issued in connection with the items above.

 (e)      STOCK PURCHASE PROGRAM

         During the year ended December 31, 1997, the Company  purchased 145,000
shares  of its  common  stock  at an  aggregate  cost of  $427,102  as part of a
treasury  stock  purchase  program  approved by its Board of Directors in May of
1997.

(f)      EMPLOYEE STOCK PURCHASE PLAN

         In June 1996, the Board of Directors  established  the Palomar  Medical
Technologies,  Inc. 1996 Employee  Stock  Purchase Plan (the  "Purchase  Plan").
Under the Purchase Plan, all employees, as defined, are eligible to purchase the
Company's  common  stock at an  exercise  price  equal to 85% of the fair market
value of the  common  stock  with a  lookback  provision  of three  months.  The
Purchase Plan provides for issuance of up to 1,000,000 shares under the Purchase
Plan. During the year ended December 31, 1997, employees purchased 15,377 shares
of the Company's common stock for approximately $40,000 pursuant to the Purchase
Plan.

(8)      RESEARCH & PRODUCT DEVELOPMENT AGREEMENTS

         During  1995,  the  Company  entered  into a multiyear  agreement  with
Massachusetts  General Hospital ("MGH"),  whereby MGH agreed to conduct clinical
trials on a laser  treatment for hair  removal/reduction  invented by Dr. R. Rox
Anderson,  Wellman  Laboratories  of  Photomedicine,  MGH.  MGH will provide the
Company  with data  previously  generated by Dr.  Anderson and further  clinical
research on the ruby laser device at MGH and other sites and remit  ownership of
all case report forms and data resulting from the study.

                                       F-27
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

         Effective  February 14, 1997,  the Company  amended the 1995  agreement
with MGH. The Company  agreed to provide MGH with a grant of $203,757 to perform
research and  evaluation in the field of hair removal.  The Company  immediately
paid $50,090 upon  execution of this  agreement,  and the Company paid a license
fee of $10,000 within thirty days of this amendment.  As consideration  for this
amended license, the Company is obligated to pay to MGH royalties of up to 5% on
net revenues as defined (See Note 12 (b)). In March 1997, the U.S. Patent Office
issued a patent protecting the laser-based hair removal technology  developed by
Dr. Anderson at MGH, for which Palomar is the exclusive worldwide licensee.

(9)      ACCRUED LIABILITIES

         At  December  31,  1996 and 1997,  accrued  liabilities  consist of the
following:
<TABLE>
        <S>                                      <C>                   <C>

                                                              December 31,
                                                       1996                  1997
                                                 ----------------      ---------------
        Payroll and consulting costs                   $2,596,867           $1,535,013
        Royalties                                         843,345              853,808
        Settlement costs                                1,755,000            1,457,020
        Warranty                                        2,854,401            2,583,677
        Deferred revenue                                  256,912            3,154,395
        Restructuring                                          --            1,981,907
        Interest and preferred stock dividends            579,739            1,659,709
        Other                                           2,089,045            3,688,720
                                                 ----------------      ---------------
            Total                                     $10,975,309          $16,914,249
                                                 ================      ===============
</TABLE>

(10)     RELATED PARTY TRANSACTIONS

         At December 31, 1996 and 1997,  approximately  $948,000 and $478,000 of
loans receivable with interest at the rate of 7% per annum were outstanding from
the former CEO and President, respectively. No amounts are currently outstanding
under these loans.  During the fourth quarter of 1997, the Company's  former CEO
paid back his outstanding loan balance,  which totaled approximately  $1,029,000
as of  September  30,  1997.  The  former  CEO made  payments  in both  cash and
marketable  securities.  In the first  quarter  of 1998,  the  Company's  former
President paid back his outstanding loan.

(11)     401(K) PROFIT SHARING PLAN

         The Company  has a 401(k)  profit  sharing  plan (the  "Profit  Sharing
Plan") which covers  substantially all employees who have attained the age of 18
and are  employed  at  year-end.  Employees  may  contribute  up to 15% of their
salary,  as defined,  subject to  restrictions  defined by the Internal  Revenue
Service. The Company is obligated to make a matching  contribution,  in the form
of the Company's  common stock, of 50% of all employee  contributions  effective
January 1, 1995. The Company contributions vest over a three-year period.

         During 1997,  the Company  issued  87,441 shares of its common stock to
the Profit Sharing Plan in  satisfaction  of its $318,154  employer match of the
1996 employee  contributions.  For the year ended December 31, 1997, the Company
has accrued  $250,000 for the 1997 match,  which will be made in common stock in
April 1998.

                                       F-28
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

(12)     COMMITMENTS AND CONTINGENCIES

(a)      OPERATING LEASES

         The Company has entered into various operating leases for its corporate
office,  research  facilities and  manufacturing  operations.  These leases have
monthly rents ranging from  approximately  $2,000 to $34,000,  adjusted annually
for  certain  other costs such as  inflation,  taxes and  utilities,  and expire
through May 31, 2000. The Company  guarantees  certain  subsidiaries'  operating
leases.

         Future  minimum  payments  under  the  Company's  operating  leases  at
December 31, 1997 are approximately as follows:

         December 31,
             1998                             $683,000
             1999                              549,000
             2000                              246,000
                                          -------------
                                            $1,478,000
                                          =============

(b)      ROYALTIES

         The  Company  is  required  to pay a royalty  of up to 5% of "net laser
sales," as  defined,  under a royalty  agreement  with MGH (see Note 8). For the
years ended December 31, 1995, 1996 and 1997,  approximately $167,000,  $175,000
and  $854,000  of  royalty  expense,   respectively,  was  incurred  under  this
agreement.  These  amounts  are  included  in cost of sales in the  accompanying
consolidated statement of operations.

         A  former   employee  and  previous  owner  of  one  of  the  Company's
subsidiaries is paid a 1% commission on the net sales of certain ruby lasers and
diode lasers, as defined.  These commissions will be paid through March 31, 2000
and are to be no less than $450,000. In accordance with the settlement agreement
with  this  individual,  the  Company  paid  advances  on  commissions  totaling
$450,000: $200,000 in 1997 and $250,000 in January 1998. (See Note 10.)

(c)      YEAR 2000 (UNAUDITED)

         The Company utilizes software and related  technologies  throughout its
businesses  that  will be  affected  by the date  change  in the year  2000.  An
internal  study was  completed to determine  the full scope and related costs to
insure that the Company's  systems continue to meet its internal needs and those
of its customers. Anticipated spending for this modification will be expensed as
incurred  and is not  expected  to have a  significant  impact on the  Company's
ongoing results of operations.

(d)      LITIGATION

         The Company was a defendant in a lawsuit filed on March 14, 1996 in the
United  States  District  Court  for  the  Southern  District  of  New  York  by
Commonwealth Associates ("Commonwealth"). In its suit, Commonwealth alleged that
the Company had breached a contract with Commonwealth in which  Commonwealth was
to  provide  certain   investment   banking   services  in  return  for  certain
compensation. In January 1997, Commonwealth's motion for summary judgment on its
breach of  contract  claim was  granted,  and in April 1997 the  District  Court
awarded  Commonwealth  $3,174,070  in damages.  That  judgment  was  appealed by
Palomar and on August 18, 1997 the case was settled for $1.875  million.  During
the year ended  December  31,  1997,  the  Company  incurred  $1.875  million in
settlement  costs related to the above matter and another $1.324 million related
to several other claims and associated litigation costs.

         The Company is involved in litigation regarding an alleged infringement
of a competitor's  patent (the "Selvac  Patent").  The Company believes that the
Selvac Patent is invalid, void and unenforceable,  and that the Company does not
infringe the Selvac Patent.  The court has granted Palomar's motion to amend its
complaint  previously  filed to allege  that 

                                       F-29
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

the Selvac Patent was obtained by inequitable conduct, and the Company has moved
for summary  judgment on the grounds  that the Selvac  Patent is invalid and was
obtained by inequitable  conduct.  The Company believes that competitor's claims
are wholly without merit.  Nonetheless,  an adverse result could have a material
adverse effect on the Company.

         On October 16, 1997, the Company brought a declaratory  judgment action
in U.S. District Court for the District of Massachusetts against the holders and
the indenture trustee of the Company's 4.5% Subordinated  Convertible Debentures
due 2003, denominated in Swiss francs (the "Swiss Franc Debentures"). Just prior
to this suit,  certain of the debenture  holders (the  "Asserting  Holders") had
alleged that the Company was in breach of certain protective covenants under the
indenture,  and on  October  22,  1997  they  sued  the  Company  and all of its
principal  subsidiaries  in the same court;  the October 16 and October 22 cases
have been  assigned to the same judge,  and the  dispute  between the  Asserting
Holders and the Company is proceeding  under the October 22 case.  The Asserting
Holders  claim  that the  Company  has  breached  certain  protective  indenture
covenants  and that the Asserting  Holders are entitled to immediate  payment of
their   indebtedness   under  the  Swiss  Franc  Debentures  (which  amounts  to
approximately  US$5,087,000 at current exchange rates). As of November 13, 1997,
acting under  applicable  provisions of the indenture,  the Company notified the
holders of the Swiss Franc  Debentures  that it is causing the conversion of all
of the  Swiss  Franc  Debentures  into an  aggregate  of  914,028  shares of the
Company's common stock. The Company believes that it has not breached any of the
protective covenants under this indenture and that its position in these matters
is  correct,  and  intends  to  contest  the  claims  of the  Asserting  Holders
vigorously.  Nonetheless, an adverse result could have a material adverse effect
on the Company.

         The Company is involved in other legal and  administrative  proceedings
and  claims of  various  types.  While any  litigation  contains  an  element of
uncertainty,  management,  in consultation  with the Company's  general counsel,
presently believes that the outcome of each such other proceeding or claim which
is pending or known to be threatened,  or all of them combined,  will not have a
material adverse effect on the Company.

         The  Company is also aware of a claim  alleging  that the  Company  had
previously  committed to make an additional  capital  contribution to Nexar. The
Company believes that this claim is without merit.

(e)      DISTRIBUTION AGREEMENT

         On  November   17,  1997,   the  Company   entered  into  an  exclusive
distribution,  sales and service agreement with an established,  worldwide laser
company ("the Distributor"). The Distributor has the exclusive right to sell the
EpiLaser(R)  and  LightSheer(TM)  laser systems and future  generation  products
worldwide. The Company pays the Distributor a per unit commission,  adjusted for
certain  events as  defined.  During the year ended 1997,  the Company  incurred
approximately $800,000 of commission expense to this Distributor. Upon execution
of this  agreement,  the  Distributor  made a lump sum payment of $3,500,000 and
received a warrant to purchase one million shares of the Company's  common stock
at a share price of $5.25. The valuation of the warrant using the  Black-Scholes
option  pricing  model was  approximately  $380,000.  The value was  credited to
additional  paid-in-capital  during  the  year  ended  December  31,  1997.  The
remaining amount of $3,120,000,  included in deferred revenue, will be amortized
to revenue over the three year life of the agreement.

         On January  20,  1998,  the  Distributor  made a loan to the Company of
approximately $2,211,000.  This loan is collateralized by the Company's accounts
receivable.  Payments against this loan will be made as the Distributor collects
receivables  from the end user of the Company's  products.  Any unpaid principal
will be paid on July  26,  1998 at an  interest  rate of 1.5%  per  month or the
highest interest rate permitted by law.

(f)      EMPLOYMENT AGREEMENTS

         The  Company  and its  subsidiaries  have  employment  agreements  with
certain  executive  officers that provide for annual bonuses to the officers and
expire on various dates through 2001. Each of these  agreements  provides for 12
months severance upon termination of employment.

                                       F-30
<PAGE>

              PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

(g)      CORPORATE GUARANTEES

         The  Company  has issued  guarantees  for  payment  of  various  vendor
liabilities for several electronic  subsidiaries that have been accounted for as
discontinued   operations   (see  Note  2).   Outstanding   guarantees   totaled
approximately $7,000,000 as of December 31, 1997.

(13)     SUBSEQUENT EVENTS

         In February 1998, the Company sold 7,200,000 shares of its common stock
to a group of investors  for  $7,200,000.  In addition,  the Company also issued
warrants to the  investors  to purchase  7,200,000  shares of common stock at an
exercise price of $3.00 per share.

         Subsequent  to year-end the Company  redeemed  2,950 shares of Series H
Preferred and paid related  dividends and interest for a total of  approximately
$3,589,000.  The Company also redeemed 6%, 7% and 8% convertible debentures with
a face value of  $2,000,000  and related  interest for a total of  approximately
$2,197,000.  On March  30,  1998,  in  resolution  of a  dispute  regarding  the
redemption of certain Series H Preferred shares,  the Company agreed with one of
the Series H Preferred  stockholders to issue 766,725 shares of common stock for
$914,864  in lieu of  redeeming  750  shares of Sheries H  Preferred  previously
redeemed.

         In the first  quarter of 1998,  debentureholders  converted  debentures
with a face value of $3,344,344 into 3,809,922 shares of convertible debentures.
Also in the first quarter of 1998, preferred  stockholders  converted 268 shares
of Series G Preferred  and 3,840  shares of Series H Preferred  into 287,908 and
4,103,650 shares of common stock, respectively.

         On March 27, 1998, the Company borrowed $2,000,000. This bridge loan is
payable the earlier of May 26, 1998 or (i) one day  following the sale of Dynaco
(ii) the sale of any other Palomar  assets in a  transaction  outside the normal
course of business or (iii) any financing  where the use of proceeds to pay back
debt is not  prohibited.  The Company issued  125,000  warrants to the lender to
purchase  125,000  shares of common stock at an exercise price of $.01 per share
in lieu of interest.

                                       F-31
<PAGE>

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

         Not applicable.

                                       30
<PAGE>

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

         The  information  concerning  directors  required  under  this  item is
incorporated  herein by reference from the material  contained under the heading
"Election of Directors" in the  Registrant's  definitive  proxy  statement to be
filed with the Securities and Exchange  Commission  pursuant to Regulation  14A,
not later  than 120 days  after the close of the fiscal  year.  The  information
concerning  delinquent  filers  pursuant  to  Item  405  of  Regulation  S-K  is
incorporated  herein by reference from the material  contained under the heading
"Section 16(a) Beneficial  Ownership  Reporting  Compliance" in the Registrant's
definitive  proxy  statement  to be  filed  with  the  Securities  and  Exchange
Commission  pursuant to Regulation  14A, not later than 120 days after the close
of the fiscal year.

ITEM 11. EXECUTIVE COMPENSATION.

         The  information  required  under this item is  incorporated  herein by
reference from the material contained under the heading "Executive Compensation"
in the  Registrant's  definitive proxy statement to be filed with the Securities
and  Exchange  Commission  pursuant to  Regulation  14A, not later than 120 days
after the close of the fiscal year.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         The  information  required  under this item is  incorporated  herein by
reference from the material contained under the heading "Stock Ownership" in the
Registrant's  definitive  proxy  statement to be filed with the  Securities  and
Exchange  Commission  pursuant to Regulation  14A, not later than 120 days after
the close of the fiscal year.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         The  information  required  under this item is  incorporated  herein by
reference  from the  material  contained  under the heading  "Relationship  with
Affiliates" in the Registrant's  definitive proxy statement to be filed with the
Securities and Exchange  Commission  pursuant to Regulation  14A, not later than
120 days after the close of the fiscal year.

                                       31
<PAGE>

                                     PART IV


ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
<TABLE>
<S>      <C>                                                                                             <C>

(a)      1.  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS.                                                 Page
                                                                                                         ----

         The following  Consolidated Financial Statements of the Company and its
subsidiaries are filed as part of this report on Form 10-K:

                  Report of Independent Public Accountants                                                F-2

                  Consolidated Balance Sheets -
                  December 31, 1997 and December 31, 1996                                                 F-3

                  Consolidated Statements of Income -
                  Years ended December 31, 1997, December 31, 1996 and December 31, 1995                  F-4

                  Consolidated Statements of Stockholders' Equity -
                  Years ended December 31, 1997, December 31, 1996 and December 31, 1995                F-5-8

                  Consolidated Statements of Cash Flows -
                  Years ended December 31, 1997, December 31, 1996 and December 31, 1995                  F-8

                  Notes to Consolidated Financial Statements                                             F-10

         2.       CONSOLIDATED FINANCIAL STATEMENT SCHEDULES

                  Report of Independent Public Accountants on Schedule II                                  36

                  Schedule II - Valuation and Qualifying Accounts                                          37
</TABLE>

                  Schedules  not listed  above  have been  omitted  because  the
                  matter  or  conditions  are  not  present  or the  information
                  required   to  be  set  forth   therein  is  included  in  the
                  Consolidated Financial Statements hereto.

(b)      REPORTS ON FORM 8-K.

         Form 8-K filed December 23, 1997.

                                       32
<PAGE>

(c)      EXHIBITS.

         The following  exhibits  required to be filed herewith are incorporated
by reference to the filings  previously  made by the Company  where so indicated
below.
<TABLE>
<S>            <C>

Exhibit
   No.                                                    Title

^^^^2.1        Stock Purchase Agreement Between and Among Biometric Technologies, Corp., 
               Palomar Medical Technologies, Inc. and Dynaco Corp.,
               dated November 17, 1997.

   -3.1        Restated Certificate of Incorporation.

   &3.2        Certificate of Designation of Series G Convertible Preferred Stock as filed
               with the Delaware Secretary of State on September 26, 1996.

  &&3.3        Certificate of Amendment to Certificate of Incorporation, as filed with 
               the Delaware Secretary of State on December 16, 1996.

  ##3.4        Certificate of Designation of Series H Convertible Preferred Stock as filed 
               with the Delaware Secretary of State on March 26, 1997.

    3.5        Certificate of Correction to Certificate of Incorporation, as filed with 
               the Delaware Secretary of State on September 23, 1997.

   ^3.6        Bylaws, as amended.

   ^4.1        Common Stock Certificate.

  *10.1        Patent License Agreement by and between the Company and Patlex Corporation,
               effective as of January 1, 1992.

   10.2        Amended 1991 Stock Option Plan.

   10.3        Amended 1993 Stock Option Plan.

   10.4        Amended 1995 Stock Option Plan.

   10.5        Amended 1996 Stock Option Plan.

   10.6        Amended 1996 Employee Stock Purchase Plan.

 **10.7        Form of Stock Option Grant under the 1991, 1993 and 1995 Stock Option Plans.

 ##10.8        Form of Stock Option Agreement under the 1996 Stock Option Plan.

  #10.9        Form of Company Warrant to Purchase Common Stock.

   10.10       Lease for premises at 45 Hartwell Avenue, Lexington, Massachusetts, 
               dated March, 1996.

 --10.11       The Company's 401(k) Plan.

                                       33
<PAGE>

   10.12       Sales Agency, Development and License Agreement between the Company and Coherent, Inc., 
               dated November 17, 1997. (Portions omitted pursuant to a request for confidential treatment.)

   10.13       Loan Agreement between the Company and Coherent, Inc., dated January 20, 1998.

   10.14       Stock Purchase Agreement, dated December 29, 1997.

   10.15       Stock Purchase Agreement, dated December 31, 1997.

   10.16       Exchange Agreement, dated December 31, 1997.

 ^^10.17       Form of 6%, 7% and 8% Convertible Debentures Due September 30, 2002

 ^^10.18       Form of Registration Rights Agreement, dated September 30, 1997.

 ^^10.19       Form of Securities Purchase Agreement dated September 30, 1997.

^^^10.20       Securities Purchase Agreement dated December 29, 1997.

&&&10.27       High Risk Opportunities Hub Fund, Ltd. Subscription Agreement, 
               dated January 14, 1997.

&&&10.28       High Risk Opportunities Hub Fund, Ltd. Debenture, 
               dated January 13, 1997.

 ##10.29       Form of Subscription Agreement, dated as of March 10, 1997.

 ##10.30       Form Registration Rights Agreement, dated as of March 10, 1997.

 ##10.31       Form of 5% Convertible Debenture due March 10, 2002.

 ##10.32       Subscription Agreement between the Company and Soginvest Bank, 
               dated as of March 13, 1997.

 ##10.33       6% Convertible Debenture due March 13, 2002.

 ##10.34       Asset Purchase and Settlement Agreement by and among the Company,
               Nexar Technologies, Inc., Technovation Computer Labs, Inc. and 
               Babar I. Hamirani, dated February 28, 1997.

 ##10.35       List of exhibits omitted from the Asset Purchase and Settlement Agreement.
               (The Company hereby undertakes and agrees to furnish copies of
               the exhibits and schedules set forth in exhibit 10.34 above to
               the Commission upon its request.)

   10.36       Employment Agreement, dated as of September 1, 1997, 
               between the Company and Steven Georgiev.

   10.37       Employment Agreement, dated as of January 1, 1997, 
               between the Company and Joseph P. Caruso.

   10.38       Employment Agreement, dated as of May 15, 1997, 
               between the Company and Louis P. Valente.

 ##10.39       Securities Purchase Agreement between the Company and 
               RGC International Investors, LDC, dated March 27, 1997.

 ##10.40       Registration Rights Agreement between the Company and 
               RGC International Investors, LDC, dated March 27, 1997.

   10.41       Binding Term Sheet between the Company and Hechtor Wiltshire, 
               dated March 27, 1998.

   10.42       Securities Purchase Agreement between the Company and various entities,
               dated February 20, 1998

   10.43       Security Agreement - Stock Pledge between the Company and
               Coast Business Credit, dated December 31, 1997.

   10.44       Secured Promissory Note between the Company and
               Coast Business Credit, dated December 31, 1997.

   23          Consent of Arthur Andersen LLP.

 27.1          Financial Data Schedule, Restated, for the Period Ended 
               December 31, 1996.

 27.2          Financial Data Schedule for the Period Ended
               December 31, 1997.

                                       34
<PAGE>

^              Previously filed as an exhibit to Form 10-KSB/A-4 filed on July 11, 1997, and
               incorporated herein by reference.

^^             Previously filed as an exhibit to Registration Statement No. 333-42129 
               filed on December 12, 1997, and incorporated herein by reference.

^^^            Previously filed as an exhibit to Registration Statement No. 333-42129/A-2 
               filed on January 9, 1998, and incorporated herein by reference.

^^^^           Previously filed as an exhibit to Form 8-K filed on December 23, 1997 
               and incorporated herein by reference.

*              Previously filed as an exhibit to Registration Statement No. 33-47479 
               filed on April 27, 1992, and incorporated herein by reference.

**             Previously filed as and exhibit to Amendment No. 4 to Form S-1 Registration Statement No. 33-47479 
               filed on October 5, 1992, and incorporated herein by reference.

#              Previously filed as an exhibit to the Company's Annual Report on Form 10-KSB 
               for the year ended December 31, 1995, and incorporated herein by reference.

##             Previously filed as an exhibit to the Company's Annual Report on Form 10-KSB 
               for the year ended December 31, 1996, and incorporated herein by reference.

-              Previously filed as an exhibit to the Company's Quarterly Report on Form 10-QSB 
               for the quarter ended June 30, 1996, and incorporated herein by reference.

--             Previously filed as an exhibit to Form S-8 Registration Statement No. 33-97710 
               filed on October 4, 1995, and incorporated herein by reference.

&              Previously filed as an exhibit to the Company's Quarterly Report on Form 10-QSB 
               for the quarter ended September 30, 1996, and incorporated herein by reference.

&&             Previously filed as an exhibit to Form S-3 Registration Statement No. 333-18003 
               filed on December 16, 1996, and incorporated herein by reference.

&&&            Previously filed as an exhibit to Form S-3 Registration Statement No. 333-22725 
               filed on March 4, 1997, and incorporated herein by reference.
</TABLE>


                                       35
<PAGE>

             REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE II


To Palomar Medical Technologies, Inc.:

         We  have  audited,  in  accordance  with  generally  accepted  auditing
standards,   the   consolidated   financial   statements   of  Palomar   Medical
Technologies,  Inc. and subsidiaries  included in this Form 10-K and have issued
our report  thereon  dated  February 6, 1998 (except with respect to the matters
discussed  in Note 13, as to which the date is March  31,  1998).  Our audit was
made for the  purpose of forming  an opinion on the basic  financial  statements
taken as a whole. The schedule listed in Item 14(2) above is the  responsibility
of the Company's  management and is presented for purposes of complying with the
Securities  and  Exchange  Commission's  rules  and is  not  part  of the  basic
financial  statements.   This  schedule  has  been  subjected  to  the  auditing
procedures  applied in the audit of the basic  financial  statements and, in our
opinion, fairly states, in all material respects, the financial data required to
be set forth therein,  in relation to the basic financial  statements taken as a
whole.



                                                             Arthur Andersen LLP


Boston,  Massachusetts  
February  6, 1998  (except  with  respect 
to the matters discussed in Note 13, 
as to which the date is 
March 31, 1998)

                                       36
<PAGE>

                                   SCHEDULE II

                       PALOMAR MEDICAL TECHNOLOGIES, INC.

                        Valuation and Qualifying Accounts

<TABLE>
<S>                                   <C>                  <C>                   <C>                 <C>

                                         Balance,
                                       Beginning of                                                  Balance, End of
                                          Period              Increases            Deductions             Period
Allowance for Doubtful Deductions:

December 31, 1995                             $18,000             $       -              $11,000               $7,000
                                      ================     =================     ================    =================

December 31, 1996                              $7,000            $1,122,000              $     -           $1,129,000
                                      ================     =================     ================    =================

December 31, 1997                          $1,129,000              $933,000          $(1,316,000)            $746,000
                                      ================     =================     ================    =================
</TABLE>

                                       37
<PAGE>

                                   SIGNATURES

         Pursuant  to the  requirements  of the  Securities  Act  of  1934,  the
Registrant  certifies  that it has caused this Report to be signed on its behalf
by the undersigned,  thereunto duly authorized,  in the Town of Lexington in the
Commonwealth of Massachusetts on April 14, 1998.


                                              PALOMAR MEDICAL TECHNOLOGIES, INC.





                                              By:  /s/ Louis P. Valente
                                                 -------------------------------
                                                   Louis P. Valente
                                                   President and
                                                   Chief Executive Officer

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

<TABLE>
<S>         <C>                                  <C>                                             <C>

                          Name                                   Capacity                             Date
            --------------------------------     -------------------------------------           ---------------

            /s/ Louis P. Valente                 President, Chief Executive                      April 14, 1998
            ---------------------------------
            Louis P. Valente                     Officer and Director

            /s/ Joseph P. Caruso                 Chief Financial Officer and Treasurer           April 14, 1998
            ---------------------------------
            Joseph P. Caruso                     (Principal Financial Officer and
                                                 Principal Accounting Officer)

            /s/ Nicholas P. Economou             Director                                        April 14, 1998
            ---------------------------------
            Nicholas P. Economou


            /s/ A. Neil Pappalardo               Director                                        April 14, 1998
            ---------------------------------
            A. Neil Pappalardo


            /s/ James G. Martin                  Director                                        April 14, 1998
            ---------------------------------
            James G. Martin

</TABLE>