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, 1998

                         Commission file number: 0-22340
                                [OBJECT OMITTED]

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

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<S>             <C>                                              <C>

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

Securities registered pursuant to Section 12 (b) of the Act:
------------------------------------------------------------
                                                       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 2, 1999,  72,145,509  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 $$43,549,606.  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. 4 to a Schedule  13G filed on January 22,
1999 and  Amendment  No. 3 to a Schedule  13D filed on February  16,  1999,  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>


                                                      INDEX
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Item                                                                                                       Page No.
----                                                                                                       --------

PART I.........................................................................................................1

     Item 1.  Business.........................................................................................1

         (a)  Introduction.....................................................................................1
         (b)  Financial Information About Industry Segments....................................................1
         (c)  Description of Business..........................................................................1
         (d)  Financial Information About Exports by Domestic Operations......................................10

     Item 2.  Properties......................................................................................10

     Item 3.  Legal Proceedings...............................................................................10

     Item 4.  Submission of Matters to a Vote of Security Holders.............................................11

PART II.......................................................................................................12

     Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters...........................12

     Item 6.  Selected Financial Data.........................................................................14

     Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations...........15

         (a)  Overview........................................................................................15
         (b)  Results.........................................................................................15
(c)      Liquidity and Capital Resources......................................................................19
(d)      Year 2000 Issues.....................................................................................21
(e)      Nasdaq Stock Market Listing..........................................................................21
(f)      Recently Issued Accounting Standard..................................................................22

     Item 7A.  Quantitative and Qualitative Disclosures About Market Risk.....................................22

     Statement Under the Private Securities Litigation Reform Act.............................................22

     Risk Factors.............................................................................................23

     Item 8.  Financial Statements............................................................................27

         Reports of Independent Public Accountants............................................................28
         Consolidated Balance Sheets as of December 31, 1997 and 1998.........................................30
         Consolidated Statements of Operations for the years ended December 31, 1996, 1997 and 1998...........31
         Consolidated Statements of Stockholders' Equity (Deficit) for the years ended
              December 31, 1996, 1997 and 1998................................................................32
         Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998...........35
         Notes to Consolidated Financial Statements...........................................................37

     Item 9.  Changes and Disagreements with Accountants on Accounting and Financial Disclosures..............63

<PAGE>

PART III .....................................................................................................64

     Item 10.  Directors and Executive Officers of the Registrant.............................................64

     Item 11.  Executive Compensation.........................................................................64

     Item 12.  Security Ownership of Certain Beneficial Owners and Management.................................64

     Item 13.  Certain Relationships and Related Transactions.................................................64

PART IV.......................................................................................................65

     Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K................................65

         (a)  Index to Consolidated Financial Statements and Schedules........................................65
         (b)  Reports on Form 8-K.............................................................................65
         (c)  Exhibits........................................................................................66

SIGNATURES....................................................................................................73
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                                       ii


<PAGE>

                                     PART I

Item 1.  Business.

(a)      Introduction

         Palomar Medical Technologies,  Inc. (the "Company," "Palomar," or "we")
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 believed  was at that time
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,  completed in May of 1998,  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. The Company's exclusive focus
is now the  use of  lasers  in  dermatology  and  cosmetic  procedures,  with an
emphasis on laser hair removal and research and development relating to that and
other  cosmetic  laser  products.  Currently,  the Company  has three  operating
subsidiaries,  Palomar Medical Products, Inc. ("PMP"),  Esthetica Partners, Inc.
("Esthetica")  (formerly  Cosmetic  Technology  International,  Inc.)  and  Star
Medical Technologies,  Inc. ("Star"). PMP, located at the Company's headquarters
in Lexington, Massachusetts,  oversees the manufacture and sale of the Company's
two ruby hair removal  laser system  currently  on the market.  Esthetica,  also
based in Lexington,  Massachusetts,  places the Company's lasers in clinical and
cosmetic  settings  and shares in a portion of the  revenue  generated  thereby.
Star, based in Pleasanton,  California,  manufactures the  LightSheer(TM)  diode
hair removal laser.  Palomar has entered into an agreement  with Coherent,  Inc.
("Coherent')  to sell Star to Coherent.  The agreement is subject to stockholder
approval and standard closing  conditions.  (On March 12, 1999,  Palomar filed a
proxy  statement with the Securities  and Exchange  Commission  that details the
Star Sale.) A Special Meeting of Palomar's  stockholders  has been scheduled for
April 21, 1999. If the Star sale is approved at that meeting by the holders of a
majority of the shares of Palomar's outstanding common stock, then the sale will
be  completed  shortly  after the  meeting  date.  (See  Item 7.,  "Management's
Discussion  and  Analysis of  Financial  Condition  and Results of  Operations -
Overview.")

(b)      Financial Information About Industry Segments

         The Company conducts business in one industry segment, medical products
and  services.  In 1998 the Company  completed  the program,  begun in 1997,  of
divesting  all  of  its  non-core   electronics   subsidiaries.   (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 Technology

         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 licensed exclusively to Palomar targets the
pigment in a hair follicle and was developed at  Massachusetts  General Hospital
("MGH"),  Palomar's research partner.  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  


                                       1
<PAGE>

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

         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 the underlying patents 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 Products

         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 cooling handpiece,  allows for safe and
effective hair removal.  In March 1997, Palomar was the first company to receive
FDA  clearance to sell and market a ruby laser (the  EpiLaser(R)  system) 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 LightSheer(TM)  diode laser system  manufactured by
Star.   The   LightSheer(TM)   diode  laser  also   incorporates   the  patented
contact-cooling  system  licensed  exclusively to Palomar.  Star's  high-powered
diode system is a compact,  solid-state laser that is significantly smaller than
most  current  systems,   and  relatively  easy  to  install  and  service.  The
LightSheer(TM)  is the only  high-power  pulsed diode laser hair removal  system
available on the market today.

         Palomar  recently  introduced  its second  generation  ruby laser,  the
Palomar E2000(TM),  a product which the Company  anticipates will be superior to
hair removal lasers currently available in a number of respects, including speed
and efficacy.  The Palomar E2000(TM) has already received FDA clearance for hair
removal.

         Studies  using  Palomar's  laser  hair  removal  process   demonstrated
significant permanent reduction of hair following treatment with the EpiLaser(R)
ruby laser. 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.  The EpiLaser(R) and the Palomar  E2000(TM)
are the only hair removal lasers on the market that have been cleared by the FDA
for "permanent hair reduction" labeling.

                           The Hair Removal Market

         The market for laser-based hair removal is in its early stages. Palomar
believes  that this market  remains a growing one.  Benefits of Palomar's  laser
hair  removal  process,  as compared  to other hair  removal  methods  currently
available,  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.

         Market  surveys  report that the great  majority 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  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 


                                       2
<PAGE>

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 dissolve hair,  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.

         Before  the  advent of laser hair  removal,  electrolysis  was the only
method  available  for the  long-term  removal of body hair.  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 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. 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.

                           Marketing, Distribution and Service

         Pursuant to an agreement  executed in November  1997,  Coherent acts as
the exclusive distributor for Palomar's hair removal lasers. Under its agreement
with Palomar,  Coherent is responsible for sales, marketing,  service,  training
and education.  However,  Coherent and Palomar agreed that, beginning January 1,
1999,  Palomar  would take over all  service  for  Palomar's  ruby hair  removal
lasers.  Coherent  has  over  200  sales  persons  worldwide,   and  50  service
representatives  in the US and over 100 worldwide.  If Star is sold to Coherent,
Coherent will continue to act as a distributor of Palomar's  products,  but on a
non-exclusive basis. If the Star sale is not completed,  Coherent will remain as
the Company's exclusive distributor through November 2001, pursuant to the terms
of the Sales Agency Agreement between the parties.  In December,  1998,  Palomar
signed a letter of intent with Continuum Biomedical, Inc., a medical division of
the scientific laser-based company Continuum  Electro-Optics (which is in turn a
wholly-owned  subsidiary  of Hoya  Corp.  of  Japan),  to  distribute  Palomar's
products (other than Star's  LightSheer(TM) laser) on a non-exclusive basis. The
Company intends to tailor distribution  methods to different  geographic regions
and may include a  combination  of  exclusive  and  non-exclusive  distributors,
independent  representatives or direct salespeople. In exchange for a payment of
$2,740  per day from  January  20,  1999  until the  closing  of the Star  sale,
Coherent  has  agreed  to waive  its  exclusive  distribution  rights  under the
Company's  Sales Agency  Agreement with  Coherent,  so that Palomar may begin to
sell  the  Palomar  E2000(TM)  immediately  through  other  channels,  including
Continuum Biomedical, without the necessity of paying commissions to Coherent or
waiting for the Sales Agency Agreement to terminate upon the closing of the Star
sale.

                  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).  The RD-1200(TM) has been on the
market for ten years. In 1998, RD-1200(TM) sales constituted less than 5% of the
Company's sales, and were primarily overseas, in Japan, Korea and other parts of
the  world.  Intense  competition  in the  medical  device  industry  and market
saturation for this type of laser have reduced  RD-1200(TM)  sales over the last
five years.  In addition,  there are less  expensive  products now available for
this purpose. Palomar expects sales of this product to continue in 1999 at a low
volume to foreign  countries where the advantages of ruby laser for treatment of
pigmented  lesions is  especially  important.  Palomar  sells and  services  the
RD-1200(TM) through distributors internationally.  In the United States, Palomar
provides service through its own service organization.

                                       3
<PAGE>

                  Cosmetic Laser Services

         An  additional  avenue  that the  Company  has  explored  for its laser
technology is the service business  conducted through its Esthetica  subsidiary,
which  was   incorporated   in  1996   (under  the  name   Cosmetic   Technology
International,   Inc.)  for  that  purpose.  During  1997  and  1998,  Esthetica
established  a  number  of test  sites to  explore  business  models.  Esthetica
provides  each of its sites with a turnkey  package of laser and medical  device
technology, equipment, training and service, strategic advertising and marketing
programs,  and management  assistance.  To date,  ten Esthetica  revenue-sharing
sites are open and under development.  

(ii)     Products Under Development

                  Other Cosmetic Applications

         Palomar  aims to address  dermatology  and cosmetic  procedure  markets
other than hair removal, and its research and development is not limited to hair
removal. (See "Research and Development.")

         Palomar  will  consider a number of  alternatives  with  respect to its
future products,  including  manufacturing them itself and selling them directly
and/or through distributors or (as in the case of Star) selling the product line
and/or  technology to others.  Palomar will choose in each case the  alternative
which it believes best maximizes long-term stockholder value.

                  Non-Cosmetic Applications Developed at Star

         The  only  non-cosmetic   products  under  development  are  all  being
developed out of Palomar's Star subsidiary, and these projects would transfer to
Coherent upon the sale of Star. One of the products under development at Star is
a diode laser for burn diagnosis. 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.  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 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.  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.

                  Non-Cosmetic Applications Developed at Palomar

         Another area of non-cosmetic laser product  development being conducted
by Palomar is laser  tonsillectomy.  In June 1994,  Palomar  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.  Palomar 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 Star's diode lasers
in connection with performing tonsillectomies. The animal studies were completed
successfully in 1997.

         Palomar  expects  that it may  take  several  years  before  commercial
products are  available as a result of any of the  above-described  non-cosmetic
product development efforts.

                                       4
<PAGE>

                  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.

                  Laser Thrombolysis

         In 1993,  the Company  entered into an  agreement  with the Edwards LIS
Division of Baxter regarding an integrated system utilizing lasers and catheters
for the  removal of blood  clots.  Under this  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.  Palomar owns  approximately  10% of
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.  The  results of
LaTIS'  operations  and financial  position  have been  immaterial to Palomar to
date.

         (iii)    Production and Sources and Availability of Materials

         Palomar's  manufacturing  operations  are  currently  located  in  both
Lexington,  Massachusetts and Pleasanton, California. The ruby laser systems are
manufactured  in  Massachusetts  and the diode laser system is  manufactured  in
California. If Star is sold to Coherent,  Palomar will no longer have facilities
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.

         (iv)     Patents and Licenses

         Certain  products  of the  Company  and  methods  for  the  use of such
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  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 thirteen  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, four of
these patents have been issued.  Additionally,  the Company  extends many of its
domestic filings into foreign  applications.  To date, ten 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.

                                       5
<PAGE>


         The  Company  believes  it owns,  or has the  right to use,  the  basic
patents covering its products. However, each year there are many 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  manufacturing  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.

         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. Palomar successfully argued that
the Selvac patent was invalid, and now Selvac has appealed that ruling. See Item
3.  "Legal Proceedings.")

         Other  than  the  matter  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.")

         In August 1995, the Company  entered into an agreement with MGH whereby
MGH  agreed  to  conduct   clinical   trials  on  a  laser  treatment  for  hair
removal/reduction  developed at MGH's Wellman Laboratories of Photomedicine.  As
part of the  agreement,  MGH  provided  the  Company  with  prior  data  already
generated at MGH with respect to the ruby laser device. 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.  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
approximately  $204,000 to perform  research and evaluation in the field of hair
removal.  During 1998,  the Company  incurred  approximately  $517,000 under its
clinical  research  agreement with MGH and other clinical  studies.  The Company
expects to incur  approximately  $350,000 of clinical  research  with MGH during
1999.  The Company is also in the process of  negotiating  another  amendment to
both extend the term and expand the scope of the clinical  trial  agreement with
MGH.

         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.  MGH  licenses
these  patents  exclusively  to  Palomar.  Palomar,  in turn,  has the  right to
sublicense  these patents to others.  Palomar also has the right to  exclusively
license any other patents arising out of MGH's  Palomar-funded  clinical trials.
As consideration for this license, the Company is obligated to pay MGH royalties
of 5% of net revenues on laser hair removal  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.

         Star owns four patents, two relating to the use of a high-powered diode
laser for the treatment of psoriasis and subsurface  blood vessels,  one related
to the design and use of  high-powered  diode  lasers,  and one related to laser
diode array packaging.  Under a patent license  agreement which will take effect
only if and when Star is sold to  Coherent  (the  "Patent  License  Agreement"),
Palomar will sublicense to Coherent the two MGH hair removal  patents  discussed
above for a royalty  of 7.5% of the net sales  price of all  licensed  products.
Licensed products means products manufactured by Coherent or Star which infringe
one or more claims of either of the two MGH hair  removal  patents.  Assuming it
purchases  Star,  then,  Coherent will have to pay Palomar a 7.5% royalty on all
LightSheer(TM)  diode lasers that are sold by Coherent.  Palomar,  in turn, will
pay a portion of this royalty income back to MGH.

         The Patent License  Agreement  further  provides that, if it is sold to
Coherent,  Star will grant to Palomar a royalty-free  license on its two patents
relating to treatment of subsurface  blood  vessels,  in the  following  limited
respect:  Palomar  may  sublicense  these  patents  only to other  companies  in
connection with their manufacture and sale of so-called "dual use devices," that
is, lasers that perform both hair removal and the treatment of subsurface  blood
vessels (for example,  leg veins).  If Palomar does enter into such sublicensing
agreements,  it will  not  have to pay any  royalty  amounts  back to  Coherent.
However,  for a period of two years from the  closing of the Star sale,  Palomar
may not  offer  to  sublicense  the two  subsurface  blood  vessel  patents  for
semiconductor   lasers  that  operate  in  a  continuous   wave  mode  or  in  a
quasi-continuous wave mode 


                                       6
<PAGE>

that  deliver  more than 5 joules  in any 50  millisecond  period  ("Competitive
Products").  After the two year period,  Palomar may sublicense dual use devices
that  constitute  Competitive  Products,  but then it must pay a royalty back to
Coherent.

         The Patent  License  Agreement  also  provides  that Star will grant to
Palomar a  royalty-free  license to Star's  high-fluence  diode laser patent for
uses other than  Competitive  Products.  Once again,  Palomar  may license  this
patent  in  connection  with  Competitive  Products  at the end of the two  year
period, but only if it pays a royalty back to Coherent.

         All licenses granted under the Patent License Agreement are granted for
the life of the respective patents. The Patent License Agreement also includes a
so-called "most favored  licensee"  provision,  which means that,  should either
party grant to a third party a license to any of these patents on more favorable
royalty terms than those established in the Patent License  Agreement,  then the
other  party can  immediately  obtain  that same  lower  royalty  going  forward
(assuming that all of the other material terms of the license agreement with the
third party are essentially like those in the Patent License Agreement).

         (v)      Seasonal Influences

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

         (vi)     Financing of Operations and Increase in Outstanding Shares

         If Star is sold to  Coherent,  Palomar  will  receive  net  proceeds of
approximately  $49 million in cash.  In  addition,  as part of the sale of Star,
Coherent has agreed to pay the Company an ongoing 7.5%  sublicensing  royalty on
future sales of its hair removal lasers. (See "Patents and Licenses.") There can
be no assurance  that the sale of Star to Coherent  will be  completed  and that
events in the future will not require the Company to seek additional  financing.
The sale must be approved by a majority of the Company's shares outstanding, and
is also  subject to standard  closing  conditions.  Financing  of the  Company's
future operating plan is now to a great extent dependant on completing the sale.
If the  sale  of Star is not  completed  the  Company  will  require  additional
financing during 1999 and there can be no assurance that any such financing will
be  available on terms  satisfactory  to the  Company.  Based on its  historical
ability to raise funds as  necessary  and  ongoing  discussions  with  potential
financing sources,  the Company believes that it will be successful in obtaining
additional financing, if required, in order to fund future operations.

         To enhance  stockholder value and increase revenues,  Palomar will also
consider  licensing  its  intellectual  property  (in  particular,  the  patents
licensed  exclusively  to Palomar by MGH under which the Company  practices  its
proprietary  method of skin  cooling  and hair  removal),  selling  intellectual
property  rights  that the  Company  does not intend to  exploit,  and  mergers,
acquisitions or other transactions.

         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.  Net cash provided by
financing  activities totaled  approximately  $7,050,000 and $31,198,000 for the
years ended December 31, 1998, and December 31, 1997,  respectively.  If Star is
not sold,  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 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 would be successful
in raising  additional  capital on  favorable  terms.  (See Notes 1, 6, and 7 to
Financial Statements,  Item 5. "Market for Common Equity and Related Stockholder
Matters," and Item 7. "Risk Factors")

         The Company  has a  $10,000,000  revolving  line of credit from a bank.
This  revolving  line of credit  matures on March 31, 2000 and bears interest at
the bank's prime rate (7.75% at December 31,  1998).  Borrowings  are limited to
80% of domestic  accounts  receivable under 90 days from invoice.  A director of
the Company has personally guaranteed borrowings under the line of credit. As of
March 20, 1999, $725,000 was available under that line of credit.  Substantially
all of Star's account  receivables provide the borrowing base under this line of
credit.

         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  

                                       7
<PAGE>

shares of common stock have  increased to 70,179,027  at December 31, 1998.  The
Company also had  additional  reserved  but  unissued  shares of common stock of
33,807,020  shares at December 31, 1998.  As of March 18,  1999,  the  Company's
issued and outstanding  shares of common stock  increased to 72,145,509  shares,
and reserved but unissued shares of common stock stood at 31,268,118  shares.  A
substantial  number of the Company's reserved shares are registered and could be
resold into the public market. (See Item 7. "Risk Factors.")

         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 89% of the Company's total
revenues in fiscal 1998. (See - "Marketing,  Distribution  and Service," Item 7.
"Risk Factors" and Notes 3(i) and 12(d) to Financial Statements.) If Star is not
sold to Coherent,  then this Sales Agency  Agreement will remain in effect until
November 17, 2001. Otherwise, the Sales Agency Agreement will terminate upon the
closing of the sale of Star.

         (viii)   Backlog

         The Company's  backlog of firm orders for its continuing  operations at
December 31, 1998,  and December 31, 1997,  was  approximately  $3.4 million and
$2.5 million, respectively.  This backlog consists almost entirely of orders for
Star's  LightSheer(TM)  diode laser. The Company has filled $2.1 million of this
year-end  backlog in 1999. As of March 20, 1999,  the Company's  backlog of firm
orders related to Star's  LightSheer(TM) was approximately $4.4 million, and, to
the Palomar E2000(TM), approximately $750,000.

         (ix)     Government Contracts

         Not applicable.

         (x)      Competition

         The  markets  in which the  Company  is  engaged  are  subject  to keen
competition and rapid  technological  change.  Nine other companies,  ThermoLase
Corporation;  Candela, Inc.; Medical Laser Technologies Ltd.  (Aesculap-Medtec);
Light Age, Inc.; Dornier Surgical Products,  Inc.; Continuum  Biomedical,  Inc.;
Polytec PI, Inc. (Lambda  Photometics);  Leisegang  Medical,  Inc. 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 1999, making laser hair removal a competitive  application  within
the  cosmetic  laser  marketplace.  The Company  also  expects that there may be
further  consolidation  of companies  within the laser hair removal industry via
acquisitions,  partnering arrangements or joint ventures. 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.

         In the  cosmetic  laser  services  industry,  the  Company's  Esthetica
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.  Esthetica's services will also compete for business with
other aesthetic service providers such as electrologists,  beauty 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.")

         (xi)     Research and Development

         Among Palomar's  research and  development  goals in the field of laser
hair removal are to design systems that (1) permit more rapid treatment of large
areas,  (2) have high gross  margins,  and (3) are lower cost,  thus  addressing
broader  markets.  Further,  Palomar  aims to address  dermatology  and cosmetic
procedure markets other than hair.

                                       8
<PAGE>

         During fiscal 1998,  fiscal 1997, and fiscal 1996, the Company incurred
approximately $7,029,000 $11,990,000 and $6,297,000, 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,  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 23 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 its
research and development  tasks to them on a project basis. In 1998, the Company
spent  approximately  $178,000 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  43 employees of the Company and its  subsidiaries  were
engaged full time in research and  development  activities at December 31, 1998.
Twenty-three of these employees work at Star and will no longer work for Palomar
if Star is sold.

         Under the Sales  Agency,  Development  and License  Agreement  that the
Company  entered into with Coherent in November 1997,  the Company  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.
Although  the Company  expects to continue to devote  substantial  resources  to
research and  development  regardless of whether the sale of Star to Coherent is
consummated, this specific commitment will terminate upon the sale.

         (See Item 7.  "Risk Factors" and Note 8 to Financial Statements.)



                                       9
<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.")

         (xiv)    Number of Employees

         As of December 31, 1998,  the Company and its PMP,  Esthetica  and Star
subsidiaries  employed 164 people,  3 independent  contractors  and 14 temporary
employees.  Of these  employees,  71 are with Star and would not remain with the
Company following the sale of Star.

         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.")

(d)      Financial Information About Exports by Domestic Operations

         Aggregate  export sales for the Company's  continuing  operations  were
approximately $3,870,000 for 1996, $5,030,000 for 1997 and $17,360,000 for 1998.
The 1996 export sales  consisted  primarily of the  RD-1200(TM)  tattoo  removal
laser  and the  EpiLaser(R)  laser  system,  the  1997  export  sales  consisted
primarily of the EpiLaser(R)  laser system,  and the 1998 export sales consisted
primarily  of  the   LightSheer(TM).   (See  Notes  3(i)  and  13  to  Financial
Statements.)

Item 2.  Properties.

         The  Company  occupies  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
25,000 square feet of office,  manufacturing  and research  space in Pleasanton,
California under two leases expiring in April 1999 and March 2001. Upon the sale
of Star to Coherent,  Coherent  will assume these leases for Star's  operations.
The  Company  believes  that  these  facilities  are in good  condition  and are
suitable  and  adequate  for its current  operations,  assuming it does not sell
Star. However,  if the Star sale is completed,  the Company expects that it will
require  additional  office,  manufacturing  and research space for its existing
operations.

Item 3.  Legal Proceedings.

         On March 7, 1997, Selvac Acquisition Corp. ("Selvac"),  a subsidiary of
Mehl Biophile  International,  Inc.  ("Mehl"),  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  subsidiaries  and a New  Jersey  dermatologist.  Selvac's  complaint
alleged that the Company's  EpiLaser(R) ruby laser hair removal system infringed
a patent licensed to Selvac (the "Selvac  Patent") and that the Company unfairly
competed by promoting the  EpiLaser(R)  ruby laser hair removal  system for hair
removal  before it had received FDA approval for that specific  application.  On
May 18, 1998 the court granted the Company's motion for partial summary judgment
on the ground that the Selvac patent is invalid  because  prior art  anticipated
it.  The court has since  denied  Selvac's  motion  for  reconsideration  of the
summary judgment ruling. 


                                       10
<PAGE>

On September 25, 1998, the court denied Selvac's motion for  reconsideration  of
its prior order  dismissing  so much of  Selvac's  unfair  competition  claim as
relied on interpreting the Food, Drug and Cosmetics Act or FDA regulations,  and
dismissed   without  prejudice  the  state  law  remainder  of  Selvac's  unfair
competition claim. On October 26, 1998, Selvac filed its notice of appeal to the
Court of Appeals for the Federal Circuit.  Selvac subsequently filed its opening
brief on appeal;  the Company  filed its  opposition.  Selvac will likely file a
reply brief in April 1999. The Company is unable to express an opinion as to the
likely outcome of Selvac's appeal.

         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").  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 know 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  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$5,600,000 at December 31, 1998 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.  Palomar  filed a motion  for  summary
judgment,  asserting that its  conversion of the debentures  into Palomar common
stock deprives the plaintiffs of standing to bring a claim. That motion has been
denied without  prejudice,  and the court also denied the plaintiffs' motion for
summary  judgment.  By mutual  agreement,  the Asserting Holders and the Company
requested that the case be removed from the Court's October 1998 trial calendar.
The  parties  have  discussed  ways to  resolve  their  dispute,  including  the
restructuring  of the  debentures  (so that  Palomar  would  withdraw its forced
conversion  and  repay  on  a  modified  schedule  the  original  debt,  with  a
substantial  prepayment of  principal).  But there can be no absolute  assurance
that all of the  debentureholders,  including  the  Asserting  Holders,  and the
Company will  complete the proposed  settlement.  If the case is returned to the
trial  calendar,  the Company  expects to  vigorously  contest the claims of the
Asserting  Holders,  as the  Company  believes  its  position  in the lawsuit is
correct,  and that the debt cannot properly be accelerated.  The court has given
the parties until April 30, 1999 to complete their agreement.

         On March 11, 1999,  the United States  District  Court for the Southern
District of New York granted  plaintiffs  leave to amend their  complaint in the
action styled VARLJEN V. H.J. MEYERS, INC., ET. AL. to join the Company,  Steven
Georgiev and Joseph Caruso as defendants.  On March 17, 1999, the Second Amended
Class Action Complaint  ("Complaint") in Varljen was served upon the Company and
Caruso. The Complaint alleges that the Company, Georgiev and Caruso violated the
federal  securities  laws in various  public  disclosures  that the Company made
directly  and  indirectly  during the period from  February 1, 1996 to March 26,
1997. In  particular,  the Complaint  alleges that Palomar,  Georgiev and Caruso
misrepresented  the Company's  financial  results and future  prospects  through
their direct disclosure and through  disclosures made by securities analysts and
other third parties.  The case is in its earliest stages, and the Company cannot
predict its outcome.

         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.

         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, at
present  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.

         (See "Risk Factor.")

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, 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

                                                           Fiscal Year Ended
                                                           December 31, 1998
                                                           -----------------
                                                           High          Low  
                                                           ----          ---  

                Quarter Ended March 31, 1998               2 11/32       5/8
                Quarter Ended June 30, 1998                1 9/16        31/32
                Quarter Ended September 30, 1998           1 7/32        3/4
                Quarter Ended December 31, 1998            1 1/8         19/32

         As of March 2, 1999,  the  Company  had 939 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 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  third  party  unaffiliated
individual investors, respectively, for an aggregate of $7,200,000. In addition,
for every share purchased the investor  received a warrant to purchase one share
of 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.

         Pursuant to Section  4(2) of the Act, on July 24, 1998 the Company sold
1,800,000  shares and  1,200,000  shares of the  Company's  common  stock to the
Rockside  Foundation  and  Mark T.  Smith,  respectively,  for an  aggregate  of
$3,000,000.  In addition,  for every share  purchased the  investors  received a
warrant to purchase  one share of 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.

         Each  of  these  sales  was  made  without   general   solicitation  or
advertising.  Each  purchaser  was a  sophisticated  investor with access to all
relevant  information  necessary to evaluate the investment in the Company,  and
each  purchaser  represented  to the  Company  that the  securities  were  being
acquired for investment.

                                       12
<PAGE>

         Convertible Debentures

         Pursuant  to Section  4(2) of the Act,  the Company  sold a  $2,000,000
convertible  debenture  on March 27, 1998 to Hechtor  Wiltshire,  an  individual
unaffiliated third party investor.  The debenture was 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 was not  prohibited.  If the  debenture  was not  repaid by the
maturity  date,  the debenture  would become  convertible at market value at the
option of the debentureholder, as defined. Interest on this debenture was in the
form of a warrant to purchase  125,000 shares of common stock for $.01 per share
exercisable over five years. The Company repaid  $1,250,000 and $750,000 of this
$2,000,000   convertible   debenture   on  April  8,  1998  and  May  27,  1998,
respectively.  The warrant to purchase  125,000  shares of common stock for $.01
per share was exercised by the individual on May 18, 1998.

         This sales was made without general  solicitation  or advertising.  The
purchaser was a sophisticated  investor with access to all relevant  information
necessary to evaluate the  investment  in the Company,  and  represented  to the
Company that the securities were being acquired for investment.

         Conversions of Preferred Stock and Debentures

         During the year ended December 31, 1998, the following  securities were
converted by the accredited  investor  unaffiliated  third-party holders for the
number of shares of common stock indicated:
<TABLE>
<S>           <C>                                                <C>                      <C>

                                                                                           Number of Shares
              Type of Security                                   Number of Shares         Common Stock Issued
              ----------------                                   ----------------         -------------------

              Preferred Stock Series G                                 1,941                    2,703,032
              Preferred Stock Series H                                 3,947                    4,188,650
              Debenture 5% Due December 31, 2001                        N/A                     1,160,999
              Debenture 5% Due January 13, 2002                         N/A                       924,029
              Debenture 5% Due March 10, 2002                           N/A                     1,561,064
              Debenture 4.5% Due October 21, 1999, 2000, 2001           N/A                        60,809
              Debenture 6%,7%,8% Due September 30, 2002                 N/A                     3,328,761
</TABLE>

         The  Company  received  no  proceeds  in  connection  with any of these
conversions.

                                       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, 1998.  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.

                             Selected Financial Data
                      (in thousands, except per share data)

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

                                                         Nine months
                                                          ended                                 Year ended
                                                        December 31,                           December 31,
                                                      -----------------------------------------------------------------------------
Statement of Operations Data                               1994             1995           1996            1997            1998
                                                      --------------    ------------   ------------    ------------    ------------

Revenues                                                    $    40         $ 5,610       $ 17,607        $ 20,995        $ 44,514

Gross Profit (Loss)                                              22           2,146          3,437             939          21,463


Operating Expenses                                            5,740          10,985         26,548          42,867          30,897

Loss from Operations                                         (5,718)         (8,839)       (23,110)        (41,929)         (9,434)

Net Loss from Continuing Operations                          (5,689)         (8,390)       (20,798)        (58,369)         (9,967)


Net Loss from Discontinued Operations                            (3)         (4,231)       (17,066)        (27,435)         (2,624)

Net Loss                                                     (5,692)        (12,621)       (37,864)        (85,804)        (12,591)

Basic and Diluted Net Loss Per Common Share:

             Continuing Operations                        $   (0.84)        $ (0.60)       $ (0.84)        $ (1.79)        $ (0.18)
             Discontinued Operations                               -          (0.30)         (0.65)          (0.78)          (0.04)
                                                      --------------    ------------   ------------    ------------    ------------

             Total Loss Per Common Share                  $   (0.84)        $ (0.90)       $ (1.49)        $ (2.57)        $ (0.22)

Weighted Average Number of
    Common Shares Outstanding                                                                                           
                                                              6,759          14,165         26,167          35,105          62,869
                                                      ==============    ============   ============    ============    ============

Balance Sheet Data:

Working Capital                                           $   2,491        $ 12,998       $ 15,203        $ (7,269)       $ (6,004)
Total Assets                                                  6,551          33,656         67,533          28,968          23,526
Long-term debt                                                2,322           1,765         14,665          12,446           3,150
Stockholders' Equity (Deficit)                                2,794          25,289         38,077          (6,184)         (6,463)
</TABLE>


                                       14
<PAGE>

Item 7.  Management's  Discussion  and Analysis of Financial  Condition  and
         Results of Operations.

(a)      Overview

         On December 7, 1998, the Company  entered into an Agreement and Plan of
Reorganization (the "Agreement") with Coherent, Inc. ("Coherent") to sell all of
the issued and  outstanding  common  stock of Star  Medical  Technologies,  Inc.
("Star"), its 99.96% majority-owned  subsidiary,  to Coherent for $65 million in
cash. The Company currently owns substantially all of the issued and outstanding
common  shares of Star.  However,  options that have been granted to Palomar and
employees of Star to purchase shares of Star's common stock remain  outstanding.
When all of the  outstanding  options  under  Star's Stock Option Plan have been
exercised,  the Company will own 82.46% of Star's common stock and the employees
will  collectively  own 17.54% at the time of the sale of Star.  Therefore,  the
Company  anticipates  that  it will  receive  net  proceeds  from  this  sale of
approximately $46 million after taxes (see Note 7 to the Consolidated  Financial
Statements).  Under the terms of the Agreement, the Company will also receive an
ongoing  royalty of 7.5% from  Coherent on the sale of any  products by Coherent
that employ certain patented  technology related to laser hair removal currently
licensed  by the  Company  on an  exclusive  basis  from  Massachusetts  General
Hospital ("MGH") (see Note 12(b) to the Consolidated Financial Statements).  The
sale  is  subject  to  stockholder   approval,  as  well  as  customary  closing
conditions.

         If  this   transaction   is   consummated,   revenues   would   decline
significantly in the near term and the successful  introduction and marketing of
new products  will become more critical to the Company's  long-term  success.  A
significant  portion  of the  Company's  current  revenue  base  will need to be
replaced with future revenues from the Company's other laser products, including
the Palomar E2000TM hair removal laser  introduced in February of 1999 and other
products  currently in development.  For the year ended December 31, 1998, gross
revenues associated with Star's  LightSheer(TM) diode laser comprised 80% of the
Company's total revenues.  There can be no assurance that the Palomar E2000TM or
the  Company's  future  products  will  achieve  market  acceptance  or generate
sufficient margins. Broad market acceptance of laser hair removal is critical to
the Company's  success.  The Company  recognizes the need and intends to broaden
its product line by developing  cosmetic  laser products other than hair removal
lasers.

         In the third  and  fourth  quarters  of 1997,  the  Board of  Directors
authorized  management  to focus the  Company  on its core  laser  products  and
services  business,  principally  related to laser hair removal,  and to proceed
with a  restructuring  plan to reorganize  the Company and divest its electronic
subsidiaries,   Dynaco  Corp.  ("Dynaco"),  Dynamem,  Inc.  ("Dynamem"),  Comtel
Electronics,   Inc.   ("Comtel")   and  Nexar   Technologies,   Inc.   ("Nexar")
(collectively, the "Electronic Subsidiaries"), and other non-core 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
Consolidated Financial Statements).

         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.

 (b)     Results

         (i)      REVENUES  AND GROSS  MARGIN:  Year Ended  December  31,  1998,
                  Compared to Year Ended December 31, 1997

         For the year ended December 31, 1998, the Company's  revenues increased
to $44.5  million as compared to $21.0  million for the year ended  December 31,
1997.  The increase in the  Company's  revenue of $23.5 million or 112% from the
year ended December 31, 1997 was mainly due to additional  sales volume of $35.6
million  associated  with the  introduction of the  LightSheer(TM)  diode laser,
partially  offset by a decrease  in revenue of  approximately  $12.1  million in
other  cosmetic  laser product  revenue.  The Company  obtained FDA clearance to
market and sell its LightSheer(TM) laser for hair removal and leg vein treatment
in the United States at the end of 1997. The decrease in sales volume associated
with other cosmetic laser 


                                       15
<PAGE>

product  revenue  was  principally  due to  declining  sales  of  the  Company's
EpiLaser(R) ruby laser. The Company focused on bringing the LightSheer(TM) laser
to market while further  developing a new generation of ruby hair removal lasers
during 1998.  Using its core ruby laser  technology,  originally  developed  for
tattoo  and  pigmented  lesion  removal,   Palomar   developed  its  long  pulse
EpiLaser(R) ruby laser 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  Company's  patented  cooling  handpiece,  allows safe and  effective  hair
removal.  Palomar expects its new generation long pulse ruby laser,  the Palomar
E2000TM,  to permit more rapid  treatment  of large  areas of the body.  In July
1998,  the Company  obtained FDA  clearance  to market and sell its  EpiLaser(R)
laser system in the United States for  "permanent  hair  reduction." In March of
1999,  the Company also  obtained  FDA  clearance to market and sell its Palomar
E2000TM laser system in the United States for "permanent hair reduction."

         Gross  margin for the year ended  December  31, 1998 was  approximately
$21.5  million (48% of revenues)  compared to $939,000 (4% of revenues)  for the
year ended  December  31,  1997.  The  increase in gross margin and gross margin
percentage was due to sales of the LightSheer(TM)  diode laser system.  This new
laser  system  has a  significantly  higher  gross  margin  than  the  Company's
EpiLaser(R) laser and other cosmetic products.  The Company  anticipates that if
the sale of Star is  consummated,  its gross margin  percentage from the sale of
Palomar E2000TM will decrease compared to the current gross margin from the sale
of its  LightSheer(TM)  product  unless and until the Palomar  E2000TM  achieves
volume production and manufacturing efficiencies.

         (ii)     OPERATING AND OTHER  EXPENSES:  Year Ended  December 31, 1998,
                  Compared to Year Ended December 31, 1997

         Research and  development  costs decreased to $7.0 million for the year
ended December 31, 1998 from $12.0 million for the year ended December 31, 1997.
Research and development expenses as a percentage of revenue totaled 16% for the
year ended  December 31, 1998 and 57% for the year ended  December 31, 1997. The
decline in  spending is  primarily  the result of the  Company's  receipt of FDA
approval for the LightSheer(TM) laser at the end of 1997. The continued spending
on research and  development  reflects the Company's  commitment to research and
development  for  medical  devices  and  delivery  systems  for  cosmetic  laser
applications  and other medical  applications  using a variety of lasers,  while
continuing  dermatology  research utilizing the Company's ruby and diode lasers.
Among the Company's  research and development goals in hair removal is to design
systems  permitting more rapid treatment of large areas,  and to produce systems
with high gross  margins.  Management  believes  that  research and  development
expenditures  will remain  constant over the next year as the Company  continues
product  development  and clinical  trials for additional  applications  for its
lasers and delivery systems in the cosmetic and dermatological markets.

         Selling and  marketing  expenses  increased  to $15.1  million  (34% of
revenues) for the year ended December 31, 1998, from  approximately $7.0 million
(33% of revenues) for the year ended  December 31, 1997. The increase in selling
and  marketing  expenses  is  attributable  to the  costs  associated  with  the
Company's  distribution  agreement  with  Coherent,  which  increase  in  direct
proportion  to  sales  volume  (see  Note  12(d) to the  Consolidated  Financial
Statements)  because  Coherent  receives a commission  for each of the Company's
products that it sells to  compensate it for its selling and marketing  efforts.
The amounts received by Coherent (as a percentage of the Company's net revenues)
are greater than the Company's selling and marketing  expenses when it performed
these functions internally during 1997. The Company anticipates that its selling
and  marketing  expenses  will  decrease as a  percentage  of revenue  after the
completion  of the sale of Star to Coherent  as the  Company  begins to sell the
Palomar  E2000TM through other sales channels,  including  distribution  through
Continuum Biomedical,  a distributor of medical products.  The Company also will
consider  establishing  its own direct  sales  force to  compliment  these sales
channels.  The Company anticipates that its selling and marketing costs incurred
through  other sales  channels  and its own direct sales force will be less than
the  commissions  currently  earned by Coherent as a percentage of the Company's
net revenues.

         General and  administrative  expenses decreased to $8.9 million (20% of
revenues)  for the year ended  December 31, 1998,  as compared to $15.3  million
(73% of revenues)  for the year end ended  December 31, 1997.  This  decrease is
attributable to the Company's  restructuring and consolidation of administrative
functions  in the third and fourth  quarters of 1997,  including a reduction  in
costs  attributable to Palomar  Technologies,  Ltd.,  Esthetica,  Inc. (formerly
Cosmetic Technology  International,  Inc.),  Palomar Medical Products,  Inc. and
corporate  costs  totaling  $1.0 million,  $2.4  million,  $1.9 million and $2.0
million, respectively.  This reduction was offset by an increase of $900,000 for
general and administrative expenses incurred at the Company's Star subsidiary to
support its successful  introduction  of its  LightSheer(TM)  laser. In previous

                                       16
<PAGE>

years, the Company used management's time and allocated  resources to developing
businesses  outside of the medical and cosmetic laser industry and financing the
non-core  businesses.  Beginning  in the  fourth  quarter of 1997,  the  Company
focused its efforts on its core business.  The Company  anticipates  general and
administrative  expense  will  continue to stabilize in the future and after the
sale of Star as the Company focuses on its core operations in the cosmetic laser
business.

         The Company incurred no business development and financing costs during
the year ended  December  31, 1998 as compared to $2.1 million (10% of revenues)
for the year ended  December  31, 1997.  This  decrease is  attributable  to the
Company's restructuring efforts to focus on its core medical business.

         Restructuring  and  asset  write-off  costs  were  approximately  $13.0
million  for  the  year  ended   December  31,  1997.   These  charges   reflect
restructuring  and asset write-off costs for certain operating and non-operating
assets  that  the  Company  believes  were  not  fully  realizable  for both the
Company's medical business and other non-medical  investments.  Included in this
charge  is  a  $2.7  million  reserve  for  severance   costs   associated  with
consolidating  selling,  general and  administrative  functions,  including  the
closing of certain  facilities.  Through December 31, 1998, the Company paid out
$2.3  million of  severance  costs and has a  remaining  liability  of  $279,000
related to two  individuals  that will be paid out in 1999,  resulting in actual
restructuring costs incurred of $2.6 million.  Accordingly, the Company reversed
the  balance of this  restructuring  accrual of  approximately  $131,000  in its
consolidated  statement of operations  during the fourth  quarter of fiscal 1998
(see Note 4 to Consolidated Financial Statements).

         For the year  ended  December  31,  1998,  the  Company  did not  incur
settlement expenses.  Settlement costs of $3.2 million were incurred in the year
ended  December 31, 1997.  These  charges  consisted  mainly of a legal  accrual
related to a legal settlement with an investment bank.

         Interest expense  decreased to $1.3 million for the year ended December
31, 1998, from $7.0 million for the year ended December 31, 1997. The amount for
1997 includes  $5.5 million of non-cash  interest  expense  related to the value
ascribed to the discount  features of the convertible  debentures  issued by the
Company  during 1996 and 1997.  This 82% decrease is  primarily  the result of a
decrease in convertible  debenture financings and the Company's increased use of
conventional  financing.  Also,  operations did not require as much financing in
1998 as compared to 1997.

         Interest  income  decreased to $33,000 for the year ended  December 31,
1998,  from  approximately  $457,000 for the year ended December 31, 1997.  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 1998.

         Net  gain  on  trading   securities   represents  a  realized  gain  of
approximately  $703,000  for the year ended  December  31,  1998  related to the
Company's investment in a publicly traded company that was sold during 1998. The
Company does not have any marketable trading securities as of December 31, 1998.

         The loss from  discontinued  operations for the year ended December 31,
1998 was $2.6  million  compared  to a loss of $27.4  million for the year ended
December 31, 1997.  The loss from  discontinued  operations in 1998 was due to a
delay  in  the  disposition  of  Dynaco  resulting  in  operating   expenses  of
approximately  $1.1 million above the estimated  operating  expenses  accrued at
December 31, 1997. A loss on disposition of  discontinued  entities for the year
ended  December  31, 1998 of $1.5  million was  incurred.  The  majority of this
charge  relates the write-off of the Company's  carrying value of its investment
in Nexar during the second quarter of 1998.

         (iii)    REVENUES  AND GROSS  MARGIN  Year  Ended  December  31,  1997,
                  Compared to Year Ended December 31, 1996

         Revenues from  continuing  operations  for the year ended  December 31,
1997 were $21.0 million as compared to $17.6 million 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) hair removal laser
system and service revenue and with the RD-1200(TM) tattoo removal and pigmented
lesion  treatment 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.

                                       17
<PAGE>

         Gross  margin for the year ended  December 31, 1997 was $939,000 (4% of
revenues) compared to $3.4 million (20% 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  under-absorbed  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  which
led to the  successful  introduction  and sales of its  LightSheer(TM)  laser in
1998.

         (iv)     OPERATING AND OTHER  EXPENSES:  Year Ended  December 31, 1997,
                  Compared to Year Ended December 31, 1996

         Research  and  development  costs  increased  to $12.0  million (57% of
revenues)  for the year ended  December  31,  1997,  from $6.3  million  (36% of
revenues)  for the year ended  December 31, 1996.  This 90% 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.

         Selling  and  marketing  expenses  increased  to $7.0  million  (33% of
revenues)  for the year ended  December  31,  1997,  from $5.1  million  (29% of
revenues) for the year ended December 31, 1996. This 37% increase  reflected the
Company's  effort to expand its  marketing  and  distribution  for the Company's
EpiLaser(R) laser system.

         General and administrative  expenses increased to $15.3 million (73% of
revenues)  for the year ended  December  31,  1997,  from $9.8  million  (55% of
revenues) for the year ended December 31, 1996. This 57% increase was the result
of  additional  administrative  resources  required at the  Company's now closed
separate  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,  totaling  approximately  $500,000.  Additional general and administrative
costs were also  incurred  at Palomar  Medical  Products,  Inc.,  Esthetica  and
Palomar Technologies, Ltd. totaling approximately $1.7 million, $2.3 million and
$1.0 million,  respectively.  The majority of these  general and  administrative
expenditures  incurred by the subsidiaries were for employee and  infrastructure
expenses  to manage  the  transition  from a  development  stage  company to the
commercialization stage.

         Business development and financing costs decreased to $2.1 million (10%
of revenues)  for the year ended  December  31, 1997,  from $2.9 million (16% of
revenues)  for  the  year  ended  December  31,  1996.   This  28%  decrease  is
attributable to the Company's restructuring efforts to focus on its core medical
product and service businesses.

         Restructuring  and asset  write-off  costs  totaling $13.0 million were
incurred  for the year ended  December  31, 1997 as compared to $1.7 million for
the year ended December 31, 1996. These charges reflect  restructuring and asset
write-off costs for certain operating and non-operating  assets that the Company
believes were not fully  realizable for both the Company's  medical business and
other  non-medical  investments.  Included  in this  charge  for  1997 is a $2.7
million charge for severance costs  associated with  consolidating  the selling,
general  and  administrative   functions,   including  the  closing  of  certain
facilities.  Through  December  31,  1998,  the Company paid out $2.3 million of
severance  costs and has a remaining  liability  of $279,000 to two  individuals
that will be paid out in 1999 resulting in total restructuring costs incurred of
$2.6   million.   Accordingly,   the  Company   reversed  the  balance  of  this
restructuring accrual of approximately $131,000 in its consolidated statement of
operations  during the fourth quarter of fiscal 1998 (see Note 4 to Consolidated
Financial Statements).

         Settlement and litigation  costs increased to $3.2 million for the year
ended  December  31, 1997 from  $880,000  for the year ended  December 31, 1996.
These costs are  primarily  attributable  to a lawsuit  brought by an investment
bank.  In 


                                       18
<PAGE>

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 $1.9 million.

         Interest expense from continuing  operations  increased to $7.0 million
for the year ended December 31, 1997,  from $272,000 for the year ended December
31,  1996.  This amount for 1997  includes  $5.5  million of  non-cash  interest
expense  related  to  the  value  ascribed  to  the  discount  features  of  the
convertible debentures issued by the Company.

         Interest  income  decreased to $457,000 for the year ended December 31,
1997,  from $1.4 million 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.

         Loss from discontinued  operations was $27.4 million for the year ended
December  31, 1997 as compared  with a loss of $17.1  million for the year ended
December  31,  1996.  The Company  also  reported a gain of $2.1  million on the
disposition of its discontinued operations.  This amount includes a gain of $6.2
million  related to the  disposition  of 1,960,736  shares of Nexar common stock
which  was  offset  by  losses  incurred  and  accrued  of $4.1  million  on the
disposition of Dynaco and its wholly owned  subsidiaries.  The Company completed
the  disposition of Comtel and Dynamem on December 9, 1997.  The  disposition of
Dynaco was  completed in May of 1998 (see Note 2 to the  Consolidated  Financial
Statements).

(c)      Liquidity and Capital Resources

         The Company is a holding  company  with no  significant  operations  or
assets  other than its  investments  in  operating  subsidiaries  and  strategic
investments. The Company depends upon dividends, cash advances and/or other cash
payments from its subsidiaries to meet its cash flow requirements.  To date, the
Company's operating subsidiaries have required cash advances from the Company to
fund their operations.

         On December 7, 1998,  the Company  entered into a Agreement and Plan of
Reorganization  (the  "Agreement")  with  Coherent to sell all of the issued and
outstanding  common  stock of Star,  its 99.96%  majority-owned  subsidiary,  to
Coherent.  The  Company  currently  owns  substantially  all of the  issued  and
outstanding  common  shares of Star.  However,  options  outstanding  granted to
Palomar and  employees of Star to purchase  shares of Star's common stock remain
outstanding.  When all of the outstanding options under Star's Stock Option Plan
have been exercised,  the Company will own 82.46% of Star's common stock and the
employees will collectively own 17.54%. See Note 7 to the Financial  Statements.
Under the terms of the Agreement,  the selling price of Star is $65 million.  In
addition,  the Company will receive an ongoing  royalty of 7.5% from Coherent on
the sale of any products by Coherent that use certain patents currently licensed
by the Company on an exclusive basis from  Massachusetts  General Hospital.  See
Note 12(b) to the Financial Statements.  This sale is subject to the approval of
the  stockholders of Palomar.  The Company  anticipates that it will receive net
proceeds of  approximately  $49 million for the sale. The Company intends to use
these funds to support its  ongoing  operations  and  research  and  development
activities.

         As of December 31, 1998,  the Company had $1.9 million in cash and cash
equivalents.  In order to meet its cash  flow  requirements  and fund  operating
losses at its subsidiaries,  the Company generated $9.8 million and $3.0 million
in net proceeds from the issuance of common stock and short-term  notes payable,
respectively,  during the year ended  December 31, 1998.  The Company's net cash
used in  operating  activities  for the year end  ended  December  31,  1998 was
approximately  $11.1 million which  includes  approximately  $2.1 million of net
cash generated from Star's operating activities.  The Company's net loss for the
year ended  December 31, 1998  included  approximately  $2.7 million of non-cash
depreciation and amortization expense.

         As of December 31, 1998, the Company's accounts receivable totaled $9.9
million as  compared  to $2.2  million as of December  31,  1997.  The amount at
December 31, 1998 is principally related to accounts receivable from the sale of
Star's  LightSheer(TM)  diode laser.  The Company began shipping this product in
the first quarter of 1998.  The increase in this balance from 1997 is related to
the sale of Star's  LightSheer(TM)  diode laser product. The Company's allowance
for doubtful  accounts totaled  approximately  $364,000 as of December 31, 1998,
compared to $746,000 as of December 31, 1997. This reduction was principally due
to a decrease in the allowance for doubtful  accounts for write-offs during 1998
of certain accounts receivable related to the sales of the Company's EpiLaser(R)
laser systems sold in 1997 totaling  approximately  $565,000, and an increase in
the allowance for doubtful  accounts for the Company sale of its  LightSheer(TM)
diode laser products during 1998.

                                       19
<PAGE>

         As of December 31, 1998 accounts  payable  totaled  approximately  $6.6
million as compared to $4.2 million as of December 31,  1997.  This  increase of
$2.4 million is  principally  due to the  additional  purchases of inventory and
additional  plant cost for the  manufacturing  of the  Company's  LightSheer(TM)
product  during the fourth  quarter of 1998 and the buildup of inventory for the
anticipated sales of Palomar E2000(TM) laser system.

         The Company  anticipates that capital  expenditures for 1999 will total
approximately  $1.0 million,  consisting  primarily of machinery,  equipment and
computers and  peripherals.  The Company  expects to finance these  expenditures
with cash on hand,  its line of credit and  equipment  leasing  lines.  However,
there can be no assurance  that the Company will be able to obtain the necessary
financing.

         The Company  has a  $10,000,000  revolving  line of credit from a bank.
This  revolving  line of credit  matures on March 31, 2000 and bears interest at
the bank's prime rate (7.75% at December 31,  1998).  Borrowings  are limited to
80% of domestic  accounts  receivable under 90 days from invoice.  A director of
the Company has personally guaranteed borrowings under the line of credit. As of
March 20, 1999, approximately $725,000 was available under this line of credit.

         The Company  entered into a Loan Agreement  with Coherent,  pursuant to
which  Coherent  agreed to loan the Company  money to help finance the Company's
working  capital   requirements.   These  loans  are  collateralized  by  Star's
inventory. As of December 31, 1998, the total amount outstanding under this loan
agreement  was  $4.0  million  (see  Note  6  to  the   Consolidated   Financial
Statements).

         In connection  with the  disposition of Comtel,  a former  wholly-owned
subsidiary in the electronics  segment, the Company guaranteed $2.5 million of a
$3.3  million  line  of  credit  extended  by a 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  $1.5 million in the event the Company
is obligated to honor this guaranty.  The amount BTC has  outstanding  under the
line of credit at December 31, 1998 was approximately $2.1 million.

         Regardless of whether the sale of Star to Coherent is consummated,  the
Company's strategic plan is to continue to fund research and development for its
medical and cosmetic laser products. The Company expects to expand the scope and
extend the term of its current  Clinical Trial  Agreement with MGH following the
sale of Star. This research and development  effort entails  extensive  clinical
trials.  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.

         The Company will consider a number of alternatives  with respect to its
future products,  including  manufacturing them itself and selling them directly
and/or  through  distributors  or selling the product line and/or  technology to
others.  The Company will in each case choose the alternative  which it believes
best maximizes profitability and long-term shareholder value.

         The Company has historically  incurred  significant  losses.  While the
Company  achieved  profitable  operations  for the  three and six  months  ended
December 31, 1998,  primarily related to the operations of Star, there can be no
assurance that this will continue.  Therefore,  the Company may need to continue
to  secure  additional  financing  to  complete  its  research  and  development
activities,   commercialize  its  current  and  proposed  medical  products  and
services, and fund ongoing operations.

         There can be no  assurance  that the sale of Star to  Coherent  will be
completed  (resulting  in cash  proceeds to the Company of $49 million) and that
events in the future will not require the Company to seek additional  financing.
The sale must be approved by the Company's stockholders,  and is also subject to
regulatory  approval and other  standard  closing  conditions.  Financing of the
Company's future operating plan is now to a great extent dependant on completing
the  sale.  If the  sale of Star  is not  completed  the  Company  will  require
additional  financing  during 1999 and there can be no  assurance  that any such
financing will be available on terms  satisfactory to the Company.  Based on its
historical  ability to raise funds as  

                                       20
<PAGE>

necessary and ongoing discussions with potential financing sources,  the Company
believes  that it will be  successful  in  obtaining  additional  financing,  if
required, in order to fund future operations.

         The  report  of  the  Company's   independent   public  accountants  in
connection with the Company's  Consolidated  Balance Sheets at December 31, 1998
and 1997, and the related Consolidated  Statements of Operations,  Stockholders'
Equity  (Deficit)  and Cash Flows for the three  years ended  December  31, 1998
includes an explanatory  paragraph stating that the Company's  recurring losses,
working capital  deficiency and stockholders'  deficit raises  substantial doubt
about the Company's ability to continue as a going concern.

(d)      Year 2000 Issues

     During 1998, the Company has been actively  engaged in addressing Year 2000
(Y2K) issues,  which result from the use of two-digit,  rather than  four-digit,
year dates in software, a practice which could cause  date-sensitive  systems to
malfunction  or fail because they may not recognize or process date  information
correctly.

         State of Readiness:

         To manage its Y2K  program,  the Company  has divided its efforts  into
four program areas:

         o        Information Technology (computer hardware and software)

         o        Physical Plant (manufacturing equipment and facilities)

         o        Products (including product development)

         o        Extended Enterprise (suppliers and customers)

         For each of these  program  areas,  the  Company  is using a  four-step
approach:

         o        Ownership (creating awareness, assigning tasks)

         o        Inventory (listing items to be assessed for Y2K readiness)

         o        Assessment  (prioritizing  the  inventoried  items,  assessing
                  their Y2K readiness,  planning corrective actions,  developing
                  initial contingency plans)

         o        Corrective Action Deployment (implementing corrective actions,
                  verifying implementation, finalizing and executing contingency
                  plans)

         At December 31, 1998,  the Ownership,  Inventory and  Assessment  steps
were essentially complete for all program areas. The Company expects to complete
Corrective Action Deployment by June 1999.

         Costs to Address Y2K Issues:

         The Company's  estimated  aggregate  costs for its Y2K activities  from
1998 through 2000 are expected to be less than  $100,000.  Through  December 31,
1998 the Company has spent approximately $20,000.

         Risks of Y2K Issues and Contingency Plans:

         The Company  continues  to assess the Year 2000 issues  relating to its
physical  plant,  products  and  suppliers.  The  Company  intends  to develop a
contingency planning process to mitigate worst-case business disruptions such as
delays in product delivery,  which could potentially  result from events such as
supply  chain  disruptions.  The  Company  expects its  contingency  plans to be
complete by June 1999.

(e)      Nasdaq Stock Market Listing

        The Company has been notified by the Nasdaq Stock Market ("Nasdaq") that
for  continued  listing on the Nasdaq  SmallCap  Market  the  Company  must meet
Nasdaq's minimum bid price requirement of $1.00 per share. Because the 


                                       21
<PAGE>

Company's  stock  price fell below  $1.00 for a 30 day  trading  period  between
August 28 and October 9, 1998, it is now subject to  delisting.  The Company met
with  representatives  of  Nasdaq  on March  18,  1999 and  presented  arguments
supporting  continued listing. At the hearing, the Company volunteered to delist
from the Nasdaq  SmallCap Market on May 18, 1999 if it is not in compliance with
the minimum bid price requirement by that date. The Company expects that it will
be in  compliance  by that date,  as a result of the reverse  split and the Star
sale.  Nasdaq's decision is still pending. To regain compliance with the minimum
bid price  requirement,  the  Company  has asked its  stockholders  to approve a
reverse split of the Company's common stock.  However, the reverse split may not
enable the Company to regain  compliance with the minimum bid price  requirement
in time to prevent  delisting.  The Company's  management  anticipates  that the
absence of the Nasdaq  listing  for the  Company's  common  stock  would have an
adverse  effect on the market  for,  and  potentially  the market  price of, the
Company's  common  stock.  The delisting of the common stock would likely reduce
stockholders'  ability to buy and sell Company  common stock,  and the Company's
ability to raise capital. If the Company's common stock is delisted from Nasdaq,
the  Company  expects  that  brokers  would  continue  to make a  market  in the
Company's common stock on the OTC Bulletin Board.

(f)      Recently Issued Accounting Standard

         In February 1997,  Financial Accounting Standards Board ("FASB") issued
Statement of Financial  Accounting  Standards  ("SFAS")  No.133  Accounting  for
Derivative  Instruments  and  Hedging  Activities.   SFAS  No.  133  establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts  (collectively referred to as
derivatives)  and for hedging  activities.  SFAS No. 133 is effective for fiscal
years beginning  after June 15, 1999. The Company  believes that the adoption of
this new  accounting  standard will not have a material  impact on the Company's
financial statements.

Item 7A     Quantitative And Qualitative Disclosures About Market Risk

         (i)      Derivative Financial Instruments, Other Financial Instruments,
                  and Derivative Commodity Instruments.

         As of  December  31,  1998,  the  Company  did not  participate  in any
derivative  financial  instruments or other financial and commodity  instruments
for which fair value disclosure would be required under SFAS No. 107. All of the
Company's investments are considered cash equivalents money market accounts that
are carried on the Company's books at amortized cost,  which  approximates  fair
market  value.   Accordingly,   the  Company  has  no  quantitative  information
concerning the market risk of participating in such investments.

         (ii)     Primary Market Risk Exposures.

         The  Company's  primary  market  risk  exposures  are in the  areas  of
interest  rate risk and  foreign  currency  exchange  rate risk.  The  Company's
investment   portfolio  of  cash   equivalents   is  subject  to  interest  rate
fluctuations,  but the  Company  believes  this  risk is  immaterial  due to the
short-term nature of these investments.

         The Company's  exposure to currency exchange rate fluctuations has been
and is expected to continue to be modest due to the fact it currently  sells its
products  in United  States  dollars.  The  Company  does not  engage in foreign
currency hedging activities.

          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 the
sale of  Star,  financing  of  future  operations,  and the  Company's  research
partnership  with MGH) 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 risk factors  identified  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  


                                       22
<PAGE>

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

IF WE DO NOT CLOSE THE SALE OF OUR STAR SUBSIDIARY, WE MAY NOT HAVE ENOUGH MONEY
TO FINANCE FUTURE OPERATIONS.

         We have recently  signed an agreement  with Coherent in which  Coherent
has agreed to buy our Star  subsidiary for $65 million in cash. The sale must be
approved by  stockholders  holding a majority  of the shares of our  outstanding
common stock. The sale is also subject to other standard closing conditions.  We
may not  receive  a  sufficient  number  of  stockholder  votes to  approve  the
transaction,  or the transaction may fail to close for other reasons. Our future
operating  plan is now to a great extent  dependant on  completing  the sale, in
that it  will  provide  us with  the  money  necessary  to  finance  our  future
operations, including research and product development.

WE MAY BE DELISTED  FROM  NASDAQ.  DELISTING  MAY REDUCE YOUR ABILITY TO BUY AND
SELL OUR COMMON STOCK AND OUR ABILITY TO RAISE MONEY.

         We have been  notified by the Nasdaq  Stock  Market that for  continued
listing on the Nasdaq SmallCap Market we must meet Nasdaq's minimum bid price of
$1.00 per share.  Because  our stock price fell below $1.00 for a 30 day trading
period  between  August 28 and October 9, 1998,  it is now subject to delisting.
Nasdaq held a hearing on our delisting on March 18, 1999.  Nasdaq's  decision is
pending.  To regain compliance with the minimum bid price  requirement,  we have
asked our  stockholders to approve a  one-for-seven  reverse split of our common
stock. At the March 18, 1999 hearing, the Company volunteered to delist from the
Nasdaq  SmallCap  Market  on May 18,  1999 if it is not in  compliance  with the
minimum  bid  price  requirement  by that  date.  We  expect  that we will be in
compliance  by that date as a result  of the  reverse  split and the Star  sale.
Nevertheless,  the reverse split may not enable us to regain compliance with the
minimum bid price requirement in time to prevent delisting. The delisting of our
common  stock  would  likely  reduce  stockholders'  ability to buy and sell our
common stock and our ability to raise  capital.  If our common stock is delisted
from the Nasdaq SmallCap  Market,  it will likely be quoted on the "pink sheets"
maintained  by the  National  Quotation  Bureau,  Inc. or Nasdaq's  OTC Bulletin
Board.  These  listings can make trading more  difficult  for  stockholders.  In
addition,  a reverse  split  itself  could hurt the  market  price of our common
stock.

WE MAY NEED TO SECURE  ADDITIONAL  FINANCING,  AND OUR AUDITORS  HAVE  EXPRESSED
DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.

         We have a history of losses. As a result, the report of our independent
public  accountants  in connection  with our  Consolidated  Balance Sheets as of
December  31,  1998  and  1997,  and  the  related  Consolidated  Statements  of
Operations,  Stockholders'  Equity  (Deficit) and Cash Flows for the three years
ended  December  31, 1998  includes an  explanatory  paragraph  stating that our
recurring losses,  working capital  deficiency and stockholders'  deficit raises
substantial  doubts about our ability to continue as a going  concern.  If we do
not sell our Star  subsidiary,  we may have to secure  additional  financing  to
complete our research and development activities,  commercialize our current and
proposed  cosmetic  laser  products,  and fund ongoing  operations.  We may also
determine,  depending upon the opportunities  available, to seek additional debt
or  equity  financing  to fund the costs of  acquisitions  or  expansion.  If we
finance an acquisition  with our stock,  our issuance of such stock could result
in dilution to the  interests  of our  stockholders.  Additionally,  if we incur
indebtedness  to fund  increased  levels of  accounts  receivable,  finance  the
acquisition of capital  equipment,  or if we issue debt securities in connection
with any  acquisition  we will be subject  to risks  associated  with  incurring
substantial additional  indebtedness.  One of those risks is that interest rates
may  fluctuate  and our  cash  flow may be  insufficient  to pay  principal  and
interest on any such indebtedness.

WE WILL CONTINUE TO BE DEPENDENT ON COHERENT IF WE DO NOT SELL STAR.

         Under our sales agency  agreement with  Coherent,  which will remain in
effect  until  November,  2001  if we do not  sell  Star to  Coherent,  Coherent
receives a marketing and sales commission, based on the end-user price, for each
of our lasers that it sells.  If Coherent  remains as our exclusive  distributor
because  we do not  close  the Star  sale,  Coherent  may not be  successful  in
distributing  our lasers or may not give  sufficient  priority to marketing  our
products.  In addition,  Coherent may develop,  market and  manufacture  its own
lasers that incorporate our proprietary  technology and compete with our lasers,
in which case it must 


                                       23
<PAGE>

pay us a  royalty  on such  sales.  Under  our  agreement,  if we are  unable or
unwilling  to  manufacture  the cosmetic  laser  products to be  distributed  by
Coherent, then we must license to Coherent the technology necessary to make such
products.

OUR FUTURE REVENUE DEPENDS ON OUR DEVELOPING NEW PRODUCTS.

         We face rapidly  changing  technology  and continuing  improvements  in
cosmetic laser technology.  In order to be successful,  we must continue to make
significant  investments  in research and  development  in order to develop in a
timely and cost-effective manner new products that meet changing market demands,
enhance existing products,  and achieve market acceptance for such products.  We
have in the past  experienced  delays in  developing  new products and enhancing
existing  products.  If we sell our Star subsidiary,  our future revenue will be
entirely  dependent  on sales of newly  introduced  products.  Although  we have
recently  introduced  a new  hair  removal  laser,  it may  not  achieve  market
acceptance or generate sufficient margins. In addition, the market for this type
of hair  removal  laser may  already be  saturated.  At  present,  broad  market
acceptance  of  laser  hair  removal  is  critical  to our  success.  We need to
diversify our product line by developing cosmetic laser products other than hair
removal lasers.

WE FACE INTENSE  COMPETITION FROM COMPANIES WITH SUPERIOR  FINANCIAL,  MARKETING
AND OTHER RESOURCES.

         The laser hair removal  industry is highly  competitive,  and companies
frequently introduce new products.  We compete in the development,  manufacture,
marketing and servicing of hair removal  lasers with numerous  other  companies,
many  of  which  have  substantially  greater  financial,  marketing  and  other
resources than we do. As a result, some of our competitors are able to sell hair
removal  lasers at prices  significantly  below the  prices at which we sell our
hair  removal  lasers.  In  addition,  if and  when we sell  Star,  our  current
distributor,  Coherent,  one of the largest and best financed  laser  companies,
will become our competitor,  and we will have to find new ways to distribute our
products.  Our laser products also face  competition  from  alternative  medical
products and procedures,  such as electrolysis and waxing,  among others. We may
not be able to differentiate  our products from the products of our competitors,
and customers may not consider our products to be superior to competing products
or medical  procedures,  especially if  competitive  products and procedures are
offered  at  lower  prices.   Our  competitors  may  develop   products  or  new
technologies that make our products obsolete or less competitive.

OUR QUARTERLY  OPERATING RESULTS MAY DECREASE IF WE SELL STAR, AND THAT MAY HURT
THE PRICE OF OUR COMMON STOCK.

         Almost  all of our  revenues  in our  most  recent  two  quarters  were
attributable to sales of the LightSheer(TM) diode laser manufactured by Star. If
we sell Star, our revenues will decline significantly.  If our operating results
fall below the expectations of investors or public market analysts, the price of
our common stock could fall dramatically.

OUR LASERS ARE SUBJECT TO NUMEROUS FDA REGULATIONS.  COMPLIANCE IS EXPENSIVE AND
TIME-CONSUMING.  OUR  PRODUCTS  MAY NOT BE  ABLE TO  OBTAIN  THE  NECESSARY  FDA
CLEARANCES BEFORE WE CAN SELL THEM.

         All of our products are laser medical  devices.  Laser medical  devices
are  subject  to  FDA  regulations  regulating  clinical  testing,  manufacture,
labeling,  sale,  distribution  and promotion of medical  devices.  Before a new
device can be introduced into the market, we must obtain clearance from the FDA.
Compliance with the FDA clearance process is expensive and  time-consuming,  and
we may not be able to obtain such clearances timely or at all.

WE ARE DEPENDENT ON THIRD PARTY RESEARCHERS.

         We are substantially dependent upon third party researchers,  over whom
we do not have absolute control, to satisfactorily conduct and complete research
on our behalf and to grant us favorable  licensing terms for products which they
may develop.  At present,  our principal research partner is the Wellman Labs at
Massachusetts  General Hospital.  We provide research funding,  laser technology
and optics know-how in return for licensing  agreements with respect to specific
medical  applications and patents. Our success will be highly dependent upon the
results of the research.  We cannot be sure that such research  agreements  will
provide us with  marketable  products in the future or that any of the  products
developed under these agreements will be profitable for us.

                                       24
<PAGE>

OUR  COMMON  STOCK  COULD  BE  FURTHER  DILUTED  AS THE  RESULT  OF OUR  ISSUING
CONVERTIBLE SECURITIES, WARRANTS AND OPTIONS.

         In the past, we have issued convertible securities,  such as debentures
and preferred  stock,  and warrants in order to raise money. We have also issued
options and warrants as compensation for services and incentive compensation for
our employees and  directors.  We have a substantial  number of shares of common
stock   reserved  for  issuance  upon  the  conversion  and  exercise  of  these
securities. Our issuing additional convertible securities,  options and warrants
could affect the rights of our  stockholders,  and could reduce the market price
of our common stock.

OUR PROPRIETARY TECHNOLOGY HAS ONLY LIMITED PROTECTIONS.

         Our business could be materially  and adversely  affected if we are not
able to protect adequately our proprietary intellectual property rights. We rely
on a  combination  of patent,  trademark  and trade  secret  laws,  license  and
confidentiality agreements to protect our proprietary rights. We generally enter
into  non-disclosure  agreements  with our  employees and customers and restrict
access to, and distribution of, our proprietary  information.  Nevertheless,  we
may be unable  to deter  misappropriation  of our  proprietary  information,  to
detect   unauthorized  use  and  to  take  appropriate   steps  to  enforce  our
intellectual  property rights.  Our competitors also may  independently  develop
technologies  that are  substantially  equivalent or superior to our technology.
Although  we believe  that our  services  and  products  do not  infringe on the
intellectual  property  rights of others,  we cannot  prevent  someone else from
asserting  a claim  against us in the future for  violating  their  intellectual
property  rights.  In  addition,  costly  and  time  consuming  lawsuits  may be
necessary to enforce  patents  issued or licensed  exclusively to us, to protect
our trade secrets and/or know-how or to determine the enforceability,  scope and
validity of others' intellectual property rights.

         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,  we can
conduct only limited searches to determine whether our 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 us 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 us on  satisfactory
terms,   or  that  we  could   redesign  our  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 us from manufacturing and selling some of our products.  This could have
a material  adverse effect on our business,  results of operations and financial
condition.

OUR  CHARTER  DOCUMENTS  AND  DELAWARE  LAW MAY  DISCOURAGE  POTENTIAL  TAKEOVER
ATTEMPTS.

         Certain provisions of our Second Restated Certificate of Incorporation,
our By-laws,  and Delaware law could be used by our incumbent management to make
it more difficult for a third party to acquire control of us, even if the change
in control  might be  beneficial  to our  stockholders.  This  could  discourage
potential  takeover  attempts and could adversely affect the market price of our
common stock. In particular,  we may issue preferred stock in the future without
stockholder  approval,  upon terms  determined  by our board of  directors.  The
rights of our common  stockholders  may be  adversely  affected by the rights of
holders of any preferred  stock issued in the future.  Our 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,  or of  discouraging a third party
from acquiring, a majority of our outstanding stock.

                                       25
<PAGE>

AS WITH ANY NEW PRODUCTS, THERE IS SUBSTANTIAL RISK THAT THE MARKETPLACE MAY NOT
ACCEPT OR BE RECEPTIVE TO THE POTENTIAL BENEFITS OF OUR PRODUCTS.

         Market  acceptance of our current and proposed products will depend, in
large part, upon our or any marketing partners to demonstrate to the marketplace
the  advantages  of our products  over other types of products.  There can be no
assurance that the marketplace will accept  applications or uses for our current
and proposed  products or that any of our current or proposed  products  will be
able to compete effectively.

WE FACE RISKS ASSOCIATED WITH PENDING LITIGATION.

         We are involved in disputes  with third  parties.  Such  disputes  have
resulted in litigation  with such  parties.  We have  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 us. An
adverse result in the MEHL patent  litigation,  the action relating to the Swiss
Franc Debentures,  or the Varljen litigation (all described in detail in Item 3)
could have a material  adverse effect on our business,  financial  condition and
results of operations.  We are 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.

WE MAY NOT BE ABLE TO RETAIN OUR KEY  EXECUTIVES  AND RESEARCH  AND  DEVELOPMENT
PERSONNEL.

         As a small company with less than 100  employees  (assuming the sale of
Star) our success  depends on the services of key  employees  in  executive  and
research and development  positions.  The loss of the services of one or more of
these employees could have a material adverse effect on us.

WE FACE A RISK OF FINANCIAL  EXPOSURE TO PRODUCT  LIABILITY  CLAIMS IN THE EVENT
THAT THE USE OF OUR PRODUCTS RESULTS IN PERSONAL INJURY.

         Our products are 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 our products.  Further, in the event that any of our products prove to be
defective, we may be required to recall and redesign such products.  Although we
have not  experienced  any material  losses due to product  liability  claims to
date,  there can be no assurance that we will not experience  such losses in the
future. We maintain general liability  insurance in the amount of $1,000,000 per
occurrence and $2,000,000 in the aggregate and maintain 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 us or that such
coverage will be adequate for liabilities actually incurred. In the event we are
found liable for damages in excess of the limits of our insurance  coverage,  or
if any claim or product recall results in significant  adverse publicity against
us,  our  business,  financial  condition  and  results of  operations  could be
materially and adversely affected. In addition,  although our products have been
and will  continue to be designed to operate in a safe  manner,  and although we
attempt  to  educate  medical  personnel  with  respect to the proper use of our
products,  misuse of our products by medical personnel over whom we cannot exert
control  may  result in the filing of product  liability  claims or  significant
adverse publicity against us.

COMPUTER  SYSTEMS ON WHICH WE RELY MAY NOT  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. We are at this time utilizing internal
resources to identify,  correct or reprogram, and test our systems for year 2000
compliance.  However,  there  can be no  assurance  that  the  systems  of other
companies on which our 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 our 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 our earnings.

                                       26
<PAGE>

Item 8.  Financial Statements

<TABLE>

                       PALOMAR MEDICAL TECHNOLOGIES, INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


<S>                                                                                                       <C>
Reports of Independent Public Accountants                                                                 28

Consolidated Balance Sheets as of December 31, 1997 and 1998                                              30

Consolidated Statements of Operations for the years ended December 31, 1996,
         1997 and 1998                                                                                    31

Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 1996,
         1997 and 1998                                                                                    32

Consolidated Statements of Cash Flows for the years ended December 31, 1996,
         1997 and 1998                                                                                    35

Notes to Consolidated Financial Statements                                                                37

</TABLE>



                                       27
<PAGE>


<PAGE>


                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To Palomar Medical Technologies, Inc:

     We have audited the  accompanying  consolidated  balance  sheets of Palomar
Medical  Technologies,  Inc. (a Delaware  corporation)  and  subsidiaries  as of
December  31,  1997  and  1998,  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, 1998. These financial  statements are the
responsibility of the Company's management.  Our responsibility is to express an
opinion  on these  financial  statements  based on our  audits.  The  summarized
financial  data  for  Nexar  Technologies,  Inc.  as of and for the  year  ended
December 31, 1997  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 audits 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, 1997 and 1998,  and the results of their  operations  and their
cash flows for each of the three years in the period ended  December 31, 1998 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 11, 1999 (except for the
matter discussed in Note 12(c)
as to which the date is March 17, 1999).

                                       28
<PAGE>


<PAGE>


              REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

To the Board of Directors and Stockholders
of Nexar Technologies, Inc.
Southborough, Massachusetts

We  have  audited  the   accompanying   consolidated   balance  sheet  of  Nexar
Technologies,  Inc. and  subsidiary  as of December  31,  1997,  and the related
consolidated  statements of operations,  stockholders' equity (deficit) and cash
flows for the year then ended.  These financial  statements (which are not shown
separately  herein) are the  responsibility  of the  Company's  management.  Our
responsibility  is to express an opinion on these financial  statements based on
our audit. The consolidated financial statements of Nexar Technologies, Inc. and
subsidiary as of December 31, 1996 and for the periods  ended  December 31, 1995
and 1996 (not shown  separately  herein),  were audited by other  auditors whose
report dated January 24, 1997 (except with respect to the  purchased  technology
matter discussed in Note 2 as to which the date is February 28, 1997), expressed
an unqualified opinion on those statements.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion,  the 1997 financial statements referred to above present fairly,
in all material respects, the financial position of Nexar Technologies, Inc. and
subsidiary as of December 31, 1997 and the results of their operations and their
cash  flows  for the year  then  ended in  conformity  with  generally  accepted
accounting principles.


                                                  /s/ BDO Seidman, LLP
                                                  ----------------------------
                                                  BDO Seidman, LLP


February 13, 1998 (except for
Note 10 which is as of
March 20, 1998)


                                       29
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

<TABLE>

                                                                                            December 31,          December 31,
                                                                                                1997                  1998
                                                                                           ----------------      ----------------
<S>                                                                                             <C>                   <C>       
ASSETS

CURRENT ASSETS:
       Cash and cash equivalents                                                                $3,003,300            $1,874,718
       Marketable securities                                                                     1,449,326                     -
       Accounts receivable, net of allowance for doubtful accounts of
            approximately $746,000 and $364,000 in 1997 and 1998, respectively                   2,248,680             9,938,121
       Inventories                                                                               4,711,474             5,416,342
       Other current assets                                                                      2,153,941             1,056,388
                                                                                           ----------------      ----------------
            Total current assets                                                                13,566,721            18,285,569
                                                                                           ----------------      ----------------

NET ASSETS OF DISCONTINUED OPERATIONS (NOTE 2)                                                   5,825,602                     -
                                                                                           ----------------      ----------------

PROPERTY AND EQUIPMENT, NET                                                                      6,455,586             3,314,087
                                                                                           ----------------      ----------------

OTHER ASSETS:
       Cost in excess of net assets acquired, net of accumulated amortization of
            approximately $1,280,000 and $1,882,000 in 1997 and 1998, respectively               2,302,348             1,699,983
       Deferred financing costs                                                                    591,609                58,923
       Other non-current assets                                                                    225,706               167,352
                                                                                           ----------------      ----------------
            Total other assets                                                                   3,119,663             1,926,258
                                                                                           ----------------      ----------------

                                                                                               $28,967,572           $23,525,914
                                                                                           ================      ================

LIABILITIES AND STOCKHOLDERS' DEFICIT

CURRENT LIABILITIES:

       Current portion of long-term debt                                                        $1,640,465            $6,290,041
       Accounts payable                                                                          4,150,982             6,553,745
       Accrued liabilities                                                                      13,759,854            10,301,624
       Current portion of deferred revenue                                                       1,284,395             1,143,796
                                                                                           ----------------      ----------------
            Total current liabilities                                                           20,835,696            24,289,206
                                                                                           ----------------      ----------------

NET LIABILITIES OF DISCONTINUED OPERATIONS                                                               -             1,680,171
                                                                                           ----------------      ----------------

LONG-TERM DEBT, NET OF CURRENT PORTION                                                          12,445,563             3,150,000
                                                                                           ----------------      ----------------

DEFERRED REVENUE, NET OF CURRENT PORTION                                                         1,870,000               870,000
                                                                                           ----------------      ----------------

COMMITMENTS AND CONTINGENCIES (NOTE 12)

STOCKHOLDERS' DEFICIT:
       Preferred stock, $.01 par value-
            Authorized - 5,000,000 shares
            Issued and outstanding -
            16,397 shares and 6,993 shares
            at December 31, 1997 and 1998, respectively
            (Liquidation preference of $8,228,082 as of December 31, 1998)                             164                       69
       Common stock, $.01 par value-
            Authorized - 120,000,000 shares
            Issued - 45,792,585 shares and 70,524,027 shares
            at December 31, 1997 and 1998, respectively                                            457,926                  705,240
       Additional paid-in capital                                                              147,356,579              160,733,433
       Accumulated deficit                                                                    (152,359,497)            (166,263,346)
       Less: Treasury stock - (345,000 shares at cost)                                          (1,638,859)              (1,638,859)
                                                                                           ----------------         ----------------
            Total stockholders' deficit                                                         (6,183,687)              (6,463,463)

                                                                                           ----------------         ----------------
                                                                                               $28,967,572              $23,525,914
                                                                                           ================         ================

</TABLE>

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



                                       30
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>

                                                                                 Years Ended December 31,
                                                                       1996                 1997               1998
                                                                 ------------------   -----------------   ----------------

<S>                                                                    <C>                 <C>                <C>        
REVENUES                                                               $17,606,871         $20,994,546        $44,514,057

COST OF REVENUES                                                        14,169,471          20,055,963         23,050,834
                                                                 ------------------   -----------------   ----------------

         Gross profit                                                    3,437,400             938,583         21,463,223
                                                                 ------------------   -----------------   ----------------

OPERATING EXPENSES:

         Research and development                                        6,297,477          11,990,332          7,029,348
         Sales and marketing                                             5,076,941           6,959,750         15,132,595
         General and administrative                                      9,752,922          15,332,241          8,866,530
         Business development
              and other financing costs                                  2,879,603           2,060,852                  -
         Restructuring and asset write-off (Note 4)                      1,660,808           3,325,000            (131,310)
         Settlement and litigation costs                                   880,000           3,199,000                  -
                                                                 ------------------   -----------------   ----------------

                 Total operating expenses                               26,547,751          42,867,175         30,897,163
                                                                 ------------------   -----------------   ----------------

                 Loss from operations                                  (23,110,351)        (41,928,592)        (9,433,940)

INTEREST EXPENSE                                                          (271,619)         (6,993,898)        (1,290,905)

INTEREST INCOME                                                          1,355,488             456,945             33,080

NET GAIN (LOSS) ON TRADING SECURITIES                                    2,033,371             (52,272)           703,211

ASSET WRITE-OFF (NOTE 4)                                                (1,397,000)         (9,658,000)                 -

OTHER INCOME (EXPENSE)                                                     591,853            (193,262)            21,311
                                                                 ------------------   -----------------   ----------------

         NET LOSS FROM CONTINUING OPERATIONS                           (20,798,258)        (58,369,079)        (9,967,243)
                                                                 ------------------   -----------------   ----------------

LOSS FROM DISCONTINUED OPERATIONS (NOTE 2):

         Loss from operations                                          (20,895,534)        (29,508,755)        (1,090,885)
         Gain (Loss) on dispositions, net                                3,830,000           2,073,943         (1,533,295)
                                                                 ------------------   -----------------   ----------------

         NET LOSS FROM DISCONTINUED OPERATIONS                         (17,065,534)        (27,434,812)        (2,624,180)
                                                                 ------------------   -----------------   ----------------

                 NET LOSS                                            $ (37,863,792)      $ (85,803,891)      $(12,591,423)
                                                                 ==================   =================   ================

BASIC AND DILUTED NET LOSS PER COMMON SHARE:

         Continuing operations                                              $(0.84)             $(1.79)            $(0.18)
         Discontinued operations                                             (0.65)              (0.78)             (0.04)
                                                                 ------------------   -----------------   ----------------

                 TOTAL LOSS PER COMMON SHARE                                $(1.49)             $(2.57)            $(0.22)
                                                                 ==================   =================   ================

WEIGHTED AVERAGE NUMBER OF
    COMMON SHARES OUTSTANDING                                           26,166,538          35,105,272         62,868,696
                                                                 ==================   =================   ================
                                                                 
</TABLE>

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



                                       31
<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, 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>




                                                                 Additional                     Unrealized
                                                                 Paid-in        Accumulated   (Loss) Gain on   Subscriptions 
                                                                 Capital         Deficit        Marketable      Receivable         
                                                                                Securities                  
                                                                 ------------------------------------------------------------
BALANCE, DECEMBER 31, 1995                                        $54,152,385  $(25,864,657)      $--          $(1,988,709)

    Sale of common stock pursuant to warrants and 
     options                                                        7,569,226           --         --                   -- 
    Sale of common stock                                            6,049,618           --         --                   -- 
    Payments received on subscriptions receivable                          --           --         --            2,441,556 
    Issuance of preferred stock, including common stock issued 
     as a placement fee, net of issuance costs                     30,821,677           --         --                   -- 
    Issuance of common stock for 1995 employer 401(k)
     matching contribution                                            160,139           --         --                   --
    Conversion of preferred stock, including accrued 
     dividends and interest of $782,602                               744,124           --         --                   --
    Conversion of convertible debentures                              145,260           --         --                   --
    Redemption of convertible debentures                              (41,530)          --         --                   --
    Value ascribed to convertible debentures                        2,757,860           --         --                   --
    Redemption of preferred stock                                  (3,123,127)          --         --                   --
    Exercise of underwriter's warrants                              1,057,500           --         --           (1,057,500)
    Exercise of stock options in majority controlled 
     subsidiary                                                        50,000           --         --                   -- 
    Issuance of common stock for conversion of debentures at
     Tissue Technologies, Inc.                                      1,019,022           --         --                   -- 
    Issuance of common stock for minority interest in
     Star Medical subsidiary                                        1,747,482           --         --                   -- 
    Issuance of common stock in exchange for license 
     rights                                                           369,574           --         --                   -- 
    Issuance of common stock for acquisition of
     Dermascan, Inc.                                                  489,650           --         --                   -- 
    Issuance of common stock for investment banking and merger
     and acquisition consulting services                              476,156           --         --                   -- 
    Compensation expense related to warrants issued to 
     non-employees under SFAS No. 123                                 532,758           --         --                   -- 
    Return of escrowed shares                                             460           --         --                   -- 
    Amortization of deferred financing costs                          (77,683)          --         --                   -- 
    Unrealized loss on marketable securities                               --           --   (342,500)                  -- 
    Preferred stock dividends                                              --   (1,242,751)        --                   -- 
    Net loss                                                               --  (37,863,792)        --                   -- 
                                                                 ------------------------------------------------------------

BALANCE, DECEMBER 31, 1996                                       $104,900,551 $(64,971,200) $(342,500)           $(604,653)
                                                                 ============================================================
</TABLE>



<TABLE>
<S>                                                             <C>




                                                                      Total 
                                                                   Stockholders
                                                                 Equity (Deficit)
                                                                -------------------
BALANCE, DECEMBER 31, 1995                                         25,288,754 

    Sale of common stock pursuant to warrants and
     options                                                        7,598,907 
    Sale of common stock                                            6,061,380 
    Payments received on subscriptions receivable                   2,441,556 
    Issuance of preferred stock, including common stock issued 
     as a placement fee, net of issuance costs                     30,823,147 
    Issuance of common stock for 1995 employer 401(k) 
     matching contribution                                            160,598 
    Conversion of preferred stock, including accrued 
     dividends and interest of $782,602                               788,687 
    Conversion of convertible debentures                              145,606 
    Redemption of convertible debentures                              (41,530)
    Value ascribed to convertible debentures                        2,757,860 
    Redemption of preferred stock                                  (3,123,152)
    Exercise of underwriter's warrants                                  5,000 
    Exercise of stock options in majority controlled
     subsidiary                                                        50,000 
    Issuance of common stock for conversion of debentures at
     Tissue Technologies, Inc.                                      1,027,156 
    Issuance of common stock for minority interest in
     Star Medical subsidiary                                        1,749,723 
    Issuance of common stock in exchange for license 
     rights                                                           370,143 
    Issuance of common stock for acquisition of
     Dermascan, Inc.                                                  490,000 
    Issuance of common stock for investment banking and merger 
     and acquisition consulting services                              476,724 
    Compensation expense related to warrants issued to 
     non-employees under SFAS No. 123                                 532,758 
    Return of escrowed shares                                              -- 
    Amortization of deferred financing costs                          (77,683)
    Unrealized loss on marketable securities                         (342,500)
    Preferred stock dividends                                      (1,242,751)
    Net loss                                                      (37,863,792)
                                                                 ------------

BALANCE, DECEMBER 31, 1996                                       $ 38,076,591
                  === ====                                       ============

</TABLE>

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



                                       32
<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 costs 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>



                                                             Additional                  Unrealized (Loss)                   
                                                             Paid-in      Accumulated    Gain on Marketable    Subscriptions 
                                                             Capital       Deficit         Securities         Receivable     
                                                             ----------------------------------------------------------------
BALANCE, DECEMBER 31, 1996                                   $104,900,551  $(64,971,200)      $(342,500)     $(604,653)

    Sale of common stock pursuant to warrants, 
     options and Employee Stock Purchase Plan                   1,606,083            --              --             -- 
    Reduction in subscriptions receivable                              --            --              --        604,653 
    Sale of preferred stock, net of issuance costs of 
     approximately $1,000,000                                  14,999,840            --              --             -- 
    Issuance of common stock for 1996 employer 401(k) 
     matching contribution                                        317,280            --              --             -- 
    Conversion and redemption of preferred stock               (3,926,317)           --              --             -- 
    Conversion of convertible debentures and issuance 
     of common stock to an investor                            16,935,713            --              --             -- 
    Issuance of common stock for investment banking, merger 
     and acquisition and consulting services                       52,925            --              --             -- 
    Value ascribed to the discount feature of
     convertible debentures issued                              3,750,812            --              --             -- 
    Unrealized gain on marketable securities                           --            --         342,500             -- 
    Preferred stock dividends                                          --    (1,584,406)             --             -- 
    Guaranteed value of common stock associated with 
     Dermascan acquisition                                       (216,562)           --              --             -- 
    Issuance of common stock for technology                     1,146,388            --              --             -- 
    Purchase of stock for treasury                                     --            --              --             -- 
    Gain related to the issuance of common stock by 
     Nexar Technologies, Inc.                                   7,409,866            --              --             -- 
    Value ascribed to warrant to purchase common 
     stock issued to Coherent, Inc.                               380,000            --              --             -- 
    Net loss                                                           --   (85,803,891)             --             -- 
                                                             ----------------------------------------------------------
BALANCE, DECEMBER 31, 1997                                   $147,356,579  $(152,359,497)    $       --      $      -- 
                                                             ==========================================================

</TABLE>


                                                                Total     
                                                             Stockholder
                                                           Equity (Deficit)
                                                           ----------------

BALANCE, DECEMBER 31, 1996                                   $38,076,591  

    Sale of common stock pursuant to warrants,                            
     options and Employee Stock Purchase Plan                  1,614,234  
    Reduction in subscriptions receivable                        604,653  
    Sale of preferred stock, net of issuance costs of                     
     approximately $1,000,000                                  15,000,000 
    Issuance of common stock for 1996 employer 401(k)                     
     matching contribution                                        318,154 
    Conversion and redemption of preferred stock               (3,865,096)
    Conversion of convertible debentures and issuance 
     of common stock to an investor                            17,010,363 
    Issuance of common stock for investment banking, merger
     and acquisition and consulting services                       53,125 
    Value ascribed to the discount feature of
     convertible debentures issued                              3,754,943 
    Unrealized gain on marketable securities                      342,500 
    Preferred stock dividends                                  (1,584,406)
    Guaranteed value of common stock associated with 
     Dermascan acquisition                                       (216,562)
    Issuance of common stock for technology                     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 
    Value ascribed to warrant to purchase common 
     stock issued to Coherent, Inc.                               380,000 
    Net loss                                                  (85,803,891)
                                                             ------------ 
BALANCE, DECEMBER 31, 1997                                   $(6,183,687) 
                  === ====                                   ============  
                                                              

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

                                       33
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

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

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

                                                                                        Preferred Stock              Common Stock  
                                                                                    -----------------------------------------------
                                                                                          Number        $0.01            Number    
                                                                                         of Shares       Par Value      of Shares  
                                                                                     ----------------------------------------------
BALANCE, DECEMBER 31, 1997                                                                  16,397   $         164      45,792,585

  Sale of common stock pursuant to warrants, options and Employee 
   Stock Purchase Plan                                                                          --              --         192,211
  Issuance of common stock for 1997 employer 401(k) matching contribution                       --              --         311,887
  Conversion of preferred stock                                                             (5,888)            (59)      6,891,682
  Conversion of convertible debentures                                                          --              --       7,035,662
  Issuance of common stock net of investment banking fees                                       --              --      10,200,000
  Redemption of preferred stock                                                             (3,516)            (36)             --
  Value ascribed to warrants issued to investment banker                                        --              --              --
  Common stock issued for advisory services                                                     --              --         100,000
  Costs incurred related to the issuance of common stock                                        --              --              --
  Preferred stock dividends and penalties                                                       --              --              --
  Net loss                                                                                      --              --              --

                                                                                     -------------   -------------     -----------
BALANCE, DECEMBER 31, 1998                                                                   6,993   $          69      70,524,027
                                                                                     =============   =============     ===========
</TABLE>
<TABLE>
<S>                                                                                  <C>             <C>             <C>           


                                                                                    Common Stock                Treasury Stock     
                                                                               ----------------------------------------------------
                                                                                        $0.01            Number
                                                                                        Par Value       of Shares          Cost
                                                                               ----------------------------------------------------
BALANCE, DECEMBER 31, 1997                                                           $     457,926       (345,000)  ($  1,638,859)

  Sale of common stock pursuant to warrants, options and Employee 
   Stock Purchase Plan                                                                       1,923             --               -- 
  Issuance of common stock for 1997 employer 401(k) matching contribution                    3,118             --  
  Conversion of preferred stock                                                             68,917             --  
  Conversion of convertible debentures                                                      70,356             --               -- 
  Issuance of common stock net of investment banking fees                                  102,000             --               -- 
  Redemption of preferred stock                                                                 --             --               -- 
  Value ascribed to warrants issued to investment banker                                        --             --               -- 
  Common stock issued for advisory services                                                  1,000             --               -- 
  Costs incurred related to the issuance of common stock                                        --             --               -- 
  Preferred stock dividends and penalties                                                       --             --               -- 
  Net loss                                                                                      --             --               -- 

                                                                                     -------------   -------------   ------------- 
BALANCE, DECEMBER 31, 1998                                                           $     705,240        (345,000)  ($  1,638,859)
                                                                                     =============   =============   ============= 
</TABLE>

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


                                                                                  Additional                              Total
                                                                                  Paid-in           Accumulated       Stockholders'
                                                                                  Capital             Deficit       Equity (Deficit)
                                                                                ---------------------------------------------------
BALANCE, DECEMBER 31, 1997                                                           $ 147,356,579   ($152,359,497)  ($  6,183,687)

  Sale of common stock pursuant to warrants, options and Employee 
   Stock Purchase Plan                                                                      64,208              --          66,131
  Issuance of common stock for 1997 employer 401(k) matching contribution                  251,163              --         254,281
  Conversion of preferred stock                                                            583,310              --         652,168
  Conversion of convertible debentures                                                   6,368,820              --       6,439,176
  Issuance of common stock net of investment banking fees                                9,738,000              --       9,840,000
  Redemption of preferred stock                                                        (3,615,522)              --      (3,615,558)
  Value ascribed to warrants issued to investment banker                                  171,000               --         171,000
  Common stock issued for advisory services                                                99,000               --         100,000
  Costs incurred related to the issuance of common stock                                 (283,125)              --        (283,125)
  Preferred stock dividends and penalties                                                      --       (1,312,426)     (1,312,426)
  Net loss                                                                                     --      (12,591,423)    (12,591,423)
                                                                                    -------------    -------------   ------------- 
BALANCE, DECEMBER 31, 1998                                                          $ 160,733,433    ($166,263,346)  ($  6,463,463)
                                                                                    =============    =============   ============= 
</TABLE>



                                       34
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>

<CAPTION>

                                                                                               Years Ended December 31,
                                                                                        1996            1997              1998
                                                                                --------------------------------------------------
<S>                                                                                <C>              <C>              <C>          
CASH FLOWS FROM OPERATING ACTIVITIES
       Net Loss                                                                    $(37,863,792)    $(85,803,891)    $(12,591,423)
            Less: Net Loss from Discontinued Operations                             (17,065,534)     (27,434,812)      (2,624,180)
                                                                                   ------------     ------------     ------------ 
       Net Loss from Continuing Operations                                          (20,798,258)     (58,369,079)      (9,967,243)
                                                                                   ------------     ------------     ------------ 

       Adjustments to reconcile net loss from continuing operations to net cash
            used in operating activities-
            Depreciation and amortization                                             2,343,013        2,246,412        2,676,651
            Restructuring and asset write-off costs                                   3,057,808       12,983,000         (131,310)
            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)              --
            Non-cash interest expense related to debt                                   163,680        5,473,077           63,652
            Non-cash compensation related to common stock and warrants                  836,982          205,238          171,000
            Realized gain on marketable securities                                     (835,197)        (577,969)              --
            Unrealized (gain) loss on marketable securities                          (1,198,174)         669,293         (703,211)
            Changes in assets and liabilities,
                 Purchases of marketable securities                                 (10,355,055)        (152,938)              --
                 Net sale of marketable securities                                   10,244,044        2,234,436        2,152,537
                 Accounts receivable                                                    (82,025)      (1,809,371)      (7,689,441)
                 Inventories                                                         (4,661,443)      (3,390,396)        (704,868)
                 Other current assets                                                (1,514,858)      (1,005,781)       1,097,553
                 Accounts payable                                                     1,243,161        1,378,637        2,402,763
                 Accrued liabilities                                                  4,727,008        3,546,543          639,934
                 Deferred revenue                                                        35,773        2,948,247       (1,140,599)
                                                                                   ------------     ------------     ------------ 
                          Net cash used in operating activities                     (16,918,640)     (33,043,310)     (11,132,582)
                                                                                   ------------     ------------     ------------ 
CASH FLOWS FROM INVESTING ACTIVITIES
       Purchases of property and equipment                                           (3,180,112)      (5,777,446)        (403,189)
       Increase in other assets                                                      (1,176,527)         (95,830)         (19,628)
       Loans to related parties                                                      (7,338,625)      (1,250,000)              --
       Loans to unrelated parties                                                    (2,236,531)              --               --
       Payments received on loans to related parties                                  9,322,284          941,288               --
       Guaranteed value associated with Dermascan acquisition                                --         (216,562)              --
       Net proceeds from notes receivable                                                    --               --               --
       Investment in nonmarketable securities                                        (2,077,054)      (1,057,631)              --
                                                                                   ------------     ------------     ------------ 
                          Net cash used in investing activities                      (6,686,565)      (7,456,181)        (422,817)
                                                                                   ------------     ------------     ------------ 
</TABLE>

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

                                       35
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (Continued)

<TABLE>
<CAPTION>


                                                                                         Years Ended December 31,
                                                                                   1996               1997              1998
                                                                               ----------------------------------------------------
<S>                                                                             <C>              <C>                     <C> 
CASH FLOWS FROM FINANCING ACTIVITIES
       Proceeds from issuance of convertible debentures                           14,169,441       16,715,169               --
       Proceeds from notes payable                                                        --        3,500,000               --
       Deferred financing costs incurred related to convertible debentures        (1,365,217)            --                 --
       Redemption of convertible debentures                                         (930,000)        (196,000)      (2,196,667)
       Proceeds from (payments of) notes payable and capital lease obligations      (260,224)      (4,856,479)       3,010,817
       Proceeds from issuance of common stock                                     13,715,287        1,462,121        9,840,000
       Proceeds from exercise of warrants, stock options
            and Employee Stock Purchase Plan                                              --               --           66,131
       Issuance of preferred stock                                                30,823,147       15,000,000               --
       Purchase of treasury stock                                                         --         (427,102)              --
       Payment of contingent note payable                                           (500,000)              --               --
       Cost incurred in connection with the issuance of common stock                      --               --         (283,125)
       Redemption of preferred stock, including accrued dividends of $71,223
            and $771,876 in 1996 and 1998, respectively                           (3,194,375)              --       (4,387,434)
       Proceeds from line of credit                                                       --               --        1,000,000
       Payments received on subscription receivable                                2,009,592               --               --
       Deferred costs                                                               (932,661)              --               --
                                                                                ============    =============     ============
                          Net cash provided by financing activities               53,534,990       31,197,709        7,049,722
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                              29,929,785       (9,301,782)      (4,505,677)
NET CASH (USED IN) PROVIDED BY DISCONTINUED OPERATIONS                           (30,073,633)          12,676        3,377,095
CASH AND CASH EQUIVALENTS, BEGINNING OF THE PERIOD                                12,436,254       12,292,406        3,003,300
                                                                                ------------     ------------     ------------
CASH AND CASH EQUIVALENTS, END OF THE PERIOD                                    $ 12,292,406     $  3,003,300     $  1,874,718
                                                                                ============     ============     ============

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
       Cash paid for interest                                                   $    280,659     $    534,037     $  1,094,759
                                                                                ============     ============     ============

SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING AND INVESTING ACTIVITIES:
       Conversion of convertible debentures and related accrued
            interest, net of financing fees                                     $  1,172,762     $ 17,010,363     $  6,439,176
                                                                                ============     ============     ============
       Subscription received in connection with warrant
            exercises                                                           $  1,057,500     $         --     $         --
                                                                                ============     ============     ============

       Conversion of preferred stock                                            $    788,687     $    414,904     $    652,168
                                                                                ============     ============     ============

       Issuance of common stock for purchase of technology
            related to discontinued operations                                  $         --     $  1,148,941     $         --
                                                                                ============     ============     ============
       Exchange of preferred stock for investment in a
            discontinued operation                                              $         --     $ (4,280,000)    $         --
                                                                                ============     ============     ============
       Investment banking and consulting fees for services related
            to the issuance of common stock and convertible debentures          $    709,224     $     53,125     $         --
                                                                                ============     ============     ============
       Issuance of common stock for employer 401(k)
            matching contribution                                               $    160,598     $    318,154     $    254,281
                                                                                ============     ============     ============
       Issuance of common stock for minority interest
            in Star Medical Technologies subsidiary                             $  1,749,723     $         --     $         --
                                                                                ============     ============     ============
      Issuance of common stock for advisory services performed
            in 1997                                                             $         --     $         --     $    100,000

                                                                                ============     ============     ============
</TABLE>

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

                                       36
<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).  The  Company  substantially  completed  the  divestiture
program in May of 1998.

         Some of the Company's  medical laser  products are in various stages of
development;  and, accordingly, the success of future operations is subject to a
number of risks  similar to those of other  companies  with  products in similar
stages  of   development.   Principal  among  these  risks  are  the  successful
development  and  marketing  of the  Company's  products,  obtaining  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  including the pending sale of its Star Medical
Technologies,  Inc. ("Star") to Coherent, Inc. ("Coherent),  as discussed below,
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.  Net cash  provided by financing  activities
totaled  approximately  $53,535,000,  $31,198,000  and  $7,050,000 for the years
ended December 31, 1996,  1997 and 1998,  respectively.  If the Company does not
complete the sale of Star to Coherent the Company  believes that it will require
additional  financing  during the next  twelve-month  period to continue to fund
operations and growth.  This additional  financing could be in the form of sales
of securities to private investors which are generally sold at a discount to the
publicly quoted market price 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.

         On December 7, 1998,  the Company  entered into a Agreement and Plan of
Reorganization  (the  "Agreement")  with  Coherent to sell all of the issued and
outstanding  common  stock of Star,  its 99.96%  majority-owned  subsidiary,  to
Coherent.  The  Company  currently  owns  substantially  all of the  issued  and
outstanding  common  shares of Star.  However,  options  outstanding  granted to
Palomar and  employees of Star to purchase  shares of Star's common stock remain
outstanding.  When all of the outstanding options under Star's Stock Option Plan
have been exercised,  the Company will own 82.46% of Star's common stock and the
employees  will  collectively  own  17.54%.  See Note 7.  Under the terms of the
Agreement,  the selling price of Star is $65 million.  In addition,  the Company
will  receive  an  ongoing  royalty  of 7.5%  from  Coherent  on the sale of any
products by Coherent that use certain patents currently  licensed by the Company
on an exclusive basis from Massachusetts General Hospital.  See Note 12(b). This
sale is subject to the approval of the stockholders of Palomar.

         The  Agreement  may only be  terminated  by (i)  mutual  consent of the
Company,  Star and Coherent, or (ii) Coherent, if Palomar's Board of the Company
approves a superior  proposal to sell Star to a different party, or (iii) either
party after May 1, 1999.  The Company  anticipates  that this sale will close by
May 1, 1999, so long as the Company obtains stockholder approval.

(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 consist of the manufacture and sale of personal computers,  high-density
flexible  electronics  circuitry and memory modules.  The Company  substantially
completed this plan in May of 1998.

                                       37
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

         Nexar  Technologies,  Inc.  ("Nexar")  was included in the  electronics
business segment. Nexar is an early-stage company that manufactures, markets and
sells personal  computers.  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.

         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. As of December 31, 1998 the Company
beneficially  owned  2,406,080  shares of  Nexar's  common  stock,  representing
approximately a 19% ownership interest and had no other significant  obligations
related to Nexar,  other than the guaranty to GFL Advantage Fund Limited ("GFL")
discussed  below.  The Company has been  actively  trying to sell its  remaining
shares of Nexar common stock;  however,  the Company may not be successful since
Nexar filed in the United States Bankruptcy Court a petition for  reorganization
under  Chapter 11 of Title 11 of the United  States Code on December  17,  1998.
Furthermore, Nexar has been delisted from The Nasdaq Stock Market due to Nexar's
failure to satisfy Nasdaq minimum listing requirements.

         The Company has accounted for its investment in Nexar as a discontinued
operation using the equity method. During 1998, the Company recorded a charge to
discontinued  operations of $1,524,966 as a result of  management's  decision to
write-down the carrying value of its investment in Nexar. During the years ended
December 31, 1996 and 1997, the Company  recognized  gains on the disposition of
shares of Nexar common stock of $3,830,000 and $6,221,689,  respectively.  These
amounts are included in "Gain (Loss) on  Dispositions,  net" in the Consolidated
Statements of Operations.

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

                                                                  December 31,
                                                        1996                        1997
                                              -------------------------    ------------------------
             <S>                                           <C>                         <C>
             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

                                                             Year Ended December 31,
                                                        1996                        1997
                                              -------------------------    ------------------------

             Net Revenues                                  $18,695,364                 $33,608,063
             Gross Profit                                    2,302,881                     740,151
             Net Loss                                       (7,510,139)                (13,346,380)

</TABLE>



         On December 31, 1997 the Company entered into an Exchange Agreement and
sold 500,000  shares of Nexar's  common stock to GFL for  $2,000,000.  Under the
terms of the Exchange Agreement,  Palomar guaranteed GFL a minimum selling price
of $5.00 per share with respect to 400,000 shares of Nexar's common stock over a
two-year time period. The Company is obligated to pay GFL on January 1, 2000 the
difference  between $5.00 and the price at which GFL sells the shares of Nexar's
common stock.  As of December 31, 1998, the deferred  liability  related to this
transaction  totaled $1,680,171 and represents the total amount due to GFL after
GFL sold their 400,000 common shares of Nexar stock.

                                       38
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


         The other  entities  that were  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 was a $850,000  unsecured  promissory note
that was due on February 15,  1998.  The second  installment  was a $2.8 million
unsecured  promissory note due in forty-eight  monthly  installments,  beginning
February 1, 1999.  This promissory note was fully reserved by the Company during
1997, as its ultimate  collectibility was believed to be uncertain.  BTC did not
make the  first  installment  on  February  1, 1998 and on  October  7, 1998 the
Company and BTC agreed to reduce the principal balances of the $850,000 note and
the $2.8 million note to a total of  $1,000,000.  BTC paid $500,000  during 1998
and the balance is due April 5, 1999.  The  amended  note is  guaranteed  by the
principal shareholders of BTC.

         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  are being made over  twenty-four
months, beginning December 31, 1997 and interest will accrue at the bank's prime
rate (7.75% at December  31,  1998) plus 2.25%.  This  promissory  note has been
collateralized  by 3,250,000  shares of the Company's common stock that are held
in escrow,  are not  entitled to vote and are not  considered  outstanding.  The
Company  also  guaranteed  up to  $2,500,000  of Comtel's  borrowings  from this
creditor  until  November  30, 1999.  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.

         In  connection  with  the  disposition  of  Comtel,  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  collectibility is uncertain.  To date,
no amounts have been received under this  restructured  note receivable from the
customer,  nor does the Company anticipate  receiving any amounts from this note
receivable in the foreseeable future.

         In phase II, BTC agreed to purchase  all of the issued and  outstanding
stock of Dynaco. The phase II purchase price was $5,346,000, of which $2,673,000
was to be paid in cash  and  $2,673,000  was to be paid in BTC  common  stock of
equal value.  Alternatively,  the Company  could have elected to have the entire
phase II purchase paid in cash at a value of $3,500,000. During phase II BTC had
the option of selling  Dynaco to a third  party if agreed to by the  Company and
BTC. Phase II was required to be completed by June 30, 1998. Consistent with the
terms of the  agreement  with BTC,  the Company  entered  into a Stock  Purchase
Agreement  with Quick Turn  Circuits,  Inc.  ("QTC") on May 26, 1998 pursuant to
which QTC purchased 100% of the issued and outstanding shares of common stock of
Dynaco for $3,200,000.

         As of December 31, 1997, the Company recognized a loss of approximately
$4,148,000 related to the phase I and phase II dispositions.  These charges have
been  netted  in  "Gain  (Loss)  on  Dispositions,   net"  in  the  accompanying
Consolidated  Statements  of  Operations.  As of December 31, 1997,  the Company
accrued for the estimate of Dynaco's 1998  operating  loss through June 30, 1998
of  approximately  $850,000.  Through  the date of  disposition  of Dynaco,  the
Company recognized additional operating losses totaling $1,090,885. During 1998,
the Company  recorded a loss on  disposition  of $8,329  related to the ultimate
sale of Dynaco to QTC.


     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,  ("APB  No.  30") the  consolidated  financial  statements  of the
Company have been reclassified to reflect the dispositions of the aforementioned
subsidiaries that comprise the electronics segment.  

                                       39
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

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  (liabilities)  of these
entities  have  been  reported  as "Net  Assets  (Liabilities)  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>
<CAPTION>

                                                                        December 31,
                                                                  1997                1998
                                                              --------------      --------------
              <S>                                               <C>                <C>
              Current Assets                                     $5,683,694       $         -
              Total Assets                                       11,506,145                 -

              Current Liabilities                                 5,375,353                 -
              Total Liabilities                                   5,680,543        (1,680,171)

                                                              --------------      --------------
              Net Assets (Liabilities) of Discontinued
                   Operations                                    $5,825,602       $(1,680,171)
                                                              ==============      ==============
 
</TABLE>

         The  assets  and  liabilities  of  the  discontinued  operations  as of
December 31, 1997  represent the financial  position of Dynaco and the Company's
liability  associated  with  the  sale of Nexar  common  stock  to GFL.  The net
liability as of December 31, 1998 represents the Company's liability  associated
with the sale of Nexar common stock to GFL.
<TABLE> 
<CAPTION>


                                                              Year Ended December 31,             Period Ended May 26,
                                                              1996              1997                   1998

                                                         ----------------  ----------------   ------------------------
              <S>                                          <C>               <C>                        <C>         
              Revenues                                       $52,491,572       $57,663,080                 $6,471,701

              Net Loss from Discontinued Operations        $(17,065,534)     $(27,434,812)               $(2,624,180)

</TABLE>


         The loss from  operations for all of the  discontinued  operations from
the  measurement  date,  October 1, 1997,  through the date of  disposition  for
Comtel  and  Dynamem  or  December  31,  1997 for  Dynaco,  total  approximately
$3,405,000.  Dynaco's loss from operations for the period  beginning  January 1,
1998 and ending May 26, 1998, the date of disposition, totaled $1,940,885.


(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  including Star, a
99.96% majority owned subsidiary as of December 31, 1998.  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.

                                       40
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

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.

         (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, 1997 and 1998.
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. There were no  available-for-sale  securities
as of  December  31,  1997  and  1998.  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.  As of  December  31,  1997,  marketable  securities
consisted  of American  Material &  Technologies  Corporation,  held for trading
purposes.  As of December 31, 1998, the Company did not have any  investments in
marketable securities.

         (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, 1997 and 1998,  inventories
consist of the following:

<TABLE>
<CAPTION>

                                                                               December 31,
                                                                         1997               1998
                                                                    ---------------    ----------------
                            <S>                                         <C>                 <C>
                            Raw materials                               $2,928,350          $2,478,289
                            Work-in-process                                727,284           1,330,822
                            Finished goods                               1,055,840           1,607,231
                                                                    ---------------    ----------------
                                                                        $4,711,474          $5,416,342
                                                                    ===============    ================
</TABLE>


         Included  in  finished   goods   inventory  at  December  31,  1998  is
approximately  $938,000  of  service  inventory  and  finished  good test  units
currently being evaluated by medical professionals.

                                       41
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

         (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:
<TABLE>
<CAPTION>

                                                                                  Estimated
                                   Asset Classification                          Useful Life
                            ------------------------------------            ----------------------
                            <S>                                                 <C>
                            Machinery and equipment                               3-8 Years
                            Furniture and fixtures                                 5 Years
                            Leasehold improvements                              Term of Lease
</TABLE>


         At December 31, 1997 and 1998,  property and  equipment  consist of the
following:

<TABLE>
<CAPTION>

                                                                               December 31,
                                                                         1997                1998
                                                                    ----------------    ----------------
                             <S>                                         <C>                 <C>
                             Machinery and equipment                     $6,328,442          $6,022,320
                             Furniture and fixtures                       1,018,931           1,120,450
                             Leasehold improvements                         480,453             567,216
                                                                    ----------------    ----------------
                                                                          7,827,826           7,709,986
                             Less:  Accumulated depreciation
                                        and amortization                  1,372,240           4,395,899
                                                                    ----------------    ----------------
                                                                         $6,455,586          $3,314,087
                                                                    ================    ================
</TABLE>

         Included in machinery and equipment as of December 31, 1997 and 1998 is
approximately $3,470,000 and $2,726,000, 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, 1996,  1997,  and 1998  amounted to  approximately
$536,000,  $554,000  and $602,000  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.  The Company has assessed the  realizability of its long-lived assets as
of December 31, 1998 and believes them to be realizable.

         (G)      DEFERRED FINANCING COSTS

         During the year ended December 31, 1996, 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).

                                       42
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


         (H)      REVENUE RECOGNITION

         The Company  recognizes  product  revenue upon shipment.  The Company's
sales of its product do not include any rights of return. 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.

         (I)      SIGNIFICANT CUSTOMERS

         For the years ended  December 31, 1997 and 1998,  Coherent acted as the
sales agent for products sold to the Company's  customers that  represented  11%
and  89% of  revenues  and 51% and  89% of  accounts  receivable,  respectively.
Coherent is the  Company's  worldwide  distributor  of laser  systems  (see Note
12(d)).  International  sales  (including sales for which Coherent was the sales
agent) for the years ended December 31, 1996,  1997 and 1998 were  approximately
22%, 24% and 39% respectively, of total revenue.

         (J)      RESEARCH AND DEVELOPMENT EXPENSES

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

         (K)      NET LOSS PER COMMON SHARE

         Basic net loss per share was  determined  by  dividing  net loss by the
weighted average shares of common stock outstanding during the year. Diluted net
loss per  share  is the same as basic  loss  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, 1996, 1997 and 1998 are as follows:

<TABLE>
<CAPTION>


                                                                   Year Ended December 31,
                                                        1996                1997                1998
                                                   ----------------    ---------------     ----------------
   <S>                                               <C>                <C>                   <C>
   Net loss from continuing operations               $(20,798,258)      $(58,369,079)         $(9,967,243)
   Preferred stock dividends                           (1,242,751)        (1,584,406)          (1,312,426)
   Amortization of value ascribed to preferred
   stock conversion discount                             ---              (2,823,529)            ---
                                                   ----------------    ---------------     ----------------
   Adjusted net loss from continuing  operations     $(22,041,009)      $(62,777,014)        $(11,279,669)
                                                   ================    ===============     ================

   Basic and diluted net loss per common share
   from continuing operations                              $(0.84)            $(1.79)              $(0.18)
                                                   ================    ===============     ================

   Weighted average number of common shares
   outstanding                                         26,166,538         35,105,272           62,868,696
                                                   ================    ===============     ================
</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 1996, 1997 and 1998, 16,140,688,  32,358,446 and 28,451,024 weighted
average common equivalent shares, respectively, were not included in the diluted
weighted average shares outstanding, as they were antidilutive.

                                       43
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


         (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 established 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. The Company has not experienced  significant losses related to receivables
from any individual customers or groups of customers in any specific industry or
by geographic  area.  Due to these  factors,  no  additional  credit risk beyond
amounts provided for collection  losses is believed by management to be inherent
in the Company's accounts receivable.

         (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, 1997 and 1998,  financial  instruments  consisted
principally of convertible  debentures and preferred stock financings.  The fair
value of  financial  instruments  pursuant  to SFAS No. 107  approximated  their
carrying  values at December 31, 1997 and 1998. Fair values have been determined
through information obtained from market sources and management estimates.

         (N)      COMPREHENSIVE INCOME

         The Company  adopted  SFAS No.  130,  REPORTING  COMPREHENSIVE  INCOME,
effective January 1, 1998. SFAS No. 130 establishes  standards for reporting and
presentation  of  comprehensive  income/loss and its components in the financial
statements. The components of the Company's comprehensive loss are as follows:

<TABLE>
<CAPTION>

                                                                        December 31,
                                                        1996                1997                1998
                                                   ----------------    ---------------     ----------------
   <S>                                               <C>                <C>                   <C>
   Net loss from continuing operations               $(20,798,258)      $(58,369,079)         $(9,967,243)
   Unrealized (loss) gain on marketable securities       (342,500)           342,500                  ---
                                                   ----------------    ---------------     ----------------
   Comprehensive loss from continuing  operations    $(21,140,758)      $(58,026,579)         $(9,967,243)
                                                   ================    ===============     ================
</TABLE>

         (O)      RECLASSIFICATIONS

         Certain   reclassifications  have  been  made  to  the  1996  and  1997
consolidated   financial   statements   to  conform  with  the  current   year's
presentation.

                                       44
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


(4)      ASSET WRITE-OFF AND RESTRUCTURING

         The Company,  in  accordance  with  applicable  accounting  principles,
determined during the third quarter of 1997 that certain  investments' and notes
receivables' carrying values would not be realizable due to the Company's change
in  strategy  to  divest  of  its  investments  in  non-core  businesses.  These
investments did not qualify for  discontinued  operations in accordance with APB
No. 30.  During  1997,  the  Company  fully  reserved  for all such  investments
resulting in a charge of approximately  $10,283,000 to continuing operations, as
follows:
<TABLE> 
<CAPTION>

                                         Description                                 Carrying Amount
                                         -----------                                 ---------------
                 <S>                                                                 <C>
                 Notes Receivable                                                       $ 2,250,000
                 Investments in Non-Core Businesses                                       8,033,000
                                                                                        -----------

                                                                                        $10,283,000
                                                                                        -----------
                                                                                        -----------
</TABLE>


         The  write-offs of the notes  receivable  and  investment  related to a
number of strategic  investments  and loans in non-medical  businesses  that the
Company  made  during  1996 and 1997.  The  notes  receivable  were  principally
mezzanine  investments  whereby  the  Company  loaned  money and, in some cases,
received  equity in early stage  companies as a condition to making these loans.
During  1996 and  1997,  the  Company  also made  other  equity  investments  in
companies  that at the time  were  believed  to be  strategic  to the  Company's
business or had the potential to yield a higher than average  financial  return.
During 1997,  based on a number of factors,  including the  Company's  change in
strategy, the book value of these companies and their poor financial performance
to date, it became apparent to management that there was significant uncertainty
as to the ultimate  realizability  of these  investments  and notes  receivable.
Accordingly,  the Company wrote off these  investments  and notes  receivable in
1997.

         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 for significant  reductions in staffing for
all areas of the Company,  including the  elimination of essentially  all of the
sales and  marketing  function  as a result of the  Coherent  transaction  (Note
12(d)). Management's plan specifically identified 33 employees who were targeted
for  termination  almost  exclusively  in selling,  general  and  administrative
functions. Actual employees terminated as a result of this restructuring totaled
45.

         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. Through  December 31, 1998, the Company paid out $2,289,690 of severance
costs and has a remaining  liability of $279,000 to two individuals that will be
paid out in 1999 resulting in total  restructuring costs incurred of $2,568,690.
Accordingly,  the Company reversed the balance of this restructuring  accrual of
$131,310 in its consolidated  statement of operations  during the fourth quarter
of fiscal 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.  In exchange, the Company received a $500,000
note  receivable  due in  monthly  installments  over the 

                                       45
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

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.
The  Company  placed  zero  value on the  equity  position  in the newly  formed
company.

         (B)      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,  1998,  the Company had  available,  subject to review and possible
adjustment  by the  Internal  Revenue  Service,  a federal  net  operating  loss
carryforward of  approximately  $101,000,000 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 completed an analysis of its availability to utilize
its operating loss in connection with the  anticipated  sale of Star to Coherent
(See  Note 1).  The  Company  estimates  that its has net  operating  losses  of
approximately  $75,000,000 that are not subject to limitation under the Internal
Revenue  Code.  The  Company  has a net  deferred  tax  asset  of  approximately
$40,400,000,  comprised mainly of the net operating tax carryforwards  discussed
above,  and the tax  effect of  certain  expenses  and  reserves  not  currently
deductible.  However,  the Company has placed a full valuation allowance against
the deferred tax asset, due to uncertainty  relating to the Company's ability to
realize the asset.

(6)      LONG-TERM DEBT

         At  December  31,  1997  and  1998,  long-term  debt  consisted  of the
following:

<TABLE><CAPTION>

                                                                                          December 31,
                                                                                      1997             1998
                                                                                 ---------------  ---------------
<S>                                                                                <C>               <C>
Convertible debentures                                                              $10,683,440       $2,150,000
Revolving line of credit with a bank                                                         --        1,000,000
Note payable in connection with guarantee on behalf of discontinued
    subsidiary (See Note 2)                                                           3,233,000        2,290,041
Short-term notes payable to Coherent                                                         --        4,000,000
Other notes payable                                                                     169,588               --
                                                                                 ---------------  ---------------
                                                                                    $14,086,028       $9,440,041
Less - current maturities                                                           (1,640,465)       (6,290,041)
                                                                                 ---------------  ---------------
                                                                                    $12,445,563       $3,150,000
                                                                                 ===============  ===============

</TABLE>

                                       46
<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, 1997 and 1998.
<TABLE>
<CAPTION>

                                                                                                                Common Shares
                                                             Initial            Amount Outstanding              Issued Upon
                                                              Face                 December 31,                  Conversion
                                                                           ----------------------------- --------------------------
   Series                                                     Value            1997            1998          1997          1998
   ----------------------------------------------------  --------------   --------------  ------------- ---------------- ----------
   <S>                                                      <C>              <C>            <C>              <C>          <C>
   4.5% Series due October 21, 1999, 2000, 2001              $5,000,000         $100,000       $--           1,381,264       60,809
   5% Series due December 31, 2001                            5,000,000          923,439        --           2,074,992    1,160,999
   5% Series due January 13, 2002                             1,000,000        1,000,000        --            --            924,029
   5% Series due March 10, 2002                               5,500,000        1,160,001        --           2,794,677    1,561,064
   6% Series due March 13, 2002                                 500,000          500,000        500,000       --            --
   6%, 7% and 8% Series due September 30, 2002                7,000,000        7,000,000      1,650,000       --          3,328,761
   4.5% Series denominated in Swiss francs
        due July 3, 2003                                      7,669,442         --              --             914,028      --
                                                          --------------   --------------  ------------- --------------- ----------

                                                            $31,669,442      $10,683,440     $2,150,000      7,164,961    7,035,662
                                                          ==============   ==============  ============= =============== ==========

</TABLE>



         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 credits the ascribed value
for the discount features  described above to additional  paid-in capital.  This
ascribed  amount is  amortized  over a period to the earliest  conversion  date,
which is six months for the convertible debentures outstanding in 1997 and 1998.

         During 1996 and 1997, the Company  recorded  approximately  $77,000 and
$5,444,000, respectively, of interest expense related to the amortization of the
discount of convertible debentures. There was no amortization of the discount of
convertible debentures in 1998.

         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. 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 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% of their debentures 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.  During the year ended December 31, 1998 the Company redeemed
$2,196,667  of  these  convertible  debentures.  This  amount  includes  accrued
interest of $196,667.


         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  and  consist  of a  convertible
debenture,  due July 3, 2002, denominated in 1,000 Swiss francs and a warrant to
purchase  24 shares of the  Company's  common  stock at $16.50  per  share.  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  accrued  at a rate of 4.5% per annum and was  payable  quarterly  in
Swiss francs. The convertible  debentures were convertible by the holder, or the
Company,  commencing October 1, 1996 at a conversion price equal to from 100% 

                                       47
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

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(c)).

         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 are
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, 1996, 1997 and 1998,
the Company amortized  approximately  $78,000,  $276,000 and $64,000 to interest
expense,  respectively.  Any remaining  unamortized deferred financing costs are
charged to additional  paid-in capital upon  conversion.  During the years ended
December 31, 1996,  1997 and 1998, the Company  charged  approximately  $41,000,
$1,820,000 and $374,000,  respectively,  of unamortized deferred financing costs
to additional paid-in-capital.

         (B)      REVOLVING LINE OF CREDIT WITH A BANK

         The Company  has a  $10,000,000  revolving  line of credit with a bank.
This line of credit  will  mature on March 31,  2000 and bears  interest  at the
bank's prime rate (7.75% at December 31,  1998).  Borrowings  under this line of
credit are secured by substantially all assets of the Company and are limited to
80% of qualified accounts receivables.  A director of Palomar has guaranteed all
borrowings  under this line of credit.  In  connection  with this  guarantee the
Company issued this director 200,000 warrants with a three-year term to purchase
the  Company's  common stock at $1.50 per share.  These  warrants were valued at
approximately  $69,000.  This amount is being amortized to interest expense over
the term of the revolving line of credit.

         (C)      BRIDGE LOAN

         On March 27, 1998, the Company borrowed  $2,000,000 from an individual.
The Company subsequently repaid this note during 1998. Interest on this note was
in the form of a warrant to purchase 125,000 shares of common stock for $.01 per
share exercisable over five years. This warrant was valued at $171,000 using the
Black-Scholes  option pricing model. The Company accounted for this warrant as a
discount  to the note  through  additional  paid-in  capital and  amortized  the
discount to interest expense over the period that the note was outstanding.

         (D)      NOTES PAYABLE TO COHERENT

         On May 22 and  June 22,  1998,  the  Company  borrowed  $3,000,000  and
$1,000,000,  respectively,  from the Company's worldwide distributor,  Coherent.
These notes accrue  interest at 8.5% per annum.  The notes are secured by all of
the inventory owned by the Company's Star subsidiary.

                                       48
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

         Under the terms of the Loan Agreement between Coherent and the Company,
in the event that sale of Star to Coherent is not  completed,  the $4,000,000 of
funds  borrowed by the Company  from  Coherent  are due 90 days from the date of
termination of the Agreement to sell Star to Coherent as discussed in Note (1).

         (E)      FUTURE MATURITIES OF LONG-TERM DEBT

         Future maturities of notes payable and convertible debentures reflected
at face value as of December 31, 1998 are as follows:

<TABLE>
<CAPTION>
                                         <S>                                <C>
                                         1999                               $6,290,041

                                         2000                                1,000,000
                                         2001                                       --
                                         2002                                2,150,000
                                                                          -------------
                                                                            $9,440,041
                                                                          =============
</TABLE>

(7)  STOCKHOLDERS' EQUITY

         (A)      COMMON STOCK

         During 1998,  the Company sold  10,200,000  shares of common stock to a
group of investors for  $10,200,000.  In addition,  the Company issued  callable
warrants with a three-year term to these investors to purchase 10,200,000 shares
of common stock at an exercise price of $3.00 per share.  The callable  warrants
are not  exercisable  for the first six months after issuance and thereafter are
callable by the  Company if the  closing  price of the  Company's  common  stock
equals or exceeds $5.00 for ten  consecutive  trading  days.  Under the terms of
this private  placement,  the Company is obligated to pay the investors a fee of
5% per annum (payable  quarterly) of the dollar value invested in the Company as
long as the  investors  continue to hold their common stock in their name at the
Company's transfer agent. During 1998, the Company paid $283,125 related to this
fee. This amount has been charged to  additional  paid-in  capital.  The Company
also paid $360,000 for investment  banking fees related to the issuance of these
common shares.  The Company  netted this amount  against the proceeds  through a
reduction in additional paid-in capital.

         On February  28,  1997,  the Company  and Nexar  entered  into an Asset
Purchase  and  Settlement  agreement  with  a  former  executive  of  Nexar  and
Technovation Computer Labs, Inc. ("Licensor").  The Licensor was affiliated with
a former officer of Nexar. Under the terms of this agreement, the Company agreed
to pay this former  executive and certain of his  affiliates  $1,250,000 in cash
and deliver $1,500,000 worth of Palomar's common stock. In exchange, the Company
and Nexar received the rights to certain technology previously licensed to Nexar
and a  complete  release  and  settlement  of all  claims  between  this  former
executive and Nexar.

         The Company  assigned to Nexar all of its rights to the  technology and
charged  Nexar for the cost  associated  with this claim and the purchase of the
technology.  Nexar recorded $1,375,000 of the consideration to settle this claim
as a  litigation  expense  in its  statement  of  operations  for the year ended
December 31, 1996. The remaining  consideration totaling $1,375,000 was recorded
as purchased  technology and was being amortized by Nexar over the  technology's
estimated  useful life. The allocation of the purchased  technology was based on
the value of anticipated  royalty  payments to the Licensor over the three years
ended December 31, 1999.

                                       49
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


         (B)      PREFERRED STOCK

         The Company is authorized to issue up to 5 million  shares of preferred
stock,  $.01 par  value.  As of  December  31,  1997 and 1998,  preferred  stock
authorized, issued and outstanding consist of the following:
<TABLE>
<CAPTION>

                                                                                                  1997             1998
                                                                                                  ----             ----
       <S>                                                                                         <C>              <C>
       Redeemable convertible preferred stock, Series F, $.01 par value per
         share Authorized, issued and outstanding - 6,000 shares
         (liquidation preference of $7,072,917 at December 31, 1998)                               $60              $60

       Redeemable  convertible  preferred  stock,  Series  G, $.01 par value per
         share  Authorized - 10,000 shares Issued and outstanding - 2,684 shares
         and 743 shares in 1997 and 1998, respectively,
                                 (liquidation preference of $874,603 at December 31, 1998)          27                7

       Redeemable  convertible  preferred  stock,  Series  H, $.01 par value per
         share  Authorized - 16,000 shares Issued and outstanding - 7,690 shares
         and 250 shares in 1997 and 1998, respectively,
                                 (liquidation preference of $280,562 at December 31, 1998)          77                2


                                 Total preferred stock                                            $164            $  69
                                                                                                  ====            =====
</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 the original
price to $7.00. The Series F Preferred may be redeemed at the Company's  option,
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
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 the original floor to $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

                                       50
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

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  less associated  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 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. 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 has been  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> 
<CAPTION>

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

     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.  The  reduction to  stockholder's  equity  (deficit) as a
result of this transaction was as follows: 
<TABLE> 
<CAPTION>
             <S>                                                                   <C>
             Value of Nexar Common Stock                                          $4,671,597
             Accrued Interest and Dividend                                          (391,597)
                                                                                  -----------
                                                                                  $4,280,000
                                                                                  ===========
</TABLE>


     During the year ended December 31, 1998, the following  shares of preferred
stock,  accrued  premium,  dividends,  interest  and other  related  costs  were
converted into shares of common stock as follows: 
<TABLE>
<CAPTION>

                 Number of                              Additional Dollar Amount
  Preferred      Preferred      Dollar Amount of      Converted, Including Accrued                           Number of Common
Stock Series      Shares        Preferred Stock       Premium, Dividends, Interest        Total Dollar       Shares Converted
                 Converted         Converted            and Other Related Costs         Amount Converted           Into
-------------- -------------- --------------------- --------------------------------- --------------------- -------------------
      <S>           <C>             <C>                          <C>                        <C>                 <C>            
      G             1,941           $1,941,000                   $268,245                   $2,209,245          2,703,032
      H             3,947            3,946,700                    383,923                    4,330,623          4,188,650
-------------- -------------- --------------------- --------------------------------- --------------------- -------------------

                    5,888           $5,887,700                   $652,168                   $6,539,868          6,891,682
</TABLE>

                                       51
<PAGE>

          PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

         In addition to the 4,188,650  shares of common stock issued  related to
the Series H Preferred conversion, the Company redeemed 3,516 shares of Series H
Preferred for $4,387,434.  This amount includes  accrued  dividends and interest
totaling $771,876.

         (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 7,350,000 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 its  discretion,  may convert the  optionee's  ISOs into
nonqualified options at any time prior to the expiration of such ISOs.

         The following table summarizes all stock option activity of the Company
for the years ended December 31, 1996, 1997 and 1998:
<TABLE>
<CAPTION>

                                                                 Number of           Exercise           Weighted Average
                                                                   Shares              Price             Exercise Price
                                                                -------------     ----------------    ----------------------
<S>                                                               <C>               <C>                      <C>              
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
            Granted                                                2,294,900                 1.50             1.50
            Canceled                                             (2,924,400)           1.50-8.125             3.38
                                                                -------------     ----------------    ----------------------
Outstanding, December 31, 1998                                     2,352,900          $1.50-$2.50             $1.51
                                                                =============     ================    ======================
Exercisable, December 31, 1998                                     1,851,371          $1.50-$2.50             $1.51
                                                                =============     ================    ======================
Available for future issuances under the Plans                                
            as of December 31, 1998                                4,354,755
                                                                =============
</TABLE>


                                       52
<PAGE>



               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


         The exercise prices for options  outstanding and options exercisable at
December 31, 1998 are as follows:
<TABLE>
<CAPTION>

                                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
--------------------- ---------------- ---------------------- -----------------------    --------------- ----------------------
       <S>                  <C>             <C>                       <C>                     <C>                <C>          
       $1.50                2,327,900       2.88 years                $1.50                   1,834,705          $1.50
       $2.50                   25,000       2.96 years                 2.50                      16,666           2.50
                      ================ ====================== =======================    =============== ======================
                            2,352,900       2.88 years                $1.51                   1,851,371          $1.51
                      ================ ====================== =======================    =============== ======================
</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  accounts for equity  instruments  issued to non-employees in accordance
with EITF 96-18 by valuing the instrument using the Black-Scholes pricing model,
as prescribed  by SFAS No. 123, and  recording a charge to operations  for their
fair value. The Company has issued options and warrants to purchase common stock
to certain  financial  intermediaries  in connection with various  financings at
below the fair market value of the underlying  stock.  The costs associated with
these  issuances  are  accounted  for as a cost of  raising  capital  and netted
against the proceeds from these issuances.

         During the year ended  December 31, 1997 and 1998, a total of 1,005,000
and 2,184,900  options to purchase  common stock were repriced to above the fair
market  value of the  underlying  common  stock to $2.50 and  $1.50  per  share,
respectively.  The majority of the remainder of the options  canceled during the
years  ended  December  31,  1996,  1997 and 1998 were the  result  of  employee
terminations.

         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,  1997 and 1998 using the  Black-Scholes  option pricing
model prescribed by SFAS No. 123.

         The assumptions used to calculate the SFAS No. 123 pro forma disclosure
for the years  ended  December  31,  1996,  1997 and 1998 for the Company are as
follows:
<TABLE>
<CAPTION>



                                                                               December 31,
                                                             1996                  1997                  1998
                                                       ------------------    ------------------    ------------------
     <S>                                                   <C>                  <C>                   <C>
     Risk-free interest rate                                 6.37%                 6.09%                 5.60%
     Expected dividend yield                                   -                     -                     -
     Expected lives                                        4.4 years            3.69 years            2.94 years
     Expected volatility                                      79%                   79%                   93%
     Grant date fair value of options granted during
           the period                                        $4.57                 $2.06                 $0.64
</TABLE>

                                       53
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

         The weighted average  fair-value and weighted average exercise price of
options  granted by the Company for the years ended December 31, 1996,  1997 and
1998 are as follows:
<TABLE>
<CAPTION>



                                                                                 December 31,
                                                                1996                1997                 1998
                                                            -------------     -----------------    -----------------
<S>                                                            <C>                 <C>                  <C>
Weighted average exercise price for options:
     Whose  exercise  price  exceeded fair market value at
      the date of grant                                        $10.00              $2.53                $1.50
     Whose  exercise  price was equal to fair value at the
      date of grant                                            $6.875                $-                   $-
Weighted average fair market value for options:
     Whose  exercise  price  exceeded fair market value at
      the date of grant                                        $8.875              $2.06                $0.64
     Whose  exercise  price was equal to fair market value
      at the date of grant                                     $6.875                $-                   $-

</TABLE>

     The  Company's  majority  owned  Star  subsidiary,  a  manufacturer  of the
Company's  diode laser,  also has  established a stock option plan that provides
for the issuance of a maximum of 650,000  shares of common  stock,  which may be
issued as  nonqualified  options and ISOs.  The following  table  summarizes the
employee stock option activity for Star:

<TABLE>
<CAPTION>

                                                                                                       Weighted
                                                                                                       Average
                                                                Number of Shares  Exercise Price    Exercise Price
                                                                ----------------  --------------    --------------
                  <S>                                                   <C>        <C>                  <C>
                  Outstanding, December 31, 1995                         95,000   $2.50 - $5.00         $3.68
                           Granted                                      150,000    6.00 - 19.00          6.27
                           Exercised                                    (20,000)       2.50              2.50
                           Canceled                                     (10,000)       6.00              6.00
                                                                ----------------- --------------- -----------------
                  Outstanding, December 31, 1996                        215,000   2.50 - 19.00           5.44
                           Granted                                       40,500        19.00            19.00
                           Canceled                                      (1,917)       19.00            19.00
                                                                ----------------- --------------- -----------------
                  Outstanding, December 31, 1997                        253,583    $2.50-$19.00         $8.04
                           Exercised                                     (6,300)     2.50-5.00           4.21
                                                                ----------------- --------------- -----------------
                  Outstanding, December 31, 1998                        247,283    $2.50-$19.00         $8.13
                                                                ================= =============== =================
                                                                ================= =============== =================
                  Exercisable, December 31, 1998                        218,870    $2.50-$19.00         $7.22
                                                                ================= =============== =================
                                                                ================= =============== =================
                  Available  for  future  issuances  under the                                                      
                    Plan as of December 31, 1998                         24,493                                     
                                                                =================
</TABLE>

                                       54
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

         The exercise prices for options  outstanding and options exercisable at
December 31, 1998 for Star are as follows:
<TABLE>
<CAPTION>

                                    OPTIONS OUTSTANDING                                   OPTIONS EXERCISABLE
                               ------------------------------------------------     ------------------------------
                                                  Weighted
                                                  Average           Weighted                           Weighted
                                 Options         Remaining          Average           Options          Average
           Exercise Prices     Outstanding    Contractual Life   Exercise Price     Exercisable     Exercise Price
                <S>                  <C>         <C>                     <C>              <C>               <C>
                 $2.50                28,000     5.45 years     $         2.50             28,000  $         2.50
                 $5.00                40,700     5.43 years               5.00             40,700            5.00
                 $6.00               120,000     7.13 years               6.00            113,332            6.00
                 $9.50                10,000     7.63 years               9.50              7,777            9.50
                $19.00                48,583     8.20 years              19.00             29,061           19.00
                             ---------------     ----------     --------------    ---------------  --------------

                                     247,283     6.89 years     $         8.13            218,870  $         7.22
                             ===============     ==========     ==============    ===============  ==============
</TABLE>


         During 1998,  Star also issued  options to purchase  378,224  shares of
common stock of Star to Palomar at $19.00 per share.

                  (II)     WARRANTS

         The following table  summarizes all warrant activity of the Company for
the years ended December 31, 1996, 1997 and 1998:

<TABLE>
<CAPTION>

                                                                                                  Weighted
                                                            Number of          Exercise           Average
                                                              Shares            Price          Exercise Price
                                                          ---------------  ----------------- -------------------
<S>                                                          <C>               <C>                 <C>
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
              Granted                                         12,585,000          0.01-3.00         2.75
              Exercised                                        (125,000)               0.01         0.01
              Canceled                                       (2,878,452)          2.25-6.75         4.13
                                                          ---------------  ----------------- -------------------
Outstanding, December 31, 1998                                19,579,578       $1.50-$15.00        $4.38
                                                          ===============  ================= ===================
Exercisable, December 31, 1998                                19,359,578       $1.50-$15.00        $4.37
                                                          ===============  ================= ===================
</TABLE>


         During the years ended December 31, 1997 and 1998, a total of 1,240,000
and 1,300,000  warrants to purchase common stock were repriced to above the then
current  fair market  values of the  underlying  common  stock.  These  repriced
exercise  prices  ranged  from $2.50 to $4.00 per share in 1997 and ranged  from
$1.50 to $2.00 per share in 1998.  The majority of the remainder of the canceled
warrants  during the years ended  December  31, 1997 and 1998 were the result of
employee  terminations.  During 1998,  the Company  also issued  warrants for an
aggregate  of 250,000  shares of common stock to various  parties in  connection
with certain financing arrangements. 

                                       55
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

The Company  valued these  warrants using the  Black-Scholes  pricing model,  as
prescribed by SFAS No.123,  and recorded a charge to  operations  for their fair
value for approximately $47,000.

         The range of exercise  prices for warrants  outstanding and exercisable
at December 31, 1998 are as follows:
<TABLE>
<CAPTION>

                                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
--------------------- ---------------- ---------------------- -----------------------    --------------- ----------------------
     <S>                   <C>              <C>                         <C>                  <C>                 <C>
      $1.50 - $2.125        2,739,500       2.44 years                  $1.71                 2,619,500          $1.72
       $3.00 - $3.00       10,560,000       4.26 years                   3.00                10,560,000           3.00
       $3.25 - $9.50        5,102,020       2.07 years                   6.45                 5,002,020           6.39
     $10.38 - $15.00        1,178,058       2.07 years                  13.98                 1,178,058           13.98
                      ---------------- ---------------------- -----------------------    --------------- ----------------------
                           19,579,578       3.30 years                  $4.38                19,359,578          $4.37
                      ================ ====================== =======================    =============== ======================
</TABLE>


     The Company has computed the pro forma disclosures  required under SFAS No.
123 for all warrants granted in the years ended December 31, 1997 and 1998 using
the Black-Scholes option pricing model prescribed by SFAS No. 123.

     The weighted-average assumptions used to calculate the SFAS No. 123 pro
forma disclosure for the years ended December 31, 1996, 1997 and 1998 for the
Company are as follows:
<TABLE>
<CAPTION>

                                                                               December 31,
                                                            1996                  1997                  1998
                                                       ----------------     ------------------    ------------------
<S>                                                       <C>                  <C>                   <C>
Risk-free interest rate                                      5.93%                6.13%                 5.44%
Expected dividend yield                                       -                     -                     -
Expected lives                                            5.9 years            4.44 years            2.58 years
Expected volatility                                          79%                   79%                   93%
Grant date fair value of warrants granted during
     the period                                             $5.39                 $2.17                 $0.76
</TABLE>

                                       56
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)



         The weighted  average fair value and weighted average exercise price of
warrants  granted by the Company for the years ended December 31, 1996, 1997 and
1998 are as follows:
<TABLE> 
<CAPTION>

                                                                                   December 31,
                                                                     1996               1997                1998
                                                               -----------------    --------------    -----------------
<S>                                                                 <C>                 <C>                <C>
Weighted average exercise price for warrants:
     Whose  exercise price exceeded fair market value at date
       of grant                                                     $11.76              $4.30               $2.78
     Whose  exercise price was less than fair market value at
       date of grant                                                 $7.07              $7.50               $0.01
     Whose  exercise  price was equal to fair market value at
       date of grant                                                 $6.67              $3.25               $-
Weighted average fair value for warrants:
     Whose  exercise price exceeded fair market value at date
       of grant                                                      $9.34              $1.10               $0.76
     Whose  exercise price was less than fair market value at
       date of grant                                                 $8.82              $0.62               $1.24
     Whose  exercise  price was equal to fair market value at
       date of grant                                                 $6.67              $2.18               $-

</TABLE>


                  (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 of the Company and Star would be
as follows:

<TABLE>
<CAPTION>

                                  December 31,
                                                                 1996                      1997                    1998
                                                          -------------------      ----------------------    -----------------
<S>                                                         <C>                        <C>                    <C>
Pro forma net loss from continuing operations               $(48,292,780)              $(62,020,782)          $(23,169,514)
Pro forma basic and dilutive net loss per share from
    continuing operations                                      $(1.89)                    $(1.89)                $(0.39)
</TABLE>

         (D)      RESERVED SHARES

         At December  31, 1998,  the Company has  reserved  shares of its common
stock for the following:
<TABLE>
<CAPTION>

              <S>                                                               <C>
              Warrants                                                          19,579,578
              Stock option plans                                                 6,707,655
              Convertible debentures                                             3,216,694
              Preferred stock                                                    3,328,894
              Employee stock purchase plan                                         419,412
              Employee 401(k) plan                                                 554,787
                                                                            ---------------
                                   Total                                        33,807,020
                                                                            ===============
</TABLE>

         (E)      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,  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 

                                       57
<PAGE>
           PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

lookback  provision of three months.  The Purchase Plan provides for issuance of
up to 500,000 shares under the Purchase Plan. During the year ended December 31,
1997 and 1998,  employees  purchased  15,377 and 65,211  shares of the Company's
common stock for approximately  $40,000 and $50,000,  respectively,  pursuant to
the Purchase Plan.

(8)      RESEARCH AND PRODUCT DEVELOPMENT AGREEMENTS

         During  1995,  the Company  entered into a  multi-year  agreement  with
Massachusetts  General Hospital ("MGH"),  whereby MGH agreed to conduct clinical
trials on a laser treatment for hair removal.  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.

         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 covering the laser-based hair removal technology developed by at
MGH, for which Palomar is the exclusive worldwide licensee.

(9)      ACCRUED LIABILITIES

         At  December  31,  1997 and 1998,  accrued  liabilities  consist of the
following:
<TABLE>
<CAPTION>

                                                                                December 31,
                                                                         1997                  1998
                                                                    ----------------      ---------------
                          <S>                                           <C>                  <C>
                          Payroll and consulting costs                   $1,535,013           $1,148,898
                          Royalties                                         853,808            1,106,352
                          Settlement costs                                1,457,020                   --
                          Warranty                                        2,583,677            2,798,836
                          Restructuring                                   1,981,907              279,000
                          Interest and preferred stock dividends          1,659,709            1,550,662
                          Other                                           3,688,720            3,417,876
                                                                    ----------------      ---------------
                              Total                                     $13,759,854          $10,301,624
                                                                    ================      ===============
</TABLE>

(10)     RELATED PARTY TRANSACTION

         At December 31, 1997,  approximately  $478,000 of loans receivable with
interest at the rate of 7% per annum were  outstanding from the Company's former
President.  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. The
Company  has  reserved  554,787  shares  of its  common  stock for  issuance  in
connection with the Profit Sharing Plan.

                                       58
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)

         During 1997 and 1998,  the Company  issued 87,441 and 311,887 shares of
its common stock to the Profit Sharing Plan in  satisfaction of its $318,154 and
$254,281   employer  match  for  the  1996  and  1997  employee   contributions,
respectively.  For the year ended  December  31,  1998,  the Company has accrued
$206,000  for the 1998 match.  The  Company  contributed  227,930  shares of its
common stock for this match in February of 1999.

(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 July 2003. The Company guarantees Star's facility operating lease

         Future  minimum  payments  under  the  Company's  operating  leases  at
December 31, 1998 are approximately as follows:
<TABLE>
<CAPTION>

                             December 31,
                             <S>                                             <C>
                             1999                                              $548,000
                             2000                                               264,000
                             2001                                                96,000
                             2002                                               101,000
                             2003                                                60,000
                                                                           -------------
                                                                             $1,069,000
                                                                           =============
</TABLE>

         (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, 1996, 1997 and 1998,  approximately $175,000,  $854,000
and  $1,332,000  of  royalty  expense,  respectively,  was  incurred  under this
agreement.  These  amounts  are  included  in cost of sales in the  accompanying
consolidated statements 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.

         (C)      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.

         On March 7, 1997, Selvac Acquisition Corp. ("Selvac"),  a subsidiary of
Mehl Biophile  International,  Inc.  ("Mehl"),  filed a complaint for injunctive
relief and damages for patent  infringement  and for unfair  competition  in 

                                       59
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

the United  States  District  Court for the  District of New Jersey  against the
Company,  two of  its  subsidiaries  and a New  Jersey  dermatologist.  Selvac's
complaint alleged that the Company's EpiLaser(R)- ruby laser hair removal system
infringed a patent licensed to Selvac (the "Selvac Patent") and that the Company
unfairly  competed by promoting the EpiLaser(R)-  ruby laser hair removal system
for  hair  removal  before  it had  received  FDA  approval  for  that  specific
application.  On May 18, 1998 the court granted the Company's motion for partial
summary  judgment on the ground that the Selvac patent is invalid  because prior
art   anticipated   it.  The  court  has  since  denied   Selvac's   motion  for
reconsideration of the summary judgment ruling. On September 25, 1998, the court
denied Selvac's motion for reconsideration of its prior order dismissing so much
of Selvac's unfair  competition  claim as relied on interpreting  the Food, Drug
and Cosmetics Act or FDA regulations,  and dismissed without prejudice the state
law remainder of Selvac's unfair  competition claim. On October 26, 1998, Selvac
filed its  notice of appeal to the Court of  Appeals  for the  Federal  Circuit.
Selvac subsequently filed its opening brief on appeal; the Company's  opposition
was filed in March,  1999. The Company is unable to express an opinion as to the
likely  outcome  of  Selvac's  appeal,  or as to the  range  of loss  if  Selvac
ultimately prevailed at trial.

         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$5,600,000 at December 31, 1998 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 the debt
cannot  properly  be  accelerated,  and  intends  to  contest  the claims of the
Asserting  Holders  vigorously.  Nonetheless,  an  adverse  result  could have a
material adverse effect on the Company in the range of $5,600,000 to $7,000,000.
By mutual  agreement,  the Asserting  Holders and the Company requested that the
case be removed from the Court's trial calendar. The parties have discussed ways
to resolve their dispute,  including the  restructuring  of the debentures,  but
there can be no absolute assurance that all of the  debentureholders,  including
the Asserting Holders, and the Company will complete a proposed settlement.

         On March 17,  1999,  the company and a former and current  officer were
added as defendants in the class action of VARLJEN V. H.J.  MEYERS,  INC. ET AL.
pending in the United  States  District  Court of the  Southern  District of New
York. The Company is unable to estimate any possible outcome or range of loss in
this  matter at this time.  An adverse  result in the VARLJEN  action,  however,
could  have a  materially  adverse  effect  upon the  financial  statements  and
operations of 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.

         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.

                                       60
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


         (D)      DISTRIBUTION AGREEMENT

         On  November   17,  1997,   the  Company   entered  into  an  exclusive
distribution,  sales  and  service  agreement  with  Coherent,  an  established,
worldwide laser company. Under this agreement,  Coherent has the exclusive right
to sell the EpiLaser(R) and  LightSheer(TM)  laser systems and future generation
products  worldwide.  The Company pays Coherent a per unit commission,  adjusted
for certain  events as  defined.  During  1997 and 1998,  the  Company  incurred
approximately  $800,000 and  $14,108,000,  respectively,  of commission  expense
related to this  agreement  which is included in sales and marketing  expense in
the accompanying  consolidated  statement of operations.  Upon execution of this
agreement, Coherent 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,  is being amortized to revenue over the three year
life of the agreement.  If the Company completes its anticipated sale of Star to
Coherent  as  discussed  in Note 1,  the  current  distribution  agreement  with
Coherent  will  be  terminated  and  replaced  with  a  one  year  non-exclusive
distribution   agreement  that  will  enable  Coherent  to  sell  the  Company's
ruby-based  laser  products.  The Company will  amortize  the  deferred  revenue
related to Coherent over this one year non-exclusive period.

         In exchange  for the payment at closing of $2,740 per day from  January
20, 1999 until  Palomar  shareholder  approval of the  Agreement,  Coherent  has
agreed to waive its exclusive rights under the distribution  agreement to market
and sell our  ruby  laser  products,  so that we may  begin to sell the  Palomar
E2000(TM)  immediately through other channels without the obligation of paying a
commission  to Coherent or waiting for the  distribution  agreement to terminate
upon the closing of the sale of Star to Coherent.

         (E)      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.

(13)     SEGMENT AND GEOGRAPHIC INFORMATION

         The Company has adopted SFAS No. 131,  DISCLOSURES ABOUT SEGMENTS OF AN
ENTERPRISE  AND RELATED  Information in the fiscal year ended December 31, 1998.
SFAS 131 establishes  standards for reporting  information  regarding  operating
segments in annual financial  statements and requires  selected  information for
those  segments  to  be  presented  in  interim   financial  reports  issued  to
stockholders.  SFAS 131 also establishes standards for related disclosures about
products and services and geographic areas. Operating segments are identified as
components of an enterprise about which separate discrete financial  information
is available for evaluation by the chief  operating  decision maker, or decision
making  group,  in  making  decisions  how  to  allocate  resources  and  assess
performance. The Company's chief decision-maker, as defined under SFAS 131, is a
combination of the Chief Executive Officer and the Chief Financial  Officer.  To
date,  the  Company  has viewed its  operations  and  manages  its  business  as
principally  one  segment,  cosmetic  laser sales.  Associated  services are not
significant.  As a result, the financial information disclosed herein represents
all of the material  financial  information  related to the Company's  principal
operating segment.

         Product revenues from international  sources were  approximately  $3.87
million, $5.03 million and $17.36 million in 1996, 1997 and 1998,  respectively.
The Company's revenues from international  sources were primarily generated from
customers located in Europe, Canada, Latin America and Asia/Pacific.  All of the
Company's  product  sales for the years ended  December 31, 1996,  1997 and 1998
were shipped from its facilities located in the United States.

                                       61
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (Continued)


         The  following  table  represents  percentage  of  product  revenue  by
geographic region from customers for 1996, 1997 and 1998:
<TABLE>
<CAPTION>

                                                                          Year ended December 31,
                                                             1996                    1997                   1998
                                                             ----                    ----                   ----
                          <S>                                <C>                     <C>                    <C>
                          United States                       78%                     76%                    61%
                          Europe                               3                       6                     17
                          Asia/Pacific                        10                       6                     13
                          Canada                               9                       4                      3
                          Latin America                       --                       8                      6
                                                             ----                    ----                   ----
                                   Total                     100%                    100%                   100%
                                                             ====                    ====                   ====
</TABLE>

                                       62
<PAGE>

Item 9.  Changes in and  Disagreements  with  Accountants  on Accounting  and
         Financial Disclosures.

              Not applicable.

                                       63
<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.

                                       64
<PAGE>

                                     PART IV

Item 14.       Exhibits, Financial Statement Schedules and Reports on Form 8-K.
<TABLE>
<S>      <C>      <C>    <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:

                  Reports of Independent Public Accountants                                                       29

                  Consolidated Balance Sheets -
                  December 31, 1998 and December 31, 1997                                                         31

                  Consolidated Statements of Operations -
                  Years ended December 31, 1998, December 31, 1997 and December 31, 1996                          32

                  Consolidated Statements of Stockholders' Equity (Deficit) -
                  Years ended December 31, 1998, December 31, 1997 and December 31, 1996                          33

                  Consolidated Statements of Cash Flows -
                  Years ended December 31, 1998, December 31, 1997 and December 31, 1996                          36

                  Notes to Consolidated Financial Statements                                                      38

         2.       Consolidated Financial Statement Schedules

                  Report of Independent Public Accountants on Schedule II                                         71

                  Schedule II - Valuation and Qualifying Accounts                                                 72

                  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.
</TABLE>

(b)      Reports on Form 8-K.

               Form 8-K filed June 3, 1998.

               Form 8-K filed November 3, 1998.

                                       65
<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.

Exhibit
No.           Title
<TABLE>
<S>           <C>

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

***3.1        Second Restated  Certificate of  Incorporation,  as filed with the
              Delaware Secretary of State on January 8, 1999.

##3.2         Bylaws, as amended.

^4.1          Common Stock Certificate.

###4.2        Form of 4.5% Convertible Debenture (denominated in Swiss Francs) due July 3, 2003.

*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.

####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     Stock Purchase Agreement, dated December 29, 1997.

####10.14     Stock Purchase Agreement, dated December 31, 1997.

####10.15     Exchange Agreement, dated December 31, 1997.

^^10.16       Form of 6%, 7% and 8% Convertible Debentures Due September 30, 2002



                                       66
<PAGE>

^^10.17       Form of Registration Rights Agreement, dated September 30, 1997.

####10.18     Form of Securities Purchase Agreement dated September 30, 1997.

^^^10.19      Securities Purchase Agreement dated December 29, 1997.

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

##10.21       6% Convertible Debenture due March 13, 2002.

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

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

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

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

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

####10.27     Securities Purchase Agreement between the Company and various entities, dated February 20, 1998.

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

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

####10.30     Continuing Guaranty between the Company and Coast Business Credit, dated December 5, 1996.

####10.31     License Agreement between the Company and Massachusetts General Hospital, dated August 18, 1995.

####10.32     First Amendment  to License Agreement between the Company and Massachusetts General Hospital,
              dated August 18, 1995.

####10.32     Second Amendment  to License Agreement between the Company and Massachusetts General Hospital,
              dated August 18, 1995.

----10.34     Letter Agreement between Palomar Medical Technologies, Inc. and Coherent, Inc. dated September 10,
              1998.

***10.35      Form of Securities Purchase Agreement between the Company, The Rockside Foundation, and Mark T.
              Smith dated , 1998

***10.36      Form of Warrant to Purchase Common Stock

@10.37        Second Amended 1996 Employee Stock Purchase Plan.

@10.38        Second Loan Agreement Between Palomar Medical Technologies, Inc. and Coherent, Inc., dated May 7,
              1998

@10.39        Loan Agreement between Palomar Medical Technologies, Inc. and Coherent, Inc., dated May 22, 1998



                                       67
<PAGE>

@10.40        Fifth Amendment to the Schedule to the Loan and Security Agreement between Palomar Medical
              Technologies, Inc. and Coast Business Credit, dated April 29, 1998.

****10.41     Agreement and Plan of Reorganization by and Among Coherent, Inc., Medical Technologies,
              Acquisition, Inc., Palomar Medical Technologies, Inc., Star Medical Technologies, Inc., Robert E.
              Grove, James Z. Holtz and David C. Mundinger, dated as of December 7,1998.

@@10.42       Form of Warrant to Purchase Common Stock

10.43         Letter Agreement between Palomar Medical Technologies, Inc. and Fleet National Bank, dated
              November 16, 1998

10.44         Guaranty Agreement between A. Neil Pappalardo. and Fleet National Bank dated November 16, 1998.

10.45         Security Agreement (Trademarks) between Palomar Medical Technologies, Inc. and Fleet National Bank
              dated November 16, 1998.

10.46         Security Agreement (Patents) between Palomar Medical Technologies, Inc. and Fleet National Bank
              dated November 16, 1998.

10.47         Promissory Note between Palomar Medical Technologies, Inc. and Fleet National Bank dated November
              16, 1998.

10.48    Guaranty Agreement between Star Medical Technologies, Inc. and Fleet National Bank dated November 16,
              1998.

10.49         Security Agreement (Patents) between Star Medical Technologies, Inc. and Fleet National Bank dated
              November 16, 1998.

10.50         Security Agreement (Trademarks) between Star Medical Technologies, Inc. and Fleet National Bank
              dated November 16, 1998.

10.51         Bonus Agreement between Palomar Medical Technologies, Inc. Robert E. Grove, James Z. Holtz and
              David C. Mundinger, dated as of December 7, 1998.

10.52         Letter Agreement between Palomar Medical Technologies, Inc. and Coherent, Inc., dated
              February 1,1999

21            List of Subsidiaries.

23            Consent of Arthur Andersen LLP.

27            Financial Data Schedule for the Period Ended December 31, 1998.


^             Previously filed as an exhibit to Form 10-KSB/A-4 for the year ended December 31, 1996 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.



                                       68
<PAGE>

^^^^          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 an 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 Registration Statement No. 333-70391 filed on January 11, 1999,
              and incorporated herein by reference.

****          Previously  filed as an exhibit to the Company's  Definitive Proxy
              Statement  for the period  ended  December 31, 1998 filed on March
              12, 1999, 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 Form S-3 Registration Statement No. 333-22725 filed on March 4,
              1997 and incorporated herein by reference.

####          Previously  filed as an exhibit to the Company's  Annual Report on
              Form 10-K for the year ended December 31, 1998,  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-Q for the quarter
              ended September 30, 1997, and incorporated herein by reference.

----          Previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter
              ended September 30, 1998, 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.

&&&&          Previously filed as an exhibit to Form S-3 Registration Statement No. 333-28251 filed on May 30,
              1997 and incorporated herein by reference.

@             Previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter
              ended June 30, 1998, and incorporated herein by reference


                                       69
<PAGE>

@@            Previously filed as an exhibit to Form S-8 Registration Statement No. 333-574031 filed on June 22,
              1998 and incorporated herein by reference.
</TABLE>



                                       70
<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 11, 1999. 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 11, 1999 (except for the 
matter discussed in Note 12(c) as 
to which the date is March 17, 1999).

                                       71
<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, 1996                                    $7,000           $1,122,000                 $--             $1,129,000
                                           =================    =================     ================     =================

December 31, 1997                                $1,129,000             $933,000         $(1,316,000)              $746,000
                                           =================    =================     ================     =================
                                           =================    =================     ================     =================

December 31, 1998                                  $746,000             $183,000           ($565,000)              $364,000
                                           =================    =================     ================     =================



                                               Balance,
                                             Beginning of                                                  Balance, End of
                                                Period             Increases            Deductions              Period
Restructuring Accrual:

December 31, 1996                                       $--                  $--                 $--                    $--
                                           =================    =================     ================     =================

December 31, 1997                                       $--           $2,700,000           $(718,000)            $1,982,000
                                           =================    =================     ================     =================

December 31, 1998                                $1,982,000                  $--         $(1,703,000)              $279,000
                                           =================    =================     ================     =================
</TABLE>

                                       72
<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 March 30, 1999.


                                              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>

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

/s/ Louis P. Valente                     President, Chief Executive                         March 30, 1999
--------------------------------------   Officer and Director
Louis P. Valente                       

                                          
/s/ Joseph P. Caruso                      Chief Financial Officer and Treasurer              March 30, 1999
--------------------------------------    (Principal Financial Officer and
Joseph P. Caruso                          Principal Accounting Officer)
                                      


/s/ Nicholas P. Economou                  Director                                           March 30, 1999
--------------------------------------
Nicholas P. Economou


/s/ A. Neil Pappalardo                    Director                                           March 30, 1999
--------------------------------------
A. Neil Pappalardo


/s/ James G. Martin                        Director                                           March 30, 1999
--------------------------------------
James G. Martin
</TABLE>


                                       73